CHAPTER ONE

1. AN OVERVIEW OF FINANCIAL SYSTEM

1.1. The role of Financial System in the Economy
Concept of the Financial System
A financial system is defined as the collection of markets, individuals, laws, polices, systems, conventions,
techniques and institutions through which bonds, stocks, and other securities are traded, interest rates are
determined and financial services are provided and delivered.
The financial system consists of the group of institutions in the economy that helps to match one person’s
saving with another person’s investment.

The primary task of the financial system is to move scarce loanable funds from those who save to those who
borrow to buy goods and services and to make investments so that the economy can grow and increase the
standard of living enjoyed by citizens. The end users of this system are people and firms whose desire is to lend
and to borrow.
The financing system is necessary to mobilize surplus funds from people and organizations, and to allocate
them among deficit people and organizations. An investor (who invests in securities) is an example of a surplus
unit, whereas a borrower is an example of a deficit unit. Mobilizing funds generates returns for surplus units,
which generally enhances their wealth and economic well-being. It also allows deficit units to enhance their
productive and purchasing capacities, and thus improves an economy's production and consumption potential.

There are at least two fundamental problems that must be solved by the financing system. First, deficit units
seek funds for terms that, on average, are longer than the periods for which funds are supplied by surplus units,
posing the problem of a maturity mismatch between the supply and demand for funds. This means that
financing processes have to be able to transform the maturity of funds - a process referred to as maturity
transformation. Second, financing processes have to develop means for managing with the risks faced by the
suppliers of funds.

The following are major roles of financial system in our daily lives

a. Saving Role/Function
The system of financial markets and institutions provides a channel for the public’s savings. Bonds, stocks,
deposits, and other financial claims sold in the money and capital markets provide a profitable, relatively low-
risk outlet for the public’s savings. Those savings flow through financial markets into investments so that more
goods and services can be produced in the future which increases society’s standard of living. When savings
flow decline, however, the growth of investment and living standards tends to elevated.

 The savings function of any financial system supplies the vital raw material of funds to invest
so that economic growth and living standards can flourish.
b. Liquidity Role/ Function
It is a means of raising funds by converting securities and other financial assets into cash balances. The
financial system provides liquidity for savers holding financial instruments but who are in need of money. In
modern society, money consists of mainly deposits held in banks and is the only financial instrument possessing
of perfect liquidity. Money can be spent as it is without the necessity of converting it into some other form.
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1. However money generally earns the lowest rate of return of all assets traded in the financial system,
and its purchasing power is seriously eroded by inflation.

That is why savers generally minimize their holdings of money and hold bonds and other financial assets until
spend able funds really are needed.
c. Wealth Role/Function

It is a means to store purchasing power until needed at a future date for spending on goods and services.
Shifting power from high earning periods to warnings periods of life. For the business and individuals
choosing to save, the financial instruments sold in the money and capital markets provide an excellent way
to store wealth (to preserve value or hold purchasing power) until funds are needed for spending in the
future periods.

 While we might choose to store our wealth in things” (e.g. automobiles and clothes), such items
are subject to depreciation and often carry great risk of loss.

However, bonds, stocks, deposits and other financial instruments, do not wear out overtime, usually generate
income, and normally, their risk of loss is less as compared to many other forms of stored wealth.

d. Credit Role/Function
The role of credit is to provide a continuous supply of credit for the business, consumers and governments; to
support both the consumption and investment spending in the economy. Example, Governments borrow funds
to construct public facilities and to cover daily expenses until tax revenues flow in.

e. Payments Role/ Function:

It provides a mechanism for making payments to purchase goods and services; certain financial assets, mainly
checking accounts and now negotiable order of withdrawal accounts, serve as a medium of exchange in the
making of payments. Example: Credit cards (plastic credit cards) give the customer instant access to short-term
credit but also is widely accepted as a convenient means of payment. Debit card (plastic credit cards) - is used
today to charge a buyer’s deposit account for purchasing of goods and services and transfer the proceeds
instantly by wire to the seller’s account.

 Debit cards and other electronic means of payment, including computer terminals at homes,
offices, and stores are likely to displace checks and other pieces of paper as the principal means of
payment.

f. Risk Role/Function:
Financial markets and the diverse financial instruments traded in those markets allow investors with the greatest
taste for risk. It provides a means to protect business, consumers, and Governments against risk to people,
property and income. The financial markets offer business, consumers and Governments protection against life,
health, property and income risks.

 Example: life insurance policy

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Thus, capital markets allow the risk that is inherent to all investments to be borne by investors most willing to
bear that risk. This allocation of risk also benefits the firms that need to wise capital to finance their
investments. When investors can self-select into security types with risk-return characteristics, that best suits
their preferences, each security can be sold for the best possible price. This facilitates the process of building the
economy’s stuck of real assets.

 Example: More optimistic or risk-tolerant investors buy shares of stock.

The more conservative individuals buy bonds.

g. Policy Role/Function:
In recent decades, the financial market has been the principal channel through which the Federal Government
has carried out its policy of attempting to stabilize the economy and avoid excessive inflation.

Goal of Financial System

There are three major goals of a financial system

A. Goal One
The first goal of the financial system (FS) is to facilitate the flow of funds from savers (entities with a surplus of
funds) to investors (entities with a deficit of funds).

Real Assets and Financial Assets.

A real asset is an entity that generates a flow of goods or services over time.

 Examples include land, people, factories, inventions, business plans, and goodwill with consumer’s
reputation.
 Key point: real assets need not be tangible.
A financial asset is a legal contract that gives its owner a claim to payments, usually generated by a real
asset.
 Examples include currency ($), stocks, bonds, bank deposit, bank loans, options, futures, etc.

Ultimate investors sell financial assets to savers; they use the proceeds to buy real assets (buying real assets is
the same thing as investment). Sometimes people sell financial assets to finance consumption too. Given this
first role, the FS is the place where savers (or, more generally, economic agents with a surplus of funds relative
to their immediate need for those funds) meet investors (or, more generally, economic agents with a deficit of
funds relative to their immediate need for those funds).

B. Goal Two
The second goal of the FS is to allow economic agents to share risks. There are many risks that have very high
costs but low likelihood of occurring such as hurricanes, early death, failure of a business etc. Risk averse
people prefer to share these risks rather than bear them alone.

An obvious example is the insurance industry.

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A less obvious example from banking is the letter of credit. A letter of credit is a promise by the issuer (the
bank) to make good on behalf of the beneficiary (the party paying a fee to the bank) if that beneficiary fails to
perform. Commercial letters of credit are commonly used to remove the risks of non-payment in import/export
industries.
C. Goal Three
The third main goal of the financial system is to generate liquidity. An asset is liquid if it can be converted into
cash quickly with little or no loss in value. In other words an asset must be considered liquid if its price tends to
be reasonably stable overtime, if it has an active resale market, and if it is reversible so that investors can
recover their original investment without loss.
1.2 Types of Markets
Definition of market
A Market is an institutional mechanism where supply and demand meet to exchange goods and services; or a
place or event at which people gather in order to buy and sell things in order to trade.

There are three major types of market these are input market, output market and financial market
i. Input/Factor markets: - are markets where consuming units sell their labor, management skill, and
other resources to those producing units offering the highest prices. i.e. this market allocates factors of
production (Land, labor and capital – and distribute incomes in the form of wages, rental income and
so on to the owners of productive resources.
ii. Output/Product market: - are markets where consuming units use most of their income from the
factor markets to purchase goods and services i.e. this market includes the trading of all goods and
services that the economy produces at a particular point in time.
iii. Financial markets: - There are markets in which flow of funds, flow of financial services, income
and financial claims is affected i.e. essentially; financial markets do have three main tasks. These are:
1. They determine the nature of credit available at a macroeconomic level;
2. They attract savers and borrowers; and
3. They set interest rate and security prices.

Types of financial market structures

i. Auction Markets
An auction market is some form of centralized facility (or clearing house) by which buyers and sellers, through
their commissioned agents (brokers), execute trades in an open and competitive bidding process. The
"centralized facility" is not necessarily a place where buyers and sellers physically meet. Rather, it is any
institution that provides buyers and sellers with a centralized access to the bidding process. All of the needed
information about offers to buy (bid prices) and offers to sell (asked prices) is centralized in one location which
is readily accessible to all would-be buyers and sellers, e.g., through a computer network.

No private exchanges between individual buyers and sellers are made outside of the centralized facility.

Many auction markets can trade in relatively homogeneous assets (e.g. treasury bills, notes, and bonds) to cut
down on information costs. Alternatively, some auction markets (e.g., in second-hand jewelry, furniture,
paintings etc.) allow would-be buyers to inspect the goods to be sold prior to the opening of the actual bidding
process.

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ii. Over-the-counter markets:
An over-the-counter market has no centralized mechanism or facility for trading. Instead, the market is a public
market consisting of a number of dealers spread across a region, a country, or indeed the world, who make the
market in some type of asset. That is, the dealers themselves post bid & asked prices for this asset and then
stand ready to buy or sell units of this asset with anyone who chooses to trade at these posted prices. The dealers
provide customers more flexibility in trading than brokers, because dealers can offset imbalances in the demand
and supply of assets by trading out of their own accounts. Many well-known common stocks are traded over-
the-counter through NASDAQ (National Association of Securities Dealers' Automated Quotation System).

iii. Organized Exchanges

The financial markets, such as the New York Stock Exchange, which combines auction & OTC market features,
are called Organized Exchanges. Specifically, organized exchanges permit buyers & sellers to trade with each
other in a centralized location, like an auction. However, securities are traded on the floor of the exchange with
the help of specialist traders who combine broker and dealer functions. The specialists broker trades but also
stand ready to buy and sell stocks from personal inventories if buy and sell orders do not match up.

iv. Intermediation Financial Markets:

An intermediation financial market is a financial market in which financial intermediaries help transfer funds
from savers to borrowers by issuing certain types of financial assets to savers and receiving other types of
financial assets from borrowers. The financial assets issued to savers are claims against the financial
intermediaries, hence liabilities of the financial intermediaries, whereas the financial assets received from
borrowers are claims against the borrowers, hence assets of the financial intermediaries.

1.3 Types of Financial Markets

Depending on the characteristics of financial claims being traded and the needs of different investors, the flow
of funds through financial markets around the world may be divided into different segments. These include: The
Money Market and Capital Market; Primary and Secondary Markets; Open and Negotiated Markets as well as
Spot; Futures, Forward, and Option Markets.

1. The Money Market versus the Capital Market

a) Money Market

The money market is designed for the making of short-term loans. It is the institution through which individuals
and institutions with temporary surpluses of funds meet the needs of borrowers who have temporary funds
shortages (deficits). Thus, the money market enables economic units to manage their liquidity positions.

By conventions, a security or loan maturing within one year or less is considered to be a money market
instrument. One of the principal functions of the money market is to finance the working capital needs of
corporations and to provide governments with short-term funds in lieu of tax collections. The money market
also supplies funds for speculative buying of securities and commodities.

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In other words, the money market is the global financial market for short-term borrowing and lending. It
provides short-term liquid funding for the global financial system. The money market is a sector of the capital
market where short-term obligations such as Treasury bills, commercial paper, certificate of deposit, bankers'
acceptances (a draft issued by a bank that will be accepted for payment, the same as cashier’s cheques).

b) Capital market

Capital market is designed to finance long-term investments by businesses, governments and households.
Trading of funds in the capital market makes possible the construction of factories, highways, schools, and
homes. Financial instruments in the capital market have original maturities of more than one year and range in
size from small loans to multimillion Birr credits.

The capital market includes the stock market, the bond market, and the primary market. Securities trading on
organized capital markets are monitored by the government; new issues are approved by authorities of financial
supervision and monitored by participating banks. This market brings together all the providers and users of
capital.

Financial products such as stocks, bonds, mutual funds, and insurance make the transfer of capital possible.
Financial intermediaries, such as banks, brokerage firms, and insurance companies facilitate the transfer of
capital. Capital market is the broad term for the market where investment products such as stocks and bonds are
bought and sold. It includes all the people and organizations which support the process. Such markets may not
necessarily have a physical presence.

The capital markets consist of the primary market, where new issues are distributed to investors, and the
secondary market, where existing securities are traded. So it is the market in which corporate equity and longer-
term debt securities (those maturing in more than one year) are issued and traded. It consists of a market for
medium to long-term financial instruments; financial instruments traded in the capital market include shares,
and bonds issued by the government, state governments, corporate borrowers and financial institutions.

2. Open versus Negotiated Markets

Another distinction between markets in the global financial system that is often useful focuses on open markets
versus negotiated markets. For example, some corporate bonds are sold in the open market to the highest bidder
and are bought and sold any number of times before they mature and are paid off. In contrast, in the negotiated
market for corporate bonds, securities generally are sold to one or a few buyers under private contract.

An individual who goes to his or her local banker to secure a loan for a new car enters the negotiated market for
auto loans. In the market for corporate stocks, there are the major stock exchanges, which represent the open
market. Operating at the same time, however, is the negotiated market for stock, in which a corporation may sell
its entire stock issue to one or a handful of buyers.

3. Primary versus Secondary Markets

a) Primary Market

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Primary Market, also called the new issue market, is the market for issuing new securities (stocks or bonds).
Many companies, especially small and medium scale, enter the primary market to raise money from the public
to expand their businesses. They sell their securities to the public through an initial public offering. The
securities can be directly bought from the shareholders, which is not the case for the secondary market. The
primary market is a market for new capitals that will be traded over a longer period.

In the primary market, securities are issued on an exchange basis. The underwriters, that is, the investment
banks, play an important role in this market: they set the initial price range for a particular share and then
supervise the selling of that share. Investors can obtain news of upcoming shares only on the primary market.
The issuing firm collects money, which is then used to finance its operations or expand business by selling its
shares. Before selling a security on the primary market, the firm must fulfill all the requirements regarding the
exchange. After trading in the primary market the security will then enter the secondary market, where
numerous trades happen every day.

b) Secondary market

Secondary market deals in securities previously issued. Its chief function is to provide liquidity to security
investors-that is, provide an avenue for converting financial instruments into ready cash. If you sell shares of
stock or bonds you have been holding for some time to a friend or call a broker to place an order for shares
currently being traded on the stock exchanges, you are participating in a secondary-market transaction.

In other words, Secondary Market is the market where, unlike the primary market, an investor can buy a
security directly from another investor in lieu of the issuer. It is also referred as "after market". The securities
initially are issued in the primary market, and then they enter into the secondary market. All the securities are
first created in the primary market and then, they enter into the secondary market. In other words, secondary
market is a place where any type of used goods is available. In the secondary market shares are maneuvered
from one investor to other. That is, one investor buys an asset from another investor instead of an issuing
corporation. So, the secondary market should be liquid.

Secondary Market has an important role to play behind the developments of an efficient capital market. It
connects investors' favoritism for liquidity with the capital users' wish of using their capital for a longer period.
For example, in a traditional partnership, a partner can not access the other partner's investment but only his or
her investment in that partnership, even on an emergency basis. Then he or she may breaks the ownership of
equity into parts and sell his or her respective proportion to another investor. This kind of trading is facilitated
only by the secondary market.

4. Spot, Futures or Forward, and Option Markets

A spot market is one in which assets or financial services are traded for immediate delivery (usually within one
or two business days). If you pick up the telephone and instruct your broker to purchase X-Corporation shares at
today’s price, this is a spot market transaction. You expect to acquire ownership of X-Corporation shares within
a matter of minutes.

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A future or forward market, on the other hand, is designed to trade contracts calling for the future delivery of
financial instruments. For example, you may call your broker and ask to purchase a contract from another
investor calling for delivery to you of Birr 1 million in government bonds six months from today. The purpose
of such a contract would be to reduce risk by agreeing on a price today rather than waiting six months, when
government bond prices might have risen.

Options markets are agreements (contracts) that give an investor the right to either buy from or sell designated
securities to the writer of the option at a guaranteed price at any time during the life of the contract.

5. International and Domestic Markets

Because of the globalization of financial markets throughout the world, a corporation is not limited to raising
funds in the financial market where it is domiciled. Globalization means the integration of financial market
throughout the world into a global financial market. From the perspective of a given country, financial markets
can be classified into two markets: an internal market and an external market. The internal market is also called
the national market. It can be decomposed into two parts: the domestic market and the foreign market. The
domestic market is where issuers domiciled in the country issue securities and where those securities are
subsequently traded.

The foreign market of a country is where issuers not domiciled in the country issue securities and where the
securities are then traded. The rules governing the issuance of foreign securities are those imposed by regulatory
authorities where the security is issued. For example, securities issued by non-Ethiopian corporations in the
Ethiopia must comply with the regulations set forth in Ethiopia securities law and other requirements imposed
by the other concerned parties.

6. Foreign Exchange Markets (FX)

Money represents purchasing power, but usually only in one country. Alternatively, different countries have
different currency and the settlement of all business transactions within a country is done/ preferred local
currency. For instance, $, £, or € have no purchasing power in Ethiopia.
The foreign exchange market provides a forum where the currency of one country is traded for the currency of
another country. Exchanging one currency for another takes place in the FX market; (converting purchasing
power from one currency into another).
Eg 1Dollar = 27.67 Birr
1.4 purposes of Financial Markets

Financial markets perform the essential economic function of channeling funds from households, firms, and
governments that have saved surplus funds by spending less than their income to those that have a shortage of
funds because they wish to spend more than their income.

1.5 financial institutions

Financial institutions are those organizations, which are involved in providing various types of financial
services to their customers.
The principal function of financial institutions is to collect funds from the investors and direct the
funds to various financial services providers in search for those funds.

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The financial institutions are controlled and supervised by the rules and regulations delineated by
government authorities. Some of the financial institutions also function as mediators in share
markets and debt security markets.
Financial institutions include: Banks, Stock Brokerage Firms , Non-Banking Financial Institutions, Asset
Management Firms, Credit Unions and Insurance Companies. Financial institutions deal with various
financial activities associated with bonds, debentures, stocks, loans, risk diversification, insurance,
hedging, retirement planning, investment, portfolio management, and many other types of related
functions.

1.6 Types of financial institutions

Types of Financial Institutions include:

 Commercial banks,  Insurance companies,

 Credit unions,  Finance companies,
 Stock brokerage firms,  Building Societies, and
 Asset management firms,  Retailers.

1.7 Functions of financial institutions

The various financial institutions generally act as the intermediaries between the capital market and debt
market. But the service provided by financial institution depends on its type. The financial institutions are also
responsible to transfer funds from investors to the companies. Typically, these are the key entities that control
the flow of money in the economy. The services provided by the various types of financial institutions may vary
from one institution to another. For example:

The services offered by the commercial banks are: insurance services, mortgages, loans and credit cards.
The services provided by the brokerage firms, on the other hand, are different and they are - insurance,
securities, mortgages, loans, credit cards, money market and check writing.
The insurance companies offer – insurance services, securities, buying or selling service of the real
estates, mortgages, loans, credit cards and check writing.
 The credit union is co-operative financial institution, which is usually controlled by the members
of the union.
The stock brokerage firms are the other types of financial institutions that help both the corporations
and individuals to invest in the stock market.
Another type of financial institution is the asset management firms. The prime functionality of these
firms is to manage various securities and assets to meet the financial goals of the investors. The firms
also offer fund management advice and decisions to the corporations and individuals.

On the other hand, these institutions are responsible for distributing financial resources in a planned way to the
potential users. There are a number of institutions that collect and provide funds for the necessary sector or
individual. Correspondingly, there are several institutions that act as the middleman and join the deficit and
surplus units. Investing money on behalf of the client is another variety of functions of financial institutions.
 Financial institutions can also be categorized as deposit taking institutions, and this include:

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  Finance and Insurance Institutions,  Pension Providing Institutions, and
 Investment Institutions,  Risk Management Institutions.

At the same time, there are several governmental financial institutions assigned with regulatory and supervisory
functions. These institutions have played a distinct role in fulfilling the financial and management needs of
different industries, and have also shaped the national economic scene. Deposits taking financial organizations
are known as commercial banks, mutual savings banks, savings associations, loan associations and so on. The
primary functions of financial institutions of this nature are:
 Accepting Deposits;  Providing Mortgage Loans; and
 Providing Commercial Loans;  Issuing Share Certificates.
 Providing Real Estate Loans;
Finance companies provide loans, business inventory financing and indirect consumer loans. These companies
get their funds by issuing bonds and other obligations. These companies operate in a number of countries. On
the other hand, there are insurance companies that provide coverage for a variety of risk factors and they also
provide several investment options. Insurance companies provide loans for a number of purposes and create
investment products.

1.8The role of financial institutions

1. Providing a payments mechanism

Most transactions made today are not done with cash; instead payments are made using checks, credit cards,
debit cards and electronic transfers of funds. These methods for making payments are provided by certain
financial institutions. Financial institutions perform check clearing and wire transfer services. A debit card
differs from a credit card in that in the latter case, a bill is sent to the credit card holder periodically (usually
once a month) requiring payments for transactions made. In the past in the case of a debit card, funds are
immediately withdrawn (that is, debited) from the purchaser's account at the time the transaction takes place.

2. Maturity transformation
The financial institutions ( e.g. banks) perform the valuable functions of converting funds that savers are willing
to lend for only short period of time into funds the financial institution themselves are willing to lend to
borrowers for longer periods. Maturity transformation function of financial institution has two implications.
First, it provides investors with more choices concerning maturity for their investments; borrowing has more
choices for the length of their debt obligations. Second, because investors are naturally reluctant to commit
funds for a longer period of time, they will require that long-time borrowers pay a higher interest rate than on a
short -time borrowing. A financial institution is willing to make long-term loans, and at a lower cost to the
borrower than an individual investor would, by counting on successive deposits providing the funds until
maturity. Thus, the second implication is that the cost of long-term borrowing is likely to be reduced.

3. Reducing risk through diversification

Consider the example of an investor who places funds in an investment company. Suppose that the investment
company invests the funds received in the stock of a large number of companies. By doing so, the investment
company has diversified and reduced its risk. Investors who have a small sum to invest would find it difficult to
achieve the same degree of diversification because they don't have sufficient funds to buy shares of a large

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number of companies. Because financial institutions acquire funds from large numbers of surplus units and
provide funds to large numbers of deficit units, substantial diversification is effected and the risk of financial
loss is reduced. The diversification is the holding of many (rather than a few) assets reduces risk. Because all
assets don’t behave in the same way at the same time, therefore, the behavior of one asset will on some
occasions cancel out the behavior of another. Financial institutions (intermediaries) also offer the risk reducing
benefits of management expertise since they do have a manpower that specializes in credit risk assessment &
monitoring of borrowers.

4. Reducing transaction costs

Not only do Financial institutions have a greater incentive to collect information, but also their average cost of
collecting relevant information is lower than for individual investor

(i.e., information collection enjoys economies of scale). An economy of scale is a concept that costs reduction
in trading and other transaction services results from increased efficiency when financial institutions perform
these services.
Such economies of scale of information production and collection tend to enhance the advantages to investors
of investing via financial institutions rather than directly investing themselves.

Money
A) Meaning and Nature of Money
Money is any token or other object that functions as a medium of exchange that is socially and legally accepted
in payment for goods and services and in settlement of debts. Money also serves as a standard of value for
measuring the relative worth of different goods and services and as a store of value. Some authors explicitly
require money to be a standard of deferred payment.

Money includes currency particularly the circulating currencies with legal tender status, and various forms of
financial deposit accounts, such as demand deposits, savings accounts, and certificates of deposit. In modern
economies, currency is the smallest component of the money supply.

B) Functions of Money
Money is generally considered to have the following four characteristics; a medium, a measure, a standard, and
a store." That is, money functions as a medium of exchange, a unit of account, a set of worth and a store of
value.
1. Medium of exchange
Money is used as an intermediary for trade. In order to avoid the inefficiencies of bartering system, which are
sometimes referred to as the 'double coincidence of wants problem, such usage is termed a medium of
exchange.

By contrast, in a barter system there must be a coincidence of wants before two people can trade - the one must
want exactly what the other has to offer, when and where it is offered, so that the exchange can occur. A
medium of exchange permits the value of a good to be assessed and rendered in terms of the intermediary, most
often, a form of money.

2. Unit of account

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A unit of account is a standard numerical unit of measurement of the market value of goods, services, and other
transactions. Also known as a "measure" or "standard" of relative worth and deferred payment, a unit of account
is a necessary prerequisite for the formulation of commercial agreements that involve debt.

The main characteristics of money as a unit of account are as follows:

 Divisible into small units without destroying its value; precious metals can be coined from bars, or
melted down into bars again.
 Fungible: that is, one unit or piece must be perceived as equivalent to any other, which is why
diamonds works of art or real estate are not suitable as money.
 A specific weight, or measure, or size to be verifiably countable. For instance, coins are often
made with ridges around the edges, so that any removal of material from the coin (lowering its
commodity value) will be easy to detect.

3. Store of value
To act as a store of value, a commodity, a form of money, or financial capital must be able to be reliably saved,
stored, and retrieved — and be predictably useful when it is so retrieved. Fiat currency like paper or electronic
currency no longer backed by gold in most countries is not considered by some people to be a store of value.

This is distinct from the standard of deferred payment function which requires acceptability to parties one owes
a debt to, or the unit of account function which requires an agreement so accounts in any amount can be readily
settled. It is also distinct from the medium of exchange function which requires durability when used in trade,
and a minimum of opportunity to cheat others.

When currency is stable, money can serve all four functions. When it isn't, such as during times of
hyperinflation or when complex and volatile forms of financial capital are involved, it becomes important to
identify alternative stores of value. The most common ones are:

 Real estate - actual deeds in protectable land;

 gold - once the basis of the gold standard;
 silver - once the basis of the silver standard;
 precious stones, and precious metals;
 Collectibles, e.g. Original art by a famous artist or antiques;
 Livestock (eg. African currency).

4. Standard of deferred payment

A standard of deferred payment is the accepted way (in a given market) to settle a debt. For example, while the
gold standard reigned, gold or any currency convertible to gold at a fixed rate constituted such a standard. As of
2003, the US dollar and the Euro are the most generally accepted standards for international settlements.

o However, for certain kinds of transactions (such as for illegal goods like drugs or weapons), gold or
diamonds may be preferred as the medium of exchange — there being no recourse in case of counterfeit
currency being used — and there is no deferral of payment: if there is, it will most likely be stated in dollars.

This is distinct from the store of value function which relates to the saving, storing, and retrieval of value, and
from the unit of account function which requires fungibility so accounts in any amount can be readily settled. It
is also distinct from the medium of exchange function which requires durability when used in trade, and a
minimum of opportunity to cheat others — as the diamond or gold example illustrate. Historically, there have

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been many times when creditors have had to hide from debtors to avoid being paid off in near worthless
currency, typically following hyper-inflation.

C) Market liquidity of Money

Liquidity describes how easily an item can be traded for another item, or into the common currency within an
economy. Money is the most liquid asset because it is universally recognized and accepted as the common
currency. In this way, money gives consumers the freedom to trade goods and services easily without having to
barter.

D) Types of Money
In economics and finance, money is a broad term that refers to any instrument that can be used in the resolution
of debt. However, different types of money have different economic strengths and liabilities. Generally, there
are four types of money: Commodity money, Representative money, Credit money, and Fiat money. Modern
monetary theory also distinguishes among different types of money, using a categorization system that focuses
on the liquidity of money.

1. Commodity money
Commodity money is any money that is both used as a general purpose medium of exchange and as a tradable
commodity in its own right. An example is coins made of precious metal. Commodity-based currencies are
often viewed as more stable, but this is not always the case.
This not only damages its stability as a medium of exchange, it also reduces its effectiveness as a store of value.
The advantage of gold and silver lies in the fact that, unlike fiat paper currency, the supply cannot be increased
arbitrarily by a central bank.
It is also possible for the trading value of commodity money to be greater than its value as a medium of
exchange when governments attempt to fix exchange rates between different commodity moneys. When this
happens people will often start melting down coins and reselling the metal used to make them. Commodity
money's ability to function as a store of value is also limited by its nature. For example, copper and tin risk rust
and corrosion, and gold and silver are soft metals that can lose weight through scratches and abrasions.

Commodity currencies may limit the geographic extent of the trading market. To make large purchases, either a
large volume or a high weight or both, of the commodities must be transported to the seller. The cost of
transportation of the currency raises the transaction cost and makes long distance sales less attractive.

2. Representative money
Representative money is money that consists of token coins, other physical tokens such as certificates, and even
non-physical "digital certificates" (authenticated digital transactions) that can be reliably exchanged for a fixed
quantity of a commodity such as gold, silver or potentially water, oil or food.

o Representative money thus stands in direct and fixed relation to the commodity which backs it, while not
itself being composed of that commodity.

3. Credit money
Credit money is any claim against a physical or legal person that can be used for the purchase of goods and
services. Credit money differs from commodity and fiat money in two ways: It is not payable on demand
(although in the case of fiat money, "demand payment" is purely a symbolic act since all that can be demanded
is other types of fiat currency) and there is some element of risk that the real value upon fulfillment of the claim
will not be equal to real value expected at the time of purchase.
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 This risk comes about in two ways and affects both buyer and seller:
 First it is a claim and the claimant may default (not pay). High levels of default have destructive
supply side effects. If manufacturers and service providers do not receive payment for the goods
they produce, they will not have the resources to buy the labor and materials needed to produce
new goods and services.
This reduces supply, increases prices and raises unemployment, possibly triggering a period of
stagflation. In extreme cases, widespread defaults can cause a lack of confidence in lending
institutions and lead to economic depression.

 The second source of risk is time. Credit money is a promise of future payment. If the interest rate
on the claim fails to compensate for the combined impact of the inflation (or deflation) rate and
the time value of money, the seller will receive less real value than anticipated. If the interest rate
on the claim overcompensates, the buyer will pay more than expected.

4. Fiat money
Fiat money is any money whose value is determined by legal means, rather than the strict availability of goods
and services which are named on the representative note.

Fiat money is created when a type of credit money (typically notes from a central bank, such as the National
Bank of Ethiopia) is declared by a Government act (fiat) to be acceptable and officially-recognized payment for
all debts, both public and private. Fiat money may thus be symbolic of a commodity or a Government promise,
though not a completely specified amount of either of these. Fiat moneys usually trade against each other in
value in an international market, as with other goods.

Representative, credit, and fiat money all provide solutions to several limitations of commodity money.
Depending on the laws, there may be little or no need to physically transport the money — an electronic
exchange may be sufficient. Other types of moneys have as their sole use to be medium of exchange, so their
supply is not limited by competing alternate uses. Credit and fiat monies can be created without limit in theory,
so there is no limit on trade volumes.

Fiat money, if physically represented in the form of currency (paper or coins) can be easily damaged or
destroyed. However, here fiat money has an advantage over representative or commodity money, in that the
same laws that created the money can also define rules for its replacement in case of damage or destruction. By
contrast, commodity money which has been destroyed or lost is gone.

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