Money and Financial Intermediaries


Money is anything that is generally acceptable as a means of payment in the settlement of all transactions, including debt. It is the commonly used medium of exchange or means of transferring purchasing power. General acceptability as a means of payment or as a medium of exchange is the unique feature of money. This makes money and money alone the general purchasing power, I.e. the power to buy things directly in all markets. It does not require to be converted into something else before it can be spent or used for the settlement of debt. General acceptability as the common means of payment is the sine-qua-non (necessary condition) or the differentia of money.

It comprises of coins and paper currency and demand deposits of banks.

Cheap Money : Money which is available at low rate of interest is called cheap money. It may be deliberate monetary policy to stimulate borrowing and economic recovery to reduce the cost of government borrowing.

Hot Money : it refers to funds which flow into a country to take advantage of favourable rate of interest in that country. They improves the balance of payments and strengthen the exchange rate of the recipient country. However, these funds are highly volatile and will be shifted to another foreign exchange market when relative interests rates favour the move.

Dear money : the money available at exceptionally high rate of interest is called dear money. It is opposite of cheap money. A dear money policy involves keeping interest rates up to restrict the money supply.

Near Money : It refers to an asset which acts like money as a store of value but which is not immediately acceptable as a medium of exchange. For eg. bonds. Thus near money is used to describe highly liquid assets that can easily be converted into cash, but are not themselves a medium of exchange. Deposits at a bank, savings and loans association are the characteristic forms of near money. Provided that the terms of the account permit immediate withdrawals, the deposit owner knows how much purchasing power he currently holds, he can turn the deposit into medium of exchange (cash or a checking deposit / current account) almost immediately. Short fixed term deposits (such as 30 days treasury bills) and government bonds which are close to their maturity date are examples of assets which are not quite as liquid as a bank account that permits immediate withdrawal but in many circumstances the difference is not important. Such assets are therefore regarded as near money.

Financial System

The financial system is concerned about money, credit and finance. The financial system is a set of institutional arrangements thorough which financial surpluses in the economy are mobilised from surplus units and transferred to deficit spenders. The institutional arrangement include all conditions and mechanisms governing the production, distribution, exchange and holding of financial assets or instruments of all kinds and the organisation as well as the manner of operation of financial markets and institutions of all descriptions.

Thus there are 3 main constituents of the financial system:

  1. Financial Assets 
  2. Financial Markets
  3. Financial Institutions 

Financial Assets are subdivided under 2 heads primary (direct) and secondary (indirect) securities. The primary securities are financial claims against real sector units. Eg,. Bills, equities, etc. they are created by real sector units as ultimate borrowers for raising funds to finance their deficit spending. The secondary securities are financial claims issues by financial institutions or intermediaries against themselves to raise funds from public. Eg., bank deposits, life insurance policies, UTI units, IDBI bonds etc.

Financial intermediaries

Financial intermediaries are institutions or firms that mediate or stand between ultimate lenders and ultimate borrowers or between those with budget surpluses and those who wish to run budget deficit. For eg., Banks, insurance companies, provident fund etc. the central function of all FI’s s to collect surplus (savings) of other economic units and to lend them to deficit spenders. Both the surplus units and the deficit spenders belong to the real sector of the economy. Their principal economic activity is to buy and sell productive factors and current output whereas the principal economic activity of financial institutions is the purchase and sale of financial assets.

The FI’s are leaders in securities. What they buy are primary securities, what they sell are secondary securities. By absorbing primary securities in their asset portfolios and producing secondary securities to finance them, they virtually transform primary securities into secondary securities. Asset transforms the alchemy which only the FI’s possess. 

Advantages of Financial Intermediaries

To lenders :

  1. Low risk : Lenders are interested in minimising all kinds of risks of capital and interest loss on loans or financial investment they make. These risk may arise in the form of risk of default or risk of capital loss on stock market asset. Such risks on secondary securities are far less than on primary securities for individual leaders. Working of major FI’s help in reducing risks of their creditors. 
  2. Greater Liquidity : FI’s offer much greater liquidity on their secondary securities to their lenders. units of the UTI can be sold back to it. Savings embodied in life insurance policies are not equally liquid, but loans can always be arranged against them form banks or the LIC itself. Primary securities do not carry any of these features because primary borrowers need funds for agreed period to finance their expenditures. FI’s can offer much greater liquidity to their creditors, and yet lend on a much longer term to their debtors. 
  3. Convenience : Secondary securities sold by FI’s can be easily bought, held and sold. The information cost and transaction cost involved are very low. Banks run branches in all urban areas and several semi-urban and rural areas. The deposits they sell are standardised and information about them are easily available. 
  4. Other services : Each of the FI’s specialises in selling special kinds of secondary securities and other services associated with them. Thus banks specialises in selling deposits with particular features. In addition, they transfer funds, collect cheques for their clients, offer safe deposits vaults and most important of all, are the dominant lender. All these and several other services attract the public to banks and induce it to hold deposits with them.

To Borrowers :

  1. FI’s have big pool of funds, so that big individual demands for funds can be satisfied only by the FI’s. 
  2. There is much greater certainty of the availability of funds with the FI’s at all times.
  3. The rate of internal charged by the FI’s is generally lower than that charged by other lenders.
  4. Regulated FI’s do not fleece small borrowers in the manner money lenders do. On the contrary, as a matter of official policy, banks and other official lending agencies are required to give small borrowers preferential treatment both in the grant of credit and in the rate of interest charged by them.

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