Notesale: Turn your study into money

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MONEY AND BANKING

Learning Objectives
At the end of the lesson the student should be able to:
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Explain why money is considered a dynamic force in modern economies
...

Explain fully the process of credit creation by commercial banks
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Explain the various theories that explain the demand for money
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Money
The nature and function of money
The development of money was necessitated by specialization and exchange
...

Disadvantages of Barter Trade
 It is impossible to barter unless A has what B wants, and A wants what B has
...

 Even when each party wants what the other has, it does not follow they can agree on a
fair exchange
...

 The indivisibility of large items is another problem
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 It is possible to confuse the use value and exchange value of goods and services in a
barter economy
...

 When exchange takes place over time in an economy, it is necessary to store goods for
future exchange
...

 The development of industrial economies usually depends on a division of labour,
specialization and allocation of resources on the basis of choices and preferences
...
Without a common medium of exchange and a common unit of account
which is acceptable to both consumers and producers, it is very difficult to achieve an
efficient allocation of resources to satisfy consumer preferences
...
For such peoples a money system is essential
...

The Historical development of money
For the early forms of money, the intrinsic value of the commodities provided the basis for
general acceptability: For instance, corn, salt, tobacco, or cloth was widely used because they
had obvious value themselves
...
Commodity
money had uses other than as a medium of exchange (e
...
salt could be used to preserve meat,

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as well as in exchange)
...
Some were difficult to transport, some deteriorated overtime, some could not be easily
divided and some were valued differently by different cultures
...
These had the advantage of being easily recognizable,
portable, indestructible and scarce (which meant it preserved its value over time)
...
Thus each time a transaction was made, the metal was
weighed and payment made
...
The state took over the minting of coins by
stamping each as being a particular weight and purity (e
...
one pound of silver)
...

It became readily apparent, however, that what was important was public confidence in the
“currency” of money, its ability to run from hand to hand and circulate freely, rather than its
intrinsic value
...

Any person receiving such a coin could afford not to mind, so long as he was confident that
anyone to whom he passed on the coin would also “not mind”
...
e
...

Paper Money
Due to the risk of theft, members of the public who owned such metal money would deposit
them for safe keeping with goldsmiths and other reliable merchants who would issue a receipt
to the depositor
...
Each time a transaction was made, the required amount of the metal would be
withdrawn and payment made
...
Initially, the gold would be withdrawn
immediately after the transaction was made
...
Eventually, the receipts were made payable
to the bearer (rather than the depositor) and started to circulate as a means of payment
themselves, without the coins having to leave the vaults
...

Initially, paper money was backed by precious metal and convertible into precious metal on
demand
...
Consequently they started to issue more bank notes than they had
gold to back them, and the extra money created was lent out as loans on which interest was
th

th

charged
...
e
...
This caused the
government to intervene into the banking system so as to restore confidence
...
This is called fractional backing, but the Bank of England put restrictions on how much
money could be issued
...
Initially, the money issued by the Central Bank was backed by gold
(fractionally), i
...
the holder had the right to claim gold from the Central Bank
...
Thus, present day money is called token money i
...
money backed by the
level of output
...
Acceptability If money is to be used as medium of exchange for goods and services, then
it must be generally accepted as having value in exchange
...
It
is true of paper money, due to the good name of the note-issuing authority
...
Portability If an item is to be used as money, it must be easily portable, so that it is a
convenient means of exchange
...
Scarcity If money is to be used in exchange for scarce goods and services, then it is
important that money is in scarce supply
...

4
...
Precious metals became
popular because they do not deteriorate rapidly in use
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It must not depreciate over time so that it can be used as a
store of wealth
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Durability Money has to pass through many different hands during its working life
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Any
asset which is to be used as money must be durable
...

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...

Functions of money
1
...
Workers accept money for their wages because they know that money can be
exchanged for all the different things they will need
...
Without money, the world’s complicated economic systems

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which are based on specialization and the division of labour would be impossible
...

2
...
The use of money for accounting purposes makes possible the
operation of the price system and automatically provides the basis for keeping
accounts, calculating profit and loss, costing etc
...
It also allows for the comparison of the relative
values of goods and services even without an intention of actually spending (money) on
them e
...
“window shopping”
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Store of Wealth/value: The use of money makes it possible to separate the act of sale
from the act of purchase
...
By refraining from spending a portion of
one’s current income for some time, it becomes possible to set up a large sum of money
to spend later (of course subject to the time value of money)
...

4
...
g
...
Money
thus provides the unit in which, given the stability in its value, loans are
advanced/made and future contracts fixed
...
The use of money again
allows a firm to borrow for the payment of wages, purchase of raw materials or
generally to offset outstanding debt obligations; with money borrowing and lending
become much easier, convenient and satisfying
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Only money, of all possible assets, can be converted into other goods immediately and
without cost
...
There are three categories of these
institutions namely:  Commercial Banks
 Central Bank
 Non-bank financial institutions
Commercial Banks
A Commercial Bank is a financial institution which undertakes all kinds of ordinary banking
business like accepting deposits, advancing loans and is a member of the clearing house i
...

operates or has a current account with the Central Bank
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Functions of Commercial Banks
In modern economy, commercial banks have the following functions:

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i
...

ii
...

iii
...
This is particularly important where large
amounts of money are involved
...
They act as agents of the central banks in dealings involving foreign exchange on behalf
of the central bank and issue travelers’ cheques on instructions from the central bank
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They offer management advisory services especially to enterprises which borrow from
them to ensure that their loans are properly utilized
...
Some commercial banks offer insurance services to their customers e
...
The Standard
Bank (Kenya) which offers insurance services to those who hold savings accounts with
it
...
Some commercial banks issue local travelers’ cheques, e
...
the Barclays Bank (Kenya)
...
This
also safe if large amounts of money is involved
...
But they form only a part
of the total money supply
...
Bank deposits can either be a current account or deposit account
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Credit Creation
The ability of banks to create deposit money depends on the fact that bank deposits need to be
only fractionally backed by notes and coins
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Central banks also usually oversee
the commercial banking system of their respective countries
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The functions of the central bank are;
i
...
Such accounts are
usually held by the Central Bank
ii
...
The Central Bank accepts deposits from the
commercial banks and will on order transfer these deposits among the commercial
banks
...
On any given day, there will be cheques drawn

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iii
...


v
...

vii
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If the person paying and the person being paid bank with the
same bank, there will be a transfer of money from the account or deposit of the payee
...
In such cases, they cancel each other out
...
Thus the central bank acts as the Clearing House of commercial banks
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This is a function it took over from the commercial banks
for effective control and to ensure maintenance of confidence in the banking system
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If all other sources failed, the central
bank would lend money to commercial banks with good investments but in temporary
need of cash
...
For this reason, commercial banks
borrow from the central bank as the lender of the last resort
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Banking supervision: In liberalized economy, central banks usually have a major role to
play in policing the economy
...
e
...
Expanding the quantity of money and
lowering the rate of interest should stimulate spending in the economy and is thus
expansionary, or inflationary
...


Tools/Instruments of monetary policy
a) Open Market Operations
The Central Bank holds government securities
...
When the bank sells
securities to be bought by members of the public, the buyers will pay by writing cheques on
their accounts with commercial banks
...
Since the banks maintain a fixed liquidity (or cash)
ratio, the loss of these reserves will bring about multiple contraction of bank loans and
deposits
...
Conversely, if the central bank wanted to
pursue an expansionary monetary policy by making more credit available to the public, it
would buy bonds from the public
...
This increase in cash and reserve assets would permit them to carry out a
multiple expansion of bank deposits, increasing advances and the money supply together
...
When commercial banks find themselves short of cash they may, instead of
contracting bank deposits, go to the central bank, which can make additional cash available in
its capacity as “lender of last resort”, to help the banks out of their difficulties
...
The central bank exercises
regulatory powers as a lender of last resort by making this help both more expensive to get and
more difficult to get
...
Similarly, when it makes cash
available by buying approved short-term securities, it can charge a high effective rate of
interest by buying them at low prices
...

The significance of this rate of interest charged by the central bank in one way or the other to
commercial banks, as a lender of last resort, is that if this rate goes up the commercial banks,
who find that their costs of borrowing have increased, are likely to raise the rates of interest on
their lending to businessman and other borrowers
...

c) Special Deposit
If the Central Bank feels that there is too much money in circulation, it can in addition require
commercial banks to maintain over and above cash or liquid assets some additional reserves in
the form of Special Deposits
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d) Direct control
Without actually using the above weapons, the central bank can attempt simply to use “moral
suasion” to persuade the commercial banks to restrict credit when they wish to limit monetary
expansion
...

e) General and Selective Credit Control
These are imposed with the full apparatus of the law or informally using specific instructions to
banks and other institutions
...
This is more effective in controlling bank lending than
the cash and liquidity ratio
...
g
...
Selective controls are especially
useful in less developed investment away from less important sectors such as the construction
of buildings, the commercial sector, or speculative purchase of land, towards more important
areas
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(i) Transactions motive
(ii) Speculative Motive
(iii) Precautionary Motive

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An individual’s aggregate demand for money is based on a decision that takes the three motives
into account
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These agencies hold money because income (money receipts)
and expenditure flows are not synchronized in time
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Money is therefore required to bridge the gap between receipts and
disbursements
...
Holding
spending habits and interval between income receipts constant, the higher the income, the
higher the amount of money held for transaction motive
...
According to Keynes
precautionary demand is determined by an individual’s income and institutional factors, which
he considered fixed in the short run, so that;
Mt = kY,
Where Mt is combined transaction and precautionary demand for real cash balances
...
The precautionary motive arises from the need to provide
for the contingencies that require sudden expenditure and for unforeseen opportunities
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(iii) Speculation Demand for Money
It refers to the amount of money held to take advantage of profitable opportunities that may
arise in financial markets
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People hold money for speculation purposes due to uncertainty about the future rate of
interest
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The Modern Quantity Theory of Money
It was put forward by Friedman
...
The other ways include consumer durables, all kinds of financial
assets, property and human wealth
...
In this model, the
equation for demand for money is given as:

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Md
P = f(W, r, w, T)
Md
Where P = real demand for money;
W = total wealth;
r = expected rate of return on various forms of wealth;
w = ratio of human wealth to non-human wealth; and
T = Society’s tastes and preferences
...
Since rates of return on bonds and equities represent the opportunity cost of
holding money, demand for money is inversely related to the expected rates of return on
wealth
...
Demand for
money also depends on various factors that influence wealth holders’ tastes and preferences
for money
...
He also assumes
that W & T are constant in the short run
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Money Supply
Money is defined in two ways: narrowly and broadly
...
The total of coins, currency, bank deposits and other checkable deposits is
what we call money supply in the narrow sense
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Coins:
Are a small proportion of the total quantity of money in an economy
...
They are made of metal and normally the value of metal in them is less than the
face value of the coin
...
g
...
Currency constitutes the second and far larger
share of the total money supply than coins
...
Initially, there used to be gold of equivalent value to the amount of
currency issued to back it and give it value
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Its value is derived from its acceptability by people
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They are much larger than coins and
currency
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These deposits are considered to be money
because they can be as easily used in transactions as cash, by simply issuing a check
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Other checkable deposits
These include negotiable order of withdrawal (NOW) accounts and other accounts that are
very close to being demand deposits
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Money supply is broadly defined as
narrow money plus savings and small time deposits, money market mutual fund balances and
money market deposit accounts
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The reason why time and savings deposits were excluded from the narrow definition of money
is that they are not readily withdrawable and so can’t perform effectively the role of being
medium of exchange
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NB
Note that there is no clear dividing line between money and non-money, since many assets
have some characteristics of money
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Assets that are easy to convert into cash are called
rear-money
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The concept of velocity of money
Velocity of circulation of money is the rate at which money stock is used to make transactions
for final goods and services
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For example if we suppose that in a given economy the number of transactions (T) = 100 and
the average price (P) is 10/=, then PT = 1000/=
...

Therefore given any three of the components of the identity MV = PT, it is possible to compute
the value of the remaining component
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Balance of payments is a summary statement of the monetary value of the flow of

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economic transaction between citizens of one country and the rest of the world over a given
period of time
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-All capital loans abroad and borrowing from foreign countries
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The BOP curve
BP curve is the balance of payments curve and it shows various combinations of interest rates
and levels of national income that produce equilibrium in the balance of payments at a given
exchange rate
Interest
rate (r)

Surplus
BOP

BP curve

Deficit BOP

Income (Y)
The BP curve is positively sloped because the higher the level of income, the smaller the net
export balance, which can only be offset by a higher interest rate, hence reducing the net
capital outflow
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A change in exchange rates
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A rise in the value of the Kenyan currency makes Kenyan goods more expensive for
foreign buyers and foreign goods less expensive for Kenyan buyers
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- For this to work, the elasticities of demand for exports and imports must according to
Marshall-Lerner, exceed one
...
In the short-run
...
This is what
is referred to as the J-curve phenomenon
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If devaluation succeeds in improving the trade balance, this represents an injection of funds
into the economy, which boost the level of national income
...

Deflationary measures are necessary especially if the element is at full employment to avoid
demand a pull inflation that would otherwise erode the competitive advantage gained by
the country through devaluation
...


2
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This
leads to a reduction in net export balance (X – M), hence BP curve shifts to the left and vice
versa
...
If the economy has a balance of payments deficit, the following measures can be
instituted to correct it
...
Unemployment rate is computed as follows

Number unemployed
 100
Total number of workforce
Types of unemployment
1
...

2
...

3
...

4
...
This land of
unemployment is caused by mobility problems in the labor market, which result in
friction in the labor market
...

5
...
g
...

6
...

7
...
g
...
Under-employment
- It occurs when people are working less than they would like to work
...

9
...
The unemployment of Prematurely Retired
- This occurs when people are retrenched before they attain retirement age
...
Lack of cooperating factors
2
...
Inappropriate technology
4
...
The education system
6
...
Rural urban migration
Policies for curing Unemployment
1
...
Subsidizing wages means lowering wages hence firms will employ
more people
...

3
...

5
...


L*

L’

Labour

If the wages is at W and you subsidize, you are lowering wage rates from W to W’ hence
employing more people
Restructuring the education system to provide more skills so that people become more
productive
...
This raises the benefits from labour
thus causes a shift in the demand for labour
Import substitution
...
This will expand output hence increase labour employment
...

Deflation
Deflation refers to persistent downward movement in the general price level overtime for an
aggregate of goods and services
...

The symptoms of this type of inflation include long queues, black
markets and diversion of scarce resources away from essential producing industries to other
industries
...

(ii) The producer price index (PPI) – measures relative changes in the prices of raw materials,
intermediate and finished goods i
...
at all stages of the productive process rather than at
the stage of the ultimate user
...
Demand-pull Inflation
It arises from a situation in which aggregate demand persistently exceeds aggregate supply at
current prices
...


Price

AS

P’

P
AD(2)
AD(1)
Real GDP
Demand-pull inflation is caused by:
(i)
Increases in the level of demand for goods and services in a situation of near
employment
(ii)
A general shortage of goods and services in times of disaster like floods and earthquake
...
These inflows become a source of inflationary pressure
...

2
...
This price
increases affects the cost of other firms and the consumer’s cost of living
...


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Firms again pass on the cost increase to the consumer in the form of a price increase
...


AS’

Price

AS
P’
P

AD

Real GDP
The following factors cause cost-push inflation:
(i)
Labour unions asking for higher wages without a corresponding increase in
productivity
...

Effects of Inflation
Internal Disadvantages
 Income and wealth are redistributed arbitrarily, for inflation imposes a tax on those who
hold money as opposed to those holding real assets
...
It benefits debtors and
penalizes lenders
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 Investment is discouraged by government anti-inflation policy
...
The
result is discouraged because postponing consumption simply means that goods cost more
if bought later
...
Indeed inflation discourages investment
in long-term projects because possible government anti-inflation policies are difficult to
forecast
...


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

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Inflation generates industrial and social unrest since there is competition for higher
incomes
...
Often
demands exceed the rate of inflation, anticipating future rises or seeking a larger share of
the national cake to improve their members’ real standard of living
...

Additional administrative costs are incurred in offsetting go-slow and work to rule
disruptions, allowing for inflation in negotiating contracts and wage rates, revising price
lists and labels, among others
...


External Effects
Inflation can create serious difficulties for a country that depends on international trade
...

 Imports tend to decline because foreign goods are relatively cheaper compared to Kenyan
goods
...

 An outward movement of capital may take place if price rises continue since foreign traders
and financiers lose confidence in the shilling maintaining its current rate of exchange
...

Remedies of Inflation
Fiscal and Monetary Policies
These are also known as demand management policies
...

The fiscal policy measures include:
 A cut in government spending
 Lowering government borrowing
 An increase in taxation
 Introduction of new taxes
These measures directly reduce aggregate demand
...
The measures include:
 Restricting direct lending to government
 Increasing cash or liquidity ratio requirement on commercial banks and financial
institutions thereby reducing their ability to create credit
...
e
...

Prices and Incomes Policy
This type of action can take a number of forms as summarized below:

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




Government exhortations to firms to avoid unjustified price rises and to unions to avoid
unjustified wage claims
The setting up of a prices and incomes board to examine proposed price increases and to
contribute to collective bargaining between employers and unions
...

The impositions of legislation to regulate or even freeze wages and prices
...
It works by linking economic variables for
example wages, salaries, and interest payments to an index of inflation like the consumer price
index
...

The Philips Curve

Inflation
Rate

Unemployment
Rate
The Philips curve postulates that in general, the rate of inflation fall as unemployment rises and
vice-versa
...
The Philips curve thus validates the Keynesian argument that in
order to achieve full employment some level of inflation is unavoidable
...
International
Trade can be in goods, termed visible or in services; termed invisibles e
...
trade in services
such as tourism, shipping and insurance
...
Some goods cannot be produced by the country at all
...

c
...

e
...
The same would apply to many foodstuffs, where a different climate prevents
their cultivation
...
In many cases, a country
could produce a particular good, but it would be much less efficient at it than another
country
...
This is in line with the principle of
comparative advantage
...
A foreign
good may be more to his or her liking
...

Shortages: At a time of high domestic demand for a particular good, production may not
meet this demand
...


Theory of Comparative Advantage
In his theory put forward in a book published in 1817, David Ricardo argued that what was
needed for two countries to engage in international trade was comparative advantage
...
Using the Labour Theory Value, Ricardo’s contribution was to
show that a sufficient basis for trade was a difference, not in absolute costs
...

Country
I
II

Cost of Producing One Unit
(in man-hours)
A
B
8
9
12
10

We can observe that country I has complete absolute advantage in the production of both
commodities since it can produce them with a lower level of resources
...

Ricardo believed that even then there could still be a basis for trade, so long as country II is
not equally less productive, in all lines of production
...

What is important is the Comparative Advantage
...
(The law of comparative advantage states that a nation should
specialize in producing and exporting those commodities which it can produce at relatively
lower costs, and that it should import those goods in which it is a relatively high cost
producer)
...

The opportunity Cost of good A is the amount of other goods which have to be given up in
order to produce one unit of the good
...
It is thus more
expensive to produce good B then A
...
One unit of B is equal to 9/8 units of A
...

Therefore he felt that: Opportunity cost of producing one unit of:
A
B Country
I
9/8 (1
...
89) A
II
10/12 (0
...
2) A
B is cheaper to produce in country II in terms of resources as opposed to producing it in
country I
...

Consider commodity A valued in terms of B
...

A country has comparative advantage in producing commodity if the opportunity cost of
producing it is lower than in other counties
...
In
country I, they should specialize in the production of A and Import B
...
Unfortunately, world markets and their prices are largely inefficient
showing influences of trade barriers, discrimination and market distortions
...

By pursuing gains from trade in the short run young nations may jeopardize long term
development prospects because:
i) It is important to protect infant industries to acquire new skills, technology and home
markets that are necessary in the early years of industrial development;
ii) Concentrating on short term comparative advantage may lead to internalizing wrong
externalities e
...
promoting use of illiterate peasants and primary sector production;
iii) Long term movements in commodity terms of trade disfavor primary commodities as
their prices rise more slowly than those of industrial manufactures (income elasticity of
demand for primary commodities is lower than for manufactures and as world incomes
rise demand for the latter rises more rapidly affecting their relative world prices)
...
This will be the result of a number of advantages which a
country can derive from international trade, namely:
The vent-for-“surplus” product

20

Many countries have products which are surplus to their own requirements and it is only by
exporting these that they have value at all
...
Without it, the coffee would mainly
be unused and remain unpicked
...
Without trade, the land and the labour used for their production
would be idle
...

Importation of what cannot be produced
A country has to import what it cannot produce
...
There is
thus necessity for international trade in respect of these essential materials
...
For instance, if we take a situation in which each
country in a simple two country model has an absolute advantage in producing either fruits
or beef but is able to produce the other commodity only if required (for simplicity we
assume constant returns to scale and full utilization of resources)
...
Country X has an absolute
advantage in citrus fruit production and Y has an absolute advantage in beef production
...

Specialization according to comparative advantage

21

Even if one country can produce the two goods more efficiently at a lower comparative cost
than the other country, there could be gains to be made from International Trade
...
Suppose that country X is
more efficient in both citrus fruit and beef production
...

Even so, if country Y produces an extra unit of citrus fruit it need give up only half a unit of
beef
...

It is evident from this example that although a country may have
absolute advantage in the production of all products, it is possible for a country such as Y to
produce some products relatively cheaply at lower opportunity cost than its trading partner
X
...

If each country specializes completely in the activity in which it possesses a comparative
advantage, the production totals are:
Units of Citrus fruits
Country X
Country Y
World total

0
40
40

Units of Beef
120
0
120

What is evident from these last calculations is that although the overall production of beef
has increased, the output of citrus fruit has fallen by ten units
...

Competition
Trade stimulates competition
...

Introduction of new ideas
International trade can introduce new ideas into a participating country; it can stimulate
entrepreneurship and generate social change
...


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Reasons for Protection
Cheap Labour
It is often argued that the economy must be protected from imports which are produced with
cheap, or ‘sweated”, labour
...

Infant Industry Argument
Advocates of this maintain that if an industry is just developing, with a good chance of
success once it is established and reaping economies of scale, then is it necessary to protect it
from competition temporarily until it reaches levels of production and cost which allow it to
compete with established industries elsewhere, until it can “stand on its own feet”
...

Structural Unemployment
The decline of the highly localized industry due to international trade causes great problems
of regional (structural) unemployment
...

Dumping
If goods are sold on a foreign market below their cost of production this is referred to as
dumping
...
Countries in which such products are
“dumped” feel justified in protecting themselves
...

Balance of Payments
Perhaps the most immediate reason for bringing in protection is a balance of payment deficit
...
If therefore becomes necessary for it adopt
some form of restriction on imports (e
...
tariffs, quotas, foreign exchange restrictions) or
some means of boosting its exports (e
...
export subsidies)
...

A country may not wish to abandon production of certain key commodities even though the
foreign product is more competitive, because it is then too dependent on imports of that
good
...
It is for this reason that countries
wish to remain largely self-sufficient in food
...
Such over specialization may make sense now, but
in the future, demand may fall and the country will suffer disproportionally
...

Strategic Reasons
For political or strategic reasons, a country may not wish to be dependent upon imports and
so may protect a home industry even if it is inefficient
...
The steel industry, energy industries, shipping, agriculture and others
have used this strategic defense argument
...

The main forms are:
Tariffs
This is a tax on each unit imported
...
Such a tax may be
ad valorem, representing a certain percentage of the import price, or specific that is, an
absolute charge on the physical amount imported as, for example, five shillings a ton
...
This can be done by giving only a limited number of import licenses
and fixing a quota on the total amount which may be brought in during the period
...

Foreign exchange restriction
Exchange controls work much the same way as physical controls
...
It can be severely restricted to whatever the
government decides it wants to see imported
...
This makes all imports dearer and thus gives protection
“across the board” to all domestic production for the home market
...
This could
amount to a substantial advantage, or protection

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