Money markets keep the world economy moving by providing a source of cash flow to pay the bills when major institutions find themselves short before payday. Investors in the money market basically lend large sums of money to governments, banks and trustworthy companies for short periods of time lasting from one day to about a year. The return on money market investments is typically low, but investors are usually satisfied with a lower return because of the perceived safety of money markets compared with the stock market.
U.S. Treasury Bills
U.S. Treasury bills are one form of money market investment. The United States raises money by selling Treasury bills at a specified rate of interest, and the government doesn't pay back the money for three to 12 months. That doesn't stop investors from selling Treasury bills to one another in the meantime.
Certificates of Deposit
Certificates of deposit (CDs) are another form of money market investment. In this case, the investor is lending money to the bank for a specified time and a set rate of interest. The center of the money market is banks lending money to banks using commercial paper or repurchase agreements; in this case, the bank borrows money without putting up collateral. The paper just says the bank will pay back the money plus a low rate of interest.
Large, established companies also raise money by selling commercial paper. These institutions do this based on a reputation for keeping their promises. Like CDs, commercial paper has a fixed maturity time, usually one to 270 days.
Banks borrow money from the Federal Reserve to maintain their bank reserves. This is usually only an overnight loan with the purpose of avoiding an overdraft. The interest rate is set at the federal funds rate.
Cities, counties, school districts and any other governmental agencies below the federal government issue bonds to investors. These municipal bonds are exempt from federal and state income taxes, making them a very desirable money market investment.
Upside of Money Markets
The money market is a good investment when the stock market is extremely volatile or low. At those times, the money market serves as a way to earn a low but steady return on one's investment. Another positive factor is liquidity, meaning that when an investor wants to take money out of the money market, it is usually easy to sell.
Downside of Money Markets
The biggest downside to investing in the money market is that sometimes, the rate of return on money market investments is lower than inflation. Another negative factor is that over time, an investor can earn a lot more money investing in the stock market, so a long-term investment in the money market is probably a poor investment.