ECONOMICS NOTES

MONEY AND BANKING

BARTER TRADE
This is form of a trade that existed before the money system where goods and services
where exchanged for other goods and services.
Advantages of barter trade
1. Buyers and sellers are able to get the goods and services they require immediately after
the exchange.
2. It improved the living standards of those involved
3. Promotes social relations of the trading communities
4. Allowed for learning of different languages for reasons of trade and this lead to
development of common languages.
5. It promotes specialization in the production of goods and services.
6. Helps a country /person to dispose their surplus.
Disadvantages:
1. Requires a double coincidence of wants.
2. Lacks standard measure of value.
3. Indivisibility of commodities.
4. Perishability of commodities.
5. Inconvenience in transporting some goods.
6. Lack of standard deferred payment.
7. Lacks units of accounts.
8. Inferior goods.
MONEY SYSTEM
Money is anything that is generally accepted as a medium of exchange for goods and services.
Qualities/characteristics of money
For money to be useful and act as a medium of exchange it must have the following qualities
 Acceptability --If this is lost, if people are no longer willing to trust it and thus refuse to
take it in exchange for real goods and services, then it is useless.
 portable – it will not be much use as an aid to transfer if it cannot easily be moved
 divisible – it must be divisible into small units to facilitate the buying of small items
capable of reflecting a range of values; animals were once a symbol of wealth but as
money they had limitations – a valuation of one and a quarter cows could prove
difficult to pay!
 durable – it must be able to maintain physical quality over length of time. Saving presents
problems if the money saved is likely to die, rot or rust away
 controllable – preferably in short supply, not too easily obtained and capable of being
controlled by an accepted authority
 recognisable – if people cannot recognise money as money they are unlikely to accept
it very readily.

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  Stable in value- the value of money should not fluctuate oftenly otherwise people
will loose confidence in it as a medium of exchange.
 Homogeneous i.e money of the same denomination must be identical or uniform in
all aspects.
 Malleability i.e. material used to make it can be changed to different shapes.
 Relatively scarce-money must not be abundant in supply so that people can work hard to get
it. Too much money supply also leads to inflation.
Functions of Money
(a) Facilitating Exchange /Medium of exchange
The basic purpose of money is to make the exchange of goods or services easier. Without
money, people have to resort to direct exchange or barter, and this is often wasteful, time-
consuming and inefficient. Money allows trade to develop much more freely.
(b) Measure of Value
Even if people do exchange goods directly, they can be more certain of fair dealing if they
can measure the value of their goods in terms of recognised money. If farmers wish to
exchange pigs and cows, they are helped if they know the values of both in money terms.
(c) Standard of deferred/ future payment or Measure of Deferred Payments
Exchange and trade can flow more freely if it is possible to carry forward debts of a known
amount. Money can help by standing as a measure for any payments that are deferred for future
settlement. For example, the farmers exchanging pigs and cattle may agree that A took cattle from
B to a higher value than the pigs he passed to B. If the difference in value is expressed in money,
then both know the size of the debt and the future payment required. Money measurement may
help them later to settle the debt – say, with some other animal, perhaps sheep.
(d) Store of Value
Money can be kept as a store of value that can be held in reserve for purchases not yet
planned. This value can be held over time – as long as money value does not fall.
The importance of acceptability has already been stressed. Without it, money cannot be
used in exchange. This is why a great deal of international trade is carried out in a relatively
few generally acceptable currencies – e.g. American dollars, Japanese yen, British pounds
and euros. These currencies are all readily acceptable and transferable in world trade and
finance markets. We can see that acceptability and transferability depend on the confidence
of traders. If this confidence is lost, then money ceases to have any value, because it cannot
fulfil its essential functions. This function causes most problems because no form of money
in the modern world has escaped the problem of inflation – the tendency for money prices to
rise as time goes by. If all prices rise, then the value of money itself is falling. The difficulty of
storing value undermines confidence, acceptability and transferability, and so makes trade
generally more difficult and uncertain.
(d)Unit of account- All accounting records and books are kept in terms of money because
the values of all items are expressed in terms of money, a unit for keeping records
Stages in the development of money
1. Commodity money-Various commodities such as cowrie shells, millet, maize e.t.c were
used as a medium of exchange
2. Metallic money- most goods were perishable, indivisible and difficult to transport. To solve
these problems, some precious metals such as gold, silver, copper e.t.c were used as a medium of
exchange. When, from time to time, the world economy becomes unstable and other forms of
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money become less acceptable, the price of gold always rises as people turn to it as a haven for
their threatened savings. However, many metals suffer deterioration over time.
3. Coinage money- to aid recognition, add acceptability and assist in measuring value, many
communities have fashioned coins from previous, semi-precious and base metals. With the
exception of a limited supply of gold, these are now used mainly for units of low value.
4. Paper money- metal is bulky and expensive to transport in large quantities so, from very
early times, traders have used paper as a more convenient substitute.
5. Representative money- In recent years plastic cards have replaced or supplemented
paper as conveyors of instructions to make payments. The development of modern
telecommunications has made such cards, with their magnetic strips, among the most
important means of carrying out everyday trading transactions. As information technology
continues to advance these cards are expect to gain further uses, but we can also expect that
transactions will be increasingly made by direct instructions through computers or over the
telephone because wealth is now stored purely in the form of credit balances recorded in
computers.
High-Powered Money
The measurement of money supply depends on how we define it. The wider our definition,
the more we have to measure. Difficulties in deciding precisely what should be counted as
money help to account for the fact that there are several possible definitions. These are can
be divided into two groups:
1. Narrow money – M0, the narrowest definition, made up of the notes and coin in
circulation with the public and banks' till money and the banks' operational balances
with the central bank.
2. Broad money – M4, made up of notes and coin and all private sector sterling bank
and building society deposits.
This distinction is more important than it might appear because of the special role of narrow
money in the banking system. The other name for narrow money is "high-powered money".
The term "high powered" indicates that it serves as the reserves of the commercial banks in
the economy and provides the basis for the creation of bank deposits. Because high powered
money is "created" by the central bank, and hence directly under its control, it enables the
central bank to control the deposit creating activities of the commercial banks and the broad
money supply.
MONETARY SYSTEMS
Monetary system is that system under which money is issued and controlled in a country.
Various monetary systems which have been prevailing in different countries of the world are:-
1. MONOMETALLISM
Under this system, coins of a specific metal are used as money. If gold is used to make
coins then it is called gold standard. Similarly, if silver coins are issued then this system
will be known as silver standard.
2. BIMETALLISM
Bimetallism is that system under which coins of two metals are used simultaneously.
This system prevailed in U.K. during eighteenth century when gold and silver coins were
used simultaneously.
3. PAPER MANGED SYSTEM

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 Under this system, paper notes are issued by the central bank of a country. The supply of
theses paper notes is controlled by the central bank according to the requirements of the
country. This system is followed by almost all countries of the World these days.
GOLD STANDARD
Gold standard is that system under which currency is based on gold various forms of gold
standard are:-
1.Gold Currency Standard
It is also known as full bodied gold standard. Under this system, gold coins are used to make
transactions. So gold is medium of exchange and measure of value. This system prevailed in
U.K., U.S.A, Germany, France and other countries before 1914.
1. Gold Bullion Standard
Under this system, paper notes are issued which are convertible into gold in the form of
bullion. So gold is used as a measure of value not as a medium of exchange. This system
prevailed in U.K. from 1925 to 1931.
3.Gold Exchange Standard
Under this system, paper notes are used to make transactions but for making foreign
payments, domestic currency can be exchanged into the currency of a country which is on
gold currency standard. This system prevailed in India before First World War
4.Gold parity Standard
Under this system, paper noted circulates in the country but the value of domestic currency
is fixed in terms of gold. This system prevailed under the supervision of International
Monetary Fund after Second World War.
VALUE OF MONEY
Value of money means purchasing power of money. The quantity of any commodity which
can be exchanged for one unit of money. It depends upon the price level. If price level is
higher, value of money will be smaller and vice-versa. Value of money can be regarded as
the reciprocal of price level. It can be explained as under:-
1. Quantity theory of money
2. Cash balance equation
3. Monetarism version of Quantity Theory
These are explained as under:-
1. Quantity Theory of Money:
According to quantity theory of money, value of money depends upon quantity of money in
circulation. This theory has been defined by Taussing in the words “Other things remaining
the same, double the quantity of money, price level will be twice as was before but value of
money will remain one half. Halve the quantity of money, price level will become half as was
before, but value of money will be double”

Irving Fisher has expressed this theory by the help of the following equation:-

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 P=MV where M=Quantity of money
T V= Velocity of money. It means the number of times one unit of
money is used to make to make transactions. .
Now if ‘V’ and ‘T’ remaining the same, quantity of money is increased, price level will go up
but value will fall and vice versa. It is explained as under:-
We assume: M=100 V 10 T=50
So P = 100x10 =20
If m =200, then P=200x10
50 =40
If m =50, then P =50x10 =10
50
Assumption of quantity Theory of Money:
This theory applies when the following factors remain constant.
1. Velocity of Money
If velocity of money decreases proportionate to increase in supply of money then price
level will remain the same and vice-versa, so it should remain constant.
2. Number of Transactions:
If the number of transactions increases with the increase in quantity of money, in that
case also, price level will remain unaffected and vice-versa. There must be no change in
the number of transactions with the change in quantity of money.
3. Barter Transactions
Barter transactions increases with the increase in quantity of money, because if the
goods which were previously exchanged for goods are now exchanged for money then
quantity theory of money will not apply.
4. Hoardings:
If the increased quantity of money is hoarded then price level will not rise and vice-
versa, so there must be no change in hoardings.
5. Quantity and Velocity of Credit Money:
Credit money or bank money ant its velocity should remain constant, otherwise, quantity
theory of money will not apply.
CRITICISM ON QUANTITY THEORY OF MONEY:
This theory has been criticized and rejected on the following grounds:-
1. It is based on weak assumptions. The factors which are assumed constant do not
remain the same over a period of time. When M changes, V and T may also
change.
2. In this theory, it has been stated that changes in price level are proportionate to
changes in quantity of money but it is not essential. The prices of different
commodities also do not change at the same proportion
3. Another objection is that it explains only how changes in value of money are
brought about and gives no explanation of how the value of money is determined.

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 4. This theory cannot be regarded as an adequate theory of money because it takes
no account of the rate of interest. The theory of money cannot be complete
without a reference to rate of interest.
5. The main objection against this theory is that it is one sided theory because it
keeps in view supply of money but ignores demand for money.
2. CASH BALANCE EQUATION OR CAMBRIDGE EQUATION
This equation is also known as demand and supply theory of money. This theory was
presented by the economists of Cambridge School of Thought. According to this theory,
value of money is determined at that level, where demand for money is defined as the
quantity of money which is kept in cash form. It is also known as liquidity preference. The
demand for money depends upon the following three motives:-
i. The transaction motive
ii. The precautionary motive
iii. The speculative motive.
The supply of money is determined by the central bank and the state. The supply of money
consists of:-
i. Currency notes
ii. Coins
iii. Bank deposits
Cash balance or Cambridge equation is as follows:-
P=M
K.R
Where:-
M=Total supply of money in circulation
P=General level of prices of consumers goods.
R=Volume of production or real income of the community for a period.
K=the proportion of the national income that people prefer to hold in form of. It
Represents demand for money
From this equation, we come to the conclusion that value of money depends on quantity of
money, size of national income and demand for money. This theory is more realistic as
compared to Fisher’s equation.
3. MONETARISM VERSION OF QUANTITY THEORY
Milton Friedman presented his version of quantity of money in 1956. A group of
economists who support this theory are known as Monetarists. They have given the
following equation:-
M.V. =P.Y.
Where:-
M=Total stock of money
V=Velocity of income
P=general level of prices
Y=Flow of real income

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This equation states that money value of gross national product must be equal to product of
average of money times velocity. Monetarists recognize that velocity of money is not
constant but it is fairly predictable. They are of the opinion that the above equation is the
best way to study economic activity. A careful study of M and V can be used to predict the
behaviour of nominal gross national product. They say that money is a form of holding one’s
wealth as an alternative to holding it in any other form like bonds, physical goods and so on.
They believe that close control of supply of money can maintain the value of money at a
specific level.
THE EFFECTS OF THE CHANGE IN THE VALUE OF MONEY
Value of money depends upon price level. When price level is higher, value of money will be
smaller and vice-versa. The changes in value of money can affect different sections of the
community. When price level goes up businessmen, industrialist, and farmers gain, but fixed
salary earners and consumers lose and vice-versa have a fall in price level is known as
“Deflation”. Big fluctuations in price level on either side are harmful for economic stability.
Measures should be taken by the Government to stabilize prices at a desirable level.
THE BALANCE SHEET OF A COMMERCIAL BANK
The balance sheet of a commercial bank is a summary statement of assets and liabilities of
the bank on a specific date. The assets and liabilities of a bank must be always equal to each
other. The structure of bank’s assets and liabilities can be seen from the following table:
Liabilities Assets
1. capital x 1. Coins, Notes and balances with the
2. Reserves x central Bank x
3. Deposits: 2. Money and are call and short notice
i. Current Account x
ii. Deposits account 3. Bills Discounted x
4. Investments x
5. Advance to customers x
6. Buildings x
7. Furniture and Equipment x

The main objective of a commercial bank is to maintain the balance between liquidity and
profitability. If the assets of a commercial bank mainly consist of investment and advances
to customers then a commercial bank will be making more profits but the liquid position of
the bank will be unfavorable. On the other hand, if the assets of a bank mainly consist of
money at call and short notice then these assets will show more favorable liquid position but
in this case a bank will not be earning high profit. The structure of a bank‘s assets must be
adjusted to maintain a balance between liquidity and profitability.
CREATION OF CREDIT
Creation of a credit means that process under which commercial banks advance loans many
times greater as compared to legal money at the disposal of commercial banks, for example,

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if legal money available with commercial banks is 100 million and on the basis of this
amount, loans of 1,000 million are issued, it is known as” creation of Credit”. By creation of
credit, we do not mean printing of new notes; it is just excessive use of instruments of credit.
The process of creation of credit can be explained by the help of the following example:
We assume there are different banks in any country. If a loan of ₤100 is issued by bank “A”,
it will result in to advance loans many times greater than this amount as shown in the
following example:-
The balance sheet of a commercial bank
Bank “A” Bank “B” Bank”C” Bank”D”
Excess Primary Primary Primary
Reserve 100 Deposit 100 Deposit 90 Deposit 81

Reserve 10% Reserve 10% Reserve 10%

Ratio Ratio Ratio

Excess Excess Excess

Reserve 90 Reserve 81 Reserve 72.9
In the above example, the loan of ₤100 is advanced by bank “A” and the person who receives
this loan will not spend this money in the short period. We assume this person deposits this
money in bank “B”. Now, the bank “B” knows from its experience that this person will
withdraw only 10% in the next period, so bank “B” will keep 10% as reserve and will
advance a loan of ₤90 to another person for one year. In this way, an other loan of ₤90 will
be advanced on the basis of the same amount. This process will continue until the total
amount which was originally advanced by bank “A” will disappear in the form of reserves
kept by different commercial banks. The loans advanced by different commercial banks can
be expressed as under:- 100+90+81+72.9 + ……….. =1000

We can use the following formula to find out the creation of credit.
Creation of Credit = Excess Reserve
Reserve ratio
In this case, the excess reserves will by that loan which will be advanced as loan by bank “A”
If: - Excess Reserve = 100
Reserve Ratio =10%
Then: - Creation of Credit =100 or
10%
100 = 100x100
10 10
= ₤1,000
406
If reserve ratio is 20% the creation of credit will be ₤500 and if it is 50% then credit creation
will be ₤200

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Limitations on Creation of Credit
The commercial banks can create credit within limits only. The limitations are:-
1. The liquidity Ratio:
The liquidity ratio is that ratio at which the commercial banks keep reserves to meet the
demands of the depositors. It is also known as reserve ratio. If the reserve ratio is lower,
the creation of credit will be greater and vice-versa. We have seen above that with
excess reserve of ₤100, the creation of credit will be ₤1000 at the liquidity ratio 10% and
it will be only ₤200 at the liquidity ratio of 50%.
2. Power of the Borrowers:
The commercial banks advance loans against certain securities. If the` borrowers cannot
offer better securities to the commercial banks, they cannot get loans from the banks. In
this way, the creation of credit is limited by the power of the borrowers.
3. Demand for Credit:
The demand for credit is another limitation on the power of commercial banks to create
credit. During depression, the commercial banks cannot create credit beyond certain
limits due to the smaller demand for credit facilities.
4. Saving and Investment habits:
If majority of population is in the habit of saving some part of their income and to deposit
these savings in the commercial banks then the creation of credit will be greater and vice
versa.
5. Policy of the Central Bank:
The central bank controls the activities of the commercial banks. These banks cannot
create beyond certain limits imposed by the central bank. The commercial banks can
create credit according to the policy of the central bank only.
Demand for money
This refers to the desire by an individual to hold onto money instead of spending it. Also
called liquidity preference. There are three motives for holding money:
1.Transaction motive- one holds money with a motive of meeting daily expenses such as
buying food, transport, entertainment etc. This demand depends on the frequency at which
income is received. The Transaction demand for money is determined by the following
factors:
 The level of income-the higher the income the higher the amount held
 The frequency of payment of an individual
 Individuals spending habits
 Availability of credit facilities
 The rate of inflation
2.Precautionary motive- one holds money as a precaution against unforeseen events that
might require additional expenditure e.g. sickness. This demand depends on the individual’s
level of income. Precautionary demand for money is determined by:
 Level of income of the individual
 The age of the individual
 The family status and size

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  Individuals pay internal
 Interest rates in the country’s financial institutions
 Individuals temperaments i.e. pessimistic or optimistic
3.Speculative motive- this is the comparing demand for cash money and securities such as
shares and treasury bills. When the returns to securities are expected to rise the needed to
hold cash money is relatively low and when returns are expected to be low the demand for
cash money is relatively high. Speculative demand for money is determined by:
 Level of income of the individual
 Interest rates
 Price of the securities in the stock market
 Level of income of the securities
 Whether the individual is pessimistic or optimistic
Supply of money
This refers to the total amount of money in circulation in an economy at a particular time.
It’s affected by the following factors.
 The central banks monetary policy
 The commercial bank ability to create credit
 Central bank’s ability to control credit
 The level of balance of payment
 Interest rate in the economy. If interest rate are high money supply will be low and
vice versa
 The national budget- when government expenditure increases the money supply will
increase and vice versa
Commercial banks
These are the banks that are formed with the main objective of making profits
through financial intermediation.
Functions
 Safe keeping of money
 Transferring of money through cheques
 Lending money to borrowers
 Safe keeping of variable items
 Giving advice to businessmen on financial and investment matter
 Facilitating international payment through letters of credit
 To act as management trustees to properties or business if a deceased person
 Acting as agents of stock exchange market
 Acting as intermediaries between savers and borrowers
 They act as guarantors for their clients

Types if accounts operated by commercial bank

1. Current accounts
Features
 Initial deposit is required when opening
 Deposits can be made at any time and in any form
 No minimum balance required to maintain the account

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  Account holders are allowed to use cheques to facilitate their payments
 Account deposits do not earn any interest
 Any amount can be withdrawn any time on demand
 The banks charges ledger fees for maintaining these accounts.
 Account holders can enjoy other facilities offered by commercial banks like credit
transfers.
 Account holders are given monthly bank statements to show summary of their
transactions in that month.
2.Saving account
Features
 An initial deposit is required when opening the account.
 It is basically meant for saving surplus money.
 Money can be deposited into the account in any form and at any time.
 Account holders must maintain a certain minimum balance.
 Withdrawals can be made once a week and there’s a limit to the amount to be
withdrawn.
 Interest is paid on money held in savings account.
 Overdrafts are not allowed.
 Withdrawal of money exceeding certain maximum might require a notice to be given
to the bank by the customer.
 A passbook is issued and is used every time when deposits of withdrawal are made.
 No cheque books are issued to account holders
3.Fixed deposit accounts
Features
 Involves large amounts of money to operate.
 They are contractual because maturity date is predetermined e.g. 6 months, 12 months,
3 years e.t.c.
 No mid-term withdrawal or additional deposits are allowed.
 Interest earned is higher than saving accounts.
 If the account holder breaches the contract he loses the interest and he is penalized.
 The account hold is given a receipt upon opening the account.
 Fixed deposits can be used as security for other forms of credit.
 On expiry of the account, the account holder must withdraw the principal and the
accrued interest.
 There is a minimum amount that can be allowed for this account.
Functions of non- banking financial institutions.
 Provide capital or loan to both existing and new businesses.
 They provide mortgage finance to individuals who want to buy houses and organizations
that want to buy premises.
 They provide advisory services and educate people on how to set up and run
investments projects.
 They support investments to individuals who would not be financed by other financial
institutions.
 They generate revenue to the government through tax and dividends.
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 Some encourage agriculture by making loans available to farmers.
 Help people to accumulate long-term savings which provide security for their families
upon death or retirement.
 They supplement the government’s effort in developing the economy e.g. Kenya
Industrial Estates.
 They create confidence and security among businesses and individuals e.g. insurance
companies.

Differences between commercial banks and non bank financial institutions

Commercial banks
Provide current accounts
Provide short term and medium term
finance
Provide finance not restricted to any
specific activity
Provide foreign exchange transactions to Don’t provide foreign exchange
their customers
Provide finance for working capital
Participates in clearing houses
Non-bank financial institutions
Do not provide current accounts
Provide medium term and long term
finance
Provide finance for a specified purpose
transactions
Provide finance for capital development
Do not participate in clearing houses

Don’t participate in capital market trade Participates in capital market

THE CENTRAL BANK

This is a government institution charged with the responsibility of regulating all monetary
activities in the country.
Functions of the central bank
 Issue of currency. It’s the only institution authorized to issue currency in the country.
 Banker to the government. The government maintains an account with the central banks
where all revenues and expenditure are passed.
 Banker to the commercial banks. All commercial banks are required by law to deposit a
certain percentage of their customers deposit in the central bank.
 Managing foreign exchange reserves. The central bank maintains a foreign exchange
equalization accounts which guards local currency from external pressure.
 Financial controller of all commercial banks i.e. must approve the financial decisions
before they are implemented.
 Lender of last resort. It can lend money to the government or commercial bank when all
other alternatives have failed.
 Administering public debts. The central bank is responsible for management and
repayment of the debts when it matured.
 Acts as a link bank to external financial institutions therefore facilitating international
financial relationships.
 Facilitates clearing of cheques between different commercial banks through its
clearinghouse.

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 Control of monetary system. It can use the instrument of monetary policy either to
expand or depress the economic activities.
THE CENTRAL BANK
The central bank does not compete for ordinary commercial banking business. It is, essentially,
the banker to the rest of the banking system: the regulating body for private sector commercial
banking and the office link with other central banks and with international financial
organisations, especially the International Monetary Fund (IMF) and the Bank for International
Settlements (BIS).
The Functions of the Central Bank
1. Banker to the government
The government holds its bank account with the central bank. This is used both for
payments made from the rest of the economy to the government and payments by the
government in the economy. The central bank may also be banker to the government in the
sense that it provides loans to the government, as well as arranging for the government to
borrow from investors in the financial system by issuing treasury bills (short-term
securities) and bonds (long-term securities).
2. Banker to the banking system
The central bank provides the paper currency and coin issued to the public through the
banking system. As banker to the banks, it keeps the accounts of the retail banks themselves.
It facilitates the process of clearing the daily balances resulting from all the transactions
undertaken each day by the customers of the banks when they receive and make payment
using their bank accounts. In the UK, the banks that maintain accounts with the Bank of
England for the purpose of settling the interbank debits and credits that result from their
customers daily cheque transactions are termed "clearing banks".
3. Lender of last resort
The central bank is uniquely placed to lend to other banks in the financial system because it
manages the government's accounts, and can call upon the government to print more money
in an emergency situation. The central bank acts as lender of last resort to the banking
system in two ways:
4. It controls the available supply of liquidity in the banking system on a daily basis to
maintain interest rates at the level it thinks appropriate to achieve its monetary policy
objective(s). It does this by determining, on a daily basis, the rate of interest at which it is
willing to provide funds to any bank facing a shortage of liquidity, in exchange for
government bonds and treasury bills.
5. It stands ready to prevent the failure of any bank, and the loss of public confidence in
the soundness of the banking system, by providing emergency loans to one or more of the
retail banks in the economy. This would be necessary if the banking system as a whole runs
short of liquidity due to factors unconnected with the central banks' own monetary policy
actions.
6. Regulation and supervision of the banking system – it is responsible for the stability
and integrity of the institutions which make up the banking system.
7. Monetary policy – it is responsible for the conduct of monetary policy. It control the
actual supply of money within the banking system.
8. Management of a country's foreign currency reserves and responsibility for its
exchange rate policy. The central bank keeps the nation's gold reserves and the

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international accounts for money entering and leaving the country, as well as the nation's
reserves in other currencies. The central banks works closely with the central banks of other
nations and also with the major international banks, especially the International Monetary
Fund (the IMF is probably closest to being a genuine world bank).The Banks have a duty to
maintain the stability of the national currency in its exchange value with other national
currencies, and to cooperate with other countries and international institutions to uphold
the stability of the world financial system. It has a special account which it can use to deal in
sterling and other currencies in order to stabilise demand, supply and exchange rates.
Tools of monetary policy
Monetary policy can be defined as a deliberate move by the government through the central
bank to manipulate the supply, availability and cost of money in order to achieve the desired
economic levels. Monetary tools used to achieve this include;
2. Bank rate
This is the rate of interest charged by the central bank to commercial banks when they
borrow money. When the central want to control the supply of money in the economy it may
do so by raising its lending interest rates to the commercial banks. The commercial bank
would in turn loan money to individual at high interest rates. Thus would reduce the
demand for loans hence reducing amount of money in circulation on the other hand the
central bank can increase the supply of money by lowering its lending interest rates
2.Open market operations(OMO)
The central bank can regulate the supply of money in the economy through selling or buying
government securities such as treasury bills and bonds in the open market. If the central
bank wants to reduce money supply they sell the securities and individuals will use their
money in commercial banks to buy them. This reduces money available to commercial banks
to lend out hence low money supply. If the central bank wants to increase money supply
they buy back the securities. The members of public receive payments and deposit in
commercial banks hence availing money to lend out and this increase money supply.
3.Cash \liquidity ratio
The central bank requires commercial banks to hold a certain proportion of total deposits in
form of cash in order to meet the needs of those customers who may wish to withdraw
cash.This is the cash ratio.The central bank may also require commercial banks to hold a
certain proportion of total deposits in form of liquids assets i.e . either cash or what is easily
convertible into cash.This is the liquidity ratio.If the central bank wants to decrease money
supply, they will increase cash\liquidity ratio and thus reduces the money available to
commercial banks for lending.If the central bank loweres cash\liquidity ratio, more money
will be available for lending.
4.Compulsory deposit requirements
The central bank requires commercial banks to maintain certain amounts of deposits with it
in special accounts where the money will stay frozen.This reduces money available to
commercial banks for lending hence reducing money supply.If the central bank wants to
increase the supply of money.It may reduce or release the deposits.
5.Selective credit control
The central bank instructs commercial banks on which sectors to lend money to and to
which credit should be restricted e.g.they can be instructed to avail credit easily for

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agricultural sector and not another sectors so as to expand agriculture.If the central bank
wants to increase money supply they will remove all forms of restrictions on lending.
6.Directives and requests\ moral persuasion
The central bank may instruct the commercial banks to either increase or lower the interest
rates depending on whether they want to expand the monetary policy or to reduce money
supply.The central bank may also appeal to commercial banks to either expand or contract
credit creation without any instructions.
Trends in Banking
1.Commercial banks are drifting from the traditional norms whereby the three types of
accounts had their distinguishing features.It is now possible to find a saving account which
had the elements of a current account and vice versa.
2.Use of computers in banks which has enabled quick and accurate transactions.It has
enabled networking such that a customer can transact business from any bank branch all
over the country
3.Automated teller machines (ATMS)-The use of ATMS enables a customer to access money
anytime of the day as well as other information on the amount from the machine.Some
ATMS like the visa card enables one to buy goods from certain suppliers who accept them
i.e.used as a credit card
4.Most of the banks can give credit nowadays without requiring a collateral security as was
the case previously.They are willing to accept only a payslip as security for loans.They have
also lowered their lending rates.
5.Mobile banks-Some banks operate mobile units which move to specific places at set days
of the week and serve their customers from either the vehicle or a hired building.
6.Customer care services-Most banks have set up customer care departments where
customers can get personal advice on various financial matters.
7.M-Banking –This modern service allows the account holder to access his\her account
anywhere by using a mobile phone.
Review Questions
1. What is the difference between narrow and broad money in an economy?
2. What is high-powered money?
3. What is the bank credit multiplier?
4. Explain, using the bank credit multiplier, how an increase in the amount of cash (high
powered money) in the banking system will affect the value of bank deposits and the
broad money supply.
5. What is the marginal efficiency of capital?
6. Explain how a reduction in the level of interest rates can affect the volume of bank
lending and the level of investment in the economy

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