Money And Banking

(1) Money  

Money can be defined as any commodity that is generally acceptable as a medium of exchange and measure of value. It enables one to trade what he has for what he wants. That is the conventional definition of money and it emphasizes the basic functions of money are medium of exchange and measure of value. However, money is highly important so as to maintain maintain good health.

  

                 Money as a medium of exchange 

  Money serves as a medium of exchange between two goods. It is considered the most important and unique definition of money. The importance of this function is that it provided solution to one of the biggest problems of barter system. For exchange to take place in barter system, there must be double coincidence of wants, i.e, one is willing to accept what the other person is willing to give in exchange. If this condition is not fulfilled, there can`t be exchange. In barter system, a person who has shoes but wants clothes for his family has to find someone who has clothes but wants shoes. 

 In modern market economy, money has solved the problem of double coincidence of wants. Since money is generally acceptable, a shoe maker can sell his shoes to anybody for money and buy clothes in exchange for the money. The purchasing power of money acceptable to all. 

                          Money as a measure of value  

  All values are measured in terms of money. As a measure of value, money works as a common denominator, as a unit of account. Money makes computation of the value all possessions of a person, group, or a country easier. Not only each good and service has a price, but also one can calculate and compare their relative prices in terms of money. With the invention of money, valuation is made easier. 

                             Characteristics of Money  

1. General acceptability: It must be generally acceptable as a medium of exchange for goods and services. 

2. Homogeneity: Each of unit of money must be identical, i.e, of the same size, quality et.c. 

3. Divisibility: It must be capable of being divided into smaller units. In USA,$100 note must be divisible to two $50 notes. 

4. Portability: It must be easily transmissible or carried about. 

5. Durability: It must be capable of staying for a long period of time without getting bad. 

6. Relative scarcity: It must be relatively scarce so as to maintain its value. 

7. Stability of value 

  

   DEMAND FOR MONEY 

 Demand for money is the total amount of money which all individuals in the economy wish to hold. It is the desire to hold money. The demand for money in economics is called liquidity preference. Classical theory explained the demand for money as essentially a demand resulting from this need for money as a medium of exchange. 

     Motives For Holding Money  

Lord Keynes postulated three (3) motives for holding money: 

(1) Transactionary Motive: People love to hold money for day to day transaction. Household needs to hold money to cater for the interval between receipt of income and their expenditure. The average amount of money held on each day is said to be the individual`s demand for money. It varies directly with the level of income, i.e the higher the level of income, the higher the demand for money for transactionary motive.  It is written as: 

                                      Mt = f(Y) 

 (2) Precautionary Motive: This is when people hold money in order to meet up with unforeseen circumstances e.g sickness. People also keep money against future emergencies due to uncertainty in life. Unlike a transactionary balance, which is something scheduled for use in the near future, a precautionary balance is to secure one against a raining day that may never come. It depends on the level of income. There is direct relationship between demand for money for precautionary motive and the level of income. Hence, it is written as: 

  

                              MpD = f(Y) 

 (3) Speculative Motive: This is a business motive specifically and refers to the desire to hold cash balance in order to embark on speculative dealings in the bond market. The desire to keep money for this motive is elastic. The demand for money for speculative motive varies inversely with interest rate.  It is a function of income and rate of interest. Hence, it is written as:  

  

                  MsD = f(Y,r)  

      SUPPLY OF MONEY  

It is the total amount of money available for use in the economy at a given period of time. It involves the currency circulating out of banking system and bank deposits in current accounts. 

There are basically two definitions:  

(1) Narrow Definition: Money supply is currency in circulation and demand deposit with commercial banks. Hence, it is written as:  

                                     M1 = C + DD  

 (2) Broad Definition: Money supply is the total currency in circulation, demand deposit and time deposit(T) at commercial banks. Time deposits are fixed deposits of customers. Hence, it is written as:  

  

                           M2 = C + DD + T 

 

          Determinants of Money Supply

Determinants of money supply are both exogenous and endogenous. By exogenous, we mean that money supply is influenced by what is happening in a country. By endogenous, we mean money supply is determined by what is happening in an economy(by level of economic activities).

Cash ratio: It is part of total deposits which the merchant and commercial banks are expected to keep as cash in bulks as deposits in the Central Bank in order to meet deposit demand. There is inverse relationship between money supply and cash ratio. The higher the cash ratio, the lower the supply of money and vice versa.

Discount rate: It is the interest collected by the Central Bank for providing reserve deposit to the banking system. There`s inverse relationship between discount rate and money supply.

Other determinants are: interest rate ceiling, aggregate credit ceiling, moral suasion and open market operation.

(2)  BANKING

     Commercial Banking
Commercial banks are the banks that provide services such as acceptance of deposits, giving business loans and basic investment products. Commercial banks are the kingpins of the financial system. They render various valuable services. They perform important functions such as: acceptance of deposits, making of advances and undertaking of of some investments. There are three major aims of commercial banks, namely: Profitability, Liquidity and Security.

Profitability is achieved by a commercial bank by lending very high proportion of the of the deposits at its disposal and getting interests in the process. 

The consideration of security is reflected in the manner in which commercial banks examine any prospective borrower with respect to credit worthiness, marketability of collateral security of prospective borrowers with respect to credit worthiness and the profitability of the investments that determine the ability to repay. 

As for liquidity, banks also keep proportion of their assets in liquid forms including treasury bills, bills from discount houses and bills of exchange.

       Credit Creation by Commercial Banks
Suppose there are a number of banks in the banking system namely Bank 1, Bank 2, Bank 3 e.t.c. and we assume that (1) banks accept only demand deposits (2) the cash reserve requirement is 20% (3) banks` assets are held only in form of cash reserves, loans ans advances. 

If Mr. A makes a demand deposit of $100,000 in Bank 1 in which the bank holds $20,000 as the 20% cash reserve requirement. The banks lends Mr. B the remaining $80,000 and he deposits the money in Bank 2 in which the bank also reserves 20% which is $16,000. Bank 2 also lends the remaining $64,000 to Mr. C. If this process continues, the excess reserve with banks  will become zero. It will lead to the following table:
 

Bank	Deposit	Reserve	Bank loans
Bank 1	100,000	20,000	80,000
Bank 2	80,000	16,000	64,000
Bank 3	64,000	12,800	51,800
--------	----------	----------	-----------
--------	----------	----------	-----------
--------	----------	----------	-----------
Bankn	0000	0000	00000
Total	500,000	100,000	400,000

From the table above, a primary deposit of $100,000 in Bank 1 leads to the creation of a total deposit of $500,000, A credit of $500,000 has been created by the banking system and maintaining a total cash reserve of $100,000 which equals the primary deposit. The total money created is the money supply by the banks.

However, money creation has some limitations such as: high legal reserve ratio, lack of collateral securities, too much reserve by banks e.t.c.

     Central Banking 
A central bank is a financial institution owned by the government of a country, managed by the board of directors, under the chairmanship of a governor appointed by the government and charged the responsibility of availability of money in the interest of public welfare.

A central bank performs the following functions: issuance of currency, banker of commercial banks, controller and regulator of money supply, government to the central government, management of foreign exchange, lender of last resort and financing of economic development. It controls money supply through open market operation, reserve requirement,bank rate e.t.c.