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Instruments and Rates

When most people think of financial markets, they think of the stock market. A stock is a share in the ownership of a corporation, and through the stock market one can buy and sell ownership in most large businesses in the world. The stock market has high visibility because it is open to anyone who can collect several hundred dollars together. However, the stock market is only a very small part of the total financial market and plays only a minor role in macroeconomic theory.

Markets for debt are much larger than the stock market in terms of their daily transactions. These markets have less visibility because many require hundreds of thousands or even millions of dollars to enter directly. As a result, individuals generally do not enter the debt market directly; most transactions involve financial intermediaries. There are many kinds of transactions that take place in debt markets, and some of these markets do play an important role in macroeconomic theory. Whenever economists include an interest rate in their discussion, a market for debt is playing a role in their thinking.

Prices in the debt market are interest rates, what one pays (or receives) for the use of funds for some period of time. Because they aggregate financial markets, economists often talk about "the interest rate." In fact there are many interest rates. Rates differ depending on factors such as the risk of default, the liquidity and time to maturity of the debt, and the tax status of the interest payments.

The press commonly reports several interest rates. The prime rate was once the interest rate that large commercial banks charged their most credit-worthy customers for short-term loans. In recent years banks have usually given their best customers discounts from the prime, so this definition is no longer accurate. A good definition of the prime is hard to give other than it is a rate that banks publicize.

The federal-funds rate is the rate that banks charge one another for funds they borrow on an overnight basis. The discount rate is the rate at which banks may be permitted to borrow from a Federal Reserve bank. Finally, the interest rate on 13 and 26 week Treasury Bills is used by many banks to determine rates that they pay on some of their accounts. This interest rate is probably the one most economists have in mind when they talk about "the interest rate." In practice all these rates tend to fluctuate together.

The market for government debt plays several roles in economic theory. Although many of us hold U.S. savings bonds, very little of the federal debt is financed with them, as the table below indicates. More of the debt is in the form of long-term debt (bonds), medium-term debt (notes), and short-term treasury bills, or T-bills for short. (It is left as an exercise for the reader to update these figures to see by how much the debt of the United States has grown.)

Debt of the United States Treasury
(numbers in billions of dollars)

December 31, 1985
December 31, 1995









Savings Bonds and Notes



Owners of the Debt

U.S. Government Agencies and Trust Funds


Federal Reserve Banks


Private Investors


Source: Federal Reserve Bulletin, February 1987, Table 1.41, p A30; June 1996; Table 1.41, p. A27.

* Most of this category consists of non-marketable debt held by U.S. government agencies and trust funds.

** The government holds its own debt because Congress has set up some programs that must keep their accounting separate from the rest of the government. An example is the Social Security system. When it has revenues in excess of its payments, it lends its excess funds to the Treasury Department, creating government debt that the government also owns.

A T-bill is short-term debt of the federal government with a maturity of 13 weeks, 26 weeks, or one year. T-bills do not pay interest but are bought and sold for less than face value and then redeemed at maturity at face value. Thus, if one buys a six-month T-bill with a face value of $10,000 for $9500, the effective interest rate is about 10% per year. The price of T-bills is determined by bids that buyers submit; the Treasury fills the highest bids first, and continues filling orders until its offering is sold out. The Treasury sells T-bills each week, but most of the proceeds are used to pay off the T-bills that are maturing.

Although some individuals buy T-bills, (you can buy one from any Federal Reserve Bank without any service charge—the Fed acts as a broker for the Treasury), most T-bills are bought by financial intermediaries, large companies, and governmental units. These organizations find them a safe and profitable way to invest funds available for short periods of time. The attractiveness of T-bills is enhanced by the secondary market that has developed. A secondary market does not sell newly-issued securities, but previously issued—or "used"—securities. (The stock and bond exchanges are examples of secondary markets.) The existence of this secondary market has made T-bills very liquid, that is, T-bills can be converted into cash quickly and cheaply. This secondary market is very large in terms of the dollar value of transactions, (well over $10 billion in government debt changes hands on a typical business day), but because it does not deal in small transactions of $50000 or $100000, it is not visible. It is an over-the-counter market, which means transactions are done by computer or telephone. The center of the market is in the trading rooms of the largest New York banks. The market in T-bills is deep, which means that it can easily handle transactions worth many millions of dollars with no visible effect on price. Finally, T-Bills are now sold as book-entry securities, which means they are not in the form of a paper certificate, but are only entries on the books of the Treasury. Getting rid of the paper and going to a completely computerized form makes large-scale trading in T-Bills much easier.

In addition to stock markets and the markets for debt, financial markets also include markets for foreign exchange and a variety of options and futures markets. In options markets people buy and sell the right to buy and sell securities at predetermined prices and in futures markets two people agree on a price at which a future delivery will be made. The market for foreign exchange is an important market as far as macroeconomics is concerned, but options and futures markets are of lesser importance for macroeconomics.

But next we examine how people act in financial markets.

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