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Economic Chapter 8: Monetary and financial systems 

Economic Chapter 8: Monetary and financial systems 

Bbosa Science02/10/2023 13:30 0

Money

Money is anything which is legally acceptable   for carrying   out transactions   and discharge   of debts. To settle legal payments, money must be legal tender meaning   that it must be acceptable   by everyone in the country in the settlement   and discharge of debts.

Functions   of money

  1. Money is a unit of account. This means   that  it  is  used   as  a  unit  of  value   for  carrying   out calculations   and accounting   procedures   so as to effect  business   transactions.
  2. Money is a medium of exchange. Money makes it possible to determine   the value and quantity of commodities   to be exchanged   hence facilitating business   transactions.
  3. Money is a standard measure of value. Through the use of money, the relative values or prices of commodities can be determined.     Money therefore   reflects   the quantity   and quality   of goods sold and bought in the market.
  4. Money is  a  standard  measure   of  deferred payments    (future  payments).Money    facilitates payments   of  debts  and  transactions    to  some  future  time.    This makes   it possible   to carry out transactions   without immediate   cash payments.
  5. Money is a store of value or wealth. When properties like land or buildings are converted   into monetary   terms, the money   can be stored.    This is because   money   is not bulky and it is not perishable.
  6. Money helps in the planning process and budgeting. This is because the estimation of costs and benefits of projects  is done  in monetary   terms.
  7. Money serves as a tool which the government uses in monetary policy. This is because monetary policy  involves  the  adjustment   of  volume  and  value  of  money   in circulation   in  order  to bring about  general  economic  stability.
  8. Money facilitates one way payments. This helps to simplify the misunderstandings between   the parties concerned e.g. taxes are paid in monetary terms.
  9. Money makes it possible for price mechanism   to operate since   prices   are   determined    in monetary terms.

Qualities   (characteristics/features)   of money

  1. Relative scarcity. Money must be relatively   scarce.    This is because,   if it is in plenty   it loses value and fails to perform the useful role of exchange.
  2. Acceptability. Money must be generally acceptable by the public for the discharge   of debts and other purposes for which money is needed. The general acceptability   is based on the confidence of the population and the concept of legal tender.
  3. Durability. Money should be able to last longer and it should not be easily damaged or destroyed during the process of exchange.
  4. Homogeneity (Uniformity). The identical   coins  and  bank  notes  must  look  the  same  and  must have  the  same  purchasing   power   i.e.  a 5,000/=  note  should  be  similar  to  all  the  other   5,000/= notes  used in the country.
  5. Portability (Convenience). Money should neither be too heavy nor too bulky to carry.   It must not be heavy relative to its value.
  6. Divisibility. Money should  be easy  to divide  into  smaller  denominations    without   losing  value  in order  to make  it possible   for smaller  transactions.
  7. Stability in value. Money should have a stable value over a long period of time.
  8. Hard to forge. Money should be difficult to forge or copy by other individuals. This reduces its supply and the loss of value,
  9. Identifiable. Money should be easy to recognize and distinguish   from fake or forged money.
  10. 10. Economy. Money should be convenient   and cheap for the government   to print.    The printing costs should not exceed the value of money printed.

Barter trade

This is the exchange   of commodities   for commodities   between   individuals   or countries.   For  barter trade  to take place,  it is necessary   to have  double  coincidence   of wants,  that  is, seeking  for one  who has the commodity   you want  and who wants  the commodity   you have.

Limitations   (Problems/Defects)   of Barter trade

  1. It is not easy to establish the double coincidence of wants which satisfy  both  parties,  that  is, it is difficult   to  find   one  party   who   exactly   has   the   commodity    you  want   and  who   wants   the commodity   you have.
  2. It restricts the number of transactions that could take place in the economy. This limits trade in the economy.
  3. It is difficult to measure the relative value of one commodity in terms of another   commodity under barter trade.
  4. It is difficult to store commodities for future exchange especially   when the commodities    are highly perishable   for example tomatoes.
  5. There is lack of divisibility of some commodities   during the exchange process e.g. a person who has a goat and wants maize faces this problem.
  6. Most of the commodities appear in plenty and therefore, they can easily lose value.
  7. It does not promote specialization and efficient allocation of resources.    This is because   there is no common medium of exchange acceptable to both consumers   and producers.
  8. Some commodities are bulky and therefore, it becomes difficult to transport them from one place to another for exchange purposes.

Definitions of concepts

  1. Token money. This is money whose metal value is less than the face value. For example,   coins, paper money etc.
  2. Intrinsic money. This is money whose metal value is equal to its face value.  That is, it is money in terms of metal value.  For example gold money
  3. Commodity money. This is money in terms of the value of commodities.     For example   beads, tobacco, cowry shells etc.
  4. Flat money. This is money issued on the directive of the government   irrespective   of the level of economic activity.
  5. Fiduciary issue. This  is the money  issued  by the central  bank  which  is not  fully backed  by gold reserves  (foreign  exchange  reserves)  but by government   securities.
  6. Hot money. This is money in liquid or cash form.
  7. Quasi (Near) money. This is money which   can easily be converted   into cash.  For example cheques, postal orders etc.
  8. Dear money. This is money borrowed at very high interest rates.
  9. Narrow money. This is currency   circulating   in the economy   plus demand   deposits   (demand deposits is money deposited   on current accounts).
  10. Broad money. This is the sum of currency in circulation,   demand   deposits,   savings   and time deposits.
  11. Nominal value of money. This refers to the monetary   (face) value of money.   For example 2,000/=.
  12. Real money value (Value of money). This refers to the amount of commodities a unit of money can purchase.    This depends on the general price level.   The higher the price level, the lower the value of money.

Real money value =Nominal money value/price index

  1. Foreign exchange reserves. This is foreign currency held by the country’s central bank.
  2. Convertible (Hard) currency. This is currency which can be exchanged   for other currencies   and it is internationally   accepted in carrying out transactions.   For example pounds, US dollars     etc.

I5. Soft (Managed) currency. This is currency  which is  used  only within  the  country  and  cannot  be accepted in carrying  out international transactions.   For example Ugandan shilling

 

Money   supply

This refers to the amount of money circulating in the economy at a given time.

Types of Money supply

  • Endogenous (Automatic) Money Supply. This is money supply which is determined   by the level of economic activity.  For example level of output, interest rates, etc.
  • Exogenous (Discretionary) Money Supply. This  is Money  supply  which   is determined    by  the monetary   authority   (Central  Bank  or Ministry   of finance)  and  it does  not  depend   on the level  of economic  activity.

Determinants of money supply

  1. Amount of money printed by the Central Bank (government). If the  central  bank  prints   more money,   money   supply   increases,   but  if  the  central   bank  does  not  print   money,   money   supply remains  constant  or decreases.
  2. Balance of payment surplus or deficit. When export earnings exceed import expenditure, money supply increases   as a result of excess foreign   exchange   earnings.    But when import   expenditure exceeds export earnings, money supply reduces in the economy.
  3. Level of credit creation by the commercial banks. The more the credit created   by commercial banks,   the more the money   supply.     This leads   to an increase   in money   supply   through   the multiplier process and vice versa.
  4. Level of foreign capital inflow or outflow. Net capital inflow increases   money   supply   but net foreign capital outflow decreases money supply in the economy.
  5. Level of economic activity. An increase in the level  of economic  activity  increases   money  supply and a decrease  in the level  of economic  activity  reduce  money  supply.
  6. Activities of open market operations. This involves which is buying and selling of government securities.   When the central bank buys government   securities (Bonds and treasury bills) from the public,   money   supply   increases.      But when   it sells   securities   to the public,   money    supply decreases.
  7. The level of monetization of the economy. The greater the subsistence    sector,   the lower   the money supply.   As the economy becomes highly monetized,   the need for money increases   hence increased money supply.
  8. The amount of gold reserves held by the central bank. The higher the gold reserves, the higher the money supply and the lower the gold reserves,   the lower the money supply.
  9. Manipulation of the Bank  rate (that  is,  the  rate  at which  commercial   banks   borrow   from  the central  bank)  when  the central  Bank. increases  the Bank rate, money  supply  reduces  and when  the bank  rate is reduced,  money  supply  increases
  10. The level of legal reserve requirements (that is, the   amount   of bank   deposits    which   the commercial banks    have    to   deposit    with   the   central    bank).The     higher    the   legal   reserve requirement,   the lower the money supply and vice versa

Demand   for money (liquidity preference)

Money  demand  (liquidity preference)  refers  to the  desire  by  individuals   to  hold  wealth   in cash  or near cash form.

Factors that influence the level of liquidity preference

  1. The income levels of individuals
  2. The degree of economic uncertainty
  3. The general price levels of goods and services (level of inflation)
  4. The level of monetization of the economy
  5. The level of development of financial    institutions
  6. The level of interest rate offered on deposits
  7. The degree of political stability
  8. The nature of time preference.   That is whether positive or negative time preference

Theories of money demand

(a)  Keynesian   theory of money demand

(b)  The Classical quantity theory of money demand

(a) The Keynesian theory of Money Demand

According   to Lord John Maynard   Keynes,   individuals   demand   for money   for three major reasons

(motives).  These include;

  • Transaction motive. Here,   individuals    demand   for money   in order   to meet   their day to day purchases   of commodities    (transactions).    The level of transactions    depends   on the individual’s income and the prices of commodities.
  • Precautionary motive. Individuals     demand    for   money    in   order   to   meet    the   unforeseen circumstance expenditures    for example   expenditure   on sickness,   car break down   etc.  This also depends on the individual’s    income.
  • Speculative motive. Individuals    demand   for money   for earning   income   through   buying   and selling government   securities.     This  depends   on  the  interest  rates  on  the  government    securities (treasury  bills  and  bonds).   When the interest rate on bonds falls, the speculators   prefer holding cash and when  interest  rates  on bonds  increases,  the speculators  prefer  holding  bonds  to cash.

From   the   graph,   when   interest    rate   is expected     to    fall     from      0r2    to 0r1, speculators    convert   bonds   to cash   and therefore   demand   more   money    m1m2    to avoid   losses.   When   the   interest   rate   is expected to   increase from    0r1 to   0r2, speculators    buy   more   bonds   and hence demand less money 0m1.

  • Liquidity trap. This refers   to  the  point  below  which  the  interest   rate  is  too  low  to  encourage speculators   to invest  in bonds  and  as a result,  they  only  hold  money.   OR. It is the point below which the interest rate is too low to break the liquidity preference.

(b) The Classical Quantity theory of Money Demand

The  classical  quantity   theory  of money   demand   states  that,  keeping  the level of transactions  and velocity of money constant, the general price level of goods and services is determined by  the stock of  money  circulating  in  the  economy.

This theory   is illustrated    by Irving   fisher’s   equation of exchange which states that MV = PT

where;

M is the stock of money (money in circulation)

V is the velocity of money (that is, the number of times money changes hands)

P is the general price level

T is the level of transactions

From   the   equation   above,   assuming V and T constant,    the   stock   of money   (M)  is directly proportional to the general   price   level.   That  is  an  increase   money   supply   keeping   the  level   of transactions   and velocity  of money  constant  increases  the general  price  level of goods  and services  in the economy.  That is

The theory is based on the following assumptions;

  1. Price is only affected by changes in money supply
  2. There is full employment of resources in the economy
  3. All money earned is spent on the consumption of goods and services
  4. Money is only demanded for transaction motive.
  5. Absence of barter trade
  6. The volume of transactions is constant
  7. The velocity of money in circulation is constant

Example 1

Given that in the economy, M = shs.300,000, V = 50, T = 300.  Calculate   the general price level.

Solution

MV=PT

Criticisms (Limitations) of the classical Quantity theory of money demand

The quantity theory of money is criticized on the following grounds;

  1. The theory only  emphasizes  the  transaction  motive  of  holding   money  and  it  ignores   the precautionary   and speculative  motives  of money  demand.
  2. It is just a truism and not a theory. It merely shows that the four variables M, V, P and T are related.
  3. The theory   ignores   commodities    that   are transacted through barter trade as a system   of exchange.
  4. The theory only explains the changes in the value of money but not how the value of money is determined.
  5. The assumption that the velocity of money (V) and the level of transactions (T) are constant is unrealistic. This is because they are affected by the expenditure   behavior   and hoarding   habits of individuals.
  6. It assumes a general price level which is unrealistic. This is because there may be a series of price levels of commodities in the economy.
  7. The four variables M, V, P and T are not independent of one another as the theory   assumes. This is because a change in one induces a change in other variables.
  8. If the country  has  many  unemployed  resources,  the  increase   in  money   supply   leads   to  an increase  in output  of goods and services  which  makes  the price  to fall or not to change  at all.
  9. An increase in money supply may result into higher savings if the marginal propensity to save is high. This reduces the velocity of circulation   and prices may fall.
  10. The theory ignores haggling as a method of price discrimination in the market. That is haggling between buyers and a seller to reach an agreeable price is not taken into account.
  11. It does not take into account other causes of price increases (inflation) like cost push, break down of infrastructure etc.
  12. It ignores influence of interest rate. The theory cannot be complete without mentioning interest as the major determinant   of money demand in the economy.
  13. The theory ignores government   control  of prices  in  the  market   as  a  way  of  ensuring   price stability.
  14. The theory does not take into account the demand for money. It only looks at money supply.

Interest rate

Interest is the reward for use of capital in the production process.

Interest rate refers to the price at which money is lent out or borrowed.

Why interest is paid or charged

  1. Reward for savings that is, interest is paid to reward those who postpone their consumption    to the future.
  2. It is paid to reverse the positive time preference of individuals that is, it is paid to encourage individuals   to save.
  3. It is charged for management that is, it is paid to meet the expenses of the lending institution. For example files, stationery, manpower   etc.
  4. It is paid for use of loanable funds.
  5. It is a charge for inconvenience to cover the opportunity cost of lending.
  6. It is a charge for risk taking for example parting with cash involves the risk of losing it.

Determinants of interest rate

  1. The level of demand for loanable funds (that is, funds available   in financial   institutions    for lending). The higher the demand, the higher the interest rate and the lower the demand, the lower the interest rate.
  2. The level of liquidity preference. The  higher  the  liquidity  preference   by  individuals,   the higher the interest  rate and the lower  the liquidity  preference,   the lower  the interest  rate.
  3. The period taken to repay the loan. The longer the period, the higher  the  interest  rate  and  the shorter  the period,  the lower  the interest  rate.
  4. The level of money supply. Increased money  supply  reduces  interest  rates  and decrease  in money supply  increases  interest  rates.
  5. The level of inflation in the country. The higher the level of inflation, the higher the interest rate and the lower the inflation rate, the lower the interest rate.
  6. Amount of money borrowed. The  higher  the  amount,  the higher  the  interest  rate  arid  the  lower the amount,  the lower the interest  rate.
  7. Risks involved in lending. High risks   increase   the interest   rate while   low risks   reduce   the interest rate.
  8. The nature of time preference. Time preference   refers to the extent to which individuals    prefer consumption   in the present than in future.   Positive   time preference   (that  is, when  the  individual prefers   consumption  today   than   in   future),   increases    the  interest   rate   while   negative    time preference   (that  is,  when  the  individual   prefers   consumption   in future  than  today)   reduces   the interest  rate.

Revision questions

Section  A questions

1    (a)  What  is meant  by liquidity  preference

(b)  Mention three factors which determine   liquidity preference   in an economy

2    (a)  Define  the term  Barter  trade.

(b) Give four limitations   of Barter system of exchange.

3    (a)   What is meant by the term “Legal tender”

(b) Mention   three circumstances   under which an increase   in money supply may not necessarily lead to inflation in an economy?

4    (a)    Define the term interest rate

(b)    Mention three determinants   of interest rate in your country

5    (a) What is meant by the Liquidity trap

(b)  Explain the relationship   between interest rate and money demand

6    (a) what is meant by instruments   of credit?

(b) Mention three instruments   of credit in an economy

7    (a)  What  is meant  by the term “money   supply”?

(b)  Give three factors that influence money supply in your country.

8    Distinguish between the following terms

(a)    Nominal money value and real money value

(b)   Fiat money and fiduciary issue

9    (a)    State the quantity  theory  of money  exchange

(b) Given  an economy  where  the quantity  of money  in circulation   is $300 million,  volume   of production   is $100 million  and the velocity  of money  in circulation  is 50 times.   Determine   the general price level.

10 The total money supply in an economy   is Ushs150   billion.  40%  of this  is held  for  transaction purpose,  while  the balance  is held  equally  for  the other  Keynesian   purposes  for holding   money. How much is held for precautionary   motive?

Section B questions

  1. (a) Explain  the qualities  of good money

(b)  Explain the functions of money in an economy

(c)   What factors limit the quantity of money supplied in the economy?

2   (a) Explain the quantity theory of money according to Fisher.

(b) Explain the limitations of the Fisher’s quantity theory of money exchange.

Financial   intermediaries

These  are  financial  institutions   which  bring  together  the  deficit  spending   units  (borrowers)    and  the surplus  spending   units  (lenders)   together.    They trade in money as their commodity    and charge a price called interest.  There are two types of financial intermediaries   that is;

  • Banking financial    These   are   financial    institutions    which   create    secondary deposits  (create  credit)  and  advance  short term  loans  mainly  to less risky  investments.    Examples are commercial   banks.
  • Non-bank financial    These  are  financial   institutions   which  do not  create  credit but  they  assist  in  channeling   long  term  loans  from  surplus   spending   units   to  deficit   spending units.   Examples    include   building   societies,   Insurance    companies,    Post   office,   saving   banks, development   banks etc.

Differences between Banking and Non-banking financial intermediaries

Banking  Financial Intermediaries

 

 Non-Bank financial Intermediaries
1.  They  create  credit  which  is considered   as money  (deposit  money)

2.  They  lend on short term  basis

3.  They pay lower  interest  rates  on deposits

4.  They maintain  short term  deposits

5. They undertake  less investment   risks

6. They charge high interest rates on borrowers.

 1. They do not create credit.   They just lend funds got from surplus spending units.

2.  They usually lend on long term basis.

3.  They pay higher interest rates on deposits.

4.  They maintain long term deposits.

5.  They undertake   greater investment   risks.

6.  They  charge  low interest  rates  on borrowers

 Central banking

A  Central bank is a financial   institution   established   by  the  government   with  the  aim  of  controlling the quantity  and use of money  in the  economy  so as to facilitate  the implementation of the monetary policies.

Functions   of the Central bank

  1. Banker to the government.  It keeps government   funds and cash balances.     It also carries out transactions   on behalf of the government   and   it acts as a financial and economic   adviser to the government.
  2. Monopoly of issuing legal tender notes and coins. The central   bank   has the sole  right   of issuing,  printing  and renewing   legal tender  coins  and notes  of the country.
  3. The lender of last resort to commercial banks. This means  that  in case  of  financial   problems, the  central  bank  provides   liquidity   (money)   to  commercial    banks   and  other   financial   agents when  they have  failed  to get money  from  other  sources.
  4. Banker to commercial banks. The central bank accepts deposits from commercial  banks and it acts as a clearing house for commercial   banks, that is, they settle their debts through   the central banks.
  5. It controls credit (money supply) in the economy. The central bank regulates  the amount   and availability of credit in the economy.   This helps to ensure economic stability.
  6. It is the manager and custodian of foreign currencies. It is the task of the central bank to maintain a stable foreign exchange rate so as to maintain the value of the domestic currency.
  7. It helps to formulate and execute the monetary policy so as to influence the level of economic activity.
  8. It supervises and examines the activities of all commercial banks so as to promote sound commercial banking.   It also advises them on issues like closing time, opening of branches, lending policies etc.
  9. Banker to International Institutions. The Central bank keeps funds of International institutions working in the country for example IMF, World Bank, and Red Cross etc.
  10. It controls the activities of foreign banks operating within the country. Such activities may not be in line with the national development strategy of the country for example profit repatriation.
  11. It regulates the country’s balance of payment position through the management of external debt.

The monetary   policy

This refers to the measures used by the Central bank to control the demand and supply of money together with the interest rate in order to influence the level of economic activity.

Aims (Objectives) of the monetary policy

  1. To maintain domestic price stability
  2. To stimulate economic growth and development
  3. To ensure equitable income distribution
  4. To help to achieve full employment of resources in the economy
  5. To maintain a stable foreign exchange rate
  6. To ensure balanced sustainable growth and development of the economy
  7. To create a broad and continuous market for government securities (bonds and treasury bills)
  8. To help establish and develop financial institutions
  9. To ensure Balance of payments stability in the economy
  10. To encourage savings through the manipulation of interest rates.

Instruments (Tools) of the monetary policy

  1. The bank rate (discount rate) policy. The bank (discount) rate refers to the interest rate charged by      the Central bank on commercial banks.  This occurs when the commercial banks borrow cash from the Central bank as a lender of last resort. If the Central bank wants to reduce money supply, aggregate demand and to check on inflation, it increases the bank rate. Consequently, Commercial  banks  also  increase  the  interest  rate  charged  on  loans  to  their customers hence limiting money supply. If the Central bank wants to increase money supply, aggregate demand and to check on deflation, it reduces the Bank rate. Commercial banks also reduce their interest rates hence increased borrowing by customers.

Note.  Rediscount   Rate.  This  refers  to  the  interest  rate  charged  by  the  Central  bank  on commercial banks by buying short term securities from them at a discount.

  1. Open Market Operations (OMO). This refers to the act of buying and selling of government securities (bonds and treasury bills) by the government through the Central bank. If the Central bank wants to reduce money supply and check on inflation, it sells government securities to the public (individuals). This leads to a fall It money supply.   However, if the aim is to increase money supply and to check on deflation, the central bank buys securities from the public.

Note.  Treasury Bills are short term financial assets which are used by the government when borrowing from the public.                                                                                     .

Bonds are long term financial assets which are used by the government when borrowing from the public.

  1. Selective Credit Control (Credit squeeze). This is where  the  Central  bank  directs   or  instructs commercial   banks  to  give  credit  (loans)  to specific  sectors  of the  economy   for  example   giving loans  to priority  sectors  like agriculture.    This reduces the number of sectors getting loans hence reducing money supply in the economy.
  2. Legal reserve requirement (Reserve requirement ratio). This refers to the percentage  of bank deposits   required   by law to be deposited   by commercial    banks   with the Central   bank.   The Central   bank   sets the minimum    amount   of bank   deposits   which   commercial    banks   should deposit with it. If the  central  bank  wants  to reduce  money  supply,  it increases   the  legal  reserve requirement   so that  commercial   banks  have  less  loanable   funds.  However,  if the  Central   bank wants  to increase  money   supply,   it reduces  the  legal  reserve   requirements    so  that  commercial banks  have more  loanable  funds.

 

  1. Cash ratio (cash reserve). This refers to the fraction of  the  total bank deposits which remain in the Commercial   bank  in cash  form  to meet  the daily  requirements   of the customers   (depositors). In this case,  if the central  bank  wants  to reduce  money  supply,  it instructs  commercial   banks  to increase  the cash ratio.  However   if the central bank wants to increase money supply, it instructs commercial banks to reduce the cash ratio.

 

Note. Reserve ratio. This  refers  to the  fraction  of the  total  bank  deposits  that is not  lent  out  by the commercial   bank.  Liquidity ratio is the proportion   of Commercial bank assets that it keeps in liquid (cash) and near liquid (cash) form.

  1. Moral suasion. This is where   the central bank persuades   and requests   commercial    banks   to follow   the general   monetary   policy.     In  periods   of  inflation,   the  central  bank  may  persuade commercial   banks  not  to  give  out  credit  and  in periods   of  depression   (deflation),   commercial banks  may be persuaded   to expand  credit  so as stimulate  economic  activity,
  2. Special deposits (Supplementary reserve requirement). This is where the central bank instructs commercial    banks   to make   certain    deposits   over   and   above   the   minimum    legal   reserve requirement.      This reduces   the money   available   for lending   (loanable   funds)   in commercial banks hence reducing money supply.                   .
  3. Margin requirements. In this case,  the commercial   bank  does not  lend up to the full amount  of the value  of the collateral   security,  but  it lends  some  amount  which  is lower.   The  central  bank may  direct  commercial   banks  to rise  or reduce  their  margin   requirements    in  order  to regulate money  supply.  A higher  margin  requirement   reduces  the  amount  of loans  given  by commercial banks  and  this  is done  in times  of  inflation.    A  lower  margin   requirement   raises  the  loanable funds  and  this  is  favourable   in  times  of  economic   depression   in order  to  stimulate   economic activity,
  4. Currency reforms. This refers to the act of changing money by the government  from one form to another.    It is aimed at reducing   money supply and knowing   the amount   of money   in the economy.    It is normally   done  when  the  currency  has  totally  lost  value  due  to  high  levels  of inflation.

Limitations of the application of the monetary policy in developing countries

  1. Lack of well-developed financial markets. In developing countries,   there are no well-developed security markets.  This makes the use of open market operations   makes ineffective.
  2. Concentration of banks in urban areas. Most of the banking  business   is concentrated    in few urban centers.   The rural sector is still under banked.    This limits the scope and effectiveness   of the monetary policy.
  3. Presence of a large subsistence sector. The existence of a large non-monetary    sector limits the operations   of the monetary   policy.   This is because   many transactions   are made through   barter trade
  4. Many Commercial banks in developing countries enjoy a lot of liquidity. This makes the use of bank rate policy and increasing   legal reserve requirement   ineffective.
  5. Presence of foreign owned commercial banks.  Foreign   owned   commercial    banks   may   not implement   the restrictive effects of the strict monetary policy as required by the central bank.
  6. Ignorance of the public about the availability of credit facilities   in commercial banks.  A Monetary    policy   like selective   credit control   favoring   a sector   like   agriculture    may   not be utilized due to ignorance of the farmers about such a credit facility.
  7. High levels of liquidity preference. Most people in developing countries do not keep their money with commercial   banks.    This makes it difficult   for the central bank to control   money   which is outside the banking system.
  8. Inadequate entrepreneurs in developing countries. In most developing countries,  there is lack of enough entrepreneurs   who can use the expanded   credit for investment.    This is due to low levels of education and entrepreneurial   ability.
  9. High levels of corruption. There is a high degree of corruption  among the bank officials   who violet the monetary policy for their personal benefits.    This makes the policy ineffective.
  10. Limited trained personnel in the banking sector. There is limited trained  personnel   and -funds to finance  manpower   necessary  to effectively  monitor   the activities  of the monetary   policy.
  11. Existence of political Instabilities. These   force   the governments    in developing    countries    to increase money supply on political grounds hence conflicting with the objectives   of the monetary policy.
  12. High degree of openness of the economies. Many economies of developing  countries   are highly open and this makes it difficult to control money supply from abroad by the central bank.

Commercial banking

A Commercial bank is a financial  intermediary   which  collects  surplus  funds  from  the public  (that  is, accepts  deposits),   safe guards  them  and makes  them  available  to the true  owners  on  demand.   It also lends  money  (credit)  not required  by the true owners  to those  who  are in need  at an interest   rate  and who can provide  collateral  securities.

Functions of commercial banks

  1. They accept deposits and safe guard them on the behalf of their customers. This is done by opening up an account with the bank.
  2. They give loans and overdrafts to their customers.    The loans may be short term, medium   term or long term.
  3. They exchange currencies for their customers.    This aids international   trade.
  4. They keep valuable articles and documents in safe custody on the behalf  of their clients   e.g. wills, land tittles etc.
  5. They facilitate easy and quick payments of debts on the behalf of their customers  through   the use of cheques or standing orders.

Note. A standing order is a document   from the customer authorizing   the bank to make regular payments        on his behalf   to his creditors   for example   rent,   Insurance    expenses,    water   bills, electricity   bills etc.

  1. They look after the property of the deceased customers and distribute   their assets as laid down in the will.
  2. They give financial advice and offer technical services to customers   on business   and money.
  3. They create deposit money (secondary   deposits)   through the process of credit creation.
  4. They   participate    in the implementation   of government policies for example    the   monetary policy.
  5. They facilitate the transfer of money from one place to another by use of travelers’ cheques

Types of deposits (Accounts)

  1. Current accounts. These are accounts where the depositor can withdraw any amount at any time by use of the cheques.    For this reason, no interest is payable on this account.    Current   accounts are also called Demand deposit account.
  2. Savings accounts. This is where a pass book with a customer’s   photograph   is used instead of a cheques when depositing   or withdrawing.     Withdrawal   on this account   is restricted   to a certain maximum   amount.    The  owner  of this  account  earns  an interest  but  it is less  than  that  earned  on the fixed deposit  account.
  3. Fixed/time deposit) account. Under this account, withdrawal   cannot be made before   the stated maturity period.   The customer who owns this account earns  a high  interest  rate  depending   on the maturity  period.

Assets and Liabilities of Commercial banks

Assets of commercial banks

Assets are items   from   which   the bank receives income   and profits    and   claims   against   other institutions. They include;

  1. Reserves with the central bank.
  2. Deposits with other banks and non-banks.
  3. Fixed assets e.g. buildings,  furniture, vehicles   etc.
  4. Loans, advances and overdrafts to customers
  5. Acceptances  and guarantees made by other parties.
  6. Investments   in securities and shares in other companies.
  7. Retained profits
  8. Bills discounted  for customers   (that is, the bank pays less money than that stated on bill before the maturity period.)

Liabilities of Commercial banks

Liabilities  are  claims  against  the commercial   bank,  that  is, what  the  bank  owes  to other  banks  and non-bank   institutions.    They include;

  1. Deposits of customers
  2. Deposits in the bank by other banks
  3. Money borrowed  from the Central banks
  4. Capital contributed   by shareholders   (Paid up capital)
  5. Acceptances, receivables and guarantees  on behalf of the customers
  6. Dividends  payable to shareholders
  7. Reserve funds.

CREDIT

  • Credit is when an individual borrows money or buys commodities   without making cash payment.
  • Credit instruments refer to the written  documents   which guarantee   payments   at a given future date   and   they   give   the   holder   the   right   to   receive   money.    Credit   instruments    include   the following:
  1. Cheques. This is an order by customers   to the bank to make specific   payment   to the required person(s) on their behalf.
  2. Promissory notes. This is a written promise by the buyer to the seller to make a specific payment at a future date.
  3. Bills of exchange discounted before the maturity period.
  4. Credit cards
  5. Bank drafts.  This  is a form  of a cheque  which  is issued  by one  bank  to another  bank.   It reduces the burden of carrying large sums of money from one bank to another by the individuals.
  6. Overdraft. This is where the customer withdraws   more money than what is on his/her   account. Interest is paid on the amount over drawn.
  7. Government   securities   (bonds and treasury bills)

Credit creation

Credit  creation   is  the  process   by  which  money   lent  out  by  commercial    banks  using   the  cheque facility  expands  to result  into greater  volume  of credit  than the amount  originally   lent out.  OR.  Credit creation   is the process   of creating new demand deposits   through   lending out excess funds to credit worthy customers by commercial   banks by use of cheques.

Credit (Bank deposit/ Money) multiplier

Credit multiplier (M) is the number of times the initial bank deposits multiply   to give the final bank deposits

Example 1

Calculate the total credit created when the initial  deposits  are 5,000/=  and the cash ratio  is 5%

Solution

Total final deposit = 20 x 5000 = 100,000/=

Example  to illustrate   the process   of credit  creation  by the  commercial   bank

  • Assume one commercial   bank which lends to several individuals    A1, A2, A3 ……An.
  • Assume the cash ratio be fixed at 20%
  • Let the initial deposits (Do) be 1000/=
  • Assume that the several individuals   A1, A2, A3 ……An are able  and willing  to borrow  money  from the bank and the bank  is willing  to

This process  of credit  creation  is illustrated  as below;

Person New deposit Cash reserve (Cr=20%) New loan (80%)
A1

A2

A3

A4

.

.

.

.

An

 1000

800

640

512

.

.

.

.

5000/=

 200

160

128

102.4

.

.

.

.

1000/=

 800

640

512

109.6

.

.

.

.

4000/=
  • From the  above  table,  person  A,  deposited   1000/= in  the  bank,    The  bank  kept   20%  as  cash reserve  and lent out 80% inform  of a cheque  to person  A2.
  • Person A2 deposited the cheque to the same bank which gave him a loan.   Then out of 800/=, the bank kept 20% as cash reserve and lent out 640/= to person A3 and the process continues.

 Total deposits   =1000+800+640+512+……………                       .

Total deposits created are given by the formula; Total deposits   = Do.

Where Do = Initial  deposits

Limitations of credit creation by Commercial banks in developing countries

  1. Use of restrictive monetary policies by the central bank.  The  central  bank  limits  the  powers  of commercial      banks   to  create   credit   by  using   the  restrictive    tools   of  the  monetary    policy   for example   increasing   bank  rate,  selling  government   securities   to the public,   increasing   minimum legal reserve  requirement   etc.
  2. Presence of inadequate credit worthy borrowers. In developing    countries,    there   is lack   of enough credit worthy borrowers due to lack collateral   securities.    This leads to excess liquidity in commercial   banks due to limited borrowing hence limiting the process.
  3. The theory assumes that borrowers deposit cheques they get in the same bank. This is not always true.   Therefore   one bank keeps on losing deposits to other banks hence limiting the process of credit creation by a single bank.
  4. The process of credit creation keeps on diminishing towards zero. This limits the amount of credit created.
  5. High levels of liquidity preference. In developing countries,   individuals   prefer   keeping   their money with them instead   of depositing   it in banks.    This results into less bank deposits   hence limiting the process of credit creation.                                                                 .
  6. Low demand for bank deposits. In developing countries, there is  low  demand   for  bank  loans because   of poor  investment   climate.    This  is mainly  due  to the  political   instabilities,    insecurity, poor  infrastructure   etc. and this results  into less money  lend  out hence  limiting  the process.
  7. High interest rates charged by Commercial banks. These discourage   the potential   borrowers from demanding   for loanable funds for investment   hence limiting the process of credit creation.
  8. Limited number of banking institutions in developing countries. The number of banks is few and they are not widely distributed to mobilize enough savings. This limits the amount of credit created.
  9. High fractions of Cash ratio in commercial banks. A lot of bank deposits are left in commercial banks in cash form instead of lending it out hence limiting the credit creation process.
  10. Ignorance of the public about the availability of loanable funds in commercial banks. This leads to a small number of individuals accessing bank loans hence limiting the process of credit creation.

Dilemma facing the Commercial banks in their Lending policy

The commercial bank is usually faced with the problem of achieving the objectives of profitability, liquidity and security simultaneously.  If it increases lending so as to earn profits, it will not meet the customers’ demands (liquidity).  On the other hand, if it maintains liquidity for its customers, it will not  get  profits  as  there  will  be  no  loanable  funds.  In order to minimize these conflicts, the commercial bank has to do the following;

Measures of commercial bank for profit maximization

  1. Giving low interest rates to the depositors and charging high interest rates on the borrowers.
  2. under taking short term and medium term commercial investments.
  3. Charging commission for the services rendered to their customers.
  4. Investment in government securities as a way of earning interest.
  5. 5. Discounting bills of exchange i.e. the bank can pay less money  to the holder  of  the bill  as compared to that stated on it before it’s maturity.                       

Measures of commercial bank for liquidity

  1. Lending out money in phases such that all the time, there is some money to meet the needs of the customers.
  2. Lending out money on short-term basis.
  3. Purchasing liquid/short term assets that can be turned into cash easily.
  4. Receiving more deposits from the customers.
  5. Borrowing from the central bank.
  6. Keeping some of the deposits with the central bank.
  7. Regulate withdrawals especially with the savings account holders where one can’t withdraw more than once a week and withdraws are limited to a given amount.
  8. Ensuring that borrowers deposit collateral / securities which may be liquidated in case of financial problems.

 Measures of commercial bank for security,

  1. The bank has to secure a collateral security from the borrower.
  2. It should have aimed personnel to safe guard the bank.
  3. The bank should be made up of strong buildings for security purposes,

 

Problems facing Commercial banks in Developing   countries

  1. Unfavorable government policies   in form of fixing high interest rates.  This discourages individuals from borrowing money from commercial banks.
  2. High levels of economic instabilities. For example inflation, exchange rate fluctuations etc. Inflation discourages savings due to loss of the real value of money hence limiting bank deposits.
  3. Low levels of technology in developing countries. There   is existence    poor   technology    in developing   countries and it is expensive to import modern equipments   from developed   countries. This increases the cost of operation by commercial   banks.
  4. Poor and inadequate infrastructural facilities. This is reflected   in form poor transport   network like inaccessible   roads, insufficient   power   supply, unreliable   telecommunication     network   etc. This makes it difficult to market financial services especially in rural areas.
  5. Limited skilled manpower in developing countries. Labour   in developing   countries   lacks the necessary   skills required to operate and manage banking activities.  This leads to mismanagement of funds.  Some banks are forced to import skilled manpower   from abroad which is expensive.
  6. High levels of political instability in developing countries.   This  makes   it  difficult   to  open  up more  branches  especially  in rural  areas  due to fear of losing  life and making  losses.
  7. High levels of poverty among the customers. In developing   countries, many customers   are poor and scattered.   Therefore commercial   banks face the challenge   of mobilizing   savings.
  8. Limited number of credit worthy customers. This limits lending by commercial    banks due to lack of collateral securities by most borrowers.
  9. High levels of illiteracy among customers. Most of the customers  are illiterates   due to low levels of education.   In addition, many customers   do not keep books of accounts.    Therefore   it becomes difficult to assess their credit worthiness.
  10. High level of competition in the banking sector. Most of the banks are concentrated in urban areas. Therefore,   they are faced with the problem of competition   for the limited customers.
  11. High levels of corruption and embezzlement of funds. There is a high degree of corruption and embezzlement   of bank funds by bank officials.   This limits the expansion of the banking   sector.
  12. The existence of a large subsistence sector. This leads to low savings due to low incomes as a result of low levels  of economic   activity.
  13. The general negative attitude by the public about banking in developing countries.    Many individuals   do not have trust in commercial   banks and therefore,   they get scared of leaving their savings with banks.  Some individuals   prefer to keep their money at home.

The role of foreign commercial banks in developing countries

Positive Role (Implications) of foreign commercial banks in developing countries

 They create employment opportunities. Foreign  commercial   banks employment to the local population   in form of bank accountants, credit officers, marketing   managers, cleaners   etc.  This increases the incomes of the people hence better standards of living.

  1. They help to increase efficiency in the banking sector. Foreign   banks   create   a competitive atmosphere    in the local banking   sector by employing   efficient   techniques   of service   delivery. This helps to improve on the quality of the services of the local banks.
  2. They are a source of government revenue through taxation.  Foreign commercial   banks help to widen   the  tax  base  in  form  of  taxes  imposed   on  their  profits,   employment    incomes   and  other business   activities   created  hence  generating   more  tax  revenue   to the  government.    The revenue realized is used to construct social and economic infrastructure   like hospitals, roads, schools etc.
  3. They increase capital inflow in the country. Foreign commercial  banks help to fill the savings-investment   gap in developing   countries   by extending   credit in form of loans to the local people. This increases investments   in the country hence economic growth and development.
  4. They help to close the foreign exchange gap.  Foreign   commercial    banks   facilitate    foreign exchange   inflow in developing   countries.   This increases the country’s   foreign exchange   reserves and its monetary   base.   Such foreign   exchange   is used to import   capital   and consumer    goods which cannot be produced locally.
  5. They facilitate the development of social and economic infrastructure.   Foreign   commercial banks   promote   the  development    of  the  social  and  economic   infrastructures    in  form   of  roads, schools,  hotels,  hospitals  etc. and this leads  to economic   development.
  6. 7. They promote technological development in the banking   Foreign   commercial    banks facilitate   technological    progress    through   technology   transfer    from   developed to developing countries. Local   banks   learn   and   adopt   the   modem    techniques    hence   improving    on   their efficiency in service delivery.
  7. They promote the exploitation and utilization of the idle local resources. This is because   they help  to  attract   foreign   investors   to  invest  their  capital   in  the  country.   This improves    on the productive   capacities in the economy hence economic growth and development.
  8. They promote industrial development. Foreign   commercial    banks   help   to mobilize    financial resources   which   are  used   for  development    of  heavy   industries    like  iron  and  steel  industries, electrical  engineering   etc.  Such industries require a lot of capital which is only accessed   through borrowing from commercial   banks.
  9. They promote entrepreneurial skills in the economy. The foreign commercial   banks  help  to train the  local  individuals  with  the  necessary   managerial  skills  required   to operate   modem   banking enterprises.   This helps to close the manpower   gap in developing   countries.   In addition,   they help to local individuals to get loans and set up business activities.
  10. They promote good international relationships between their   countries   of origin   and other countries   where   their business   activities   are extended.   This   enhances   mutual   understandings among countries.
  11. They help to facilitate and promote international trade. This is because they finance export and import trade by providing foreign exchange and money transfer services to the traders.

Negative role (Implications) of foreign commercial banks in developing countries

  1. They accelerate regional income inequalities in economy. This is because most of their banking activities are mainly concentrated  in urban areas neglecting   the rural areas.  This creates regional imbalance.
  2. They lead to profit repatriation. Foreign commercial banks tend to plough back the profits made to their home countries   instead   of re-investing   them in the countries   where   they operate.   This leads to low capital accumulation   in the economy.
  3. They undermine the provision   of banking services to the small scale local investors.  This discourages   the production   of cheap goods and services for the local people.
  4. They lead to unemployment in the economy.  This   is  because   they   tend   to  employ   mainly foreigners   especially   at  the  level  of  management    and  they  use  capital   intensive   techniques    of service  delivery  hence  technological   unemployment.
  5. They encourage rural -urban migration. This is because   most of their business   activities   are concentrated in urban centers due to poor infrastructure   in rural areas. Tills leads to congestion in urban areas and minimal contact with the local population,
  6. They lead to divergence between private and society   interests.   This   is   because    foreign commercial   banks aim at maximizing   profits at the expense   of the society.  Some of their policies are not in line with the national   development   goals of the country   like poverty   eradication,   rural development   etc.
  7. They discourage the development of local financial institutions.   This   is because    foreign commercial   banks  have  huge  capital   and  they  have  the  capacity   to operate  on  a large  scale  and provide  better  quality  services  to their  customers  at competitive   rates.  This undermines   the growth of the local banking sector.
  8. They interfere in the politics of developing countries. Foreign   commercial    banks   use   their economic power to influence national policies and politics   of the countries   in which they operate in their favor. This results into loss of independence   in local decision making.
  9. They limit the successful implementation of the monetary policies. This is because  the central bank has little control over their activities.

 Revision   questions

 Section A questions

  1. (a) Distinguish with   the   help   of   examples    between    Banking    and   Non-Banking    financial intermediaries

(b) Outline two features of banking financial intermediaries   in your country

2    (a) Differentiate   between cash ratio and liquidity ratio

(b) Give two reasons as to why liquidity is desired  in the economy

3    Given  that  a bank  has  an  initial  deposit   of  shs.  1 million   and  the  required   cash  ratio  of  25%.

Calculate  the;

(i)  Credit  multiplier           (ii)  Total  deposits  created.

4  (a) what  is meant  Bank  deposit  (credit)  multiplier?

(b) State three determinants   of bank deposits multiplier     in your country

5  (a) What  is a Central  bank?

(b) Mention three functions of the Central bank.

6  (a) Define  the term  “credit  creation”

(b) Given that the initial deposit amounts to 10,000/= and final deposit amounts to 200,000/=. Calculate   the cash ratio of the commercial   bank

7  Given  cash ratio  of 0.2 and initial  deposit  of USD. 1000. Calculate the total credit in Uganda shillings that is created on the basis of this deposit.  (USD 1. = Ug, Shs.  1,500/=).

  1. Distinguish  between the following terms

(i) Cash ratio and liquidity ratio.

(ii)  Treasury bills and bonds

(iii)  Bank rate and re-discount   rate

(iv) Reserve ratio and legal reserve requirement

(v)  Credit squeeze and cash reserve

(vi) Nominal money value and real money  value

Section B questions

1    (a) Explain the objectives of the monetary policy.

(b)  What factors limit the effective implementation    of the monetary policy in your country?

2    (a) What is meant by the monetary  policy?

(b) Explain the various monetary policy instruments   used by the central bank of your country.

(c) Explain  the factors  that influence  the application   of the monetary  policy  in an economy?

5   (a)  Given  the  initial  deposit  of  250,000/=   and  cash  ratio  of  20%,  show  how  a commercial    bank would  create  credit.

(b)    What are the limitations   of credit creation in your country?

6    (a) Illustrate how commercial   batiks create credit in an economy

(b)  Explain the factors that influence the process of credit creation in your country?

7    (a)   What is the role of foreign commercial   banks in the development   process of your country?

(b)   What problems   do commercial banks face in developing countries?

8    (a)  What  are the assets  and liabilities  of a commercial   bank?

(b)  How are commercial   banks able to achieve both liquidity and profitability?

(c)  Explain the functions of the commercial   bank.

 

 

Dr. Bbosa Science            +256 778 633682

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