MONEY
AND BANKING
MONEY
The Nature and Functions of Money
What is Money?
- Money is anything accepted to pay for goods and services or to
settle a debt.
- Money is best
defined in terms of its functions.
Functions of Money
1. Money
as Medium of Exchange…
As a medium of exchange it solves the “double coincidence “of wants
problem in barter system. With money a person can buy anything he likes.
2. Money
as a Measure of Value
In money economy value of all goods and services are expressed in terms
of price like ( price for wheat in Kg and Cloth in meter etc).
3 Standard
of Deferred Payments.
In a money economy the contracts are made for future payments in money
terms, with a promise to repay the loan in money.
4.
Money as a Store of Value.
Money acts as a store of value without loss in its value over period of
time. in barter system much difficulty was faced in storing value in terms of
goods.
5. Source
of Government receipts.
Government can collect taxes from the people with the help of money easily.
On the other hand Government gives salaries and pensions to the people without
any difficulty.
6. Money
as Unit of Account.
We count the amount of different goods and services with the help of
money. Different countries have different unit of account such as Pound for UK,
Yen for Japan etc. In this way the figure of National income, wealth and assets
are expressed in terms of money.
Features
of money
For an object to serve efficiently as money, it should posses the
following features:
1.
It must be widely accepted as a means of
payments
2.
It must be divisible, that is, it must
exist in different denominations
3.
It must be easily identified
4.
It must not be easily duplicated or
counterfeited(i.e. must be relatively scarce)
5.
It must be easily transported
6.
It must be durable, allowing it to last
for very long periods
Kinds
of Money
- Notes and coins constitute currency.
- Canadian currency is Fiat Money, not backed by gold or any other
precious metal.
- Legal Tender money must be accepted in settlement of debts.
- The face value of Good Money is equal to the value of metal it
contains.
- The face value of Bad Money is greater than the metal’s value.
- Gresham’s Law states that bad money drives out good money.
- Checking accounts
are bank deposits that are transferable by cheques, these are known as Demand
Deposits.
Near Money and Money Substitutes
Near
Money
- Notice Deposits are interest-earning deposits subject to notice
before withdrawal.
- Near Money is any
highly liquid asset that can be easily converted into currency or demand
deposits without much loss of value.
Money
Substitutes
- Credit cards are not money; they are money substitutes.
- The use of money in
transactions discharges debts, but the use of credit cards establishes debts
that must ultimately be discharged by using money.
DEMAND
AND SUPPLY OF MONEY
Theories of the demand for money:
i. Classical theories: start of
20th century, Irving Fisher, Alfred Marshall, and A.C. Pigou
• The Purchasing Power of Money. Irving Fisher. 1911
ii. Keynesian theories
• The General Theory of Employment, Interest, and Money.John
Maynard Keynes. 1936
iii. Modern quantity theory:
Milton Friedman
• The Quantity Theory of Money: A Restatement. Milton Friedman. 1956
Keynesian
Liquidity Preference Framework
Why do individuals hold money?
i. Transactions
motive
• Money is a medium of exchange
that can be used to carry out everyday transactions.
• The transactions component of
the demand for money is proportional to income.
ii.
Precautionary motive
• Cushion against an unexpected
need Also proportional to income.
iii. Speculative
motive
• People hold money as a store of
wealth.
• Why would individuals decide to
hold their wealth in the form of money
rather than bonds?
• Negatively related to the level of interest rates.
The
Central Bank
In
most countries there is a single bank that exercises control over the entire
monetary and banking system. The central bank is operated as a public
corporation so that it is subject to government control.
The Central Bank of Kenya was established in 1966
through an Act of Parliament - the Central Bank of Kenya Act of 1966.
Mandate of the Bank
The Central Bank of Kenya's objectives is laid down in the
Central Bank of Kenya (Amendment) Act, 1996 as follows:
Principal Objectives
- To formulate and implement monetary policy directed to achieving and maintaining stability in the general level of prices
- To foster the liquidity, solvency and proper functioning of a stable market based financial system
Secondary Objectives
Without prejudice to the generality
of the above two principal objectives, the Bank's secondary objectives shall be
to:
- Formulate and implement foreign exchange policy
- Hold and manage its foreign exchange reserves
- License and supervise authorised dealers in the money market
- Promote the smooth operation of payments, clearing and settlement systems
- Act as a banker and adviser to, and as fiscal agent of the Government; and
- Issue currency notes and coins
The above are roles of the central bank in a liberalized
money market.
Traditionally, the
role of the Central bank has been;
·
Banker to the Government
·
Banker to the commercial bank
·
Management of Public debt
·
Holding of foreign exchange reserves
·
Implementation of monetary policy
·
Lender of Last resort
·
Issuing of notes and coins
Monetary
Policy
What is monetary policy?
Monetary policy is the process by which the Central Bank influences the level of money supply credit in the economy in order to minimize excessive price fluctuations, and promote economic growth.
Monetary policy is the process by which the Central Bank influences the level of money supply credit in the economy in order to minimize excessive price fluctuations, and promote economic growth.
What does monetary policy do? (Objectives
of Monetary policy)
Monetary policy guards against inflation and ensures stability of prices, interest rates and exchange rates. This protects the purchasing power of the Kenya shilling and promotes savings, investment and economic growth. Through monetary policy, the Central Bank creates conditions that allow for increased output of goods and services in the economy, thereby improving the living standards of the people.
Monetary policy guards against inflation and ensures stability of prices, interest rates and exchange rates. This protects the purchasing power of the Kenya shilling and promotes savings, investment and economic growth. Through monetary policy, the Central Bank creates conditions that allow for increased output of goods and services in the economy, thereby improving the living standards of the people.
INSTRUMENTS
OF MONETARY POLICY
The Central Bank formulates a policy
to expand or contract money supply in the economy after detailed analysis and
estimation of the demand for money in the economy. The following instruments
are used to conduct monetary policy in Kenya: .
Reserve Requirement: The
Central Bank may require Deposit Money Banks to hold a fraction (or a
combination) of their deposit liabilities (reserves) as vault cash and or
deposits with it. Fractional reserve limits the amount of loans banks can make
to the domestic economy and thus limit the supply of money. The assumption is
that Deposit Money Banks generally maintain a stable relationship between their
reserve holdings and the amount of credit they extend to the public.
Open Market Operations: The
Central Bank buys or sells ((on behalf of the Fiscal Authorities (the
Treasury)) securities to the banking and non-banking public (that is in the
open market). One such security is Treasury Bills. When the Central Bank sells
securities, it reduces the supply of reserves and when it buys (back)
securities-by redeeming them-it increases the supply of reserves to the Deposit
Money Banks, thus affecting the supply of money.
Lending by the Central Bank: The
Central Bank sometimes provide credit to Deposit Money Banks, thus affecting
the level of reserves and hence the monetary base.
Interest Rate: The
Central Bank lends to financially sound Deposit Money Banks at a most
favourable rate of interest, called the minimum rediscount rate (MRR). The MRR
sets the floor for the interest rate regime in the money market (the nominal
anchor rate) and thereby affects the supply of credit, the supply of savings
(which affects the supply of reserves and monetary aggregate) and the supply of
investment (which affects full employment and GDP).
Direct Credit Control: The
Central Bank can direct Deposit Money Banks on the maximum percentage or amount
of loans (credit ceilings) to different economic sectors or activities,
interest rate caps, liquid asset ratio and issue credit guarantee to preferred
loans. In this way the available savings is allocated and investment directed
in particular directions.
Moral Suasion: The
Central Bank issues licenses or operating permit to Deposit Money Banks and
also regulates the operation of the banking system. It can, from this
advantage, persuade banks to follow certain paths such as credit restraint or
expansion, increased savings mobilization and promotion of exports through
financial support, which otherwise they may not do, on the basis of their
risk/return assessment.
Prudential Guidelines: The
Central Bank may in writing require the Deposit Money Banks to exercise
particular care in their operations in order that specified outcomes are
realized. Key elements of prudential guidelines remove some discretion from
bank management and replace it with rules in decision making.
Exchange Rate: The
balance of payments can be in deficit or in surplus and each of these affect
the monetary base, and hence the money supply in one direction or the other. By
selling or buying foreign exchange, the Central Bank ensures that the exchange
rate is at levels that do not affect domestic money supply in undesired
direction, through the balance of payments and the real exchange rate. The real
exchange rate when misaligned affects the current account balance because of
its impact on external competitiveness. Moral suasion and prudential guidelines
are direct supervision or qualitative instruments. The others are quantitative
instruments because they have numerical benchmarks.
Limitations
of Monetary Policy
- Unbanked population in developing countries makes it difficult for the central bank to control money supply using monetary policy tools
- Lack of knowledge of monetary policy tool such as selective credit control, OMO etc makes it difficult to implement monetary policy
- Less sensitive commercial banks to changes in cash ratios and bases rates
- Corruption
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