MONEY AND BANKING

Money is anything that is generally acceptable as a means of exchange for goods and in
the settlement of debts in a given period of time.
Before the present form of money goods were exchanged for goods and this is called
barter system of exchange.

Barter system. This is where commodities are exchanged for commodities without
money as a medium of exchange. It is the earliest form of exchange which involves
exchange of goods for goods, goods for services or services for services for example
chicken for salt, beans for sheep etc.
Benefits of barter trade /Advantages of Barter trade:
 It saves the scarce foreign exchange. Countries that are not having foreign
exchange can easily participate in international trade through the barter system.
 It facilitates trade among small countries and this enables such countries to avoid
trading with more developed countries which sometimes exploits them e.g.
through the evil trade barriers.
 It reduces the balance of payment problems. Most developing countries spend
much on imports than what they earn from the exports hence Balance of payment
problem i.e. barter trade can be used as a means of exchange which reduces
foreign exchange expenditure hence reducing the Balance of payment problems.
 Barter trade allows some degree of specialization. A country specalises in
production of those commodities which can be used in exchange of other goods
that it does not produce hence enjoying the advantages of specialization.
 It expands the range of markets. Many countries are limited by the market,
however barter trade can offer solutions as long as the country has the goods
desired/wanted by other countries.
 Barter trade does not experience the problem of inflation. This is because there is
no money involved in the exchange of goods and service
 Barter trade creates and expands friendship with other countries. This helps in
improving international relationship.

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 Disadvantages of barter trade:
 Lack of double coincidence of wants. It is difficult to find someone in need of
what the buyer is selling and has what the buyer wants. For example: A man
wanting to exchange goats for beans may spend several weeks before finding
anyone who has beans for sale and happens to want goats
 Indivisibility of some items /commodities. Some items can hardly be divided into
smaller portions hence limiting small transactions to take place, e.g. an individual
with a goat finds it hard to exchange it with a hen.
 Difficulty in transportation of bulky items/commodities. Some items are heavy
and difficult to move from one place to another in the process of looking for
buyers.
 Difficulty in storage. Many items are difficult to store in large quantities because
they are perishable. This limits volume of trade
 Difficult in valuing commodities. It is hard to determine the value of one
commodity in terms of the other without thinking about money e.g. it is difficult
to compare fertilizers and maize without using money.
 It is difficult to arrange credit transactions. Many commodities lose or gain value
overtime. Therefore it is difficult to exchange them in a credit or lending
arrangement. E.g. a transaction involving a promise to receive a goat is very hard
to make because the goat can grow bigger or smaller.

NB: Because of the above challenges, a generally acceptable medium of exchange was
developed and this is called money

EVOLUTION OF MONEY
 Barter trade was the earliest form of exchange where goods were exchanged for
goods, services for services and goods for services .It was later discovered by
people that they were missing functions of money.
 It was then decided that commodities of high value were to be used as a medium
of exchange. These included salt, tobacco, grains, hides and skins etc. These
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 commodities were used to determine the value of other commodities and also
served many purposes hence their ability to satisfy human wants/needs.
However ,these commodities could not measure well the value of all commodities
because they were bulky and perishable
 Later durable commodities were used and these included; gold, iron, silver, beads,
cowrie shells. After sometime, it was later discovered that some of these
commodities were in plenty and they would not act as a good as good medium of
exchange.
 It was therefore decided that gold and silver should be the only ones to act as a
medium of exchange. This is because the two were relatively scarce, durable,
rustless and could be divided into smaller units to enable small transactions to take
place. These metals had many uses e.g. people would at time melt them into
coins. Whenever the value of metals increased they would be melted into metal
itself and this resulted into scarcity of money hence deflation. However when the
value of metals reduced, people would turn metals into money which increased
money supply hence causing inflation. This became a loophole/weakness as a
medium of exchange.
 Later on token money was formed as a medium of exchange. Token money refers
to that money whose face value is greater than the metal value.
 It was later discovered that paper money should be introduced.

Advantages of money as a medium of exchange

 It enhances the monetary sector i.e. the use of money enables an economy to
transform from a subsistence sector to a commercial sector since individuals produce
for sale/exchange which increases their incomes.
 It allows division of labour and specialization. Individuals specialize in the production
of goods and services in order to obtain money which use in getting other
commodities.
 Money facilitates the transfer of loans .This is mainly done from the financial
institutions to different sectors of the economy e.g. Agriculture, Industry, Tourism etc.
 The government transfer credit facilities/assistance to the public by use of money.
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 Money allows deferred/ future payments. These are payments to be effected in future
and they can be easily estimated before hand by use of money.
 Money facilitates international trade. Countries can participate in international trade in
order to earn foreign exchange which helps them to purchase the goods that they do
not produce.
 Money act as an incentive/attraction for the factors of production .Many individuals
offer their factors of production in order to earn money e.g. labour is offered to earn
wages and salaries, land is offered to earn rent.
 Money is also used to demand for factors of production. This enables the production
of goods and services to take place which increase economic growth.
 It measures the value of goods. Money helps in valuing goods and services i.e. it
determines the quality and quantity of goods to be produced.
 Money can be used as a substitute/ a solution to problems encountered in barter trade.
It is a way in which societies try to overcome the problems encountered in barter
trade.
 It encourages hard work and effort i.e. money encourages people to work harder to
accumulate more of it.
 It encourages proper allocation of resources i.e. this is where people produce those
commodities that are highly demanded.

Disadvantages of money as a medium of exchange

 Leads to misallocation of resource. Usually the rich individual dictates the goods to be
produced in their favour may leave out those goods demanded by the poor who are
always the majority.
 Money leads to overexploitation of resources in order to accumulate more of it thus
leading to their quick depletion.
 Money can lead to inflation. This is mainly experienced when there is too much
money in circulation.
 It leads to income inequality .This is because people earn differently such that some
individuals are earning more while others are earning less or nothing at all hence
creating a gap between the rich and the poor.
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 Money encourages rural urban migration and its associated problems/evils. This is
mainly experienced when the labour force leaves rural areas to urban centers in search
of high incomes. However some individuals are mainly unemployed which results
into problems like congestion, creation of slums, robbery, prostitution etc.
 Money encourages corruption and embezzlement of funds. This comes about as
individuals ask for bribes and other still funds to accumulate more money.
 Money can lead to pride and hatred among the people. This kills social cohesion/unity
in an economy
 Lack leads to poor standards of living, i.e. those who fail to earn enough money live
under poor conditions.

FUNCTIONS OF MONEY:
 It is a medium of exchange. Money makes it possible to determine the value and
quantity of commodities to be exchanged. It facilitates the day-to-day transactions and
enables people to easily get goods and services in exchange for money.
 It is a unit of account. Money permits pricing of goods and services, enables
accounting and auditing of business transactions.
 It is a store of value/wealth. Money makes it easy for people to store their wealth
in money terms.
 It is a measure of value. The relative value of goods and services or prices is
determined through the intermediary of money. It reflects the quality and quantity of
goods and services exchanged in the market.
 It is a standard of deferred payment. Money makes it easy for purchases to be
made without immediate payment. This means that money facilitates and encourages
international trade.

QUALITIES OF GOOD MONEY:

1 .It should be generally acceptable /Acceptability. This means that it should be
approved by everyone in the country as the official legal tender. This is to ensure
that it is accepted by everyone in the making of different transactions.
2. It should be portable/Portability. One should be able to carry money from one
place to another easily. This is to ensure security for money and its holder.
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3 It should be divisible/Divisibility. Good money should be divisible into small
denominations so as to enable small transactions to take place.
4. It should be durable/Durability. Good money should be long lasting. It should be
made out of high quality papers and metals. This is to reduce the cost of replacing
the worn out money.
5. Homogeneity/Good money should be uniform. Money should be uniform
throughout the country i.e. one denomination should be as good as others. E.g. one
thousand notes should be similar to all one thousand notes used in the country.
6 Cognizability. Money should be easily seen and deduced with ease in relation to
material, colour and structure. It should not look like other forms of paper or coins.
7. Scarcity/ Good money should be relatively scarce. Money should be scarce as
compared to its demand so as to enable people maintain it or even work harder to
get it.
8. Malleability/ It should be malleable. Money should be hard or difficult to imitate
because if it is easy, it can easily be forged hence an increase in supply and its
related problems such as inflation.
9. It should be stable in value. It should maintain its value without over appreciating
or over depreciating. This is to maintain people’s confidence and trust in money

CONCEPTS USED IN CONNECTION WITH MONEY:

1. The gold standard
Gold standard is a monetary system in which the standard unit of a currency has a
fixed weight of gold. For example 1 ounce=$4.86. Or Gold standard is an
agreement set by countries to fix the price of their currencies in terms of gold.

2. The dollar standard. This is where the value of a country’s currency is defined
is defined terms of the dollar reserves held in the country.

3. Fiduciary issue (Representative money)

Fiduciary issue is money issued by central bank at its discretion and it’s not
backed by gold or foreign exchange reserves but backed by government securities.
It is money issued over and above that backed by foreign currency.
4. Fiat money
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 Fiat money refers to money printed and issued by the central bank on government
orders irrespective of the level of economic activities, and it is not backed by
securities or gold. E.g. money printed to finance a war.
5. Common money
Common money refers to bank notes and coins in circulation (hands of the public),
and it’s used to carry out day-to-day transactions.
6. Near /Quasi money
Near money refers to near-liquid assets which can easily be turned into cash for
example treasury bills and government stocks, Cheques, foreign currency.
7. Intrinsic money
Intrinsic money refers to money (coins) whose metallic value is equal to the face
value.
8. Token money.
Token money refers to money whose face value is greater than the value of the
metal used in making it.
9. Hot money
Hot money refers to short-term capital movements such as treasury bills,
commercial bills, and speculative purchase of foreign currency that can be moved
from one country to another.
10. Bank deposits
Bank deposits refer to money deposited with financial institutions and can be used
to settle any financial obligations. Bank deposits are of two types:
a. Sight (Demand) deposits. Sight deposits are those which are withdrawn on
demand by customers with current accounts.
b. Time deposits. Time deposits are those which are withdrawn subject to
some notice being given by customers of a bank.
11. Money market
A money market is one in which short-term financial assets (securities) are
exchanged. Money markets have got the following features:
 They are mainly urban based.
 They charge mainly high interest rates.

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  They mainly operate on small scale basis.
 There are few participants in the markets.
 They deal in a limited variety of financial assets.
12. Capital market
A capital market is one where long-term financial assets (securities) are traded. It
is a market for long-term company loan capital, share capital and government
bonds.
The institutions involved in the capital market include the central Bank,
commercial Banks, and saving-Investment institutions e.g. insurance companies.
The functions of a capital market
 Mobilization of savings.
 Encourage investment.
 Regulate the prices of financial assets.
 Promote ease of convertibility of assets (from near cash to cash form).

13. Stock exchange markets. These are financial institutions where already issued
share are sold and bought.
14. Treasury bill
Treasury bill is a financial security issued by a country’s central bank as a means
for government to borrow money for short periods of time, for example treasury
bills of 90 days.
15. A bond
A bond is a financial security issued by businesses and government as a means of
borrowing long term funds, for example bonds for several years.
16. Loan.
A loan is a specified sum of money advanced to an individual or a firm by a
financial institution with a specified rate of interest over a given period of time.
NB: (i) Soft loan is a loan having either no interest rate or a very low
interest rate and it has a long term repayment period
(ii) Hard loan is a loan with a very high interest rate and a very short
repayment period.
Reasons why countries continue to rely on loans:
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  To supplement on low tax revenue (public revenue).
 To finance long term development projects.
 To fill the persistent budgetary deficits of government.
 To supplement on low domestic savings.
 To supplement low export earnings yet there is rising need for imports.

17. Collateral security. This refers to an asset of value that is mortgaged against a
loan given.
18. Overdraft. This is a short term financial assistance by commercial bank to the
current account holder where the customer is allowed to withdraw more money
than he/she has on the account.
19. Bank draft. This is a cheque is issued by the commercial bank on behalf of bank
customer at a fee where by the payee is not willing to accept a personal cheque.

20. Bill of exchange. Bill of exchange is unconditional order issued by a person or

business directing the recipient to pay a fixed sum of money to a third party at a
future date.
21. Paper note. This is money made out of paper materials by the central bank of a
country e.g. a note of Shs. 1000.
22. Coins. This is money which is minted out of metallic materials e.g. a coin of
Shs.100.
23. Legal tender. This is money which according to the law must be accepted in
making of transactions in a country at a given time. Money is legal a legal tender
in its country of issue.
24. Currency. This refers to the paper notes and coins that are being used as money
in a country.
OR: Currency refers to the total stock of money in the country which includes
foreign currencies that are not legal tender to the country.
25. Dear Money. This is the money where the government deliberately keeps the rate
of interest very high in order to reduce borrowing from the commercial bank

THE ROLE OF MONEY IN AN ECONOMY

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1. It encourages specialisation in the economy associated with high level of output.
2. It promotes commercial production due to increased resource utilization and
reduces subsistence production.
3. It promotes development of credit markets for borrowing and lending which is
difficult with barter trade.
4. It promotes savings hence increased investments in an economy.
5 It encourages hard work by individuals so as to improve standard of living.
6. It makes it possible for the government to influence economic activities in the
country through monetary and fiscal policies.
7. Money provides a means through which price mechanism operates through
pricing of commodities.
8. Money enables the distribution of income among factor owners. The rewards to
factors of production are expressed in form of money making it possible to
determine distribution of income among them.

THE DEMAND FOR MONEY (LIQUIDITY PREFERENCE THEORY)

Demand for money is the desire by the public to hold wealth or assets in form of money.
Or Demand for money is the desire to hold wealth as money rather than interest earning
assets.

Determinants of liquidity preference/demand for money

1. Level of interest rate. High interest rate acts as an incentive for people to earn
much from their money which encourages them invest it hence a fall in liquidity
preference. On the other hand, low interest rate increases the level of liquidity
preference because people do not see much reward in investing their money to
earn interest.
2. The general price levels. High general price levels prices leads to high liquidity
preference as people tend to hold much money so as to enable them meet their
needs but as prices stabilize, the level of liquidity preference also tends to fall.
3. Availability of investment incentives. Favourable investment climate in a
country leads to low liquidity preference as people invest their money in different

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 economic activities for a profit. On the other hand, unfavourable investment
climate leads to high liquidity preference as people feel safe keeping their money
in cash form rather than risking it.
4. Knowledge of banking facilities. Awareness about banking facilities encourages
people to make use of them by keeping their money in banks thus low liquidity
preference. On the other hand, prevalence of ignorance about banking facilities
makes people hold much cash especially when they feel that they have to go
through much hustle to bank or withdraw their money thus high liquidity
preference.
5. Level of transactions. High the level of transactions by customers leads to high
liquidity preference because there is much need by people to have daily needs for
survival. On the other hand, when the level of transaction falls, liquidity
preference reduces since there is less need to hold money for purpose of carrying
out transactions.
6. Income levels. High level of income among people leads to low liquidity
preference since they can easily invest their money elsewhere to earn them interest
both in the short run and long run. On the other hand, people with low incomes
tend to hold most of their wealth in cash since they are likely to need it any time.
7. Level of speculation. High level of speculation in securities with high interest
leads to low liquidity preference as speculators invest their money in bonds and
treasury bills to earn a profit. On the other hand, low level of speculation in
securities with low interest leads to high liquidity preference as speculators prefer
to have their money in cash form rather than investing it in securities.
8. Level of development of financial institutions/Nature of distribution of
commercial banks. High level of development of financial institutions leads to
low liquidity preference as people make use of banks by keeping their money in
them. On the other hand, low level of development of financial institutions leads
to high liquidity preference because banking becomes an inconvenience

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According to John Maynard Keynes, people do not demand for money for its own sake
but due to influence of some motives which include the following:
1. The Transaction motive. This is the desire to hold money in cash balances for
carrying out day-to-day transactions for example buying food, fuel, clothes, paying
for transport. The transaction motive is influenced by the following factors:
 The level of income
 The general price levels
 Level of monetization of the economy
 Level of economic activities
 The time it takes for one to receive money/income.

2. The precautionary motive. This is the desire to hold money so as to cater for
unforeseen circumstances for example, getting visitors, falling sick. The
precautionary motive is influenced by the following factors:
 The level of income of people.
 The cost of insurance and health facilities.
 Business opportunities for unexpected profitable deals.
 The level of inflation in an economy.
 The time it takes for one to receive money

3. The speculative motive. This is the desire to hold money in cash balances by
people so as to earn more incomes and profits in near future through speculation.
The amount demanded for this purpose depends on interest payable to treasury
bills and bonds i.e. at a high rate of interest speculators prefer to hold securities
instead of money whereas at low rate of interest speculators prefer to hold money
instead of securities.

NOTE: The least (minimum) rate of interest below which people would rather
hold their money instead of investing it in bonds or stocks is known as Liquidity
trap.
Liquidity trap is a situation where the interest rate is too low to induce people invest in
securities.
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Or
Liquidity trap is a situation where the interest rate is too low to break the liquidity
preference.

Diagram

When the rate of interest is expected to fall from Or 2 to Or1, speculators convert bonds
into cash to avoid capital loss. On the other hand, when the interest rate is expected to
increase from Or1 to Or2, speculators buy bonds hence less money in their hands. The
speculative motive is influenced by the following factors:

 The interest rate in financial institutions in relation to returns.

 The level of people’s income to buy securities.
 The business trends in the country whether favourable or unfavourable.
 The willingness of the public to buy securities.

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4. Finance (investment) motive. Finance motive is the desire to hold money in cash
balances in order to finance ongoing investments. The finance motive is
influenced by the following factors:
 Marginal efficiency of capital.
 Availability of investment incentives/Government policies towards
investment
 The political climate.

MONEY SUPPLY
Money supply refers to the total amount of money in circulation and on demand deposit
on current Accounts at a particular time.
There are two types of money supply:
 Exogenous money supply:
This is where the amount of money supplied by the mintinting authority like the
central bank, ministry of finance or any other authourised monetary authority is
independent of the economic activity in the country.
The money supply is usually fixed in supply and it can be illustrated as follows;

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According to the diagram, the money supply is fixed (perfectly inelastic) and it is
independent of the levels of economic activities .It neither expands nor contracts with the
flow of economic activities.
 Endogenous money:
This is a type of money supply which depends on the level of economic activities
within an economy e.g. output, interest, interest rate, price levels.

An illustration of Endogenous money

From the illustration above at lower interest R1, there is less money supply(Q1) ,
however an increase in the interest to R2 leads to an increase in money supply to
Q2.
Factors that influence the money supply in an economy include the following;
 The level of economic activity. In an economy where there is a policy of
expanding economic activities e.g. agriculture, tourism, etc more money is
required leading to an increase in supply. However, where there is limited
expansion of economic activities which requires little money result onto low
money supply.
 Level of Inflow and outflow of funds. High level of inflow of funds (by foreign
investors, remittances by nationals living abroad, by tourists) from abroad leads to
high the level of money supply. On the other hand, high level of capital outflow in
form of profit and income repatriation, expenditure on imports, investing in the
outside economy leads to low level of money supply.

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 Government monetary policy through the central bank. An expansionary
monetary policy leads to high level of money supply because the intention is to
increase the amount of money in circulation. On the other hand, restrictive
monetary policy leads to low level of money supply because the intention is to
reduce the amount of money in circulation.
 Level of liquidity preference. High level of liquidity preference leads to high
money supply because people prefer holding money rather than assets. On the
other hand, low level of liquidity preference leads to low money supply because
people prefer holding assets other than money itself.
 The Interest rate. High interest rate means low rates of borrowing which
eventually leads to low level of money supply. On the other hand, low interest rate
means high rate borrowing which eventually leads to high level of money supply.
 Level of monetization in the economy/size of the subsistence sector. An economy
that is highly monetized, the level of money supply is high since production is for
commercial purpose and more money is required for exchange. On the other hand,
an economy with a big subsistence sector, the level of money supply is low
because production is for own consumption and not for sale, therefore less
money is required.
 Level of government expenditure. The higher the level of government expenditure
especially on productive projects the higher the money supply. On the other hand,
the lower the level of government expenditure, the lower the money supply.
 The level of credit creation. High level of credit creation implies that more money
is created which results into high money supply in an economy. On the other hand
low levels of credit creation, limits the amount of money/credit created leading to
low money supply.
 Government level of borrowing and expenditure. This is mainly done through the
buying of securities i.e. when the public buys securities , money is borrowed by
the government which lowers the level of money supply in the economy. On the
other hand where the government/ the central bank buys back securities from the
public it leads to high money supply in the economy.

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 The balance of payment position of a country. The balance of surplus in an
economy leads to increase in money in circulation leading to high levels of money
supply, While a balance of payment deficit leads to low amount of money in
circulation leading to low levels of money supply in the economy.
 The level of printing/minting of money. Printing of more money by the central
bank increases the amount of money in circulation hence increasing money
supply, on the other hand limited printing of money by the central bank reduces
the little money in circulation hence low levels of money supply.

THE QUANTITY THEORY OF MONEY: IRVING FISHER 1911

The quantity theory of money states that the general price level is determined by the
quantity of money in circulation assuming that the velocity of circulation (V) and the
level of transactions (T) are constant. The quantity theory of money is represented by the
Fisher equation,

MV
MV = PT or P=
T
Where;
M= Quantity of money in circulation
V= Velocity of circulation of money (average number of times each unit of a currency
changes hands in financing a transaction)
P= General Price level
T= Level of transactions (total amount of goods and services supplied.

Examples:
1. Given that the volume of money in an economy is £ 20 billion, total level of
transaction is £ 250million and the velocity of circulation is 20.Calculate the
general price level in the economy.
2. Given that the quantity of money is Shs. 1million, Velocity of circulation is 20 and
the price level is Shs. 80000, calculate the volume of transaction.

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3. Assuming Velocity of circulation and transactions made are held constant i.e. 10
and 50 respectively but money supply is doubled from Shs. 100 to Shs. 200,
calculate the new price level.

Assumptions of the quantity theory of money

 The theory assumes that, the velocity of circulation and the level of transactions
are held constant , this is to allow the money in circulation and the general price
level to change in the same proportions.
 The theory assumes that all the money received by the people is spent on goods
and services or it is for transctionary motive
 Prices are assumed to be determined by the amount of money supplied only.
 The theory assumes that there is no hoarding or saving of money because if money
supply is increased and volume of savings is also increased at the same rate, the
general price level would remain constant.
 The theory assumes that all transactions use money as a medium of exchange for
goods and services and ignores the barter trade system/Assumes that there is no
barter trade.

Limitations of the quantity theory of money

 The theory only attempts to explain changes in the value of money, but does not
show how the value of money is determined.
 The theory assumes that the demand for money is only for transaction motive,
ignoring other motives like precautionary and speculative motives.
 The theory does not take into account other factors that bring about a change in the
general price level other than money supply e.g. costs of production(cost push
inflation), forces of demand and supply(demand pull inflation), changes in foreign
exchange rates.
 The theory assumes that velocity of circulation (V) and the level of transactions
(T) are constant and this is not the case in real life as the two variables can change
according to changes in economic conditions.

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 There is no general price level but rather a series of price levels given the fact that
price is responsive to forces of demand and supply.

 The theory ignores the influence of interest rate on the general price level and
money supply, this is because high interest rate discourages borrowing hence low
money supply.

 An increase in money supply may result into high level of savings if the marginal
propensity to save is high this reduces the velocity of circulation the rate at
which money changes hands) and then the prices may fall instead of increasing.

 In a situation where a country has many unemployed resources/idle resources the

increase in money supply leads to an increase in output of goods and services
which makes prices fall or not change at all.

 Bargaining /haggling between buyers and sellers to reach agreeable price is not
taken into account by the theory ,i.e. the buyer may be in a strong bargaining
position an the price will not increase.

 Government price legislation /control in form of maximum price is not catered for
by the theory.

 The quantity theory of money is just an expression (truism) which merely shows
the relationship between four variables M, V, P, T but not a true theory.

 The four variables M, V, P and T are not independent of one another because a
change in one induces change in others.
 It ignores barter trade because it assumes that all transactions are effected by use
of money.
 It ignores the demand for money and only looks at money supply in an economy
and yet there could be genuine demand for money.

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 CIRCUMSTANCE UNDER WHICH AN INCREASE IN MONEY SUPPLY
MAY NOT NECESSARILY LEAD TO AN INCREASE IN THE GENERAL
PRICE LEVEL;
 When there is a corresponding increase in the level of output of goods and
services in a country.
 If the increased money supply is used to purchase capital goods for
investment, prices will remain constant.
 When there is a high marginal propensity to save, the increased money
supply will not lead to inflation/ increase in price the money will be saved.
 Where there is government control over prices i.e. if the government fixes
the maximum prices.
 Where the interest rate on capital is high.

THE VALUE OF MONEY

Value of money refers to the amount of goods and services a unit of money can buy. Or
Value of money refers to the purchasing power of a unit of money. If the volume of
goods and services is big from a fixed quantity of money, then the value of money is said
to be high and vice-versa.

Value of money can be categorized as:

 Nominal value. This refers to the face value of notes and coins irrespective of
what value it can command in terms of goods and services.
 Real value. This refers to the amount of goods and services that can be bought
using a given amount of money.
 Intrinsic value. This refers to value of paper or metal from which money is
obtained.

Factors influencing the value of money

 The price level/rate of inflation. High rate of inflation leads to a reduction in
purchasing power of money and a fall in value of money. On the other hand, low
rate of inflation leads to a rise in purchasing and value of money.
20
 The quantity of money in circulation. High level of supply of money leads to an
increase in purchasing power and a fall in value of money. On the other hand, low
level of supply of money leads to a reduction in purchasing power and rise in
value of money.
 Availability of goods and services /level of transactions. High level of
transactions makes goods more available thereby increasing the value of money.
On the other hand, low level of transactions leads to a reduction in the volume of
goods available leading to an increase in price level and a fall in money value.
 The velocity of circulation of money. High velocity of circulation of money
leads to a fall in value of money because it leads to high price level. On the other
hand, low velocity of circulation of money leads to a fall in price level and high
value of money.
 Government policy of devaluation. Government can deliberately reduce the
value of money through devaluation and increase the value of money through
revaluation.

BANKING
Banking is a business activity of accepting and safeguarding money owned by
individuals and business entities, and then lending it out in order to earn a profit.
Banking is done by financial institutions which direct the flow of money to productive
use and investments.

FINANCIAL INSTITUTIONS (INTERMEDIARIES)

Financial institutions are specialized business units which are developed to provide
finance required in the modern sector.
These institutions deal in money as their commodity and they usually serve as channels
through which savings flow into productive investments, and they charge a price known
as interest. Financial institutions are broadly categorized as:
1. Banking Financial Intermediaries/Institution.
These are firms/organizations/financial institutions that receive deposits, give out
loans and create credit/create new deposits.

21
2. Non- Banking Financial intermediaries/Institutions.
These are firms/organization/financial institutions that receive deposits, give out
loans but do not create credit. Examples are: Development banks, state co-
operatives, Insurance Corporations, Housing finance companies, Post office
savings Banks etc.

DIFFERENCES BETWEEN BANKING AND NON-BANKING FINANCIAL

INTERMEDIARIES
 Banking financial institutions require high value assets as collateral security to
access to loans while non-banking financial institutions do not require a lot of high
value assets as collateral security for loans.
 Non-banking financial intermediaries are development oriented for instance
development banks unlike the banking financial institutions such as commercial
banks.
 Banking financial institutions only invest in less risky ventures or projects such as
certificate of deposits, savings accounts while non-banking financial institutions
undertake investments in risky projects such as mining, agriculture etc.
 Banking financial intermediaries have a high profit motive unlike the non-banking
financial institutions with low profit motive.
 Banking financial intermediaries create credit through use of cheques which is not
the case with non-banking financial intermediaries which obtain funds from
development oriented institutions such as IMF and World Bank.
 Banking financial institutions charge a high interest rate as they are profit
motivated unlike the non-banking financial institutions which charge a low interest
rate as they are development oriented.
 Banking financial intermediaries carry out investments in financial assets like
treasury bills, bonds, stocks, foreign exchange while non-banking financial
intermediaries carry out investments in real assets like roads, houses, factories, and
railways.

22
 Banking financial institutions normally offer short-term loans to customers while
non-banking financial institutions offer long-term loans for capital development
expenditure.

THE ROLE OF NON- BANK FINANCIAL INTERMEDIARIES IN

DEVELOPMENT
 They provide savings in the country because they allow the public to
deposit their money with them.
 They facilitate investment in the economy by extending loans to the people
especially those dealing in long-term projects.
 They lead to development of infrastructures in the economy because they
participate in putting up of good infrastructure to enhance the running of
their business.
 They create employment opportunities for the public, because the public
secures jobs in different areas of the institutions.
 They provide revenue to the government through taxes that are imposed on
these institutions.
 They promote the development of entrepreneurial skills through providing
investment resources institutions.
 They provide for the social welfare of the people through pension schemes
by the social security institutions and the insurance companies.

 They promote trade and commercial activities by lending people for various
purposes.
 They act as capital markets where capital resources can be obtained for
long term investments.

THE BANK
A bank is a business institution which accepts deposits from surplus spending
units in form savings especially from the public and then lends the same to
earn a profit.
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 TYPES OF BANKS

DEVELPOPMENT BANKS
This is a bank mainly created by a state or governments of neighbouring countries to
promote the development of infrastructure in the country or region.
They also promote industrial growth within the country or within the region the country
or within the region e.g. the East African development, Uganda development bank,
African Development Bank, Arab Bank for Economic Development in Africa.
Their sources of funding is mainly Africa Development Bank, OPEC fund, United States
Agency for Development, and the World Bank.

Development banks are development oriented non-bank financial institutions offering

long-term loans for investment at low interest rate, especially in agriculture, industry and
infrastructural development (roads, ports, power dam projects, irrigation schemes)

Development banks perform the following functions:

 They give out loans for investment purposes especially where commercial banks
cannot manage.
 They encourage growth of risky but developmental ventures like mining,
agriculture.
 They attract foreign technical assistance required in the development of vital areas
 They initiate long term lending to individuals, institutions whose projects are
deemed necessary for development of the country.

THE CENTRAL BANK

A central bank refers to a central monetary institution which is responsible for financial
management, and controlling other financial institutions in a country operating on non-
profit motive. Examples include: Bank of Uganda, Central Bank of Kenya, Bank of
England etc.

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SPECIALISED BANKS
These are commercial banks which are set up to serve a special type of customers with
specific services. E.g. Housing Finance Bank, Development Finance Company of
Uganda(DFCU)

SAVINGS BANKS
These are banks which are set up to promote the culture of savings among people in the
country. They attract deposits of any size but limit the withdraw facilities.

COMMERCIAL BANKS
Commercial banks are financial institutions which carry out financial businesses by
accepting deposits from the public and lending out money on profit motive. Examples in
Uganda include; Standard Chartered Bank, Stanbic Bank, Centenary Bank, Diamond
Trust Bank etc.

FUNCTIONS OF COMMERCIAL BANKS/BANKING FINANCIAL

INSTITUTIONS
NB: (These are mandatory duties of commercial any commercial bank)

 Accepting deposits. . This is done by allowing customers to open different types of

accounts like, savings account, current account, fixed deposit, by doing so they
safeguard customers’ money.

 Advancing loans to trustworthy customers. This is done through offering different

loan products on short term and long term basis .Such loans help the customers
with financial difficulties e.g. a bank over draft is an example of a short term loan.

 Act as custodians of their customers valuables/clients .Commercial banks provide

strong rooms to keep customers valuable items like academic documents, land
titles, important business agreements/contracts etc.

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 Issuance of various forms of instruments credit/provide easy means of payment
such as cheques ,drafts, credit and debit cards. They provide excellent means of
enabling payments. These facilitate the transfer of money from debtors to creditors

 They issue letters of credit to and act as referees to their clients. Commercial banks
act as referees or guarantors’ on behalf of their clients who are buying goods on
credit.

 Provide advice to the investors on possible investment choices. This is advice is

mainly financial or business related. E.g. they assist customers to make realistic
business proposal and business plans.
 Underwrite shares and debentures of companies as wells as discount bills of
exchange/ financial securities. Commercial banks trade in the issued securities as
primary dealers who sell them to other interested clients.
 They act as trustees and executors of property and will of their deceased clients/
customers. Here they accept to manage the property or estates of their deceased
clients to benefit the deceased’s family.
 They help in the exchange of currencies of different countries .They buy and sell
local and foreign currencies, here they act as foreign exchange bureaus.

THE ROLE OF COMMERCIAL BANKS IN DEVELOPMENT

 They facilitate the process of investment by moblising savings from the public as
well as extending loans to people/public.
 They provide employment opportunities because commercial banks employ
people to perform different tasks in their different branches and departments e.g.
accounts, managers, cleaners security guards etc
 Commercial banks facilitate/assist the government in implementation of the tools
of the monetary policy .i.e. they help the central bank in circulating the newly
issued currency.
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 They encourage monetisation of the economy by promoting exchange using
money.
 Commercial banks promote skills development by providing on job training to
their employees.
 They facilitate and stimulate the development of infrastructures in the economy
i.e. they participate in the construction of buildings, roads, communication
networks in order to improve their services.
 They increase government revenue .This is because they pay different taxes to the
government.
 They facilitate and promote trade both internal and external by enabling traders to
transfer their money safely.
 They are instrumental in promoting capital accumulation process. This is because
of their capacity to mobilize savings from the public.
 They contribute investment capital in the country through buying shares from
various public limited companies.
 They assist potential investors by giving them advice on investment opportunities.
 They giving recommendations and covering letters to potential investors which
facilitate internal and foreign and internal trade.
 They offer specialized and diversified services which are necessary for peoples
welfare and development e.g. issuing travellers’ cheques.

FOREIGN COMMERCIAL BANKS

These are banks established in the country i.e. Uganda by foreigners and they have their
headquarters in their mother countries.e.g. Barclays bank, Standard Chattered bank, Cairo
international bank etc.

Role of foreign commercial banks

Positive roles:
 They provide employment opportunities because commercial banks employ
people to perform different tasks in their different branches and departments e.g.
accounts, managers, cleaners security guards etc
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 They promote good international relationships among countries i.e. between their
mother country and their host country and this promotes international peace.
 They facilitate investment in the private sector through the provision of loans to
the potential investors.
 They promote efficiency in the banking sector through creating stiff competition
with the local banks.
 They facilitate the process of international trade by exchanging the foreign
currencies for importers and exporters.
 They offer international banking services because government collects taxes from
the banks.
 They lead to development of local managerial skills through demonstration effect
since the people employed learn a lot of from expatriates and in addition the banks
provide training banking skills.
 They increase the rate of monetisation of the economy because the loans they give
out help people to produce for commercial purposes.
 They contribute to the development of infrastructure in attempt to improve on
their services. They participate in construction of roads, buildings, extension of
power supply in rural areas etc.
 They facilitate technological development in the economy because transfer
modern methods of banking into the country. E.g. computerised banking services
including the use of Automated Teller Machines(ATM).
 They increase the rate of capital inflow into the country by facilitating the transfer
of money by citizens of the host countries.

Negative role of foreign commercial banks

 They worsen the balance of payment deficit because of the increased profit
repatriation.
 There is limited creation of employment opportunities in the country because the
banks mainly use capital intensive technology which is labour saving and also they
have discriminating employment policies in that they prefer employing foreign
manpower especially at ranks jobs.
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 They outcompete local banks because they have more finances and better
technology than the local banks.
 They encourage rural urban migration and its related evils since the banks are
concentrated in urban areas which attract people from rural areas to urban areas.
 They make the implementation of the monetary policy difficult because they do
not co-operate with the central bank since they have a lot of to inject in the
economy from their mother banks abroad.
 They discourage mobiliastion of savings because they require high initial deposit
which many people cannot afford.

PROBLEMS FACING COMMERCIAL BANKS IN DEVELOPING COUNTRIES

(UGANDA)
 The limited/small size of bank deposits because of the high level of poverty among
the people which limits the number of clients to the bank.
 The limited number of credit worthy customers/There are a few credit worthy
borrowers who can pay back the loans advanced to them hence limiting expansion
of the banking sector
 Political interference in the management of commercial banks and this makes it
difficult for banks to make decisions on their own, i.e. they are forced to function
according to the desires of the government.
 Political instability/ High levels of insecurity where people fear to borrow for
investment therefore funds remain underutilized in commercial banks.
 Limited skills among banking officials which makes them incompetent to run the
commercial banks, the inadequate supply of skilled manpower to manage the bank
forces the banks to hire foreign managers who are highly paid.
 Low levels of accountability or high level of corruption among banking officials
which makes commercial banks to incur huge losses leading to closure of many
of them.
 Stiff competition with other financial institutions such as microfinance institutions,
post office savings banks, savings and credit cooperatives all of which make
commercial banks earn little profit.
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 High liquidity preference by the people which reduces savings with commercial
banks.
 High costs of operation in terms of insurance cover, high wage bill, high power
bills, rent
 Uneven distribution of commercial banks where the majority are urban based
hence neglecting the potential borrowers and savers in rural areas.
 Ignorance of the public/People about banking facilities, this limits the use of
commercial banks by the population resulting into low deposits.

MEASURES THAT MAY BE TAKEN TO IMPROVE THE PERFOMANCE OF

THE BANKING INDUSTRY IN DEVELOPING COUNTRIES(UGANDA)
 Encourage extension of banking services to rural areas
 Close the banks that do not meet the minimum requirements
 The central bank should Undertake close supervision of the commercial banks
 Sesnitise the public on the importance of banking
 Encourage training of more bankers
 Increase people’s incomes so as to increase their deposit with banks
 Government should reduce her interference in the activities of commercial banks
 Ensure political stability so as to promote economic activities which will motivate
people to borrow for investment purposes.

FEATURE OF COMMERCIAL BANKS IN UGANDA

 They are mainly urban based
 They are generally weak and underdeveloped
 Many are foreign owned
 Many have a weak capital base
 They mainly charge high interest and service fees
 They mainly offer free for few products(services)
 They have few branches.
 Many are privately owned

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ASSETS AND LIABILITIES OF COMMERCIAL BANKS:
ASSETS OF COMMERCIAL BANKS
Assets are possessions of a bank and all other claims on other financial institutions and
customers. Assets include the following:
 Cash at hand in local and hard currencies.
 Reserves with central bank.
 Investment in securities including; treasury bills, bonds.
 Fixed assets in form of land, buildings etc.
 Loan advances and overdrafts to customers.
 Long-term investments.
 Deposits with other banks and non-bank financial intermediaries.
 Interest on loans advanced to customers.

LIABILITIES OF COMMERCIAL BANKS

Liabilities are claims against the assets of the bank by its creditors, depositors or what the
bank owes.
Liabilities include the following;
 Share capital.
 Customer deposits.
 Deposits by other banks.
 Government funds deposited in the bank.
 Dividends payable to shareholders.
 Reserve funds payable to the central bank.
 Bills discounted with the central bank.

CONFLICTING OBJECTIVES OF COMMERCIAL BANKS

Commercial banks are always faced with the dilemma of achieving various objectives of
liquidity , profitability and security. .g. if the banks increases lending so as to earn more

31
profits, it won’t meet the customers money demand which will make them lose
confidence in the bank and thereby depositing less of their money in the bank.
In the same way, when they maintain liquidity to attract confidence in the customer the
banks will not get profits and therefore there will be no funds for lending. Commercial
banks therefore have to find a way of reconciling the conflicting objectives.

How commercial banks ensure liquidity

Commercial banks undertake the following to ensure that they always have cash to give
their clients.
 By purchasing of short term securities that can be turned into cash easily e.g.
buying treasury bills.
 They lend out money in phases such that at all times there is some money to
meet the daily cash requirements.
 By maintaining the cash ratio. The cash ratio is the proportion of deposits that
commercial banks or liquid form in their premises in order to meet the daily
requirements of their customers .
 Maintaining a minimum balance on the different accounts of their customers.
 Commercial banks lend on short term basis such that the cash is easily restored
 They ensure that the borrower deposit a marketable security with the bank which
can be liquidated in case of failure to pay the loan.

How Commercial banks ensure profitability/Maintain profitability

The commercial banks undertake the following to ensure that they make profits,
 Advancing loans and overdrafts at a given interest. Here commercial banks charge
interest depending on the amount of money borrowed and the time taken. The
interest earned improves profitability.
 Undertaking investment in profitable projects. The commercial banks invest their
money in businesses/project that are highly profitable e.g. investing in real
estates ,investing in securities.

32
 They charge fees for their different services e.g. they have bank charges,ledger
management fees, charges on money withdrawals etc, such money is accumulated
to create profits for the banks.
 Charging a commission for services rendered to customers e.g. where they act as
custodians of estates of the deceased. The commission they earn improves their
revenue and profitability.
 By discounting bills of exchange and promissory notes at a fee.
 They buy shares in other companies like other members of the public. Commercial
banks buy shares floated by companies. From these they earn dividends annually
to improve their revenue and profits.

How commercial banks ensure security:

Commercial banks ensure security in the following ways;
 They demand for marketable collateral security to extend loan to their
customers.
 They spread their assets in different categories of liquid assets e.g. cash
deposits with other banks, fixed assets etc.
 They extend short term loans and avoid long term loans
 They put up strong buildings where they carry out their activities
 They employ security guards
 They take up insurance covers against various risks.

CREDIT CREATN
Credit creation is the process by which commercial banks create excess deposits out of
the initial deposits made by customers.

Assumptions of credit creation

 It assumes that there is a fixed cash ratio e.g. 10%
 It assumes a fixed initial deposit e.g. Shs. 100,000

33
 It assumes that there are several banks in the system (multi-bank credit creation
process) or there is only one bank with very many branches (Uni-bank credit
creation process).
 It assumes that when people get loans in form of cheques, such cheques are
deposited in other banks or in other branches of the same bank.
 It assumes that the public/ are willing to borrow money from commercial banks.
 It assumes that the public should be credit worthy.
 It assumes the use of cheques i.e. there must be a large number of current account
holders so that commercial banks use the deposits to create credit.
 It assumes that there are many people willing to deposit money in the bank
therefore have confidence in the bank.
 It assumes that commercial banks are willing to give/lend money to the public.

The basic terms used in credit creation

Bank deposit/ Credit Multiplier.
Credit multiplier is the number of times by which an initial bank deposit multiplies itself
to generate a final change in total credit created/total bank deposits
Total deposit 1 1
(
Credit multiplier ¿ Initial deposit ∨ r cash ratio )
The size of the bank deposit depends on the following;
1. Level of liquidity preference
2. Interest rate on deposits
3. The willingness by the masses/public to borrow
4. The size of the cash ratio
5. Number of banks in the system
6. Size of initial deposit
 Cash ratio. This is the proportion/ fraction/percentage of commercial
banks deposits that must be kept/remain in the bank in cash form to meet
the cash demands of depositors.

34
  Reserve ratio. This refers to percentage/fraction of the commercial bank’s
total deposits which law must either be kept with the commercial bank or
with the central bank.
Factors that influence the reserve ratio
1. The rate of inflation/The amount of money in circulation
2. The level of credit creation
3. Level of liquidity of the commercial bank
4. The level of uncertainty in the financial sector
 Liquidity ratio. This is the proportion of total deposits of a commercial
bank in form assets that can easily be turned into cash such as bank drafts,
cheques
Reasons for adoption of reserve ratio in an economy
1. To control inflation/reduce the amount of money in circulation.
2. To restrict credit creation by commercial banks.
3. To protect interests of depositors in times of crisis and financial instability.
4. To safe guard commercial banks against uncertainties i.e. during periods of
economic recession.

THE PROCESS OF CREDIT CREATION

1. Receiving enough initial deposit of shs.100, 000= by the first bank (Bank A) from
customers/ depositors.
2. Keeping a certain percentage of the initial deposit as cash ratio i.e. 30% or
shs.30, 000 as cash reserves.
3. Lending out the remaining percentage of the initial deposit as a loan to a trusted
borrower, for example shs.70, 000.
4. Receiving the money lent out as new deposit by another/the second bank
(Bank B) i.e. 70,000=
5. Keeping a percentage of the new deposit by the second bank as cash ratio, for
example 30% of shs.70, 000= or shs.21, 000=.
6. Lending out part of the new deposit to a trusted borrower by the second bank for
example, shs.49, 000=.

35
7. The process continues until the initial deposit defuses into the banking system.
8. At the end of process the total credit created is equal to initial deposit x Bank
multiplier.

Total credit created = Initial deposit x bank multiplier but bank multiplier is equal to 1/r

( cash1ratio ) = 100, 000 × 5

= shs.500, 000

ILLUSTRATION OF CREDIT CREATION

Given that Bank A has initial deposit of UgShs.100, 000, and the required cash ratio is
30%, credit is created as shown in the table below.
Banks/Branch Initial Cash Ratio (30%) New loans/Excess Reserves
es Deposit
A 100,000= 30 x100,000= 30,000 100,000-30,000
100 = 70,000
B 70,000= 30x70,000= 21,000 70,000-21,000
100 = 49,000
C 49,000= 30x49,000= 14,700 49,000-14,700
100 = 34,300
D 34,300= 30x34,300= 10,290 34,300-10,290
100 = 24,010
E - - -
Up to n
NB. Total credit created for four banks = 100,000+70,000+49,000+34,300 = 253,300/=

FACTORS INFLUENCING THE PROCESS OF CREDIT CREATION

 Level of liquidity preference by individuals. High demand for cash implies that
people deposit less in commercial banks and this reduces the ability of commercial
banks to lend hence low credit creation, on the other hand low liquidity preference
implies that individuals make large deposits into commercial banks. This increases the
funds available for lending thus promoting the process of credit creation.

36
 Size of the cash ratio. The higher the cash ratio, the lower the level of credit creation
since banks are able to retain a lot of money which they use for lending, however the
lower the cash ratio, the higher the level of credit creation since banks are able to
retain less of the customer’s deposits which limits the amount of money for lending.

 Interest rates on loans. High interest rate on loans lead to low demand for loans as
borrowing becomes expensive hence limiting credit creation, on the other hand low
interest rate on loans lead to high demand for loans as borrowing becomes cheap, thus
promoting the process of credit creation.

 Availability of collateral security. . Presence of collateral security encourages

commercial banks to lend out money to the public hence high level of credit creation.
On the other hand, absence of collateral security discourages commercial banks from
lending out money to the public thus low level of credit creation.
 Level central bank interference through the monetary policy. Restrictive monetary
policy by the central bank reduces the amount of money to be held by commercial
banks for lending hence limiting the process of credit creation, on the other hand, an
expansionary monetary by the central bank increases the amount of money held by
the commercial banks for lending thus promoting the process of credit creation.
 Level of monetisation of the economy/Size of the subsistence sector. High level of
monetization of the economy leads to high level of credit creation because most
economic activities require use of money hence increased borrowing from
commercial banks. On the other hand, a large subsistence sector reduces the amount
of credit created as most of activities done do not require a lot of funds hence reduced
borrowing from commercial banks.
 Nature of distribution of commercial banks/Level of development of the banking
sector. Even distribution of commercial banks in a country promotes credit creation
as lending services are within the reach of the customers, alternatively even
distribution of commercial banks encourages saving thus increasing the size of bank
deposits, On the other hand, poor distribution of commercial banks limits the credit

37
 creation as lending services are not wholly accessed by the public and at the same
time it limits the size of bank deposits.
 Level of awareness of people about the banking services. High level awareness
about banking services promotes the process of credit creation ,this is so because
many people are knowledgeable about the existence of bank loans and therefore
go for them borrowing. On other hand limited knowledge about bank loans limit
the process of credit creation because few people go for bank loans.

 Availability of funds for lending/Size of bank deposit. A large amount of bank

deposits increases the loanable funds and there promotes the process of credit
creation On the other hand, a small amount of bank deposits reduces the loanable
funds which limits the process of credit creation
 Degree of accountability in the commercial banks. Transparency in commercial
banks promote the process of credit creation because bank officials do not ask for
bribes before advancing loans, thus encouraging the public to borrow, on the other
hand low level of accountability in commercial banks limits the process of credit
creation because bank officials make it hard for customers to access loans since
they ask them for loans.
 Availability of investment opportunities. Existence of man investment promotes
borrowing since different people need money to take on such opportunities and
this leads to high level of credit creation, on other hand existence of few
investment opportunities in the country results into low demand for loans hence
limiting the process of credit creation.
 Availability of credit worthy borrowers/ customers. Existence of many
creditworthy customers promotes the process of credit creation because there are
many people qualify for bank loans, on other hand a small number of credit
worthy customers limits the process of credit creation because few people qualify
for bank loans.
 Political climate/Atmosphere ,political instability discourages borrowing and
lending and this limits the process of credit creation because people fear to lose

38
 their lives and property, on the other hand political stability encourage borrowing
and lending which encourages investment because people are not scared of losing
their lives and property.

LIMITATIONS OF CREDIT CREATION

 High liquidity preference.
 High cash ratio
 Lack of collateral security (houses, gold, machinery, land titles, vehicles Limited
number of commercial banks.
 Limited number of commercial/poor distribution of commercial banks.
 Limited investment opportunities.
 Ignorance of the public about banking service
 High interest rates on loans.
 Restrictive monetary policy.
 Large subsistence sector/low levels of commercialization.
 Political instability/Political turmoil
 Low levels of accountability
 Limited number of credit worthy borrowers.
 Low level of bank deposits/Low level of savings

FACTORS THAT PROMOTE CREDIT CREATION

 Low level of liquidity preference.
 Low cash ratio
 Presence of collateral security (houses, gold, machinery, land titles, vehicles
Limited n
 High number of commercial banks/ Even distribution of commercial banks.
 Large number of investment opportunities.
39
 High level awareness of the public about banking services
 Low interest rates on loans.
 Expansionary monetary policy.
 Low level of subsistence sector/High levels of commercialization.
 Presence of political stability
 High levels of accountability
 Large number of credit worthy borrowers.
 High level of bank deposits/High level of saving
INTEREST RATE DETERMINATION
Interest rate is the cost of borrowing money from a lender for a given period of time. Or
Interest is monetary reward /payment by a borrower to a lender for use of a sum of
money for a period of time.

Reasons why interest is paid by borrowers to lenders

 Lending involves foregoing present consumption which is painful; therefore the
lender should be paid for this in form of interest.
 Capital cannot be accumulated without savings which involves a lot of sacrifices;
therefore interest is paid as a reward for savings.
 Lending involves risks; and the lender should be rewarded for undertaking such
risks.
 Different expenditures are incurred during lending for instance keeping proper
accounts which requires stationery, manpower, licenses, legal charges, which
implies that interest is charged as reward for proper management.
 As a reward for inconvenience

DETERMINANTS OF INTEREST RATE IN A COUNTRY

 Supply of liquid/investment capital. High level of supply of liquid capital attracts
lower interest rate because banks want to increase funds available for investment
purpose. On the other hand, low level of supply of liquid capital attracts high
interest rate because banks are reluctant to increase funds for investment purpose.

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 Period of loan repayment. Long repayment period attracts high interest rate
because the time is too long to recover money lent out by banks. On the other
hand, short repayment period attracts low interest rate because the time is short to
recover money lent out by banks.
 Level of demand for loanable funds (investment capital). High level of demand for
loanable funds attracts high interest rate since customers show a lot of interest in
using loanable funds. On the other hand, low level of demand for loanable funds
reduces interest rate so as to attract customers to borrow money.
 Level of money supply in an economy. High level of money supply in an economy
leads to lower interest rate since the intention is to increase amount of money in
circulation. On the other hand, low level of money supply attracts high interest rate
because the intention is to reduce the amount of money in circulation.
 Economic situation for example, inflation and deflation. Inflation leads to high
interest rate so as to discourage people from borrowing due to loss of money
value. On the other hand, a deflation leads to low interest rate so as to increase the
amount of money in circulation and increase peoples purchasing power.
 Level of stability in banking sector. High level of stability in the banking sector
leads to low interest rate since banks are assured of recovering their money from
borrowers. On the other hand, instability in the banking sector leads to high
interest rate because banks may not be certain on recovery of their money from
borrowers.
 Policy of individual lender. Liberal money lenders charge lower interest rate to
attract many customers. On the other hand, strict money lenders charge high
interest rate especially in a situation where customers are not trust worthy.
 Number of banking institutions/level of development of banking sector. High level
of development of banking institutions leads to low interest rates since there is
competition for available customers thereby capturing big market. On the other
hand, low level of development banking institutions leads to high interest rates
since competition is limited in business.
 Government monetary policies. Restrictive monetary policy attracts high interest
rate because the central bank wants to reduce amount of money in circulation. On
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 the other hand, expansionary monetary policy attracts low interest rate because the
central bank wants to increase amount of money in circulation

MORE CONCEPTS USED IN BANKING

1. Credit. Credit is a financial facility which enables an individual or firm to borrow
money to purchase products, raw materials over an extended period of time.

2. Instruments of credit. Instruments of credit are written documents which

guarantee payment in near future and they give the holder a right to receive
money. Examples of instruments of credit include: Cheques, Promissory notes,
Bills of exchange, Bank drafts ,Bank overdraft, Travelers cheques, and Credit
cards.

ADVANTAGES OF CREDIT
 It helps to develop trade and industry by providing working capital
 Facilitates the process of credit creation leading to increased investment
 It economies the use of cash which helps to reduce inflation
 It encourages the development of entrepreneurship in the economy.

Disavadvantages of credit
 Excessive use of credit leads to demand pull inflation
 It encourages unnecessary expenditure since it encourages people to live beyond
their incomes.

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3. Liquidity. Liquidity refers to the extent to which an asset can quickly be converted
into currency notes and coins to be used as a medium of exchange. The level of
liquidity can be influenced by the following factors:
 Level of income
 Level of transaction
 Price levels
 Nature and duration of wage payment
 Monetary policy of the country

4. Credit crunch (squeeze or crisis)

A credit crunch is a reduction in the general availability of loans (credit). A credit
crunch is usually an extension of an economic recession. It makes it nearly
impossible for companies to borrow money because lenders are scared of
bankruptcies (defaults) which results into very high interest rates.
Causes of credit crunch in an economy
 Anticipated decline in the value of collateral used by banks to secure loans.
 The central government imposing direct credit controls on the banking
system.
 Sudden and unexpected increase in legal reserve requirements by the
central bank.
 Sustained period of careless and inappropriate lending which results into
losses for lending institutions.
 Reduction in market prices of previously over inflated assets/securities.

2. THE CENTRAL BANK

 A central bank refers to a central monetary institution which is responsible
for financial management, and controlling other financial institutions in a
country operating on non-profit motive. Examples include: Bank of
Uganda, Central Bank of Kenya, Bank of England etc.
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Functions of the central bank
1 Printing and issuance of currency. It has the sole authority of issuing national
currency i.e. notes and coins which are sufficient to enable the public carry out
transactions.
2. It is a banker to the government and various government institutions by keeping
government funds. This is because the central bank keeps all the government
money ie it manages the government treasury.
3. It acts as banker to commercial banks and other financial institutions. The
central bank accepts deposits from commercial banks and commercial banks
are required by law to have an account in the central bank.
4. It acts as a banker to International financial institutions such as international
Monetary Fund, World Bank. Each of these financial institutions operate an
account in the central bank for their operation s in the country.
5. It is a lender of last resort to the commercial banks, ie if commercial banks
fail to raise money to set their customers’ demands from other sources; they
borrow from the central bank.
6. It is the supervisor of other financial institutions banks specially the
commercial banks to ensure that they operate within the laws established.
7. It is responsible for management of foreign exchange reserves through
enforcing foreign exchange regulations and it acts as the chief custodian of
all the currencies in the country both local and foreign.
8. It is the advisor to the government on good and sound monetary and
economic issues depending on the level of economic activities e.g.
formulating budget, taxation, devaluation.
10. The Central bank manages a country’s public debt i.e. it manages payment
of money borrowed by the government.
11. It is a clearing house for all commercial banks i.e. they settle their
indebtedness through it.
12. The central bank is the controller of credit in the economy ie it uses the
monetary policy tools to regulate the amount of money in circulation

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MONETARY POLICY
Monetary policy refers to the deliberate attempt by the government through the central
bank to regulate the amount of money in circulation so as to attain certain or desired
development objectives ; such as price stability, stable economic growth rates, equitable
distribution of income etc.
Categories of monetary policy
 Restrictive/contractionary monetary policy. Restrictive monetary policy is a
deliberate government effort through the central bank to control the level of
economic activities by reducing the amount of money in circulation.
 Expansionary monetary policy. Expansionary monetary policy is a deliberate
government effort through the central bank to control the level of economic
activities by increasing the amount of money in circulation.

Objectives of monetary policy:

 To ensure price stability in the economy by either increasing or decreasing
purchasing power.
 To influence the level of employment/To ensure full employment of resources in
the country for both labour and other factors of production.
 To influence balance of payments position by ensuring that the foreign exchange
expenditure is less than foreign exchange earnings.
 To ensure stability of exchange rates in a foreign exchange market. This is through
regulation of both local and foreign currencies to avoid fluctuations in exchange
rates.
 To influence the level of economic growth by encouraging the production of
goods and services through the expansionary monetary.
 To encourage growth of financial sector through encouraging commercialization
of the economy.
 To influence the level and nature of investment by encouraging the commercial
banks to offer credit facilities to the priority sectors and limiting accessibility to
credit by investors in non priority sectors.
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 To help create a broad and continuous market for government securities e.g.
treasury bills and bonds through educating masses about the benefits of investing
government securities.

TOOLS /INSTRUMENTS OF MONETARY POLICY

These are guidelines employed by the government through the central bank to regulate
the amount of money in circulation so as to achieve development objectives

The tools of monetary policy include:

1. Open market operation. This refers to the central bank action of selling and
buying of government securities such as treasury bills and bonds to or from the
public with an aim of reducing or increasing the amount of money in circulation.
To increase the amount of money in circulation, the central bank buys securities
from the general public and to reduce the amount of money in circulation, the
central bank sells securities to the general public with an intention of withdrawing
money from people.

2. Bank rate/Discount rate. This is the rate at which commercial banks borrow
money from the central bank. An increase in bank rate by the central bank
discourages commercial banks from borrowing money. Commercial banks
therefore increase interest rate on loans given to customers thereby discouraging
the public from money from commercial banks. However, to increase on the
amount of money in circulation, the central bank lowers its bank rate so that
commercial banks can be able to lower the interest rate hence encouraging
borrowing money by the public from commercial banks.

3. Legal reserve requirement. This is the minimum amount of money that

commercial banks are legally required to deposit/keep with the central bank. To

46
 increase the amount of money in circulation, the central bank lowers the legal
reserve requirement so that commercial banks are left with enough money for
lending. However, to reduce the amount of money in circulation the central bank
increases the legal reserve requirement so that commercial banks have limited
amount of money to lend to the general public.
,
4. Variable reserve requirement /Cash Ratio. This is the proportion of commercial
bank’s total deposits/assets which it keeps in cash form to meet day-to-day
requirements of customers and other financial commitments. To increase the
amount of money in circulation, the central bank instructs commercial banks to
lower the cash ratio so as to increase the loanable funds, and to reduce the amount
of money in circulation, the central bank instructs commercial banks to increase
cash ratio so as to reduce the amount of money for lending.

5. Margin requirement. This is the difference between the value of collateral

security and the value of a loan to be advanced. The value of collateral security
must exceed the value of a loan to be advanced with the interest to be paid. Margin
requirement is increased to discourage people from borrowing money from
commercial banks thereby reducing on the amount of money in circulation. On the
other hand, margin requirement is reduced to encourage people borrow money
hence increasing the amount of money in circulation.
Example: If a building worth 200, 000,000/= is presented as collateral security
against a loan of 150,000,000/=; margin requirement will be 50,000,000/=.

6. Rationing of credit. Rationing of credit is where the central bank allocates

credit/loans to avoid over borrowing from commercial banks by some sectors. In
case of reducing the amount of money in circulation, commercial banks are given
little money by the central bank in form loans hence reducing their lending
capacity. On the other hand, in case there is need to increase money in circulation,
the central bank increases the amount of money which is lent to commercial banks
hence increasing their lending capacity.

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7. Selective credit control. Selective credit control refers to situation where the
central bank encourages commercial banks to give loans to specific sectors of
importance or priority like agriculture, industry and denying other sectors from
acquiring loans so as to reduce the amount of money in circulation. On the other
hand, in case the central bank wants to increase lending, it abolishes the policy of
selective credit control hence encouraging borrowing by all sectors of the
economy.

8. Special deposits (supplementary reserve requirement). Special deposits are

those deposits that the central bank demands from commercial banks on top of
legal reserve requirement. Such deposits are intended to reduce excess liquidity
with commercial banks and to reduce capacity to advance loans therefore reducing
the amount of money in circulation, however in order to increase amount of
money in circulation the central withdrawals the supplementary reserve
requirements.

9. Moral suasion. This is a way of persuading or advising commercial banks and

the general public about dangers of too much money or too little money in
circulation. The central bank does this by writing letters or circulars to commercial
banks encouraging them to reduce lending to the public the period of high rate of
inflation.

10. Currency reforms. This refers to replacement of the country’s currency that has
lost value with another currency of stronger value. This tool is used when there is
too much money in circulation resulting into loss of money value and loss of
confidence in the currency. The government through the central bank may decide
to execute a currency reform e.g. 1987 in Uganda. Here the old currency is
completely withdrawn from the circulation and replaced with a new currency of
higher value.

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FACTORS INFLUENCING THE OPERATION OF MONETARY POLICY
1. Level of liquidity preference among the general public. High level of liquidity
preference among the public limits effective use of commercial banks and other
financial institutions as a lot money is in hands of the people thereby limiting
operation of monetary policy. On the other hand, low level of liquidity preference
means that a lot of money is deposited with commercial banks and other financial
institutions thereby making the monetary policy effective.

2. Level of development of the money markets and capital markets i.e. stock
exchange markets to do with securities through which the central bank can
operate. High level of development of money and capital markets leads to
effective operation of monetary policy because of many people who trade in
securities. On the other hand, underdeveloped money and capital markets limit
effective operation of monetary policy as there are a few people who are aware
and trade in securities such as treasury bills and bonds.

3. Level of liquidity in commercial banks which influences their frequency of going

to the central bank. Excessive liquidity in commercial banks reduces the rate at
which they go to central bank to borrow. This makes them remain with a lot of
money thereby limiting effective operation of monetary policy , in particular the
bank rate tool. On the other hand, low level of liquidity in commercial banks
increases the rate at which they go to the central bank to borrow thereby making
the monetary policy effective through implementation of its tools.

4. The size of monetary sector/subsistence sector. With a large size of a monetary

sector, the monetary policy operates effectively since all transactions are effected
through use of money which can easily be controlled by the central bank through
use of the monetary tools. On the other hand, with a large subsistence sector, the
monetary policy fails to operate effectively since exchange is effected through
barter system which does not require use of money.

5. Level of dominance of foreign commercial banks. With many foreign commercial

banks, the monetary policy is ineffective because such banks are not directly under
49
 control of central bank but are mostly answerable foreign central banks. On the
other hand, where there are few foreign commercial banks and many domestic
commercial banks, the operation of monetary policy is effective because such
banks are under direct control of the central bank and tools can easily be
implemented.

6. Level of foreign interference especially from International Monetary Fund and

World Bank. High level of foreign interference in form of imposing conditions on
a country causes conflicts with the monetary policy of the central bank, for
example the central bank may have objective of improving balance of payments
position through devaluation but IMF and World Bank may be against it, thereby
failing it to make independent decisions. On the other hand, low level of foreign
interference into central bank activities, enables it to undertake independent
decisions with limited interference from IMF and World Bank thereby effectively
implementing the monetary policy.

7. Nature of distribution of commercial banks. Even distribution of commercial

banks promotes the effective operation of the monetary policy, because many
people deposit their money in those several banks hence enabling the central bank
to control the many in those banks, yet uneven distribution of commercial banks
limits the effective operation of the monetary policy since few people deposit their
money in commercial banks, thereby making it hard for the central bank to control
such money.

8. Degree of political interference in central bank activities. High level of political

interference in central bank activities in terms of influencing lending policies leads
to excessive amount of money in circulation thereby failing the monetary policy.
On the other hand, low level of political interference in central bank activities,
reduces the amount of money in circulation thereby making the monetary policy
effective.

9. Level of accountability by the central bank officials especially in the

implementation of some tools like selective credit control. High level of
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 accountability by central bank officials makes them advance loans to only priority
sectors of the economy and this reduces excessive lending by commercial banks.
On the other hand, low level of accountability by central bank officials makes
them advance loans to non-priority sectors. This increases lending capacity of
commercial banks leading to too much money in circulation thereby limiting the
effective operation of the monetary policy.

10. Nature of government objectives,. In a situation where government has clearly

stated objectives such as reducing the amount of money in circulation without
favouring certain sectors, the monetary policy becomes effective. On the other
hand, government’s failure to have clearly stated objectives limits the success of
monetary policy, for example restrictive monetary policy amidst increasing wages.

11. Level of effective use of commercial banks based on availability of collateral

security, existence of alternative sources of finance. Presence of collateral
securities by intending borrowers from commercial banks makes the monetary
policy effective as the amount of money in circulation is easily controlled. On the
other hand, absence of collateral securities by intending borrowers from
commercial banks makes the monetary policy ineffective as this reduces
borrowing by the public.
12. Degree of ignorance/awareness of the public about facilities offered by
commercial banks for example open market operations. High level of ignorance of
the public about facilities offered by commercial banks makes the monetary policy
ineffective as people do not understand the working of monetary policy
instruments. On the other hand, high level of awareness about facilities offered by
commercial banks makes the monetary policy effective as people have knowledge
on how the instruments work for example open market operations.

FACTORS LIMITING THE EFFECTIVE OPERATION OF MONETARY

POLICY;

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1. Ignorance of the public about the facilities offered by commercial banks for
example open market operation.
2. Limited effective use of commercial banks due to limited collateral security,
existence of alternative sources of finance.
3. government objectives for example reducing the amount of money in circulation,
and at the same increasing output and employment opportunities.
4. Poor distribution of commercial banks where most of them are mainly found in
urban areas. This means that the monetary policy has less control over the money
in rural banks.
5. High liquidity preference among the general public which limits the use of
commercial banks
6. Excess liquidity in commercial banks such that they rarely go to the central bank
to borrow money
7. Existence of a large subsistence sector with low income levels, hence individuals
are unable to save with commercial banks thus limiting monetary policy.
8. Dominance of foreign commercial banks which are not under direct control of
central bank. Such banks continue to lend out money even in times of high rate of
inflation therefore making it hard for central bank to control the amount of money
in circulation.
9. Low level of accountability by commercial bank officials especially in the
implementation of some tools like selective credit control.
10. Political interference which limits central bank’s plans of expanding credit
facilities through selective financing.
11. Under developed money markets e.g. stock exchange markets to do with
securities, through which the central bank can operate.
12. Foreign interference especially from International Monetary Fund and World Bank
on issues to do with monetary policy objectives.

FACTORS PROMOTING THE EFFECTIVE OPERATION OF THE

MONETARY POLICY

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 High level of awareness of the public about the facilities offered by commercial
banks for example open market operations.
 High level of effective use of commercial banks due to presence collateral
security, absence of alternative sources of finance.
 Existence of clearly stated government objectives.
 Even distribution of commercial banks.
 Low level of liquidity preference among the general public which promotes the
use of commercial banks
 Limited liquidity in commercial banks such that they often go to the central bank
to borrow money
 Existence of a large commercial sector with high income levels, hence individuals
are able to save with commercial banks thus promoting effective use of the
monetary policy.
 Limited number of foreign commercial banks
 High level of accountability by commercial bank officials especially in the
implementation of some tools like selective credit control.
 Limited political interference which promotes central bank’s plans of expanding
credit facilities through selective financing.
 Well/Highly developed money markets.
 Limited foreign interference especially from International Monetary Fund and
World Bank on issues to do with monetary policy objectives.

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