As previously described, the money market is where the central bank supplies money, and households, businesses, and government demand money at various nominal interest rates. Firms, banks, and governments are able to obtain short-term financing in the money market. Securities (financial instruments such as stocks and bonds) with maturities of less than one year are included in this market.
Businesses with excellent credit can easily borrow in the money market by issuing commercial paper, which is nothing more than a short-term IOU. For example, Behemoth Corporation is expecting payment from its customers at the end of the month, but has to pay its employees before then. In this case, Behemoth Corporation can issue commercial paper in exchange for cash with which to pay its employees. As soon as the customers make their payment to Behemoth Corporation, the company can turn around and repay whoever holds its commercial paper. For the company, commercial paper allows them to manage their cash flow at a cheaper rate than taking on longer-term debt would allow, and for the lender it provides a liquid and relatively safe way to earn some interest on their extra cash.
Commercial paper is an unsecured debt, meaning that it doesn’t represent any type of ownership interest and no collateral is offered in exchange. You’re repaid by cash flow (as in the example just presented, once the customers pay Behemoth Corporation at the end of the month, you’ll get your original investment plus interest back). If the firm defaults on their repayment, you’re stuck without a lot of good options. It’s not as if you can send out the neighborhood repo guy and seize the office furniture.
Companies with less-than-perfect credit have to offer higher interest rates in order to get any takers, who will be assuming more than the usual risk. Demand is much greater for higher-rated commercial paper. Commercial paper is usually sold in big chunks (say, $100,000 per issue), the interest is taxable, and the Securities and Exchange Commission (SEC) doesn’t regulate their sale. This is why money market funds are popular with private investors (the little guys like you and me). They allow for diversification, spreading the risk out over a number of different commercial paper investments.
Like corporations, sometimes the U.S. government needs a little cash on hand to make the wheels of governance run smoothly. When it does, it auctions Treasury bills (T-bills) for its short-term cash needs. The T-bills have various maturities of less than one year. Investors like T-bills because they allow them to earn risk-free interest while maintaining liquidity in case they need their cash quickly for other purposes. The government benefits because T-bills provide the government with easy access to cash for government spending, and what government doesn’t love easy access to cash?
T-bills are different from other forms of government securities in that they are sold at a discount from face value. T-bills have a face value of $1,000, but buyers pay less than that. The difference between the face value and the amount paid represents an interest payment. For example, if Rich Personne buys a 52-week $1,000 T-bill for $950, he will receive interest of $50 at maturity, which is equivalent to earning 5.26% on a $950 investment.
Banks, like any other business, sometimes have to have access to more cash than they have tucked away in the vault. To meet their short-term financing needs, they lend and borrow federal funds, also known as fed funds. Banks may borrow from each other in the fed funds market to satisfy their legal reserve requirements or to meet their contractual clearing balances. This component of the money market is important for maintaining bank liquidity. It also increases efficiency by encouraging banks to put all of their available excess reserves to work earning a return. Because banks keep most of their reserves on deposit with the Fed, the exchange of these federal funds occurs almost immediately as the banks exchange their reserve balances between each other. The Federal Reserve affects this market by influencing the fed funds rate, which is the interest rate banks charge each other for the use of overnight federal funds.