MONEY AND BANKING

Introduction
The use of money for transactions is useful in a large, complex society. Imagine, for a moment, that there
was no item in the economy widely accepted in exchange for goods and services. People would have to
rely on barter – the exchange of one good or service for another – to obtain the things they need. To get an
exercise book, for instance, you would have to offer the book shopkeeper something of immediate value.
You could offer to clean his car or something. An economy that relies on barter will have trouble allocating
its scarce resources efficiently. In such an economy, trade is said to require the double coincidence of wants
– the unlikely occurrence that two people each have a good or service that the other wants.

THE MEANING OF MONEY

Economists use the term money to refer to a set of assets in an economy that people regularly use to buy
goods and services from other people. The cash in your wallet is money because you can use it to buy a
meal at a restaurant or a shirt at a clothing store. By contrast, if you happened to own most of the shares of
a company, you will be wealthy, but this asset is not considered a form of money. You could not buy a meal
or a shirt with this wealth without first obtaining some cash. According to the economists’ definition, money
includes only those few types of wealth that are regularly accepted by sellers in exchange for goods and
services. We could thus define money, in simple terms, as anything that is generally accepted in exchange
for goods and services and as payment for debt.

THE FUNCTIONS OF MONEY

Money performs four main functions (exchange and asset) in the economy: It is a medium of exchange, a
unit of account, a store of value, and a standard of deferred payments. These four functions together
distinguish money from other assets.
A medium of exchange (Means of Payment): - By this function money is an item that buyers give to
sellers when they purchase goods and services. When you buy a shirt at a boutique, the store gives you the
shirt, and you give the storekeeper your money. This transfer of money from buyer to seller allows the
transaction to take place. By serving as a medium of exchange, money separates a single bilateral exchange
into sale and purchase. In other words, money makes transactions simple. The problem of double
coincidence of wants comes in hand with the barter system. For instance, given two individuals A and B
who desire to exchange commodities, the barter system requires that, for individual A to be able to exchange
a commodity he has to locate individual B (whom at that point in time desires to exchange a commodity),
the second requirement is that individual B should have exactly what individual A wants and the third
requirement is that individual B should desire what individual A is prepared to offer. Ideally, barter trade
requires that consumers have a variety of goods and services since the exchange process is very
cumbersome. This requirement minimizes the advantages of specialization. Money therefore solves the
problem of double coincidence of wants and facilitates specialization and division of labour for improved
standard of living. Money is able to function effectively as a medium of exchange when it has a stable
value.

A unit of account: - Money serves as a common unit in which values of commodities are measured and
expressed as basis for making comparisons. In other words, money makes it possible for economic
transactions to be measured in consistent terms. Thus, economies need to measure values in a common
denominator such as Cedis or Dollars. Such values expressed in money are referred to as prices.
Consequently, it is money as a unit account that makes the price system possible, to enable the ‘invisible
hand’ to determine what goods are produced, how they are produced and who gets what. Money, by serving
as a unit of account, provides the basis of rational decision making so that people are able to make the most
economical use of their resources. Invariably therefore, this calls for stability in the price system. Otherwise,
money cannot perform this function efficiently.

A store of value: - As a store of value, money acts as an item that people can use to transfer purchasing
power from the present to the future. When a seller accepts money in exchange for a good or service, that
seller can hold the money and become a buyer of another good or service at another time. Of course, money
is not the only store of value in the economy. A person can also transfer purchasing power from the present
to the future by holding stocks, bonds, real estate, etc. The term wealth is used to refer to the total of all
stores of value, including both money and nonmonetary assets. Money functions very effectively as a store
of value due to its highly liquid and durable nature. Because money is the most liquid (economists use the
term liquidity to describe the ease with which an asset can be converted into the economy’s medium of
exchange) of all assets, it is the most convenient form in which to store wealth. Secondly, it is less perishable
compared to other forms of assets and last for a longer time period.

A standard of deferred payments: - Money is the standard people use to record debts. If you take a loan
from a bank, the size of your future loan repayments will be measured in cedis, not in a quantity of goods
and services. Similarly, when goods are supplied on credit the buyer uses them immediately whereas
payment could be postponed over a period. A complex trading organisation based upon a system of credit
can only operate in a highly monetized economy, that is, when residents have confidence in the nations’
money. In other words, a payment to be made in the future can be denominated in money terms in just the
same way as payments are made in the present. It should be noted that this function of money derives from
the fact that it performs the first three functions.
Having considered the functions of money in the economy, we can now have a functional definition of it:
Money is anything that is generally accepted as a medium of exchange, a store of value, a unit of
account, and a standard of deferred payment. In other words, money is what money does.

THE CHARACTERISTICS OF MONEY

For money to perform the above functions properly, it should at least possess the characteristics listed below
1. Acceptability: - For money to perform its functions effectively it must be readily acceptable to all
people. This attribute of good money satisfies the function of money as a medium of exchange.
2. Portability: - It must be convenient to use money. That is, money must be easy to carry about and
used. In the case of money that physically changes hands, this means that it must be light and small
to carry around.
3. Divisibility: - Money must come in different denominations so as to be able to pay for an item of
any value, how large or small. It must be sub-divisible into smaller units without any loss in value.
4. Homogeneity: - Money of the same value must be of uniform quality. It should be For instance in
Ghana all two thousand Cedi notes must be of the same quality..
5. Duplicability: - It must not be easily counterfeited, for money that can be easily duplicated by
anyone will quickly lose its value. In other words, it must be hard for individuals to produce/ forge
money on their own.
6. Durability: - Money must last a reasonable length of time before deteriorating, certainly if it is to
be used as a means of storing wealth.
7. Stability of Value: - If money is to fulfil its various functions (especially, as a store of value and
as a means of evaluating future payments) it must retain its value. In terms of money produced by
the state, the requirement here is that the government keeps its supply under control. There must
be some limitations on its supply, otherwise people will naturally not have confidence in it.

DEVELOPMENT OF MONEY
The history of money can be traced back to the barter economy where goods were exchanged for goods.
The associated problems including double coincidence of wants and problems with divisibility and
portability called for the introduction of a means of exchange. Consequently, the development of money
has gone through six stages. The first to be introduced was precious metals such as gold and silver, largely
due to their durability, scarcity and divisibility. However, this means of exchange was faced with the
problem of portability. This led to its rejection as money. As a result of that, metal coinage was introduced
to solve the weight problem intrinsic in these precious metals. This is the melting of gold bars into coins,
shaping it and placing on it some authoritative imprint, which certifies their money value. This however,
led to some rulers enriching themselves by always reducing the gold content. This seriously led to the
acceptability of money and consequently led to the formulation of Gresham’s law which stated that “bad
money drives out good”
The next great step forward in the history of money was the introduction of paper money (Banknotes).
This can be traced to the safe keeping of valuables with gold smith and issuing of receipt of which gold
smith will make instant payment on demand. With time, it became a common practice for a person to pay
his debts by endorsing his receipts with an instruction to the gold smith to transfer his deposit to another
person. This developed into what was termed as FRACTIONAL BACKING. That is with time banknotes
itself came to be regarded as money and was passed from hand to hand financing numerous transactions.
That is when an individual deposited his /her valuable with the goldsmith; the receipt given in return (bank-
notes) had a 100 percent backing in the form of precious metals.
Unfortunately, when people had built enough confidence with the bankers they began to issue notes in
excess of their holdings of gold and silvers. Since it was profitable to them, borrowers had to pay interest.
With time these bankers failed to meet demands from depositors, most banks were forced into liquidation,
and depositors incurred heavy losses. Bank notes lost its value tremendously and after1838 the state was
obliged to regulate the note issue.
This led to what has been termed as FIAT MONEY. This is paper money that was not backed by gold and
silver. Fiat money according to M. Arkin is money because government says it is. It is a legal tender,
which obliges everybody to accept it to function as money. If the law states that money has been cleared
of its entire indebtedness, such money is called fiat money. Although fiat money (paper and coin) has a
relatively less intrinsic value and are not backed by gold it possesses all the attributes of a commodity
deemed as money.

TYPES OF MONEY
In modern economies, there are two things that performs all four of the basic functions of money namely
currency and demand deposit.
Currency simply refers to paper money and coins and its evolution is what we just discussed in the
proceeding section.
Demand deposit, like time and savings deposit is the acceptance of customer’s deposits for safekeeping.
Unlike time and savings deposit, demand deposit constitutes funds that can be withdrawn (demanded) from
a depository institution at any time without restrictions. These funds are usually withdrawn by writing a
cheque. Another, terminology for demand deposits are checking accounts. The inclusion of checking
accounts in the definition of money depends on the country under consideration. In most developed nations
where the economy is highly monetized, demanded deposits are included in the definition whereas in less
developed nation one can easily refuse a cheque as a means of payment.

SOME TERMINOLOGIES
1. COMMODITY MONEY: - This is money that takes the form of a commodity of intrinsic value. The
term intrinsic value means that the item would have value even if it were not used as money. One e.g. of
commodity money is gold. Gold has intrinsic value because it is used in industry and in the making of
jewellery. Although today we no longer use gold as money, historically gold has been a common form of
money because it is easy to carry, measure, and verify for impurities. When an economy uses gold as money
(or uses paper money that is convertible into gold on demand), it is said to be operating under a gold
standard. Other forms of commodity money include silver, cigarettes, salt, corn, cowry, etc.
2 FIAT MONEY: - This is money without intrinsic value that is used as money because of government
decree. A fiat money is simply an order or decree, and fiat money is established as money by government
decree. Examples include currency notes and coins. Each currency note reads: “This note is issued on
statutory authority and is legal tender for the payment of all debts…”. Although the government is central
in establishing and regulating a system of fiat money (such as by prosecuting counterfeiters), other factors
such as the people’s confidence are also required for the success of such a monetary system.
3. LEGAL TENDER: Money, which is backed by law and should be accepted as a means of payment. If a
creditor refuses to accept, he cannot take a court action against the debtor. Legal tender consists of coins
and notes depending on the country. Cheques are not part of legal tender.
4. CONVERTIBLE MONEY: This is simply made up of bank notes promising to pay the bearer an amount
of gold for example until 1931 the holder of a U.S.A dollar could present a dollar bill to a U.S.A treasury
for gold in return. (Redemption). Gold standard of a currency makes it convertible.
5. FIDUCIARY MONEY: It is paper money that is not backed by gold or silver. It sets the limits of notes,
which can be issued by a central bank at any given point in time. If the issue of notes goes beyond the stated
amount then it needs to be fully backed by gold.
6. NEAR MONEY: This is an asset, which can be converted into money. It serves as a store of value but
it is not a means of exchange for example shares bonds etc.
7. MONEY SUBSTITUTE: Anything that does not serve as a store of value but serve as a temporary
means of exchange, for example a credit card gives the holder a time to purchase goods and services without
cash. A slip is filled, signed and handed over to the shopkeeper. The shopkeeper then sends the slip to the
credit card company, and then to the banks for settlement.
THE MONEY SUPPLY (The Money Stock)
The money supply or the money stock refers to the quantity of money circulating/available in an economy.
Different countries use different criterion for distinguishing their monetary aggregates. The important point
is that the money stock for an economy includes not just currency but also deposits in banks and other
financial institutions that can be readily accessed and used to buy goods and services. The money stock of
Ghana includes the following:
1. High-Powered Money or The Monetary Base (M0): - This is made up of currency (paper notes,
and coins) issued by the Central Bank.
2. Narrow Money Supply (M1): - This includes currency outside banks and demand deposits.
3. Broad Money Supply (M2): - This is made up of M1 and all quasi-money (savings deposits, time
deposits, certificate of deposits).
4. M2+: - This is made up of M2 plus foreign currency deposits.

BANKING
The primary question we will pose is that what constitutes a bank?
Simply it can be explained as any institution that performs these essential functions
(a) Accept deposits
(b) Offer draft (check writing privileges) and
(c) Make loans
Apart from the central bank of a nation, all other institutions that perform these functions are technically
referred to as commercial banks. A commercial bank is thus, any bank that accepts deposit and transacts
business (including creating credit) with the aim of making profit.

FUNCTIONS OF COMMERCIAL BANKS

1. Accepting Deposits: Primarily, all commercial banks accept money from their customers termed as
deposits for safe keeping on their behalf. Technically, there are three types of deposits, namely, demand
deposits (current account), time deposits and savings deposit.
Demand deposits constitute money kept with the commercial banks, on which the customer can withdraw
some or all of his/her money at any time without giving the banks any prior information. This is a non-
interest earning deposit rather, customers are charged (commission) for the safekeeping services provided.
This commission charged is dependent on the number of times a customer withdraws money from his/her
account. The other two types of deposits (fixed and savings) are interest-reaping deposits and with these
types of deposits cheques are not drawn on them for withdrawing money.
2. Lending Money to Their Customers
The second and third major functions of the commercial banks can be summed up as lending money to
customers.
a. Overdraft Facility: Offering overdraft facility is the granting to worthy customers the opportunity
to draw-up on the current account when he /she has no personal money with the bank. There is a
limit to the amount of overdraft a customer is granted and this normally varies among customers
depending on the financial status and dealings of the customer. Interest is charged on the amount
overdrawn.
b. Advancing Loans To Customers: The bank may lend to the customer a definite sum of money for
a fixed period of time and at a negotiated interest rate. In this case, the customers’ account is debited
with the sum advanced to him/her and he/she will be expected to repay it including the interest
when the time for repayment is due.
c. Discounting Bills Of Exchange: Banks may also lend to their customers by means of discounting
bills of exchange for them. A bill of exchange is an order addressed by one person to another
ordering him to pay a sum of money at a fixed date to a third party.

MISCELLANEOUS FUNCTIONS OF THE COMMERCIAL BANKS

(1) Act as Agents to Their Customers
(2) Foreign Trade Financiers
(3) Store of Valuables for Their Customers
(4) Acts as Agents to their Customers
(5) Foreign Trade and Currency Transfer:- Commercial banks transact foreign exchange business
on behalf of their customers with the Central Bank e.g. by establishing letters of credit. They
also issue travellers’ cheques as well as arrange mail and telegraphic transfers on behalf of their
customer.
(6) Provision of Safe custody for Customers’ Valuables: Commercial banks, primarily, provides a
safe place for the deposit of cash and other valuables by customers, and advance money to
customers when they are in need. e.g. the customers can keep Jewellery with the commercial
banks.
(7) Investing in the Economy: - They invest directly in productive enterprises e.g.
agriculture and industry.
(8) Acts as Trustees and Executors of Wills.
(9) Payment of Wages on Behalf of their Customers and the Government
(10) Special Customer Services:-
(i) receiving payments (salaries, rent etc) on behalf of customers
 (ii) making payments on standing order for regular payments such as insurance premium
(iii) issuing of banker’s draft
(11) Business and Investment Advice:- They provide expert advice to their customers on the
viability or otherwise of their business
MONEY CREATION
Once we have reached a consensus on what money is, it will be prudent to explain how it is ascertained or
guaranteed. Part of the explanation is quite simple, since most nations have the option to print more of their
own currency.
Printing of currencies constitutes an infinitesimal fraction of a nation’s total money supply. Other origin
that account for a change in a nation’s stock of money is termed as money creation or deposit creation. In
our earlier discussion narrow money (M1) is said to constitute currency in circulation plus demand deposit.
Now the argument being put across is that commercial banks through the demand deposit increase stock of
money.
Commercial banks create money out of a system called fractional-reserve banking. This is a banking
system in which banks hold only a fraction of deposits as reserves. Deposits that banks have received but
have not loaned out are called reserves. When a bank receives deposits it has to keep some reserves so that
currency is available if depositors want to make withdrawals. The reserve over the total deposits is called
cash ratio. The rest called excess reserve is then loaned out, which goes a long way to increase money
supply in the economy. To explain this concept let us make the following assumptions:
I. There is only one commercial bank in the economy with other branches.
II. Highly Monetised Economy: This simply means that citizens have confidence in the nation’s
money and the banking system. People keep current accounts with the banks and have confidence
that prompt payment will be effected on demand.
III. No Cash Drain In The System: Money’s withdrawn from the banks returns to the banking system.
Money recycles only within the monopoly bank.
IV. The people in the economy use only cheques in transacting business.
V. The reserve ratio or cash ratio – the fraction of total deposits that the bank holds as reserves – is
10%.
VI. Constant Cash Ratio: We assume that the cash ratio does not vary in the process of deposit creation.
VII. All residents have account in the bank.
VIII. The aim of the bank is profit maximisation.
IX. The only investment opportunity is the giving out of loans.
To explain the process of money /deposit creation we need to familiarize ourselves with some basic
terminologies.
TERMINOLOGIES
(1) Total Reserves/Deposits: This is made up off the total amount of money that customers deposit with
the bank for safekeeping.

(2) Minimum Reserve Ratio/Cash Ratio: This is a statutory requirement from the central bank stipulating
that commercial banks should hold a fraction of their total deposits against possible demands or
withdrawals. The stated fraction is known as the” Cash Ratio” and the minimum required reserve is the
ratio times the total deposits.
Required reserves =Minimum reserve ratio / cash ratio X Total Deposits
This reserve requirement directly limits the ability of banks to grant new / more loans.
(3) Excess Reserves: This is the difference between the minimum required reserves and the total deposit.
This is what the commercial banks lend out to the public and consequently create money. Framed
differently these are bank reserves in excess of required reserves.

EXCESS = TOTAL - REQUIRED

RESERVES RESERVES RESERVES

DEPOSIT CREATION PROCESS

Now, assuming that somebody deposits GH1000.00 with the bank. It will keep 10% of this deposit in
reserve and loan out the rest. The balance sheet of the bank before and after granting the loan will look like
as shown in Tables 1 and 2:
Table 1: The Balance sheet of Bank A before granting loans
Assets GH Liabilities GH
Cash 1000 Deposits 1000

In Table 1, the bank’s assets are made up of cash of 1000 and the liabilities are also 1000. Here, because
the bank is not giving out loans, the money supply does not change. If the bank keeps only a fraction of the
deposit against possible withdrawal and lends out the rest, then its balance sheet will be as shown in figure
2.

Table 2: The Balance sheet of Bank A after granting loans

Assets GH Liabilities GH
Reserves 100 Deposits 1000
Loans 900

In Table 2, the bank has GH1000.00 in liabilities because it will have to pay its customers anytime they
call for money. However, it has two kinds of assets: It has GH100.00 of reserves in its vault, and it has
loans of GH900.00. These loans are liabilities of the people taking out the loans but they are assets of the
bank making the loans, because the borrowers will later repay the bank. In total, the bank’s assets equal its
liabilities.
Before the bank makes any loans, the money supply is the GH1000 of deposits in the bank. However,
money supply increases when the bank makes these loans. The depositors still have demand deposits
totalling GH1000, and now the borrowers hold GH900 in deposits. The money supply equals GH1900.
Thus, when banks hold only a fraction of deposits in reserve, they create money.
The creation of money does not stop with the first borrower. Suppose the first borrower buys something
worth GH900.00(using a cheque) from someone, who also pays the amount into his account in the same
bank. Again, the bank will keep 10% of the new deposit against possible withdrawal and loan out the rest.
That is, the bank keeps assets of GH90 in reserve and makes GH810 in loans. In this way, the bank
creates an additional GH810 of money. If this GH810 is spent in buying goods by the borrower by
drawing a cheque on the bank, the recipient of the cheque will in turn pay the money into his or her account
with the bank. Gh81, the cash ratio will be kept against possible withdrawals and the remaining GH729
loaned out. The process goes on and on. Each time that money is deposited and a bank loan is made, more
money is created.
How much money is eventually created in this economy? Let us add up:
Original deposit =GH1000
Bank A lending = GH900 [= 0.9 *1000]
Bank B lending = GH810 [= 0.9 * 900]
Bank C lending = GH729 [= 0.9 * 810]
•
•
•
Total money supply = GH10000

PERIOD CUSTOMER P.C.C C.R E.R.

 1 A 1000 100 900
It turns out that 2 B 900 90 810 even though this
process of 3 C 810 81 729 money creation
can continue 4 D 729 72.9 656.1 forever, it does
not create an “ E 656.1 65.6 590.5 infinite amount
of money. If “ “ you add the
infinite “ “ sequence of
numbers in the “ “ foregoing
example, you “ “ 0 0 0 find the
GH1000 of TOTAL 10,000 1000 9000 reserves
generate GH10000 of
money.
The amount of money the banking system generates with each cedi of reserves is called the money
multiplier (also known as the credit or deposit or bank multiplier). In this imaginary economy, where the
1000 of reserves generate 10000 of money, the money multiplier is 10.
10
Minimum Required Reserve / Cash Reserve = x 1000 = 100
100
Therefore; Excess reserve = GH¢1000 - GH¢100 = GH¢900
The commercial bank may create new deposits by lending money to businesses, in the form of new
accounts, up to the points at which the total deposits of the bank are equal to 10 times (the inverse of 10%)
its reserves.

TABULAR ILLUSTRATION OF THE PROCESS

P.C.C - Passively Created Cash
E.R - Excess Reserve
C.R. - Cash Reserve
From the above table, it is evident for the monopoly bank to make a maximum of 9000 new deposits with
an initial excess reserve of 900 and a cash reserve ratio of 10%. The monopoly bank can create new
checkable deposits that amount to a multiple of the initial injection of excess reserves into the banking
system.

MONEY/RESERVE MULTIPLIER
This is the number of deposits (loan) that the banking system can create for each cedi increase in reserve.
In our example, it was computed as 10 times the reserve and the formula is:
 1 1
RM / MM = Consequently, MM = 1 = = 1 101 = 10
RRR 10 1
100 10
Where: RM = Reserve Multiplier
MM = Money Multiplier
RRR = Required Reserves Ratio
The maximum money supply effect [change in stock of money ( M)] of these excess reserves will be

computed as the excess reserves multiplied by the reserve multiplier (ER  RM)
 M = ER  RM
 M = 900  10
 M = GH¢9000
To obtain the change in the total deposit (ΔD) of the banking system, we multiply RM with the initial
deposit.
ΔD = RM x Initial Deposit
= 10 x 1000
= GH¢10,000
Alternatively, initial deposit + ΔM
GH¢1000 +GH¢9000 = GH¢10,000
The money multiplier is the reciprocal of the reserve or cash ratio. If R is the reserve or cash ratio for the
bank in the economy, then each cedi of reserves generates 1/R cedis of money. In our example, R = 1/10,
and the reciprocal is 10, so the money multiplier is 10. If the cash reserve is increased to 20% then, the
multiplier will become 5, leading to less money being created. Alternatively, if the cash ratio is reduced
from the initial 10% to 5% then, the money multiplier will be 20, meaning more money can be created.
Thus, the higher the reserve ratio, the less of each deposit banks loan out, and the smaller the money
multiplier and the money created in the economy.
In sum the ability of the commercial bank to create deposit depends on
1. The size of their total reserves and
2. The cash ratio / Excess reserve

Setbacks to the Deposit Creation Process

1. Other sources of investment opportunities will debilitate against the commercial banks’ ability to
create more money. Since people will look elsewhere for sources of funds and will not follow the strict
assumption of ‘what goes out of the bank must necessarily come-in’.
2. The Demand For Cash: The Demand (borrowing) for cash from the banking system requires that
customers must be credit-worthy and most often the criteria for being credit-worthy is rigorous and requires
some collateral security. This in most cases reduces some customers’ ability to borrow from the bank.
Thus, although the banks might have excess reserves, inability to meet these rigorous requirements will
hamper or thwart the ability of banks to create credit.
3. The Cash Deposits Made at the Commercial Banks: Commercial Banks create credit based on
excess reserves. Given the cash ratio, the extent of excess reserves they will acquire will depend on the
amount of cash deposits made at the Commercial Banks. “The bigger the amount, the larger the credit that
can be created”. The amount of cash deposits at the Commercial Banks may depend on the following vis-
à-vis., people’s attitude towards saving, the level of monetisation, rate of interest, etc.
4. Instrument of Monetary Policies: These are tools available to the Central Bank for controlling the
activities of the Commercial Banks. They include the following: Cash ratio, open market operations,
special deposits, the bank rate, directives and moral suasion. These tools can be used to limit or expand the
ability of the Commercial Banks to create credit. For example, the higher the cash ratio, the lower the
multiplier by which deposits can be increased and vice versa.
5. Leakages in The Circulation Process: We assumed that when money is borrowed and spent, it finds
its way back into the Commercial Banks in the form of fresh deposits. There is no guarantee that this will
happen. Leakages may occur which limit the expansion process.
6. The Degree of Monetisation in The Economy: The degree of monetization of the economy refers
to how effectively money serves as a medium of exchange in an economy. The more the use of money
permeates the society, the higher will be the savings, all other things being equal. This implies that more
deposits will be accumulated to expand the money creation activity.

THE CENTRAL BANK

A Central Bank is the bank at the apex of the banking system of a country. It is an institution designed to
oversee or supervise the banking system and regulate the quantity of money in the economy. It is normally
referred to as the government’s bank because of its involvement in controlling economic activities through
the monetary system. The primary aim of a Central Bank is not profit maximisation. An example of a
Central bank is the Bank of Ghana (BOG). It should be noted that the Central Bank has traditional functions
to perform but in many cases, non-traditional functions are added.

FUNCTIONS OF CENTRAL BANKS

(TRADITIONAL)
1. Supervision of the financial system: - The first job is to regulate banks and other financial
institutions and ensure the health of the banking system. In particular, the Bank monitors each
bank’s financial condition and helps to facilitate bank transactions by clearing cheques. The central
bank has developed an elaborate system of rules and regulations for the proper functioning of the
banks and for the protection of their customers.
2. Issues and withdraws notes and coins: - Central banks have the sole prerogative to issue currency.
In Ghana, for instance, the notes and coins we use are supplied by the central bank. Notes are
printed and released into the economy in line with the laws relating to notes issue and the needs of
the country. Also the Central bank is responsible for taking out of circulation worn-out defaced
currency notes and coins and replacing them with new ones.
3. Government’s Bank: - The central bank keeps the accounts of the government. Thus,
government’s income from taxes, trading activities, privatisation proceeds is paid into this account.
Out of this account, the central government pays for its expenditure on health, education, police,
and so no. In addition, it may grant the government straightforward loans. The Central Bank also
keeps the gold and foreign exchange reserves of the country. Consequently, any banking
transaction between the government and a second party is undertaken by the Central Bank on behalf
of the government.
4. Management and administration of national debt: - The national debt
The national debt comprises domestic and external debt and includes monies borrowed directly by
the government and indirectly by the State-owned Enterprises (SOEs). On behalf of Government,
the central bank borrows from the banking and non-banking public through the sale of treasury
bills and bonds or may borrow from external sources. Interest is paid to national debt holders. Also,
the central bank can negotiate for a rescheduling of national debt repayment.
In Ghana, at the moment, most short term debts i.e. debt accruing from the sale of treasury bills
have been converted to long term bonds by the central bank since it is not feasible to pay such debt
now given our present circumstances (i.e. HIPC condition).
5. Implementation of Monetary Policy: - The central bank carries out the government’s monetary
policy objectives (while the ministry of finance undertakes fiscal policy). Monetary policy is
concerned with controlling the money supply in the economy and the interest rate to achieve
economic growth and development. For instance, the central bank has to ensure that the amount in
circulation in an economy is just enough to prevent either inflation or deflation. If for one reason
or the other the central bank believes that there is just too much money in the economy it may
reduce through the use of such instruments as Open Market Operation (OMO), Cash reserves or
Reserve requirements, Bank rate, special deposits, moral suasion, and directives. If, by contrast,
 the amount of money is just too small to promote growth and development, the central bank may
use the same policy instruments to increase the quantum of money in circulation. We shall consider
how each of these policy instruments works in the next session.
6. Acts As Government’s Monetary Agent Abroad: The Central bank also acts as Government’s
agent abroad and represents the country with such matters as exchange control, monetary transfer
between countries, e.g. loans, investment and debt servicing.
7. Acting As The Banker’s Bank:The Central Bank is also the banker’s bank. It holds the reserves
of the various Commercial Banks so that any payment between them may be effected by a transfer
of the necessary amounts from one account to another.
8. Lender of Last Resort: The Central Bank acts as the lender of last resort to the money market and
the government. If the Commercial banks are facing liquidity problems, the Central Bank lends to
them as the last resort. The tradition has been established that the Central Bank will never refuse
to lend to them and similarly, the government can always cover any temporary deficit by borrowing
from the Central Bank.
9. Manages the Exchange Rate Policy: - In pursuit of this function the central bank holds the
country’s official reserves of gold and foreign exchange and intervenes occasionally in the
exchange rate market. This is meant to influence the exchange rate between the domestic currency
and other major currencies of the world.

10. Research Work: The Central bank is charged with the responsibility of collecting information
about various aspects of the economy. This is done by the Research Department of the Bank.
Information is collected about such things as the level of bank’s deposits, exports, imports,
employment, inflation, etc. This helps economic analysts to take good decisions for the state.

TOOLS OF MONETARY CONTROL

1. Open-Market Operations (OMO): - The Central Bank conducts OMO when it buys or sells
government bonds from the public. To increase the money supply, the central bank buys bonds
from the public. The money the Bank pays for the bonds increase the amount of currency in
circulation. Some of these new currencies are held as notes and coins, and some are deposited in
banks. These increase supply of money to an even greater extent because it increases reserves and,
thereby, the amount of money that the banking system can create.
 To reduce the money supply, the central bank does just the opposite: It sells government bonds to
the public. The public pays for these bonds with its holdings of currency and bank deposits, directly
reducing the amount of money in circulation. In addition, as people pay for these bonds using their
deposits with the banks they find themselves with a smaller quantity of reserves. In response, banks
reduce the amount of lending, and the process of money creation reverses itself.

2. Reserve Requirements: - The Central Bank influences the money supply with reserve
requirements, which are regulations on the minimum amount of reserves that banks must hold
against deposits. Reserve requirements influence how much money the banking system can create
with each cedi of reserves. An increase in reserve requirements means that banks must hold more
reserves and, therefore, can loan out less of each cedi that is deposited; as a result, it raises the
reserve ratio, lowers the money multiplier, and decreases the money supply. Conversely, a decrease
in the reserve requirement lowers the reserve ratio, raises the money multiplier, and increases the
money supply. This policy is very effective because it affects directly the reserve position of the
banks and hence their ability to create money.

3. The Discount Rate: - This is the interest rate on loans that the central bank makes to the banks.
The central bank can alter the money supply by changing the discount rate. A higher discount rate
discourages banks from borrowing reserves from the central bank. Even where the banks borrow
money at the high interest rate they also lend out such cash to their customers at very high rates and
that also discourages people from borrowing from the banks and hence help curtail money creation.
Thus, an increase in the discount rate reduces the quantity of reserves in the banking system, which
in turn reduces the money supply. Conversely, a lower discount rate encourages bank borrowing
from the central bank, increases the quantity of reserves, and increases the money supply. The bank
rate will only be an effective policy instrument when the banks do not have monies of their own to
lend out. In other words, where banks have excess reserves, then they would not need to go to the
central bank to borrow and hence they will not be affected by the policy.

4. Moral Suasion: - This tool of monetary policy is not binding on the banks. That is to say, the
commercial banks may or may not obey it. Moral suasion as the name implies is just an appeal
from the central bank to the commercial banks to, for example, reduce money creation when there
is inflation. Also, the central bank may appeal to the banks to reduce their lending rates to promote
investment, economic growth and development. In addition, the central bank may appeal to the
 banks not to indulge in mass transfer of foreign currency abroad as that could cause the country’s
currency to depreciate in value.

5. Special Deposits: - With this policy instrument, the central bank just asks the banks to deposit
more of the excess cash with it so as to reduce their ability to create more credit. This normally
happens when there is too much money in circulation that is causing inflation.
6. Directives / Selective Credit Control: - With this policy, the central bank directs the banks as to
how much credit they are to give to the various sectors of the economy. For example, the central
bank may decide in a particular year that 40% of all bank credit should be given to the agricultural
sector, 40% to industry and the remaining 20% to the service sector.

PROBLEMS OF CONTROLLING THE MONEY SUPPLY

1. The first problem is that the central bank does not control the amount of money that households
choose to hold as deposits in banks. The more money that households deposit, the more reserves
banks have, and the more money the banking system can create. And the less money that household
deposit, the less reserves banks have, and the less money the banking system can create. More
money is held (and less is deposited with banks) by households if they begin to lose confidence in
the banking system.
2. The second problem of monetary control is that the central bank does not control the amount the
banks choose to lend. Once money is deposited in a bank, it creates more money only when the
bank loans it out. Yet banks can choose to hold reserves above what the central bank requires. To
see why excess reserves complicates control of money supply, suppose that one day bankers
become more cautious about economic conditions and decide to make fewer loans and hold greater
reserves. In this case, the banking system creates less money than it otherwise would. Because of
bankers’ decision, the money supply falls.

DEMAND FOR MONEY/LIQUIDITY PREFERENCE

In the classical economists the only variable that impacts on the aggregate demand is the quantity of money.
They assume that quantity of money demanded by households is a constant fraction of their income. The
Keynesian theorists averted this view and argued that the aggregate demand is influenced not only by
quantity of money but other variables as well determine the aggregate demand.
At this level, emphasis will be placed on the classical quantity of money. As said earlier, the classicalists
were of the view that money held by individuals is a fraction of their income and assumed that the
propensity (tendency or inclination) to hold money is constant. That is demand for money describes the
desire or willingness to hold a given stock of money for any reason. It is the desire of individuals and
firms to hold cash instead of investing it.
However, Keynes identified three motives for holding money: Transactionary, Precautionary and
Speculative. In reality the propensity to hold money for any of the above reasons depend on the returns of
money if it was invested in another economic venture (rate of interest).

THE OPPORTUNITY COST OF HOLDING MONEY.

The above analysis presupposes that money held by individuals for diverse reasons have an opportunity
cost. The opportunity cost of holding money is the return if money had been used to purchase an income-
earning asset. Ideally, people should hold money only on the account that its value is equal to its’
opportunity cost.
At this level we will not bother ourselves with the determination of money rather we will concentrate on
just the motives for holding money.

MOTIVES FOR HOLDING MONEY (LIQUIDITY PREFERENCE)

Transactionary Demand for Money: This refers to the amount of money held by households and firms
to meet daily expenditure trend. Transaction balances is kept to satisfy the function of money as a medium
of exchange. These monies are kept for anticipated and unavoidable day-to-day expenses. Money is
generally accepted in the settlement of all debts and is thus the most liquid asset and gives the holder an
instantaneous command over all goods and services desired. Transaction balances to a very large extent is
dependent on the holders income level and it is postulated to have a positive relationship with the income
level. That is the higher the income level the higher the money that an individual will hold for transactionary
purposes.
In recent times some macroeconomists such as James Tobin have argued that transaction balances is not
only dependent on income levels and the general price level but it is also dependent on the rate of interest.
Other factors influencing the transactions purpose for holding money are follows:
I. The price level: - At higher prices, larger nominal transactions balances are required to
finance the same level of expenditure.
II. Financial Innovation: - The growing use of money substitutes such as credit card (Sika
Card) and Automatic Teller Machine (ATM card) reduces the need to hold more transaction
money balances.
III. Institutional factors: - The length of time between paydays tends to influence the
transactions balances, which people hold. People who are paid fortnightly will definitely
keep lesser transactions balances than people who are paid monthly.
 IV. The size of the firm: - A bigger firm will need more transactions balances to meet its daily
purchases than a smaller firm.
Precautionary Demand for Money: Households in most cases set aside some money to meet occasional
uncertain and unexpected expenses. A typical example is sickness, though unexpected it can occur at
anytime as such household’s deliberately hold money against such uncertain occurrences. This also satisfies
the function of money as a medium of exchange and is dependent on the level of income and the rate of
interest. PM is anticipated to be positively related to income levels and negatively related to the rate of
interest. That is if the opportunity cost of holding money is high people will tend to keep less money for
precautionary purposes. The precautionary motive springs up due to the fact that individuals and firms are
uncertain about the degree to which payments and receipts will be synchronized.
It is instructive to note that both transactions and precautionary demand for money are the desire to keep
money balances for transaction purposes
Consequently, we can collectively represent the two diagrammatically as follows

Figure 21: Transactions Demand for Money

Interest Rate
M1

Money Balances

In figure 21, the transactions demand for money is vertical, indicating that it is not influenced by the interest
rate.
Speculative Demand for Money: This motive satisfies the role of money as a store of value. The British
Economist John Maynard Keynes propounded this theory. Keynes studied on the willingness of individuals
and firms to invest their money after setting aside some money against both anticipated and unanticipated
expenditures. Investing money into an interest-earning venture such as bonds and shares involves risk
taking. This is primarily due to the fluctuations in interest earning securities, in Ghana an example is the
Treasury Bill. He argued that since individuals and firms are risk averse1 and the prices of these securities
do fluctuate they strike a balance as to holding money and holding bonds. Holding money against the
uncertainty inherent in the fluctuating prices of bonds and other financial assets is termed as speculative
balance. That is the expectation of the directional change in the financial assets influences the speculative
balance. For example if the price of bond is low as viewed by buyers, there will be the tendency to purchase
bonds now and postpone the sale of bonds until a better price can be offered. People in this instance, will
hold less money and more in bonds. In this case possible money kept to hedge against fluctuations
(speculative balance of money) will reduce. The speculative motive will imply that the demand for money
will be negatively related to the rate of interest.
Diagrammatically, the demand for money for speculative reasons can be represented as follows:

Figure 22: The Speculative Demand for Money

Interest Rate

Md
Money Balances

In figure 22, the desire to hold money for speculative purposes increases as interest rate falls.

The Demand for money

The liquidity preference curve is the summation of the transactions, precautionary and speculative
demand curves as shown below.

1
A person is risk averse when he or she prefers a certain sum of money to an uncertain outcome for which the
expected outcome is the same.
Figure 23: The Derivation of the liquidity preference curve.

A B
r r C
Md1 r Md2 Md

+ =

M M M

In figure 23, diagram A is the transactions demand for money curve (transactions and precautionary demand
curves), B is the speculative demand curve and C is the demand for money curve. Note that the demand for
money curve is inversely related to the interest rate.

EQUILIBRIUM IN THE MONEY MARKET

Demand for and supplies of money determine the value of money. For the purpose of this section, we shall
assume that the supply of money is constant. In other words, it is a policy variable that the central bank
controls directly. At equilibrium, shown in figure 24, the quantity of money demanded balances the quantity
of money supplied at point e. At that point, the interest rate is determined as re.

Figure 24: Money market equilibrium

r MS

re e

Md
0 Me M

Changes in the demand for money

 1. Increase in the demand for money: - The demand for money curve will shift upwards from, say
Md0 to Md1 (see fig 25). Interest rate rises.

Figure 25: Increase in the demand for money.

r Ms

r1

r0 Md1
Md0
0 M0 M

2. Decrease in the demand for money: - The demand for money curve will shifts downwards from,
say Md1 to Md0 (see fig 26). Interest rate falls.

Figure 26: Decrease in the demand for money.

r Ms

r0

r1 Md0
Md1
0 M0 M

Changes in the supply of money

1. Decrease in the supply of money: - The supply of money curve shifts to the left from MS0 to MS1 in
Fig.27 below. Interest rate rises.

Figure 27: Decrease in Money Supply

r Ms1 Ms0

r1
r0
Md0
Increase in the supply of money: - The supply of money curve will shift to the right from, say Ms0 to Ms1
(see fig 28). Interest rate falls. If money supply increases further, all the money will be held as idle balances
without interest rate falling any further. Such a situation is referred to as Liquidity Trap.

Figure 28: Increase in the supply of money and Liquidity Trap

Ms1 Ms2 Ms3 Ms4

r

Liquidity Trap
Md
Md

0 M

In figure 28, when money supply increases from Ms3 to Ms4 , the interest does not change. Such a
situation is referred to as the liquidity trap.