ECONOMICS

MONEY AND BANKING

Money is one of the terms most readily associated with the study of economics.
So, its importance cannot be undermined as far as the subject matter of economics is
concerned. This chapter is concerned with the functions, characteristics and evolution of
the modem monetary system. It also includes the banking system with emphasis on the
functions, the process of deposit creation and the methods of monetary control by the
central bank. The chapter also covers inflation which is a macroeconomic aggregate
related to the monetary and the banking policies of any country.

MONEY

Money is any commodity that serves as a medium of exchange. In other words, it is

anything that is generally accepted in the community to serve as a means of exchange and
settlement of debts. Money is any commodity that is generally acceptable as a medium of
exchange and settlement of debts. As one of the greatest inventions of man, it comes to solve
the drawbacks of the barter system.

The barter system is a system of trade in which goods are directly exchanged for goods.
The barter system slows down transaction because of many disadvantages. Such
disadvantages include.

• Double coincidence of wants. One must look for somebody who has what he needs and
is in need of what he has for exchange
• Problem of carrying some goods which are too heavy from place to place problem of
sub-dividing the goods into smaller units
• The problem of non-durability of some goods

Faced with these difficulties, man decided to choose ane single commodity to serve as
a medium of exchange. Such a commodity is what we refer to as money.

CHARACTERISTICS OF MONEY

A good form of money should have the following characteristics

1. General acceptability A good form of money is one that people will all accept to use as a
medium of exchange. This is the most important characteristics of money. In most countries,
people are compelled by low to accept the commodity that is chosen as money.

This means that all monetary unity is a legal tender.

A Legal tender is any form of money that people are compelled by law to accept as a medium
of exchange and settlement of debts.

2. Portability. A good form of money should be the type which can easily be carried from one
place to another.

3. Divisibility. Money should easily be subdivided into smaller units or it should easily be
broken down into smaller units for smaller transactions.

4. Durability. A good form of money should last for long periods of time without deteriorating
and losing value

5. Scarcity or limited in supply. The commodity to be used as money should be scarce in

supply. This scarcity can be natural or artificial. The commodity can be scarce naturally like
gold and silver or the government can make it scarce by placing a ban on counterfeiting.

6. Uniformity. Each unit of money must be homogenous or identical to each other for ople to
easily recognize. They should be uniform in colour, shape and size

THE FUNCTIONS OF MONEY

1. Money serves as a medium of exchange: This means that goods are converted into money
which can be used again to purchase other goods and services. This is the most important
function of money. Money is a 'go between' goods and services

2. Acts as a store of value: Wealth and other properties can be converted into money which
could be stored for future use. This is because money is durable.

3. It serves as a standard of deferred payment. Deferred payment is to postpone payment.

With the use of money, people can obtain goods on credit for payment to be made in future
using money. This function makes credit and hire purchase facilities possible.

4. A unit of account: Money acts as a means of expressing the value of goods and services. It
is a common denominator capable of expressing the current value of all commodities; all goods
which have money prices can easily be compared.

FORMS OF MONEY

1. Commodity money: This refers to the early forms of money when some chosen
commodities where performing the functions of money. Examples of such commodities
include: salt, shells, tobacco, cowries, corn.

2. Coins: This refers to pieces of meter which are produced and certified by the Central Bank
to serve as money. Their values are written on the coin and these values are known as their face
values.

The metallic content of the coin is known as the intrinsic value. The coins that we use
today are described as token coins. A token coin is a coin whose face value is greater than the
intrinsic value.

3. Paper money or bank notes: This is another form of money printed Bank. The money is in
the form of paper which caries the official stamp of the central by the bank. In Cameroon bank
note exists in units of 500, 1000, 2000, 5000 and 10,000. Paper money is described today as
fiduciary issue because they cannot be converted into gold. Fiduciary issue is any paper money
that is not backed by gold in the Central Bank.

Coins and paper money constitute what is known as the currency of the country and
they are issued by the Central Bank.

4. Bank Deposits: This refers to any amount of money that is standing in the name of a
depositor in a commercial bank or any financial institution. The use of cheques helps banks
deposit to serve as a medium of exchange. The bulk of money in circulation is made up of
bank deposits. Coins and paper money are only used for small transactions.

MONEY AND NEAR SUBSTITUTES

Near money: It is any liquid. Assets that acts as a store of value but cannot be used as a medium
of exchange. These are assets which can easily be converted into liquid without a loss in value.
They are also known as quasi money. E.g. treasury bills, government bonds, and other short-
term bills. These are bills which have just about 91days to mature.

Money substitute: This is anything which acts as a medium of exchange but not as a store of
value. They are those things that can be used to exchange for goods and services and also to
settle debts. Examples are cheques and credit cards.

The development and use of near money and money substitutes today have reall
affected money in performing some of its functions.

People are increasingly using near money to store their wealth and property. This is
because the value of money can easily fall in future. The function of money as a medium of
exchange is also affected by the use of money substitutes. Many people today in developed
countries prefer to use cheques and cred cards to pay for goods and services and to settle debts.

THE SUPPLY OF MONEY

The supply of money refers to the quantity of money in circulation in a country

at any given time. It is the amount of money that circulates in an economy during a given
period of time. The stock of money in circulation at any given time constitutes the money
supply. This stock of money is made up of coins, paper money and bank deposits. Coins and
paper money constitute the currency of the country, which is just a small proportion of the
money supply. The bulk of the money supply in a country is in the form of bank deposits.

It is sometimes necessary to define the supply of money according to its components.

There is the narrow and broad definition.

According to the narrow definition, the supply of money consists of coins, paper
money and money that people have in their sight deposits. This definition is concerned only
with the forms of money that can be used as a medium of exchange.

Broad definition sees the supply of money to include narrow definition and also money
in all deposit accounts.

THE DEMAND FOR MONEY

The demand for money is the desire to hold money in liquid form. It is also known
as the liquidity preference. There are three main reasons why people may want to hold money
in liquid form.

1. Transaction motive: This is money that people keep to carry out their day to day activity.
This is excess cash which is used in financing normal daily activity like transportation, payment
of bills and buying of food.

2. Precautionary motive: This refers to money kept in liquid form to take care of unforseen
circumstances.e.g. Money for illness, unexpected visitors, accident etc.

Money kept for transaction and precautionary motives are described as active balances because
they are currently being used. The amount that people keep for active balances depends on the
following factors.

• Their level of income

• The interval of payment of salary
• The volume of transaction
• The level of prices

3. Speculative motive: This is excess money that people keep above the active balances which
is meant for business in the money or capital market. Such excess balances are called idle
balances which can be used at any time to buy financial securities. Money kept for speculative
purpose is common with big businessmen. They use such money to buy financial securities
when they speculate prices to rise in future.

INFLATION

Inflation is defined as a continuous rise in the general price level in an economy.

It is a period when the value of money is persistently falling,

TYPES OF INFLATION

1. Creeping or mild inflation: This is a situation of inflation where prices are slowly. This
type of inflation stimulates economic activities and reduces the burden of the national debt and
is common with industrialized countries.

2. Suppressed inflation: This is a situation of rising prices in which the government is using
measures to suppress the rising prices. For instance, the use of maximum price control.

3. Hyperinflation (Galloping inflation): This is the most serious case of inflation where prices
are rising at a very high speed. It occurs when the value of money falls so rapidly that it ceases
to perform it functions effectively. When inflation reaches this degree, economic collapse is
certain to follow and the only solution is to replace the currency with a new one.
4. Strato-inflation: This is a high rate of inflation which is combined with fluctuation in the
rate at which prices are rising. More precisely, it is a period of rising but fluctuating rate of
inflation.

5. Slumpflation: This is a period of economic recession (economic crisis) which is

characterized by rising prices.

6. Stagflation: This is a period of high rate of unemployment co-existing with high rate of
inflation.

CAUSES OF INFLATION

The causes of inflation are usually analyzed under two main types of inflation, namely;
demand-pull and cost push inflation.

DEMAND-PULL INFLATION

Meaning

This is a period of rising prices caused by excess demand. Aggregate demand

persistently exceeds aggregate supply at full employment such that prices are being pulled
upwards.

CAUSES OF DEMAND-PULL INFLATION

1. A budget deficit: When there is an increase in government expenditure without a

corresponding increase in tax revenue collection, there is going to be an increase in the level
of income. This may increase aggregate demand causing demand pull inflation. A budget
deficit is when government expenditure is more than income.

2. An increase in autonomous investment: This is investment that does not depend on the
level of demand. It generates more income though the multiplier effect and if this is not
followed by a corresponding increase in savings, there will be excess demand in the economy.

3. An increase in money supply: A loose monetary policy can create excess demand if the
economy is already at full employment. There will be an increase in money supply without a
corresponding increase in the output of goods and services.

4. A balance of payment surplus: A BOP surplus implies a surplus of the value of exports
over the value of imports. This will generate more income at home and at the same time create
shortage of consumer goods. Prices of consumer goods will be rising.

5. A war period: During a war, a country may be using more of its resources to produce war
equipment. This will generate income and at the same time reduces the production of consumer
goods. Prices of these goods will be forced to rise.

6. Post war period: Heavy savings occurs during war time but when the war is over, there is
a strong desire to spend the accumulated savings but less desire to work. Supply will be
inadequate to meet the demand for goods and services in the market.

7. Expectation of future price increase: When rising prices starts, the fear of consumers may
help to push up prices further. This is because consumers will rush to spend when they are
expecting future rise in prices.

REMEDIES OF DEMAND-PULL INFLATION

1) A budget surplus: An increase in the level of taxes and a reduction in government spending
can reduce aggregate demand. A budget surplus has a contraction effect on the level of income.
This will lead to a reduction in the level of prices.

2) An increase in income taxes: An increase in this type of tax reduces the disposable income
in the economy. This will consequently reduce the level of aggregate demand and cause prices
to fall.

3) A tight monetary policy: The government should reduce money supply in order to reduce
aggregate demand. It can increase bank rate or called for special deposits from commercial
banks. This will reduce the amount of loan that commercial banks grant to their customers.
This policy is known as credit squeeze which is any policy that reduces the availability of
credits in the economy.

4) Encourage import and discourage export: Policies should be taken to encourage the
importation of consumer goods from other countries in order to increase supply at home. This
can be in the form of reduced tariff on import.

Export can be discouraged by imposing high taxes on the export industries.

COST-PUSH INFLATION
 Cost push inflation occurs when the rising prices is initiated by rising costs of
production which push up prices. The costs of factors are rising and the tendency will be for
output to fall and prices will be pushed upward. These prices are rising independently of the
state of demand.

THE CAUSES OF COST PUSH INFLATION

1) Increase in wages: When wages are increasing more than productivity, the supply of goods
and services in the market will fall because costs of production will be rising. A fall in the
supply of goods and services in the market will led to rising prices.

Increase in wages can be initiated by trade unions irrespective of the state of productivity.
Producers will be forced to push up prices to cover the increase in wages. Rising wages is the
main cause of cost push inflation. This explains why this type of inflation is usually called
wage push inflation.

2) An increase in indirect taxes: Indirect taxes are taxes levied on producers and are usually
considered as part of total costs. An increase in indirect taxes can initiate cost push inflation.

3) Rising prices of raw materials: When the prices of raw materials are rising the cost of
producing the finished goods will also rise. This will led to a fall in supply in the market and
rising prices. It is usually the rising prices of imported raw materials that easily initiate cost
push inflation because it is difficult to control such prices.

4) Increase in interest rate: Most production activities are financed with loans. The cost of
these loans is the interest rates on loans. Rising interest rates will therefore increase the costs
of production leading to rising prices.

REMEDIES OF COST PUSH INFLATION

1. Income policy: This refers to any measures that the government can use to control wages.
Such policies include:

• Wage freeze: The government can limit wages from rising above a defined level in
each industry. This means that the government can impose a maximum wage rate in
those industries where wages are rising.
• Indexation: This is an automatic adjustment for inflation in the wage contract such that
wages should increase as a proportion to increases in the general price index. This
 means that there is an inclusion in the wage contract of an automatic adjustment in
wages according to changes in the price index.

2. Reducing trade union bargaining powers; the government can implement decisions that
will help to reduce the powers of trade union e.g. the government can restrict the formation of
closed shop trade union and encourage the formation of open shop trade unions. It can also
make picketing unlawful. Picketing is taking the job of a striking worker.

3. A reduction in indirect taxes: When indirect taxes are reduced on producers, their costs of
production will also reduce. This may cause prices in the market to fall.

4. Increase in subsidies to producers: Financial grants to producers (subsidies) reduce the

costs of production and increase supply in the market. This will cause prices to fall. 5. Currency
revaluation: This is a deliberate increase or official increase in the exchange rate of the
currency. It makes exports dearer and imports cheaper. More goods will be imported to increase
supply at home.

6. Encourage productivity: In order to compensate for rising prices or rising wages, industries
should encourage productivity in order to increase output per worker. An increase in
productivity will enable producers to realise the same output with a smaller work force.

THE INFLATIONARY SPIRAL

Two main causes of inflation are excess demand and rising costs of production.

Sometimes it might not be easy to identify which of them initiates the rising prices. If
there is an increase in demand at full employment prices will rise. This is demand pull inflation.
Real wages of workers will fall and they will put pressure on their employers to pay higher
wages. If this demand is granted cost of production will rise and push prices upwards. This is
cost push inflation. The rising wages implies rising income which have to be spent. This will
create excess demand bringing in demand pull inflation again. Prices will start rising and
workers will again start demanding for higher wages and the process will continue. This
process is known as the inflationary spiral.

An inflationary spiral is a continuous increase in the rate of inflation caused by the

interaction of rising costs of production and rising final price.