Structure of financial markets and assets | AQA Economics notes

This page contains notes on topic 4.2.4.1, the structure of financial markets and financial assets, for AQA Economics.

Contents

What is money?

The money supply measures the total amount of money in the economy at a given point in time.

There are different definitions of the money supply. For example:

• Narrow money refers to cash (notes and coins). 
• Broad money could include cash plus deposits at commercial banks.

Narrow money is the most liquid form of money, but broad money is less liquid than narrow money. Liquidity measures how quickly a type of money can be converted into cash.

Money has the following functions:

• Medium of exchange – money allows firms and consumers to exchange goods and services.
  • For example, consumers can use money to pay for food.
  • Critically, money means that transactions do not require the double coincidence of wants.
    • In a barter economy without money, where people trade say cows for bricks, one party must want the bricks and the other must want the cows.
    • However with money, a consumer can buy a good, without needing to offer another specific good in return – they can pay using money instead.
• Measure of value – money can act as a way to measure the value of goods and services.
  • This allows the comparison of the value of different goods and services.
• Store of value – money can be kept and retrieved in the future without losing its purchasing power or value.
• Method of deferred payment – you can consume a good now and pay for it over time with a loan.
  • Loans include mortgages (a loan to buy a house), car loans, business loans, buy now pay later loans such as Klarna and so on.

Money has the following essential characteristics [Note these are different from the functions of money]:

• Limited in supply, so that its value is broadly maintained over time.
• Acceptable – most people accept the money as a means of payment.
• Portable – money should be easy to carry.
• Durable – money should be able to withstand repeated use without deteriorating.
• Fungible – individual units of money should be interchangeable with one another.
  • For example, you could interchange a £1 coin with two 50p coins, 100 pennies or another £1 coin.
  • Diamonds would be different weights and cuts, so they are not fungible.

Case study: Is Bitcoin money? Some people argue Bitcoin is money. In particular, it can be used as a medium of exchange, to pay for goods and services at some companies. El Salvador even went so far as to allow Bitcoin to be an official currency in the country in 2021. However, others may argue Bitcoin does not fulfill the functions of money. Its volatility in value makes it more challenging to use Bitcoin as a measure of value and as a medium of exchange. A supermarket would have to change its prices all the time in response to Bitcoin’s fluctuations. Few companies allow customers to buy items with Bitcoin.  Eventually, under pressure from the International Monetary Fund, El Salvador concluded its experiment with Bitcoin. Bitcoin was no longer an official currency of the country as of 2025.

What are the different types of financial markets?

You need to know three main types of markets:

• The money market
  • Provides short-term loans to governments, individuals and firms.
  • One example is overnight interbank lending (one bank lends to another).
  • Another example is short-term government debt, called “UK Treasury Bills”, lending to the government for periods of 1, 3 or 6 months.
• The capital market
  • Provides medium- and long-term loans for firms and governments.
  • Companies can raise funds by borrowing from banks, issuing corporate bonds or selling shares in the company [see the sections on debt versus equity and bonds for more on this].
  • On primary markets, the borrower directly sells new bonds or shares to potential bondholders or shareholders.
  • On secondary markets, the bonds or shares that were issued before are traded among different bondholders or shareholders.
• The foreign exchange market
  • This is where currencies are bought and sold.
  • For example a firm importing oil from the US to the UK may need to buy US dollars, by selling pounds, to pay for oil imports from the US. 
  • Spot markets are for immediate trades of one currency for another.
  • Forward markets are for agreeing to trade one currency for another at a guaranteed price on a particular future date.
    • This allows exporters and importers to have greater certainty, reducing exchange rate uncertainty.

Other types of financial market exist. Examples include:

• Commodity futures
  • This involves buying a commodity such as oil or wheat at a guaranteed price on a particular future date. 
• Insurance products.
  • This includes life insurance, insurance against catastrophic events such as natural disasters and even insuring footballers against injury.
• Derivatives.
  • The value of a derivative depends on the value of an underlying asset, such as a mortgage. 

What is the role of financial markets in the wider economy?

The key roles of financial markets are to:

• Facilitate saving
  • Households can save their money in a high street bank in a saving account to earn interest.
  • Current accounts also provide interest but often at lower rates than saving accounts.
  • Households can also use financial markets to invest in assets such as bonds and stocks.
• Lend to businesses and individuals
  • High street banks lend out a large proportion of the funds deposited in the bank by savers.
  • This lending can go to businesses in the form of business loans. This greater availability of loanable funds allows businesses to invest more and grow their company.
  • Similarly lending can go to households, for example mortgages are a type of loan used for buying a house.
  • Lending can also be used to spread the payments for cars, washing machines or other products over time. A newer type of this kind of lending is “buy now pay later” schemes, which includes companies such as Klarna.
  • Bonds allow bondholders to lend to governments and corporations. In exchange, households can also earn interest payments.
  • Government bonds entitle the bondholder to fixed interest payments from the government, in exchange for providing upfront funds to the government. Corporate bonds work similarly.
• Facilitate the exchange of goods and services
  • To buy a good or service, the payment must flow in the opposite direction.
  • Financial markets provide ways for people to make payments for goods and services.
  • This could be as simple as a bank providing a bank account and instantly approving an online transaction. By providing credit and debit cards as well as online banking apps, people can transfer money instantly in exchange for receiving goods.
  • Foreign exchange (forex) markets enable currencies to be converted, allowing domestic residents to buy imports and foreign residents to buy exports.
• Provide forward markets for currencies and commodities
  • A forward market can provide a guaranteed price at a specified future date by buying a “futures contract” (sometimes just called futures)
  • For example, the ability to lock in a price for a currency transfer in one year’s time. This could be useful for firms who engage in cross-border exporting or importing.
  • This can also apply to commodities (raw materials used in production) such as oil. A firm that uses oil in its production process can lock in a guaranteed price to buy oil in six months’ time.
  • This allows firms to have greater certainty about their future costs. This makes firms more likely to invest.
    • However those using futures contracts have to pay a fee in exchange for being able to lock in this price.
    • This may increase firm costs and lead to firms overpaying for commodity inputs or currencies in some cases.
  • Forward markets also give producers such as farmers a guaranteed future price for selling their goods. This makes farmers more certain about their revenue, so again farmers are more likely to invest.
• Provide a market for equities
  • Equities can refer to shares.
  • A share is a financial asset that gives the holder a small percentage stake in the company.
  • The shareholder makes money if they buy the share for a low price and sell the share for a high price.
  • The shareholder also makes money when part of the company profit is paid out directly to shareholders. This is known as a dividend payment.
  • Selling shares enables companies to raise funds for investment or expansion.
  • This can boost aggregate demand as investment is a component of AD.
  • Higher investment also improves the quality of factors of production, increasing productivity and shifting LRAS right.
  • As a result the economic growth rate rises.

We should note that these roles of financial markets can overlap. For example, providing loans to consumers to buy cars also facilitates the exchange of goods.

Banks act as an intermediary – they take savings for those who deposit money in the bank and lend them out to businesses and individuals.

Evaluating the role of financial markets in the wider economy Not all businesses may have access to financial services. It has been reported that businesses outside of London and the South East of the UK may find it more difficult to access finance. Banks may not always be willing to lend. For instance in a downturn or if confidence is low among banks, banks may be worried about the higher likelihood of business failure.  The financial system can support economic growth but it also creates new risks. An example is the 2008 financial crisis. A failure of a single bank may not only risk the failure of other banks, but could put customers’ savings at the bank at risk. This could lead to a downturn of the wider economy if consumer confidence declines. For more on bank failure, see the link here.

What is the difference between debt and equity?

Firms can raise funds by issuing shares (equity) or issuing debt (corporate bonds or borrowing from a bank).

• Debt includes bonds and more broadly, any form of borrowing.
  • The borrower receives the money upfront. 
  • Over time, the lender receives the money back with interest.
• Equity includes shares.
  • Shares give the owner (the “shareholder”) a small percentage ownership of a company. 
  • This gives the shareholder voting rights at the shareholders’ annual general meeting.  
  • If the firm also pays its shareholders a portion of the profits as a “dividend” payment, the shareholder may be entitled to receive a dividend too. 

What is a bond?

A bond is a type of debt. 

A government or a firm may issue a bond. 

The bond gives the borrower (the government or firm) some money upfront. In return, these funds are paid back to the bondholder over time, with interest. It is a type of debt or borrowing. 

The interest payments for bonds are called “coupon” payments.

A bond’s maturity refers to the end date of the bond. This is when the initial amount lended (also known as the “principal”) must be paid back in full. 

Why is there an inverse relationship between market interest rates and bond prices?

For AQA A-Level Economics, you need to know the following equation:

The coupon amount is fixed when the bond is first created.

So the bond yield and bond price may vary depending on market conditions (supply of and demand for bonds).

For example, suppose a bond is priced at £100 and the bondholder receives annual coupons of £2 a year. 

In other words, each year, the bondholder is receiving a 2% return on the bond price each year (2/100). So the bond yield is 2%.

What happens if the bond price doubles to £200? The coupon remains the same at £2 a year. So the bond yield falls to 1% (2/200). 

In other words, to receive the same coupon payment, you would have to pay twice as much. So your rate of return from buying a bond is cut in half.

This is why there is an inverse relationship between bond prices and bond yield.

[For mathematicians, the inverse relationship is self-evident from the formula. Given the coupon payment is fixed, the bond price and bond yield are inversely proportional.]

More generally, bond yields are likely to follow market interest rates:

• Suppose market interest rates fall. 
• Then, the yield for bonds may temporarily exceed market interest rates.
• Investors would sell other assets and buy bonds, to increase their rate of return.
• This drives up bond demand, increasing bond prices. 
• This reduces bond yield, due to the inverse relationship between bond price and bond yield. 
• This is known as “arbitrage”. If there is a large gap between market interest rates and bond yields, investors will buy/sell bonds and sell/buy other assets until interest rates have converged.

There is therefore an inverse relationship between bond prices and market interest rates. 

Real world data on government bonds Different bonds have a different yield.  See the link here (external link to Bloomberg), which compares government bond yields for selected governments.  Which countries among the ones shown have the lowest bond yields and which have the highest bond yields? Some governments have higher bond yields than others. One reason for this is that investors may view some bonds as safer investments than others. This could be based on a belief that some governments are more likely than others. to make good on their bond repayments.

Practice question on financial markets

Here  is a practice question written in the style of AQA Economics A Level.

The financial and insurance services sector makes up £208.2bn or 8.8% of the UK’s real output as of 2023. However, the financial sector also matters for the wider economy. In 2022, companies in the UK financial sector possessed assets of about £27 trillion, half of which was held by banks.

Source: UK Parliament Commons Library (external link)

Question: Explain the role of financial markets in the wider economy. [15 marks].

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