Money and Banking

Question 1

Money

Answer 1

anything that is readily and widely accepted as a medium for the exchange for goods and services or in settlement of debts

Question 2

Problems associated with barter system

Answer 2

1. Double coincidence of wants: It entails finding a person who has what you want and requires what you have. This process is cumbersome and leads to a waste of time.
2. No common unit of measure: It is difficult to arrive at a uniform or an easily acceptable exchange rate between different commodities
3. The absence of a means of storing wealth or value: Under the barter system. It is difficult to store wealth because most articles of trade, especially agricultural products are easily perishable.
4. Difficult in making deferred payment: As a result of exchange rate problem, it is difficult to store wealth because most articles of trade, especially agricultural products are easily perishable.
5. Problem of bulkiness and indivisibility of most goods: The goods are often too bulky to be carried from one place to the other, and are not capable of being into divided similar units to facilitate transaction

Question 3

Functions of money

Answer 3

1. Unit of account: it is a unit of measurement and therefore facilitates quick comparison of the values of various goods and services. It also aids in financial accounting of business as well as expressing the values of a country’s GNP and balance of payment.
2. Store of value: It enables individuals to delay a potential purchase to the most convenient time by providing them with a way in which to store their purchasing power. Its efficiency as a store of value however, is affected by inflation.
3. Medium of exchange: It simplifies the transaction process since the double coincidence of wants, requirement for barter is unnecessary.
4. A standard of deferred payment: Since many transactions are conducted on the basis of credit, it is convenient for the debts to be expressed and payment made in money terms. This particular role of money is also affected by inflation, making money less efficient.

Question 4

Characteristics of money

Answer 4

1. General acceptability:- It must be acceptable by all economic agents in the country in which it is used in payment for goods and services, and in settling debts and obligations.
2. Divisibility: It should be available in units of a standard size sufficiently divisible to facilitate the purchase and sale of goods and services over a wide range of prices.
3. Durability: It should be able to last for a long time without losing its value. This is the reason why high quality papers are used to print paper currency and precious metals are used in minting coins.
4. Stability in value: It should keeps its value (more or less) over time
5. Portability: Money should be convenient to carry about for easy transfer to other people during transactions.
6. Homogeneity: One unit of money must be the same in all respects (i.e. identical) everywhere throughout the country. This will promote general acceptability.
7. Relative Scarcity: It must be unique, not something that can be found easily anywhere. And it must not be supplied in excess so as not to lose its value whereby will not be able to serve effectively as a store of value and a standard of deferred payment.

Question 5

Types of money

Answer 5

1. Paper money and coins: These are money deposited with financial institutions, especially commercial banks and the Central Bank.
2. Bank deposits: These are money deposited with financial institutions, especially commercial banks which are withdrawable or transferable without prior notice by writing a cheque. Such deposits are held in current account of the customer, and a fee is charged for processing the cheque.
3. Quasi - money or near money: These are assets which adequately serve as a store of value but do not fulfill the medium of exchange function. Examples include saving and time deposits, stock and shares, postal and money orders, treasury bills etc.

Question 6

Types of bank deposits

Answer 6

1. Demand deposits: It is deposit of funds (usually paper money and coins) with a bank which are withdrawable or transferable without prior notice by writing a cheque. Such deposits are held in current account of the customer, and a fee is charged for processing the cheque.
2. Saving deposit: It is a deposit of fund with a bank which can be withdrawn with or without a notice of withdrawal. Savings deposits are held in savings account and they yield interest for the depositor.
3. Time Deposit: It is a deposit of fund that cannot legally be withdrawn from the bank without at least 30 days notice of withdrawal. Time deposits are held in fixed deposit accounts opened for depositors and they yield interests.

Question 7

The Nature of money

Answer 7

a. Legal tender: Money which by nature must be accepted in payment for goods and in discharge of debt obligations. Currency notes and coins are legal tender in all modern economies.
b. Fiat money: Money that is not a commodity and it is not redeemable in any commodity. What gives such money value and acceptability is their being declared as legal tender by the government. Money in the form of currency notes fit into this description.
c. Token money: This refers to money whose face value is greater than the actual value of the material of which it is made. In most economies, coins are token money, whose value as metal is less than their monetary value.

Question 8

The supply of money

Answer 8

Money supply or money stock refers to the total amount of money in the economy (Money in circulation).
There are two major alternative definitions of money
1. Narrow money or narrow definitions
2. Broad money or broad definitions

Question 9

Narrow money

Answer 9

Refers to money balances which are easily available to finance day-to-day spending, that is, for transactions purposes
The main definitions of narrow money include: M0 = notes plus coins held outside banking system and M1= M0 + demand deposits of banks

Question 10

Broad money

Answer 10

Refers to money held both for transactions purposes and as a form of saving. It includes assets which could be converted with relative ease and without capital loss into spending on goods and services
Broad money is denoted as M2 = M1 + quasi money deposits i.e. time and savings deposits of banks.
The central bank of Kenya (CBK) also defines an extended broad money; M3 = M2 +resident foreign currency deposits.

Question 11

Concepts of money

Answer 11

M0: This is the narrowest concept of money and
comprises currency held by the non-bank public
M1: This includes M0 and demand deposits with commercial banks
M2: This includes M1 and time and savings deposits held with the commercial banks
M3: This includes M2 and time and savings deposits held with non-bank financial institutions
M3X: This includes M3 and residents foreign currency denominated deposits held with commercial banks
MX3T: This comprises M3X and holdings of government securities

Question 12

Demand for money

Answer 12

Demand for money refers to the amount of wealth that everyone in the economy wishes to hold in the form of money balances.
There are different theories of money demand;
1.The Quantity Theory of Money(classical)
-Fisher’s version
-Cambridge version
2.Keynesian Theory of Demand for Money
3.The Modern Quantity Theory of Money (Post-Keynesian)

Question 13

The Quantity Theory of Money (Irvin Fisher Version)

Answer 13

It follows that the value of money equals the value of the good or service for which the money was exchanged.
In any time period the value of all goods and services sold must equal the number of transactions in that time period, T, times the average price of the transactions, P (i.e. PT).
MV = PT which denotes the proposition that the value of goods and services sold must be equal to the total amount of money handed over in exchange;
M is the nominal stock of money in circulation.
V is the transactions velocity of circulation i.e. the average number of times the given quantity of money changes hands in transactions.
P is the average price of all transactions.
T is the number of transactions that take place during the time
Both MV and PT measure the total value of transactions during the time period.
This identity only tells us that the total amount of money handed over in transactions is equal to the value of what is sold.
It follows that changes in M initiated by the monetary authorities will cause proportional changes in P.
That is to say that the general price level P is determined exclusively by the nominal quantity of money and is proportional to it.
Thus the demand for money is called the transaction demand. For example, when the supply of money is increased, people find themselves holding more money than they need for current transactions and so attempt to spend the excess.
It is this extra spending and given full employment and fixed number of transactions which pushes up the price level. As prices rise, the value of transactions rises and so the demand for money rises.

Question 14

Cambridge Version of QTM

Answer 14

This approach places primary emphasis on money as a store of wealth rather than as a medium of exchange. Individuals decision to hold money will be influenced by several factors such: Interest rate, wealth owned by the individual, convenience in making purchases, expectations of future interest rates and prices of goods and services, etc.
In short run, changes in the above factors would be fixed or proportional to changes in an individuals income.
An individuals demand for cash balances (or nominal money) is proportional to the individuals money income.
If this is true of all individuals, then the aggregate demand for money MD could be written as proportional to nominal national income(Y) as:
MD= kY
k is the factor or proportionality and is constant.
Y is money value of spending on all final goods and services produces during the time period
Y can be divided into price P and quantity Q components.
Where P = the general price level; Q = real income (or output)
Note that k is the reciprocal of the income velocity of circulation of money (which is the average number of times the money supply changes hands in financing the national income)
If we continue to assume that the money supply (M) is under the control of the monetary authorities, we can write the equilibrium as: M=MD
Substituting from above we have; M=kPQ
With k constant, and Q fixed because economy is at full employment, an increase in M will create an excess supply of money
This leads people to increase their spending directly on goods and services so that the general price level is pulled upwards. As this happens, the demand for money increases and eventually becomes equal to the money supply again.

Thus both the Fisher and Cambridge version of the QTM postulate that; an increase in the money supply leads directly to an increase in spending and, with full employment, the general price level is proportional to the quantity of money in circulation.

Question 15

Keynesian Theory of Demand for Money

Answer 15

Transactions motive/transactions demand for money
Speculative Motive
Precautionary Motive

Question 16

Transactions Demand for Money

Answer 16

This is the amount of money that households, firms and the government hold, for future exchange of goods and services.
These agencies hold money because income (money receipts) and expenditure flows are not synchronized in time.
Expenditure tends to be continuous while receipts are discrete.
Money is therefore required to bridge the gap between receipts and disbursements
The amount of money held for transaction purposes depend on: Level of income Spending habits and Time interval in-between income receipts
Money is held at an opportunity cost of the interest it would earn if it were invested.
Holding spending habits and interval between income receipts constant, the higher the income, the higher the amount of money held for transaction motive.
Transactions demand for money is given by
Lt=f(Y)
Where; Y = Level of income,
Lt = transactions demand for money
Generally there is a stable relationship between transactions and GDP hence a rise in GDP also leads to a rise in the total value of all transactions and hence to an associated rise in the demand for transactions balance.

Question 17

Precautionary Demand for Money

Answer 17

This is the amount of money held to provide for unexpected expenditures.
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 M is combined transaction and precautionary demand for real cash balances.
Unlike in the classical quantity theory where the world is assumed to be perfect with all receipts and expenditures known, in the Keynesian model, there exists uncertainty, hence need for precautionary money balances.

Question 18

Speculation Demand for Money

Answer 18

It refers to the amount of money held to take advantage of profitable opportunities that may arise in financial markets.
Whereas the transactions and precautionary motives of demand for money look at money as a medium of exchange, the speculative motive looks at it as store of value.
People hold money for speculation purposes due to uncertainty about the future rate of interest.
A fall in the interest rate leads to an increase in the speculation demand for money.

Question 19

Total demand for money

Answer 19

According to Keynes, the aggregate demand for money (Md) is the sum of speculative demand, transactions demand and precautionary demand for money, i.e.
Md= Mt+MSP
Where Mt= Transaction and precautionary motives and MSP is speculative motive
Thus
Md= kY +L(r)

Question 20

Liquidity trap

Answer 20

Due to the effects of the speculation demand for money, the aggregate demand for money is downward sloping and convex to the origin.
At a certain level of interest (r), the aggregate demand for money curve becomes horizontal, which means that demand for money is perfectly interest-elastic.
This implies that further fall in interest has no effect on the speculative demand for money.
This situation is referred to as liquidity trap.
r is the liquidity trap interest rate.
At this rate people prefer to hold their wealth in cash rather than bonds, since the interest foregone is very low.
At this level of interest, the net return to bonds is zero.
At low interest rate, bond prices are high and therefore likely to fall.
This poses a risk of capital loss for investors, hence their decision to hold wealth in cash.

Question 21

The Modern Quantity Theory of Money (Post-Keynesian)

Answer 21

According to this theory, money is just one of the many ways in which wealth can be held.
The other ways include consumer durables, all kinds of financial assets, property and human wealth.
This theory postulates that money has a convenience yield in the sense that holding it saves time and effort in carrying out transactions.
In this model, the equation for demand for money is given as:
Md/P = f(W,r,w,T)
Where:
Md/P is the real demand for money
W = total wealth
r = expected rate of return on various forms of wealth
w = the ratio of human wealth to non human wealth
T = the society’s tastes and preferences
Demand for money is directly related with total wealth as long as wealth holders regard money as a normal good.
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.
The higher the ratio of human to non-human wealth the greater will be the demand for money in order to compensate for limited the limited marketability of human wealth.
Demand for money also depends on various factors that influence wealth holders’ tastes and preferences for money.

Question 22

The Banking system

Answer 22

This consists of all those institutions which determine the supply of money.
The main element of the Banking System is the Commercial Bank (in Kenya).
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.

Question 23

Functions of the central bank

Answer 23

1. Government’s need to hold their funds in an account into which they can make deposits and against which they can draw cheques. Such accounts are usually held by the Central Bank
2. Commercial banks need a place to deposit their funds; they need to be able to transfer their funds among themselves; and they need to be able to borrow money when they are short of cash. The Central Bank accepts deposits from the commercial banks and will on order transfer these deposits among the commercial banks.
3. In most countries the central bank has the sole power to issue and control notes and coins. This is a function it took over from the commercial banks for effective control and to ensure maintenance of confidence in the banking system.
4. Commercial banks often have sudden needs for cash and one way of getting it is to borrow from the central bank. If all other sources failed, the central bank would lend money to commercial banks with good investments but in temporary need of cash. To discourage banks from over-lending, 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. For this reason, commercial banks borrow from the central bank as the lender of the last resort.
5. Managing national debt: It is responsible for the sale of Government Securities or Treasury Bills, the payment of interests on them and their redeeming when they mature.
6. Banking supervision: In liberalized economy, central banks usually have a major role to play in policing the economy.
7. Monetary policy is the regulation of the economy through the control of the quantity of money available and through the price of money i.e. the rate of interest borrowers will have to pay. Expanding the quantity of money and lowering the rate of interest should stimulate spending in the economy and is thus expansionary, or inflationary. Conversely, restricting the quantity of money and raising the rate of interest should have a restraining, or deflationary effect upon the economy.

Question 24

Commercial banks

Answer 24

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.e. operates or has a current account with the Central Bank. They are sometimes known as Joint Stock Banks.

Question 25

Functions of commercial banks

Answer 25

1. They provide a safe deposit for money and other valuables.
2. 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.
3. They provide safe and non-inflationary means for debt settlements through the use of cheques, in that no cash is actually handled. This is particularly important where large amounts of money are involved.
4. 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.
5. They offer management advisory services especially to enterprises which borrow from them to ensure that their loans are properly utilized.
6. Some commercial banks offer insurance services to their customers e.g. The Standard Bank (Kenya) which offers insurance services to those who hold savings accounts with it.
7. Some commercial banks issue local travelers’ cheques, e.g. the Barclays Bank (Kenya). 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. This also safe if large amounts of money is involved.