MONEY AND BANKING

Posted by Resource Center 21/09/2019 0 Comment(s) Investing, Finance & Economics,Career Development,Business and Management,Accounting, statistics and Commerce,

 

 

MONEY AND BANKING

Money is anything that is generally accepted as a medium of exchange for goods and services.  A medium of exchange is anything that will be accepted by virtually everyone in a society in exchange for goods and services.

 

Before the development of modern money, people used to practice the barter trade system where people exchanged commodities for other commodities e.g. you exchange a debe of maize for a pair of shoes.

 

 

FUNCTIONS OF MONEY

  1. Medium of Exchange:- Money is anything acceptable to the buyer and the seller as a means for exchanging goods and services.  The seller and the buyer must accept and have confidence with the money as a medium of exchange.  The man with the cow who wants to purchase a bag of maize need not hunt for a maize –seller who wants a cow. He can sell his cow in the market for money and then purchase a bag of maize with the money thus obtained.  The inconveniences associated with double coincidence of wants in the barter trade system is eliminated.
  2. Money is used as a standard measure of value.  Since money is divisible into smaller units, it can be used as the yardstick for measuring the relative value of different commodities. Money is an objective measure of the value of a commodity. For example to produce 1 bag of maize the farmer may have spent shs. 700.  To make a dress, the tailor may have spent shs 1500.  We can therefore use money to express the value of different commodities. We can keep elaborated records of the value of commodities in the books of accounts.
  3. Money is used as a store of value. Money enables a person to keep a portion of his assets liquid.  Liquid assets are those which can be used for any purpose at any time one likes. For example, you can sell a perishable item today and keep the money raised in  the bank for future use. Most persons in the modern world have to keep currency notes in their pockets or at home or in the bank accounts.  The necessity arises from the fact that the stream of income and that of expenditure do not keep time with each other.

An employee receives salary once in a month but his/her expenditures spreads throughout the month.  Money therefore stores value.  However the value of money should remain stable i.e. not lose value.

  1. Money is used as a standard of making deferred payments i.e. payments to be made at a latter date. The value of money remains stable over a period of time compared with the value of commodities. Money has facilitated the credit transactions. For example if a shopkeeper sell some maize worth shs. 500 on credit to a customer now, payable a month later the value of equivalent quantity of maize may be low (shs. 200) or higher (shs. 700).  To eliminate such drastic change in value, the shopkeeper would prefer the debtor (customer) to pay this debt using money and not maize.  By serving as a standard measure of payment over time, money makes borrowing and lending  much less risky.
  2. Money is used as a means of transferring value. A person  can sell his/her immovable properties (e.g. land) and movable properties (like furniture) in one place (e.g. Nakuru) and use the money raised to buy them at another place (e.g. Mombasa).  Value will thus be transferred.

 

When does money cease to perform its functions?

-When the money loses its value very rapidly i.e. during inflation, it can no longer be used as medium of exchange, as a store of value, as a means of transferring value or as a standard of making deferred payments or as a standard measure of value.

 

 Characteristic of money

  1. It must be stable and not rapidly change in value.  People will like to store value in money that is not rapidly changing in value.  If the value of money depreciates very fast and frequently, people will lose confidence with the money and would therefore prefer to keep their value in form of properties rather than in form of cash.
  2. It must be a generally acceptable medium of exchange.  The sellers and the buyers must have confidence with the money and therefore accept it as an effective medium of exchange.
  3. Items used as money should be easily carried from one point to another irrespective of the amount involved.  The paper money clearly demonstrates this quality of portability e.g A shs. 1000 note is very light in weight but it carries a large monetary value.
  4. Money item should be scarce and people should put some effort to earn money.  The demand for money should be relatively high compared to the supply.  People must work in order to earn money and this will sustain the value of money i.e. money will not be rendered valueless.
  5. Money should be divisible into units of different values and denominations e.g. shs. 1 coin, shs. 5 coin, shs. 20 coin, shs. 50 note, shs. 100 note to facilitate the settlement of even small debts.
  6. Money should be durable i.e. materials used to make money should be capable of lasting longer and withstand the wearing due to handling by many hands. It costs the government a lot of money to replace the worn out money.
  7. Money should be easily recognized by all. Money of a specific denomination.e.g shs. 100 note must have similar features which distinguish it from money of another denomination e.g shs. 1000. There should be no confusion as far as identification of money by all is concerned.
  8. Money should be made in such a way that it is difficult to counterfeit i.e. difficult to mint or print money by unauthorized persons.

 

EVOLUTION OF MONEY

Because of the problems associated with the barter trade, people have gradually over time developed various forms of medium of exchange or money.

 

1.         Commodity Money

In different communities, people attached superior value to certain commodities and used such commodities as money.  Example of such commodities include wheat, corn, tobacco, skins, beads, cowrie shells, gold, live animals, silver etc.  Some of these commodities like foodstuffs, animals are not durable, not divisible and therefore their usage as money greatly diminished with the passage of time.

 

2.         Metallic and coin money

Gradually as time passed by, the most attractive metals like gold and silver were adopted as money almost everywhere because they were durable, easily divisible, scarce and therefore more valuable. The traders would therefore use metal bars as money for their exchange purposes.Later on the metal bars were cut into coins due to the convenience of carrying them and coins enhanced the divisibility quality of money. Certain values were inscribed in the coin to indicate their values.

 

3.         Paper Money

Because of the insecurity of  moving around carrying the precious metals and coins, the owners(traders) of these items deposited them with Goldsmiths who could keep them under lock and key in return, the goldsmith issued the owners with receipts (notes) showing the value of the metal deposited within them and these notes acted as paper money.Traders (people) would exchange the notes with the goods and services they purchased. Those who received the notes if they so wished would convert them into precious metals and coins in the Goldsmith houses or use them for further trading activities.  The notes (receipts) were backed by precious metals and coins kept by the Goldsmith. 

 

Later one the Goldsmith issued notes not backed by the precious metals and coins as demand for paper money increased.  This was caused by rapid increase in trading activities i.e. selling and buying.The precious metal reserves could not increase at the same high pace.  The  goldsmith houses were later converted into commercial banks whose role was to issue such notes.  To regulate the demand and supply of paper money, the role of issuing the notes was taken over by central banks.  The central bank could issue paper money not backed by the precious metals which is known as non-convertible paper money. This money is known as legal tender and all citizen are bound by law to accept it as a medium of exchange.

 

4.         Demand deposit

Consists of the money deposited in a bank account which can be withdrawn anytime without restriction using cheques. The cheque has been accepted as a means of making payments.

 

5.         Plastic Money

It is the use of credit card to make payments. These cards are issued by banks to account holders.  The latter use the cards to purchase goods and services and after some time their accounts are debited with amount equivalent to the value of goods and services they have purchased plus commission for the service.

 

Demand for Money

According to Lord Keynes, a famous English Economists, demand for money or liquidity preference as he called it, means the demand for money to hold.  People hold money for three main motives or reasons:-

(i) Transaction motive:- This can be looked at :

  1. From the point of consumers who want income to meet the household expenditure which may be termed as the income motive.  Individuals hold cash in order to bridge the interval between the receipt of income and its expenditure.  Most of the people receive their incomes by the end of the month while the expenditure goes on day by day.
  2. From the point of view of the businessmen who require money and want to hold it in order to carry on their business i.e. the business motive.  Businessman need money all the time in order to pay for raw materials and transport, to pay wages and salaries and to meet all other current expenses incurred by any business.

(ii) Precautionary motive for holding money refers to the desire of the people to hold cash for unforeseen contingencies e.g. money to provide for the risk of unemployment, sickness, accidents and other more uncertain perils.

(iii) Speculative Motive – relates to the desire to hold cash in order to take advantage of unforeseen business opportunity which will generate profit for the business.

 

CONCLUSION:

The amount of money required to be held under the various motives constitutes the demand for money.

 

SUPPLY OF MONEY:

Means the sum total of all the forms of money which are held by a community at any given moment i.e. money in circulation within the economy which includes:-

  • Currency notes and coins issued by the central bank
  • Demand deposits are deposits kept in current accounts, which can be withdrawn at any time.

 

The supply of money in a country, by and large, depends on the credit control policies pursued by the banking system of the country.

 

 

 

 

COMMERCIAL BANKS

Commercial banks are institutions, which acts as financial intermediaries in the money market. They receive (collect) the savings of some people and give them to others who can use them productively.  In the process, they earn a commission out of which they pay interest to those who save and deposits funds with them.

 

 

 

Functions of Commercial Banks

(i) Accept deposits from their customers and this money is kept in any of the following accounts

  1. Current account – money kept in this account is known as demand deposit. Customers can withdraw all the money in the account any time without a notice.  Such deposits do not earn interest and customers are given cheque books.
  2. Fixed deposit account – money kept in this account is known as time deposit because money kept in this account can only be withdrawn after the expiry of a predetermined fixed period e.g. 6 month, 1 year, agreed upon by the bank and the depositor.  Interest earned depend on the length of time the deposit will remain in the account  i.e. the longer the period the higher the rate of interest.
  3. Savings account – money deposited in this account is not freely withdrawn. These are restrictions e.g. withdrawable once per week etc.  Money kept in the account earns a lower interest than money kept in fixed deposit account.

(ii) The commercial banks gives loans to traders and individuals who requires funds for various economic activities. Bank  charge interest on such loans.  The banks can give overdraft facilities to the current account holders i.e. allow such customers to overdraw from their accounts.  Commercial banks usually give loans on short term and medium term basis because they must satisfy the withdrawal needs of their depositors.

(iii) Safe custody of valuable items: Ornaments and valuable documents like title deeds, certificates are accepted by the bank from its customers. They are kept in strong rooms safely in the bank.  The bank    charge a commission for this service.

(iv) They provide references about the financial position of their customers when required.  Then supply this information confidentially.  This is done when their customers want to establish business connections with some new firms within or outside the country.

(v) Banks offers foreign exchange services to their customers e.g. buying and selling of foreign currencies.

(vi) Commercial banks acts as agents of their customers in various ways. They receive money on behalf of their customers e.g. rental proceeds, dividends on shares remittances from overseas.  They also make payments on behalf of thir customers inform of standing orders etc.

(vii) Commercial banks  provide investment advice to their customers i.e. identify the profitable business opportunities where their customers can invest their surplus funds.

(viii) Commercial bank acts as trustees i.e. manage properties on behalf of the certain beneficiaries e.g. can manage properties on behalf of a minor (a child whose parents has passed away) until they gain the maturity age.

 

CREATION OF CREDIT:-

It is a situation where a commercial bank is able to give loans of a larger amount compared with the deposits it has received from its customers e.g.

  • The bank can advance a loan (credit) of shs. 500,000 with only cash deposits (reserves) of shs. 100,000.
  • The bank does not give cash (shs. 500,000) to the borrower, but opens an account and credit the account with shs. 500,000.  This is simply a book entry. The borrower is then given a cheque book. The bank book deposits increases from shs. 100,000 to shs. 600,000.  The cash ratio =

  • The borrower can pay his/her debts by writing cheques which will definitely be honoured because his/her account has a credit balance.
  • Banks involved in these transactions can settle their owings or obligation in the bank clearing system.
  • Even if the borrower withdraws cash, the bank will protect itself by limiting the cash withdrawable and this condition may be very clearly stated in the terms of the loan. At times the cash withdrawn by the borrower would be paid to the suppliers who may consequently deposit the cash in the same bank.
  • The banks are able to do with small cash reserves because all the depositors do not come to withdraw money simultaneously, some withdraw, while others deposit at the same time.
  • The bank is able to lend money and charge interest without parting with cash.
  • The bank loan creates a deposit or it creates a credit for the borrower as his/her account is credited.

 

LIMITATIONS ON CREDIT CREATION

  1. Credit can be created on the basis of cash.  The larger the cash (i.e. legal tender money), the larger the amount of credit that can be created.  The amount of cash the bank can have depends on:
    1. total amount of cash in the country
    2. the amount of cash which the public wish to hold.
    3. The amount of cash the bank is authorized by the central banks to have. The central bank for the cash reserve ratio while the commercial bank must deposit in the central bank, if the ratio is raised the liquidity position of the bank is reduced and credit creation ability is also reduced. If the ratio is reduced the liquidity position of the bank is increased and credit creation ability is also improved.

 

  1. If the customers use cheques in their transactions, the banks cash reserves are improved and this improve its credit creation ability.  If customers are fond of using cash, then the bank cash reserves is greatly reduced and this reduces the credit creation ability of the bank.
  2. Failure by the loan applicants to meet the stringents conditions of the banks before they qualify to get loans.
  3. Lack of demand for loans
  4. If the bank raise its cash ratio, then little cash is available for credit creation exercise and vice versa.

 

CENTRAL BANK

  • It is an institution established by the government to issue and regulate the amount of money in the economy as well as control the operations of the banking system.  The demand and supply of money must be well managed in order to achieve economic prosperity.

 

FUNCTIONS OF THE CENTRAL BANK

  1. To issue new currency notes and coins which will appropriately support the economic activities in the country. The bank must be cautious not to issue excessive money which will harm the economy through inflation. At the same time the bank should not under-issue currency which in equally harmful to the economy.
  2. The central bank acts as a bank to the government i.e. it receives payments on behalf of the government and also makes payments on its behalf.
  3. Banker to the commercial banks. Commercial banks are bound by the law to keep a certain proportions of their total deposits as reserve with the Central Bank. These reserves help the Central Bank to control the issue of credit by commercial banks.  Commercial banks also keep their spare cash with the Central Bank on which they draw as and when needed.  Central Bank does not pay interest on deposits kept by commercial bank.
  4. The Central Bank act as a lender of last resort.  Commercial banks can borrow loans from Central bank to meet their needs, if these loans cannot be obtained from other competing institutions.
  5. The Central Bank keep stable the external value of the home currency. A stable exchange rate is necessary to maintain and promote a country’s foreign trade  and encourage the inflow of foreign investments, which is so essential for accelerating the pace of economic growth. In order to maintain the rate of exchange stable, the central bank is always prepared to buy and sell foreign currencies at the rates fixed by it.  However, this rate will be changed depending on local and international economic and trading forces.
  6. Custodian of national reserves: The central keep safe the nation’s reserves of gold and international currency.
  7. The central bank performs the duty of a clearing House for cheques.  Commercial banks meet and settle their obligations to each other arising from cheque transactions by their customers.
  8. The central bank control the credit in the country i.e. regulating the volume of loans commercial  bank gives to their customers.
  9. The central bank advices the government on financial matters.

 

 

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