Money and Banking Lecture notes

DBM 614: ECONOMICS LECTURE NOTES
UNIT 7: MONEY AND BANKING

Definition

• Money refers to anything which is widely acceptable in payment for commodities and in settling debts, not for itself but because it can be similarly passed on.
Banking:
• Is an industry that handles cash, credit, and other financial transactions

Characteristics of money

1. Acceptability-If money is to be used as medium of exchange for goods and services, then it must be generally accepted as having value in exchange. This was true of metallic money in the past because it was in high and stable demand for its ornamental value. It is true of paper money, due to the good name of the note-issuing authority.
2. Portability-If an item is to be used as money, it must be easily portable, so that it is a convenient means of exchange.
3. Scarcity- If money is to be used in exchange for scarce goods and services, then it is important that money is in scarce supply. For an item to be acceptable as money, it must be scarce.
4. Divisibility-It is essential that any asset which is used as money is divisible into small units, so that it can be used in exchange for items of low value.
5. Durability- Money has to pass through many different hands during its working life. Precious metals became popular because they do not deteriorate rapidly in use. Any asset which is to be used as money must be durable. It must not depreciate over time so that it can be used as a store of wealth.
6. Homogeneity– It is desirable that money should be as uniform as possible.

Functions of money

  1. a. Medium of exchange: Money facilitates the exchange of goods and services in the economy. Use of money as an intermediary in transactions therefore, removes the requirement for double coincidence of wants between transactions. The use of money enables a person who receives payment for services in money to obtain an exchange for it, the assortment of goods and services from the particular amount of expenditure which will give maximum satisfaction.
  2. b. Unit of account: Money is a means by which the prices of goods and services are quoted and accounts kept. The use of money for accounting purposes makes possible the operation of the price system and automatically provides the basis for keeping accounts, calculating profit and loss, costing etc. It facilitates the evaluation of performance and forward planning.
  3. c. Store of Wealth/value: The use of money makes it possible to separate the act of sale from the act of purchase. Money is the most convenient way of keeping any form of property which is surplus to immediate use; thus in particular, money is a store of value of which all assets/property can be converted.
  4. d. Standard of deferred payment: Many transactions involve future payment, e.g. hire purchase, mortgages, long term construction works and bank credit facilities. Money thus provides the unit in which, given the stability in its value, loans are advanced/made and future contracts fixed. Borrowers never want money for its own sake, but only for the command it gives over real resources.

 

The Demand and Supply of Money

A. Demand for money

  • It refers to the desire to hold one’s assets as money rather than as income-earning assets (or stocks).
  • Holding money therefore involves a loss of the interest it might otherwise have earned. There are two schools of thought to explain the demand for money, namely the Keynesian Theory and the Monetarist Theory
  • The demand for money and saving are quite different things. Saving is simply that part of income which is not spent. It adds to a person‟s wealth. Liquidity preference is concerned with the form in which that wealth is held. The motives for liquidity preference explain why there is desire to hold some wealth in the form of cash rather than in goods affording utility or in securities

B. Supply for money

  • Refers to the total amount of money in the economy.
  • Most countries of the world have two measures of the money stock – broad money supply and narrow money supply. Narrow money supply consists of all the purchasing power that is immediately available for spending.
  • Two narrow measures are recognized by many countries.
    1. M0 (or monetary base), consists of notes and coins in circulation and the commercial banks‟ deposits of cash with the central banks.
    2. M2 which consists of notes and coins in circulation and the NIB (non- interest- bearing) bank deposits – particularly current accounts. Also, in the M2 definition are the other interest-bearing retail deposits of building societies. Retail deposits are the deposits of the private sector which can be withdrawn easily. Since all this money is readily available for spending it is sometimes referred to as the “transaction balance”.

Banking system

Consists of all those institutions which determine the supply of money. The main element of the Banking System is the Commercial Bank (in Kenya). The second main element of Banking System is the Central Bank and finally most Banking Systems also have a variety of other specialized institutions often called Financial Intermediaries.

A. Central Bank

• These are usually owned and operated by governments and their functions are:

  1. Government‟s banker: Government‟s need to hold their funds in an account into whichthey can make deposits and against which they can draw cheques. Such accounts are usually held by the Central Bank
  2. Banker’s Bank: Commercial banks need a place to deposit their funds; they need to be able to transfer their funds among themselves; and they need to be able to borrow money when they are short of cash. The Central Bank accepts deposits from the commercial banks and will on order transfer these deposits among the commercial banks.
  3. Issue of notes and coins: In most countries the central bank has the sole power to issue and control notes and coins. This is a function it took over from the commercial banks for effective control and to ensure maintenance of confidence in the banking system.
  4. Lender of last resort: Commercial banks often have sudden needs for cash and one way of getting it is to borrow from the central bank. If all other sources failed, the central bank would lend money to commercial banks with good investments but in temporary need of cash. To discourage banks from over-lending, the central bank will normally lend to the commercial banks at a high rate of interest which the commercial bank passes on to the borrowers at an even higher rate. For this reason, commercial banks borrow from the central bank as the lender of the last resort.
  5. Managing national debt: It is responsible for the sale of Government Securities or Treasury Bills, the payment of interests on them and their redeeming when they mature.
  6. Banking supervision: In liberalized economy, central banks usually have a major role to play in policing the economy.
  7. Operating monetary policy: Monetary policy is the regulation of the economy through the control of the quantity of money available and through the price of money i.e. the rate of interest borrowers will have to pay. Expanding the quantity of money and lowering the rate of interest should stimulate spending in the economy and is thus expansionary, or inflationary. Conversely, restricting the quantity of money and raising the rate of interest should have a restraining, or deflationary effect upon the economy.

B. Commercial Banks

A Commercial Bank is a financial institution which undertakes all kinds of ordinary banking business like accepting deposits, advancing loans and is a member of the clearing house i.e. operates or has a current account with the

Central Bank. They are sometimes known as Joint Stock Banks.

Functions of Commercial Banks

In modern economy, commercial banks have the following functions:

  • They provide a safe deposit for money and other valuables.
  • They lend money to borrowers partly because they charge interest on the loans, which is a source of income for them, and partly because they usually lend to commercial enterprises and help in bringing about development.
  • They provide safe and non-inflationary means for debt settlements through the use of cheques, in that no cash is actually handled. This is particularly important where large amounts of money are involved.
  • They act as agents of the central banks in dealings involving foreign exchange on behalf of the central bank and issue travellers‟ cheques on instructions from the central bank.
  • They offer management advisory services especially to enterprises which borrow from them to ensure that their loans are properly utilized.

Non-banking Financial Institutions

  • Is an institution that offers loans and financial products but does not have a full banking license.
  • These types of institutions are privately owned which gives them more leverage and flexibility with the rates and fees they can offer customers. This allows them to offer low-cost loans and generate competition in the banking world, forcing the banks to lower their rates to compete.
  • Many people consider using an NBFI when looking to secure a small business, personal or business loan. Some types of non-bank financial institutions include:

1. Insurance Companies
Risk-pooling institutions like insurance companies work with economic risks such as death, damage and risks of loss to make a return. The two main types of insurance companies are general insurance and life insurance. General insurance is more of a short term contract while life insurance is long term and is active until the insurer’s death.

2. Payday Lenders- Specialized sectoral financiers like payday lending companies and real estate financiers provide short term loans and limited financial services to a targeted demographic. Payday lenders can help with unsecured business loans and are a quick fix for borrowers. Those struggling to get credit or with limited recourse to funds are more likely to use a payday lender when securing a loan.

3. Financial Service Providers-Financial service providers are made up of management consultants, security and mortgage brokers and financial advisors. They operate on a fee-for-service basis and offer advice to investors and brokers. They improve informational efficiency for investors and offer a transactions service for investors to liquidate their assets.

4. Institutional Investors-Institutional investors are organizations that trade securities in volumes that qualify for lower commissions. This kind of non-bank financial institution can be found working with pension funds and mutual funds.

Trends, challenges and future of modern-day banking

A. Trends

1. Electronic cheques. Customers can electronically instruct the bank to issue a cheque and so eliminate the need to keep a cheque book.
2. Insurance cover. Some banks have introduced insurance cover for customers holding certain amounts of money in their accounts. Under this scheme, people get insurance cover for certain amounts, depending on the amount of money held in their accounts.
3. Credit cards. These enable customers to obtain goods and services on credit.
4. E- Banking. Customers are able to access their accounts through the use of desktop computers in the comfort of their home or office.
5. Package banking. Banks strive to offer more value- added services to their clients without necessarily asking for payment.
6. Other modern technology includes: ATMs and mobile banking.

2. Challenges

(i). ATM Card Skimming – Of late there have been numerous cases of people being ripped off their money through card fraudsters. These fraudsters no longer use force to get your card details. What they do is install gadgets in ATM machines which are able to capture/steal your card information when you use your ATM card. Once they have your card information, they are able to use that to withdraw money from your account. These rising cases of fraud have seen local banks experience great losses because they often have to compensate their customers.

(ii). High cost of borrowing – The cost of borrowing is still high and Kenyans are finding it very expensive to borrow money from banks. The interest rates in local banks are still high and unless these rates go down, Kenyans will shy away from borrowing money from banks. This is quite a challenge because loans are a major source of income to the banks.

(iii). Theft cases – There have been a lot of theft cases in the banking industry. Banks have lost lots of money stolen from them by their own employees, their security providers, and other external individuals.

(iii). Competition from mobile money transfer services – Local mobile money transfer services like Mpesa and Airtel money have brought in a lot of competition to banks. Since their introduction, many people are finding it easier to save and transfer money through these mobile money transfer services as opposed to banks.

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