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Title: MONEY AND BANKING
Description: Learning Objectives At the end of the lesson the student should be able to:  Explain why money is considered a dynamic force in modern economies.  State clearly the functions of a central bank and commercial banks.  Explain fully the process of credit creation by commercial banks.  Explain fully the meaning of monetary policy and instruments of monetary policy.  Explain the various theories that explain the demand for money.  Explain the various theories of interest rate determination.

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

 Explain fully the process of credit creation by commercial banks
...

 Explain the various theories that explain the demand for money
...

2
...

Money was needed to overcome the shortcomings and frustrations of the barter
system which is system where goods and services are exchanged for other goods and
services
...

This is called double coincidence of wants and is difficult to fulfill in practice
...

A good deal of time can be wasted sorting out
equations of value
...
For instance if a cow is
worth two sacks of wheat, what is one sack of wheat worth? Once again we
may need to carry over part of the transaction to a later period of time
...
Such confusion precludes a rational allocation of
resources and promotion of economic efficiency
...
If such goods are perishable by nature, then the
system will break down
...
Economic efficiency is achieved by economizing on the use of the
most scarce resources
...


For these reasons the barter system is discarded by societies which develop beyond
autarky to more specialized methods of production
...

Money may be defined as anything generally acceptable in the settlement of debts
...
These could be regarded as
commodity money
...
g
...
But money commodities were not
particularly convenient to use as money
...

As the trade developed between different cultures, many chose precious metal’s
mainly gold or silver as their commodity money
...

The value of the metal was in terms of weight
...
Due to the inconvenience of
weighing each time a transaction was made, this led to the development of coin
money
...
g
...
They were later given a
rough edge so that people could guard against being cheated by an unscrupulous
trade filling the edge down
...
As a result there was deliberately reduced below the
face value of the coinage
...

Debasement represents an early form of fiduciary issue, i
...
issuing of money
dependent on the “faith of the public” and was resorted to because it permitted the
extension of the supply of money beyond the availability of gold and silver
...
The metal could not be withdrawn without
production of the receipt signed by the depositor
...

It was later discovered that as long as the person being paid was convinced the
person paying had gold and the reputation of the goldsmith was sufficient to ensure

acceptability of his promise to pay, it became convenient for the depositor to pass on
the goldsmith’s receipt and the person being paid will withdraw the gold himself
...

But eventually it was discovered that so long as each time a transaction was made
the person being paid was convinced that there was gold, the signed receipt could
change hands more than once
...
This led to the
development of paper money, which had the added advantage of lightness
...
However, the goldsmiths or early bankers discovered that not all
the gold they held was claimed at the same time and that more gold kept on coming
in (gold later became the only accepted form of money)
...
This became lucrative
business, so much so that in the 18th and 19th centuries there was a bank crisis in
England when the banks failed to honour their obligations to their depositors, i
...

there were more demands than there was gold to meet them
...
Initially
each bank was allowed to issue its own currency and to issue more currency than it
had gold to back it
...

Eventually, the role of issuing currency was completely taken over by the Central
Bank for effective control
...
e
...
However, since money is essentially needed for purchase of goods
and services, present day money is not backed by gold, but it is based on the level of
production, the higher the output, the higher is the money supply
...
e
...

Over time, therefore, it became clear that for an item to act as money it must possess
the following characteristics
...
This
was true of metallic money in the past because it was in high and stable demand
for its ornamental value
...


 Portability If an item is to be used as money, it must be easily portable, so that it
is a convenient means of exchange
...
For an item to be acceptable as
money, it must be scarce
...






Durability Money has to pass through many different hands during its working
life
...
Any asset which is to be used as money must be durable
...

Homogeneity It is desirable that money should be as uniform as possible
...
Medium of exchange: Money facilitates the exchange of goods and services in
the economy
...
Use of
money as an intermediary in transactions therefore, removes the requirement for
double coincidence of wants between transactions
...
The use of money enables a person
who receives payment for services in money to obtain an exchange for it, the
assortment of goods and services from the particular amount of expenditure
which will give maximum satisfaction
...


Unit of account: Money is a means by which the prices of goods and services
are quoted and accounts kept
...
It facilitates
the evaluation of performance and forward planning
...
g
...


c
...
Money is the most convenient way of keeping
any form of property which is surplus to immediate use; thus in particular,
money is a store of value of which all assets/property can be converted
...
Less durable or otherwise perishable
goods tend to depreciate considerably over time, and owners of such goods
avoid loss by converting them into money
...


Standard of deferred payment: Many transactions involve future payment, e
...

hire purchase, mortgages, long term construction works and bank credit
facilities
...
Borrowers never
want money for its own sake, but only for the command it gives over real
resources
...
It’s about making commerce and industry more
viable
...


The Determination of the Value Money
Since money is primarily a medium of exchange, the value of money means what
money will buy
...
Since money itself
is used as unit of account and a means of measuring the “value” of other things, its
own value can be seen only through the prices of other things
...

2
...
In its crudest form is stated that an increase in the
quantity of money would bring about an appropriate rise in prices
...
Algebraically, this could be
stated as:
P=aM
Where a is constant, P the price level, and M the supply of money
...

After being long discarded, the theory was revived in the 1920s by Professor Irving
Fisher, who took into account the volume of transactions, that is to say, the amount
of “work” that the money supply had to do as a medium of exchange
...
Money circulated from hand to hand
...

As modified by Irving Fisher, the quantity theory came to be expressed by the
equation
of exchange
...

The symbol V represents the velocity of circulation, i
...
the number of times during
the period each unit of money passes from hand to hand in order to affect a
transaction
...

MV therefore represents the amount of money used in a period
...
The symbol T is the total of all transactions that have taken
place for money during the year
...

ii
...


Thus prices may rise without any change taking place in the quantity of money if a
rise occurred in the velocity of circulation
...

Even in its revised form, however, the Quantity Theory has been subjected to the
following criticisms:
a
...
it shows
that only the total quantity of money, as determined by the actual amount of
money in existence the velocity of circulation, is equal to the value of total trade
transactions multiplied by their average price
...
Not only must MV be equal to PT, but MV is PT, since they are
only two different ways of looking at the same thing
...


Even if the equation of exchange is only a truism, it would not be quite
correct to say that it demonstrates nothing
...
It informs us, too, that if there is to be a change in one or more
of the variables of the equation, there must be a change in one or more of the
other variables
...


c
...
For example, a change in M is likely of itself to
bring a change in V or T or both
...


d
...

Price changes do not keep in step with one another
...
A study
of price changes shows that some prices increased by many times while others
by fewer times
...


e
...


f
...


2
...
Demand for money The demand for money is a more difficult concept than the
demand for goods and services
...

Holding money therefore involves a loss of the interest it might otherwise have
earned
...

The demand for money and saving The demand for money and saving are quite
different things
...
It adds to a
person’s wealth
...
The motives for liquidity preference explain why there is desire to
hold some wealth in the form of cash rather than in goods affording utility or in
securities
...
The supply of money Refers to the total amount of money in the economy
...

Narrow money supply consists of all the
purchasing power that is immediately available for spending
...
The first, M 0 (or monetary base), consists of
notes and coins in circulation and the commercial banks’ deposits of cash with the
central banks
...
Also in the
M 2 definition are the other interest-bearing retail deposits of building societies
...

Since all this money is readily available for spending it is sometimes referred to as
the “transaction balance”
...

The broad measure of the money supply includes most of bank deposits (both sight
and time), most building society deposits and some money-market deposits such as
CDs (certificates of deposit)
...


Determinants of the money supply Two extreme situations are imaginable
...
In such a case, economists say that the money supply is
exogenous and speak of an exogenous money supply
...
In such a case
economists would say that there was an Endogenous money supply, which means
that the size of the money supply is not imposed from outside by the decisions of the
Central Bank, but is determined by what is happening within the economy
...

Measurement of changes in the value of money
Goods and services are valued in terms of money
...
When prices go up, the amount which can be bought with a given sum of
money goes down; when prices fall, the value of money rises; and when prices rise,
the value of money falls
...

The usual method adapted to measure changes in the value of money is by means of
an index number of prices i
...
a statistical device used to express price changes as
percentage of prices in a base year or at a base date
...

If the prices of these commodities rise by 1 per cent during the ensuing twelve
months the index number next year will be 101
...

Problems of Index Numbers
The construction of Index Numbers presents some very serious problems and, as
they cannot be ideally solved, the index numbers by themselves are limited in their
value and reliability as a measurement of changes in the level of prices
...
This is the problem of weighting
...
Assume
that there are only three commodities, A, B, C and the prices of which are
Kshs
...
20/= and Kshs
...
By taking one unit of each that
is, without any weighting – the index number for the base year constructed as
follows:-

Base Year
Commodity
A
B
C

Price
50
20
10

Weight
Index
Kshs
...
45/=, B Kshs
...

15/=
...

45
25
15

1
1
1
3

90
125
150
365

index for all items = 121
...
6, showing an increase in price of 21
...
If the commodities A, B, C are all differently weighted
a different result will be obtained
...

1
4
20
25

Index
100
400
2,000
2,500

Index for all items = 100
Second Year
Commodity
A
B
C

Price
Kshs
...
6 per cent, although
individual prices show only the same change as before
...

b) The next problem is to decide what grades and quantities to take into account
...
An even greater difficulty occurs when the prices of a commodity
remain unchanged, although the quantity has declined
...
This would preferably be a year when prices are
reasonably steady, and so years during periods either of severe inflation or
deflation are to be avoided
...

Changes in taste or fashion reduce the demand for some commodities and
increase the demand for others
...

Changes may occur in the distribution of the population among the various
age groups
...


e) Changes in the taxation of goods and services affect the index
...
4 The Banking System
Consists of all those institutions which determine the supply of money
...
The second
main element of Banking System is the Central Bank and finally most Banking
Systems also have a variety of other specialized institutions often called Financial
Intermediaries
...


Government’s banker: Government’s need to hold their funds in an account
into which they can make deposits and against which they can draw cheques
...
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 on A for B and on B for A
...
If the two people

do not bank with the same bank, such cheques end up in the central bank
...
But if there is an outstanding balance,
say in favour of A, then A’s deposit with the central bank will go up, and B’s
deposit will go down
...

iii
...
This is a function it took over from the
commercial banks for effective control and to ensure maintenance of confidence
in the banking system
...
Lender of last resort: Commercial banks often have sudden needs for cash and
one way of getting it is to borrow from the central bank
...
To discourage banks from overlending, the central bank will normally lend to the commercial banks at a high
rate of interest which the commercial bank passes on to the borrowers at an
even higher rate
...

v
...


vi
...

Vii Operating monetary policy: Monetary policy is the regulation of the economy
through the control of the quantity of money available and through the price of
money i
...
the rate of interest borrowers will have to pay
...
Conversely, restricting
the quantity of money and raising the rate of interest should have a restraining,
or deflationary effect upon the economy
...
It
can sell some of these, or buy more, on the open market, buying or selling
through a stock exchange or money market
...
This means a cash drain for these banks
to the central bank, represented by a fall in the item “bankers” deposits’ at the
central bank, which forms part of the commercial banks’ reserve assets
...

By going into the market as a buyer of securities, the central bank can reverse
the process, increasing the liquidity of commercial banks, causing them to
expand bank credit, always assuming a ready supply of credit-worthy
borrowers
...
It would pay sellers by cheques drawn on itself, the sellers would
then deposit these with commercial banks, who would deposit them again with
the central bank
...

b) Discount Rate (Bank Rate) This is the rate on central bank advances and is also
called official discount rate or “minimum lending rate”
...
The
Central Bank can make cash available on a short-term basis in either of two
ways; by lending cash directly, charging a rate of interest which is referred to as
the official “discount rate”, or by buying approved short-term securities from
the commercial banks
...
It can do the former by charging a very high “penal” rate of interest, well
above other short-term rates ruling in the money market
...
The effective rate
of interest charged when central bank buys securities (supplying cash) is in fact
a re-discount rate, since the bank is buying securities which are already on the
market but at a discount
...
Other interest rates such as those charged by building
societies on house mortgages are then also likely to be pulled up
...
The cash ratio is:
Cash Reserves
Deposits
The Central Bank might require the commercial banks to maintain a certain
ratio, say 1/10
...
The liquidity ratio can be rewritten as:

Cash + Reserves Assets = Cash
Deposits
Deposits

+

Reserves Assets
Deposits

= Cash Ratio + Reserve Assets Ratio
If the liquidity ratio is 12
...
5 x Reserve Assets
...
e
...
This
level shall be varied by the Central Bank depending on whether they want to
increase money supply or decrease it
...
The effects are immediate
...
However, increased liquidity requirements may still be offset in part if the
banks have access to credit from their parent companies
...
Ratio of the banks may simply leave them with
surplus liquidity and not cause them to expand credit
...

The
commercial banks are asked to maintain additional deposits in their accounts at
the central bank, deposits which cease to count among their reserve assets as
cover for their liabilities
...
Its effectiveness depends on the cooperation
of
the
commercial
banks
...
For instance, the central
bank can dictate a ceiling value to the amount of deposits the bank can create
...
It can also encourage banks to lend more to a certain sector of the
economy (e
...
agriculture) than in another (estate building)
...


B
...
e
...
They are
sometimes known as Joint Stock Banks
...

They provide a safe deposit for money and other valuables
...
They lend money to borrowers partly because they charge interest on the loans,
which is a source of income for them, and partly because they usually lend to
commercial enterprises and help in bringing about development
...
They provide safe and non-inflationary means for debt settlements through the
use of cheques, in that no cash is actually handled
...

iv
...

v
...


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
...
g
...
This is useful in that it guards against loss and theft for if the cheques are
lost or stolen; the lost or stolen numbers can be cancelled, which cannot easily be
done with cash
...

Bank Deposit
Bank notes and coins together constitute the currency in circulation
...
The larger part of the money supply in
circulation today consists of bank deposits
...
These are created by commercial banks and the process
is called credit creation
...
Because the bank does not
need to keep 100 per cent reserves, it can use some of the money deposited to
purchase income-yielding investments
...
A Single Monopoly Bank
Consider first a country with only one bank (with as many physical branches as is
necessary) and assume that the bank has found from experience that it needs only to
hold 10% of cash s a proportion of total deposits – proportion of transactions that
customers prefer to settle by means of cash, rather than cheque
...
Assets consist of cash held by the
bank, plus loans, which represents the obligations of borrowers towards the bank
...

Suppose now a customer deposits (liabilities) in this initial position will be:
120
1,020

x

100 = 11
...
The bank can therefore safely make additional interest-bearing loans
...
The final
position is as shown below, and indicates that bank deposits have been created to the
extent of ten times the new cash deposit
...
Borrowers will make out cheques to other people in
payment for goods and services supplied
...
There will follow no more than a book
transaction within one bank, the bank deposits being transferred from one customer
to another
...

Comparing the initial position in the first table with the final position in the table
below, we can see that the increase in bank deposits, which we can call ΔD is 200
and the increase in cash held by the banks, which we can write as ΔC, is 20
...

Thus ΔD = ΔC
r
Restoration of conventional cash ratio by creation of additional bank deposits
Liabilities
Deposits
Total

£1,000

Assets

1,200
1,200

£1,000
Cash

Loans
Total

120
1,080
1,200

ii
...

What is usually found is where the bank receiving the new deposit is one of several
independent banks
...
It will know that
the borrowers will use the credit granted to them to pay for goods and services, or to
repay debts; and that therefore they will be making cheques out to other individuals
who by now have accounts in other banks
...
Either the borrowers will withdraw cash directly, with which to pay
individuals who then deposit this cash with other banks, or if they pay by cheque
these cheques will be deposited with other banks, and the other banks themselves
will present them for cash at the first bank
...

It will create only a relatively small amount of extra deposits, just sufficient to
restore its cash ratio
...
That will restore its cash ratio as shown below
...
0
--

Second position
11
...
0
--

However, the £18,000 lost in cash through cheques drawn by borrowers will be
received by other banks who in turn will find themselves with excess cash reserves,
and in turn create additional loans
...
This new drain of cash will
generate more deposits, and so on, each new round being nine-tenths of the value of
the previous one as follows (£’000s)
...
20 + 14
...
12 + …
which can be written as
{1 + 9/10 + (9/10) 3 + (9/10) 4 +……
...
Mathematically, the series will eventually add up to converge
to 200
...

In an example z = 9/10, which is between 0 and 1, so on the formula applies
...
} = {

1
} = 200
1 – 9/10

if we use ΔD to refer to the final increase or increment in bank deposits, ΔC too the
initial increase in cash received, and “r” to the cash ratio, then ΔD = 200, ΔC = 20,
r = 1/10
...
}
ΔD =

ΔC
= ΔC
1 – (1 – r)
r

Given the increase in cash received, the additional deposits created will depend on
the fraction of cash retained as backing
...


Limits on the process of bank deposit creation
On the demand side, there may be a lack of demand for loans, or at least of
borrowers who are sufficiently credit worthy
...

2
...
The money market is not
located in a place – it is rather a network of brokers, buyers and sellers
...

Function of Money Markets
The money markets are the place where money is “wholesaled”
...

It is also used by the central bank to make its monetary policy effective
...
6 Capital Markets
Markets in which financial resources (money, bonds, and stocks) are traded i
...
the
provision of longer term finance – anything from bank loans to investment in
permanent capital in the form of the purchase of shares
...
It can also be defined as the institution through which, together with
financial intermediaries, savings in the economy are transferred to investor
...
The payment of interest to the providers of
loanable funds may be justified on the following grounds:


The lender postpones present consumption and enjoyment and interest is paid as
persuasion for him/her to make this sacrifice
...




There is loss of purchasing power due to increases in prices over time, and
interest is paid as compensation for this loss
...


2
...
There are many rates of interest
depending on the degree or risk involved, the term of the loan, and the costs of
administration, namely, real, nominal and pure rate of interest
...
All rates of interest are related to
each other and if one rate changes so will others
...

a
...
e
...


Interest
Rate %

S
SSss

S
Loanable Funds

Figure 2
...
The demand comes from firms wishing to invest
...

Thus, the demand curve for funds will slope downwards from left to right
...
If people are to save they will
require a reward-interest – to compensate them for forgoing present consumption
...
If the interest
rate is low, people will be discouraged from saving and lending
...


Interest
Rate %

S

S
Loanable Funds

Figure 2
...

Geometrically this corresponds to the point of
intersection between the supply curve and the demand curve for loanable funds
...
3Interest Rates Vs Loanable Funds

Loanable Funds

I is the equilibrium market rate of interest and L the equilibrium level of loanable
funds
...
Below i there is excess of demand over supply and interest rates
will be forced upwards
...

Although this theory has a certain amount of validity, it has been criticized on the
following grounds:
i
...

This is not true because money can be borrowed for the purchase of consumer
goods (e
...
cars or houses)

ii
...

This is not the case, for business expectations play more important role in the
decision to invest
...


iii
...
This
is not true for people can save for purposes other than earning interest, e
...
as
precaution against expected future events like illness or in order to meet a
certain target (this is called target savings) or simply out of habit
...


The Keynesian Theory
Also called the Monetary Theory of Interest, was put forward by the Lord John
Maynard Keynes in 1936
...
He thus
viewed money as a liquid asset, interest being the payment for the loss of that
liquidity
...

Thus Keynes contended that an individual’s aggregate demand for money in any
given period will be the result of a single decision that would be a composite of
those three motives
...
Transactions demand for money
Keynes argued that holding money is a cost and the cost is equal to the interest rate
foregone
...
But money’s most important function is as medium of exchange
...
People therefore hold money
because income and expenditure do not perfectly synchronize in time
...

The amount of money that consumers need for transactions will depend on their
spending habits, time interval after which income is received and Income
...
Keynes thus concluded that transactions demand for
money
is
Interest
Inelastic
...
Precautionary Demand for Money
Individuals and businessmen require money for unseen contingencies, Keynes
hypothesized that individuals’ demand and institutional factors in society to be
considered in the short run
...

The demand for active balances is
independent of the rate of interest
...

Interest
Rate %

Liquidity
Reference

c
...
This looks at money as a store
of value i
...
money is held as an asset in preference to an income yielding asset such
s government bond
...


According to Keynes, securities can be bought and sold on the free market before
the government redeems them, and the price at which they are sold does not have to
be equal to their face value
...
He defined the market rate of interest as
Market rate of
Interest

=

fixed government rate of interest on securities
Market price of securities

It follows therefore, that when the market price of securities is high the market
interest rate will be low
...
Hence the demand for money is high
when the interest rate is low
...
Also if the market price of securities
is low, it can be expected to rise
...
In buying securities, people part with money
...
It follows, therefore,
that the demand curve for money for the speculative motive slopes downwards as
shown on the next page
...
4 Interest Rates and Liquidity Preference
It flattens out at the lower end because there must be a minimum rate of interest
payable to the people to persuade them to part with money
...

The total demand for money at any given interest rte is the sum of the demands for
the active balances and the speculative motive
...


Interest
Rate %

Interest
Rate %

Interest
Rate %

La
L

L1

Active
Balance
i1

i1

i2

Total

speculativ
e i1
Motive
i2

i2

Demand

1
i3

i3 2
Liquidity
Preference

i3 4

3

5

L i 1 L31
Liquidity
Preference

Liquidity
Preference

1+2=4
Figure 2
...
At interest rate i 1 , the demand for speculative motive is Li 1
...
This gives rise to
the total demand curve LL
...
6 Interest rates and liquidity preference
At any given time, the supply of the money is fixed, as determined by the monetary
authorities
...


The equilibrium rate of interest is determined by the interaction of demand and
supply forces, and this corresponds to the point of intersection between the demand
curve and the supply curve
...
7 Interest rates and liquidity preference
i is the equilibrium rate of interest
...
Below it there will be excess demand
over supply and interest rates will be forced upwards
...
An increase in supply is indicated by a shift to the right of the
supply curve
...
8 Interest rates and liquidity
When supply increases from M1 to M2, interest rates fall from i1 to i2
...
Thus when supply falls from M2 to M1, interest rate will rise from i2 to
i1
...


Interest
Rate %

L
M1 M2

i1

i2
L
Liquidity
Figure 2
...
This
is because at the initial rate of interest the increase in demand creates excess of
demand over supply which causes interest rates to rise
...
Thus, when demand falls from L2 to L1, interest rate falls form i1 to i2
...
8 The IS – LM Model
IS – LM analysis aims to find the level of income and rate of interest at which both
the commodity market and money market will be in equilibrium
...

The IS curve is shown in the diagram below:

Interest
Rate
(i)

IS curve

0
Figure2
...


The LM curve is a locus of points representing all the different combinations of
interest rates and income levels consistent with equilibrium in the money market
...


Interest
rate
(i)

LM curve

0
Figure2
...

IS – LM analysis aims at obtaining simultaneous equilibrium in both the commodity
and the money markets
...
11 Equilibrium in both the commodity and money markets
...

The commodity market for a simple two – sector economy is in equilibrium when
Y = C + I
...
The demand for money is in
turn made up of the transaction – precautionary demand (M DT ) and speculative
demand
for
money
(M DS
)
...

Assume that:
C = 178 + 0
...
2 Y
M DS = 480 – 500i
Commodity market equilibrium (IS) exists where;
Y=C+I
= 178 + 0
...
6Y = 418 – 300 i
0
...
2y + 480 – 500 i
0
...
4Y + 300 i – 418 = 0 …………… (i)
0
...

2 Y+ 1500 i – 2,090 = 0
0
...
6Y
_= 2,300
Y =2,300
= 885

substitute Y = 885 into (i) or (ii)

61

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Title: MONEY AND BANKING
Description: Learning Objectives At the end of the lesson the student should be able to:  Explain why money is considered a dynamic force in modern economies.  State clearly the functions of a central bank and commercial banks.  Explain fully the process of credit creation by commercial banks.  Explain fully the meaning of monetary policy and instruments of monetary policy.  Explain the various theories that explain the demand for money.  Explain the various theories of interest rate determination.