PART 1

CONCEPTS AND EVOLUTION OF MONEY

STUDY SESSION 1
DEFINITIONS, NATURE AND HISTORICAL DEVELOPMENT

1.0 INTRODUCTION
This session begins with an overview of the definitions, nature and the historical development of
money as we know them today. We will see that money is not simply bills and coins; it is
anything widely used to pay for goods and services. The value of money is another important
concept that is often misunderstood by students of economics. We will discuss and explain the
important functions, properties and different types of money. In this study session, you will
attempt to fill the gaps in your understanding of the concept of money. Also, this study session
briefly overviews instances in the history of thought which have emphasized the nature of money

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and explain why we use money and compare the alternative trading strategies, both with and

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without money.

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Learning Outcomes for Study Session 1
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At the end of this study Session, you should be able to:
1.1 explain the concept of Monetary economics (SAQ 1.1)
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1.2 define money in economic terms (SAQ 1.2)
1.3 state the different functions of money (SAQ 1.3)
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1.4 list and describe what the different types of money are (SAQ 1.4)
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1.5 discuss the physical properties of money (SAQ 1.5)

1.6 describe the Concept of Liquidity (SAQ 1.6)
1.7 explain the historical development of money (SAQ 1.7)
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1.1 THE CONCEPT OF MONETARY ECONOMICS

What can you say is the meaning of “Monetary Economics”, as defined in McCallum‟s (1989)
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textbook, "is concerned with the effects of monetary institutions and policy actions on economic
variables (such as) commodity prices, wages, interest rates, and quantities of employment,
consumption, and production" The subject covers the origin, functions and value of money, a
large part of macroeconomics with an emphasis on monetary policy, central banking and
financial institutions and financial markets. As an area of research and teaching monetary
economics is frequently merged with the related field of finance (i.e. macro-finance) and is then
referred to as financial economics.

Monetary economics can also be define as the branch of economics that provides a framework
for analysing money in its functions as a medium of exchange, store of value, and unit of
account. It considers how money, for example fiat currency, can gain acceptance purely because
of its convenience as a public good. It examines the effects of monetary systems, including
regulation of money and associated financial institutions and international aspects. The discipline
has historically prefigured, and remains integrally linked to, macroeconomics.

Monetary Economics” examines how currencies enter the marketplace and become accepted as
mediums of exchange for goods and services. It also analyses government regulation of money
and financial institutions, the structure and interaction of monetary systems, financial history and
the demand for money basically, anything involving bankers and banknotes. Because the
exchange of money pervades the economic system at every level, monetary economics is largely
a study in macroeconomics

Modern analysis has attempted to provide micro foundations for the demand for money and to

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distinguish valid nominal and real monetary relationships for micro or macro uses, including

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their influence on the aggregate demand for output. Its methods include deriving and testing the
implications of money as a substitute for other assets and as based on explicit frictions.

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Traditionally, Research Areas in Monetary Economics have included:
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 empirical determinants and measurement of the money supply, whether narrowly-,
broadly-, or index-aggregated, in relation to economic activity
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 debt-deflation and balance-sheet theories, which hypothesize that over-extension of credit
associated with a subsequent asset-price fall generate business fluctuations through the
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wealth effect on net worth and the relationship between the demand for output and the
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demand for money

 monetary implications of the asset-price and macroeconomic relation
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 the quantity theory of money, monetarism, and the importance and stability of the
relation between the money supply and interest rates, the price level, and nominal and
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real output of an economy.

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 monetary impacts on interest rates and the term structure of interest rates
 lessons of monetary and financial history
 transmission mechanisms of monetary policy as to the macro economy
 the monetary and fiscal policy relationship to macroeconomic stability
 neutrality of money vs. money illusion as to a change in the money supply, price level, or
inflation on output
 tests, testability, and implications of rational-expectations theory as to changes in output
or inflation from monetary policy
 monetary implications of imperfect and asymmetric information and fraudulent finance
 game theory as a modelling paradigm for monetary and financial institutions
 the political economy of financial regulation and monetary policy
  possible advantages of following a monetary-policy rule to avoid inefficiencies of time
inconsistency from discretionary policy
 "anything that central bankers should be interested in"

Question: Why do Economists take the study of money seriously?

Solution: Economists take the study of money seriously because evidence suggests that (1) the
money supply and the price level move closely together. (2) Money and interest rate
movements are related. (3) Business cycle downturns are preceded by downturns in money
growth.
1.2 DEFINITION OF MONEY
Money is something that we use every day. We earn it and spend it but don‟t often think much
about it. In the past, money has taken different forms through the ages; examples include cowry

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shells in Africa, large stone wheels on the Pacific island of Yap, and strings of beads called

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wampum used by Native Americans and early American settlers. Also, corn, rice, cattle, various
precious metals and more recently, pieces of paper issued by governments. In all cases though,

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money was and is used as a means of payment in exchange. The payer in a transaction (he or she
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who is purchasing a good or service) hands over money to the value of the item bought and at
this point the payee (the seller of the good or service) accepts that the payment is complete. The
payee neither holds any further claims on the payer, nor on any third party who may have
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produced or issued the money.
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Economists define money as any item or verifiable record that is generally accepted as payment
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for goods and services and repayment of debts in a particular country or socio-economic context.
In other words, money is generally defined as anything accepted as a medium of exchange. It
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represents anything people are willing to accept for exchange of goods and services. A
medium of exchange is virtually anything used to pay for goods and services or settle debts.
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Thus the distinguishing feature of money is that society widely accepts it to settle transactions.
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Other financial assets, such as saving account balances, are sometimes considered money.
However, saving account balances clearly are not a as a medium of exchange, since it is difficult
to literally exchange your savings account balance for a meal at a restaurant, or as payment for
goods and services in a market. Instead, you must first convert your savings account into another
asset, such as currency or a cheque and then exchange the currency or cheque for a meal. Some
assets, let say, your house or your car for instance cannot be quickly and easily converted into a
medium of exchange. It often takes substantial real estate commissions and time to convert a
house into currency or cheque-able deposits.

Your automatic teller machine (ATM) card is not money either, since you cannot directly buy a
meal by handing over the card. You can however, use your ATM card to obtain money from
your current or savings account. Thus, ATM cards are instruments that allow the user to convert
a current or savings account balances into currency.
Question: Determine whether the statements are true or false
i. Economists define money as currency in circulation plus reserves. False
ii. Money is defined as anything that is generally accepted in payment for goods and
services or in the repayment of debts. True

1.3 FUNCTION OF MONEY

You have an overview of what money is. Below, we will discuss the four roles of money in an
economy. As we will see, money serves as a medium of exchange, a unit of account, a store of
value and standard of deferred payment.

i. Money as a Medium of Exchange: As mentioned earlier, the primary function of money

in an economy is to serve as a means of payment, money being used to pay for items

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purchased or to settle any debts. A related role of money is that as a medium of exchange,
which Wicksell defined as „an object which is taken in exchange, not on its own account,

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not to be consumed by the receiver or to be employed in technical production, but to be
exchanged for something else within a longer or shorter period of time.

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This means that money is widely accepted as a method of payment. This simply means
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that when you buy goods, services, or financial instruments (such as stocks, bonds), you
pay with money. When I go to supermarket store, I am confident that the cashier will
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accept my payment of money. In fact, Nigeria. Paper money carries this statement: “This
note is legal tender for all debts, public and private.” This means that the Nigeria
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government protects my right to pay with Nigeria Naira.

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ii. Money is a Unit of Account: Meaning that, the values of goods and services are stated
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in units of money, just as time is measured in minutes and distance in feet. This function
is also described as money acting as a measure of exchange value, money acting as a
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standard of value, or money as a numeraire. The essential point about this function is that
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money is acting as a common denominator, in terms of which the value in exchange of all
goods and services can be expressed. Money is simply acting as a unit of measurement in
the same way that metres measure length and kilograms measure weight. Money in this
sense is being used to measure the value of goods, services and assets relative to other
goods, services and assets. If it is convenient to trade all commodities in exchange for a
single commodity, so it is convenient to measure the prices of all commodities in terms of
a single unit, rather than record the relative price of every good in terms of every other
good. If there is to be a single unit of account, it is again clearly convenient (though not
necessary) that the unit of account be the medium of exchange, given that goods actually
exchange against the medium of exchange.

You can think of money as a yardstick-the device we use to measure value in economic
transactions. If you are shopping for a new computer, the price could be quoted in terms
 of t-shirts, bicycles, or corn. So, for instance, your new computer might cost you 100 to
150 bushels of corn at today‟s prices, but you would find it most helpful if the price were
set in terms of money because it is a common measure of value across the economy.
The use of money as the unit of account reduces the amount of information individual
need to make purchase decisions. In a monetary economy, prices are quoted in terms of
the unit of account (be it naira, dollar, yen, or shells). In the modern Nigerian economy,
the Naira is the unit of account and prices are quoted in Naira: ₦250 for one loaf of
bread, ₦100,000 for one cow and so on.

iii. Money is a Store of Value: Money also serves as a store of value. It is means of storing
today‟s purchasing power to purchase, say, a house or a car tomorrow. In the absence of
money or other assets as a store of value, individual and companies would have to
maintain stocks of goods to use to trade in the future. This approach would be inefficient

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for two reasons. First, some commodities, like fruit and milk, are perishable and would be

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of little or no value if stored for future use. Second, even when a commodity is not
perishable, a car for instance, it can be very costly to use it to store value over time.

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If I work today and earn ₦5,000, I can hold on to the money before I spend it because it
will hold its value until tomorrow, next week, or even next year. In fact, holding money is
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a more effective way of storing value than holding other items of value such as corn,
which might rot. Although it is an efficient store of value, money is not a perfect store of
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value. Inflation slowly erodes the purchasing power of money over time.
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Of course, money is not the only store of value. Indeed, many other assets such as
savings account, and bonds etc. are often better stores of value than money. These assets
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pay interest or dividends, whereas currency and many cheque-able deposits do not. Thus,
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while money provides a convenient store of purchasing power, it is not wise to use
money as a store of value over long periods of time. However, money is unmatched by
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other assets in its liquidity, which gives it an advantage over other assets as a temporary
store of value.

iv. Standard of Deferred Payment: Finally, money serves as a standard of deferred

payment, that is, a payment that is deferred to the future is usually stated as a sum of
money. This simply means that if something is bought today although payment for it
does not have to be made until some later date, then the amount due for deferred payment
can be measured in terms of money.

For example, if Odior owe money to a friend and plan to pay it back in a week, Odior
usually state the amount he owe in money terms, such as ₦10,000. In the absence of
money, you would have to plan on making payment in terms of some other good. Having
 a common standard for deferred payments, which is the same as the medium of exchange
and the unit of account makes it relatively easy to determine exactly how much a deferred
payment will be. There are efficiencies in thinking of payments today and payments
tomorrow or nest year in terms of a common item-money.

Question: Of money's four functions, which one distinguishes money from other assets?
Solution: Medium of exchange.

1.4 TYPES OF MONEY

Currently, most modern monetary systems are based on fiat money. However, for most of
history, almost all money was commodity money, such as gold and silver coins. As economies
developed, commodity money was eventually replaced by representative money, such as the gold
standard, as traders found the physical transportation of gold and silver burdensome. Fiat

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currencies gradually took over in the last hundred years, especially since the breakup of the

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Bretton Woods system in the early 1970s.

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i. Commodity Money: Many items have been used as commodity money such as
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naturally scarce precious metals, conch shells, barley, beads etc., as well as many other
things that are thought of as having value. Commodity money value comes from the
commodity out of which it is made. The commodity itself constitutes the money, and the
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money is the commodity. Examples of commodities that have been used as mediums of
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exchange include gold, silver, copper, rice, salt, peppercorns, large stones, decorated
belts, shells, alcohol, cigarettes, cannabis, candy, etc. These items were sometimes used
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in a metric of perceived value in conjunction to one another, in various commodity

valuation or price system economies. Use of commodity money is similar to barter, but a
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commodity money provides a simple and automatic unit of account for the commodity
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which is being used as money.

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ii. Representative Money: is a certificate or token that can be exchanged for the
underlying commodity. It consists of token coins, paper money or other physical tokens
such as certificates, that can be reliably exchanged for a fixed quantity of a commodity
such as gold or silver For example, instead of carrying the gold commodity money with
you, the gold might have been kept in a bank vault and you might carry a paper certificate
that represents-or was “backed”-by the gold in the vault. It was understood that the
certificate could be redeemed for gold at any time. Also, the certificate was easier and
safer to carry than the actual gold. Over time people grew to trust the paper certificates as
much as the gold. Representative money led to the use of fiat money-the type used in
modern economies today.

iii. Fiat Money: Fiat money or fiat currency is money that does not have intrinsic value and
does not represent an asset in a vault somewhere. Its value is not derived from any
 intrinsic value or guarantee that it can be converted into a valuable commodity (such as
gold). Its value comes from being declared “legal tender”-an acceptable form of
payment-by the government of the issuing country. In this case, we accept the value of
the money because the government says it has value and other people value it enough to
accept it as payment. For example, I accept Nigeria naira as income because I‟m
confident I will be able to exchange the dollars for goods and services at local stores.
Because I know others will accept it, I am comfortable accepting it. Nigeria currency is
fiat money. It is not a commodity with its own great value and it does not represent gold-
or any other valuable commodity-held in a vault somewhere. It is valued because it is
legal tender and people have faith in its use as money.

Fiat money, if physically represented in the form of currency (paper or coins) can be
accidentally damaged or destroyed. However, fiat money has an advantage over

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representative or commodity money, in that the same laws that created the money can

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also define rules for its replacement in case of damage or destruction.

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iv. Coinage Money: These factors led to the shift of the store of value being the metal itself:
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at first silver, then both silver and gold, and at one point there was bronze as well. Now
we have copper coins and other non-precious metals as coins. Metals were mined,
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weighed, and stamped into coins. This was to assure the individual taking the coin that he
was getting a certain known weight of precious metal. Coins could be counterfeited, but
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they also created a new unit of account, which helped lead to banking. Coins could now
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be easily tested for their fine weight of metal, and thus the value of a coin could be
determined, even if it had been shaved, debased or otherwise tampered with.
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In most major economies using coinage, copper, silver and gold formed three tiers of
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coins. Gold coins were used for large purchases, payment of the military and backing of
state activities. Silver coins were used for midsized transactions, and as a unit of account
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for taxes, dues, contracts and fealty, while copper coins represented the coinage of
common transaction. This system had been used in ancient India since the time of the
Mahajanapadas. In Europe, this system worked through the medieval period because
there was virtually no new gold, silver or copper introduced through mining or conquest.
Thus the overall ratios of the three coinages remained roughly equivalent.

v. Paper Money: The need for credit and for circulating a medium that was less of a burden
than exchanging thousands of copper coins led to the introduction of paper money,
commonly known today as banknotes. The advantages of paper currency were numerous:
it reduced transport of gold and silver, and thus lowered the risks; it made loaning gold or
silver at interest easier, since the specie (gold or silver) never left the possession of the
lender until someone else redeemed the note; and it allowed for a division of currency
 into credit and specie backed forms. It enabled the sale of stock in joint stock companies,
and the redemption of those shares in paper.

However, these advantages held within them disadvantages. First, since a note has no
intrinsic value, there was nothing to stop issuing authorities from printing more of it than
they had specie to back it with. Second, because it increased the money supply, it
increased inflationary pressures. The result is that paper money would often lead to an
inflationary bubble, which could collapse if people began demanding hard money,
causing the demand for paper notes to fall to zero.

vi. Commercial Bank Money: Commercial bank money or demand deposits are claims
against financial institutions that can be used for the purchase of goods and services. A
demand deposit account is an account from which funds can be withdrawn at any time by

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check or cash withdrawal without giving the bank or financial institution any prior notice.

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Banks have the legal obligation to return funds held in demand deposits immediately
upon demand (or 'at call'). Demand deposit withdrawals can be performed in person, via

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checks or bank drafts, using automatic teller machines (ATMs), or through online
banking.
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Commercial bank money is created through fractional-reserve banking, the banking
practice where banks keep only a fraction of their deposits in reserve (as cash and other
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highly liquid assets) and lend out the remainder, while maintaining the simultaneous
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obligation to redeem all these deposits upon demand. Commercial bank money differs
from commodity and fiat money in two ways: firstly it is non-physical, as its existence is
only reflected in the account ledgers of banks and other financial institutions, and
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secondly, there is some element of risk that the claim will not be fulfilled if the financial
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institution becomes insolvent. The process of fractional-reserve banking has a cumulative

effect of money creation by commercial banks, as it expands money supply (cash and
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demand deposits) beyond what it would otherwise be. The money supply of a country is
usually held to be the total amount of currency in circulation plus the total amount of
checking and savings deposits in the commercial banks in the country. In modern
economies, relatively little of the money supply is in physical currency.

Question: Can you explain what fiat money implies?

Solution:
i. The government has control over the money supply.
ii. The commodity value of the circulating media is zero.

1.5 PHYSICAL PROPERTIES OF MONEY

There have been many forms of money in history, but some forms have worked better than
others because they have physical properties that make them more useful. What makes a
commodity a good choice to serve as money? Ideally, money should be durability, portability,
divisibility, uniformity, limited supply, recognisable value and acceptability. Let‟s run down our
list of characteristics to see how they stack up.

i. Durability: Money should be durable, that is it should not wear out in use and should not
depreciate quickly when not in use. A cow is fairly durable, but a long trip to market runs
the risk of sickness or death for the cow and can severely reduce its value. One thousand
and Five hundred-naira notes are fairly durable and can be easily replaced if they become
worn. Even better, a long trip to market does not threaten the health or value of the bill.
ii. Portability: For ease of use in transaction, money should be portable. While the cow is
difficult to transport to the store, the currency can be easily put in my pocket and be carry
around.
iii. Divisibility: To permit transactions of various sizes, money should be made of a

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commodity that is divisible into smaller units to facilities making change. A 100-dollar
bill or 100 naira note can be exchanged for other denominations, say a 20, 10 and 5. A
cow, on the other hand, is not very divisible.

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iv. Homogeneity: the individual components of the money stock must be of the same
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physical form. Perceived differences in the quality of moneys in circulation is likely to
undermine the general acceptability of money. Cows come in many sizes and shapes and
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each has a different value; cows are not a very uniform form of money. For example, 100
naira notes are all the same size and shape and value.
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v. Limited Supply: In order to maintain its value, money must have a limited supply. While
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the supply of cows is fairly limited, if they were used as money, you can bet ranchers
would do their best to increase the supply of cows, which would decrease their value.
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vi. Acceptability: Even though cows have intrinsic value, some people may not accept cattle
as money. In contrast, people are more than willing to accept 1000 naira notes. In fact,
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the U.S. government protects your right to use U.S. currency to pay your bills.
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vii. Recognisable Value: money should have easily recognisable value; that is, it should be
easy for people engaged in exchange to agree to the value of the good used as money. A
desire for recognisable value is also behind efforts to foil counterfeiting of fiat currency.
Modern paper currency has complicated engraving, rare papers and inks and sometimes
embedded metal strips. All of these attributes make it easier to recognise genuine
currency and more difficult to produce counterfeit bills.

Question: can you explain why metals satisfy the functions of money better than other
commodities?
Solution: Because they are
i. easily recognizable
ii. highly durable
iii. readily portable
 iv. divisible into any size

1.6 THE CONCEPT OF LIQUIDITY

The term liquidity is usually an attribute of a financial asset. It is the term economists use to
describe how cheaply and easily as asset may be converted into a medium of exchange. A liquid
asset is one which can be realised or turned into cash quickly without any capital loss. However,
the fact that a financial asset may be readily sold in an active market does not necessarily imply
that the asset is liquid, since the sale of the asset may involve a financial loss. The length of time
taken to obtain the full nominal value of the asset is crucial to the strict liquidity concept.

Money in pocket is, of course, the most liquid of all assets because it is cash. Savings account
balances are also liquid asset, since they can be quickly and easily converted into a medium of
exchange. Chequing accounts are the second most liquid of assets because they can be, in effect,

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converted into cash by the writing of a cheque. Real estate or car on the hand, are not quickly

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and convertible, and therefore is an illiquid asset. Naira and Dollar (i.e., currency) and cheque-
able deposits, the primary media of exchange in Nigeria, are the most liquid of all assets

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The financial assets that are usually classified as liquid assets include: (see (NOUN, 2010)
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i. time deposits at banks
ii. shares and building society deposits
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iii. treasury bills
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iv. certificates of deposits

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v. call monies
vi. commercial bills
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Any financial asset which is close to maturity can be regarded as being liquid, irrespective of its
original maturity date
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1.7 HISTORICAL DEVELOPMENT OF MONEY

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The origins of money are little known. Historians believe money originated as religious objects
of value, which ultimately evolved into a medium of exchange, by the ancient Babylonian, Greek
and Roman civilizations, monetary systems included coins.

Economists say that the invention of money belongs in the same category as the great inventions
of ancient times, such as the wheel and the inclined plane, but how did money develop? Early
forms of money were often commodity money-money that had value because it was made of a
substance that had value. Examples of commodity money are gold and silver coins. Gold coins
were valuable because they could be used in exchange for other goods or services, but also
because the gold itself was valued and had other uses. Commodity money gave way to the next
stage-representative money.
Barter economy: The use of money helps facilitate trade since in the absence of money, trade
has to proceed through barter that is the direct exchange of one good for another. Barter tends to
be associated with primitive economies in which individual households operate in an isolated
manner, and in particular have no sophisticated information systems concerning what is going on
in the rest of the economy. For various reasons households may wish to consume a different
bundle of goods from those they produce, so that there are gains from trade. The problem is
how to achieve these potential gains, given that trade is a voluntary activity and can proceed only
when it is to the benefit of both parties.

In barter, there has to be what is known as a „double coincidence of wants‟. If I grow corn but
want to consume apples, not only do I have to find someone willing to trade apples but they must
also want what I have to offer, namely corn. In other words for trade to be mutually beneficial, it
is necessary not only that trader A has what trader B wants but also that trader B has something

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to offer in exchange which trader A wants. It is quite possible that no trade will occur, especially

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in cases where the goods desired are so specialised that the probability of a double coincidence
of wants occurring is so low that the cost of finding a match (for example in terms of advertising,

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transport, and so on) becomes very large and outweighs the increased utility derived from trade.
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Even if the goods offered for trade are readily available, it may still be the case that no trade
occurs.
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In order to appreciate the conveniences that money brings to an economy, think about life without
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it. Imagine a lecturer who has a car that needs to be repaired. In a world without money, I would
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need to barter for car repair. In fact, I would need to find a coincidence of wants-the unlikely
case that two people each have something that the other wants at the right time and place to make
an exchange. In other words, I would need to find a mechanic who would be willing to exchange
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car repairs for a private teaching hour. In an economy where people have very specialized skills,
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this kind of exchange would take an incredible amount of time and effort; in fact, it might be
nearly impossible.
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Money reduces the cost of this transaction because, while it might be very difficult to find a
mechanic who would exchange car repairs for bassoon concerts, it is not hard to find one who
would exchange car repairs for money. In fact, without money, every transaction would require
me to find producers who would exchange their goods and services for bassoon performances. In
a money-based economy, I can sell my services as a lecturer to those who are willing to pay for
lecturing hours with money. Then, I can take the money I earn and pay for a variety of goods and
services. The use of money eliminates these drawbacks of barter economy, and it is no wonder
that the use of money and the development of a money economy have come to be associated
with economic progress.

Summary
Monetary economics examines how currencies enter the marketplace and become accepted as
mediums of exchange for goods and services. It can also be defined by its function rather than
the form in which it takes. Money, in some form, has been part of human history for at least the
last 3,000 years. Before that time, it is assumed that a system of bartering was likely used.
Bartering is a direct trade of goods and services - I'll give you what I produce that is of interest to
you in exchange for what you produce that is of interest to me. Money as a means of payment is
the most important functions of money while general acceptability is the most important
characteristics of money.

1.8 SELF-ASSESSMENT QUESTIONS

1.1 Can you state some characteristics under a bimetallic standard?
1.2 Discuss why commodity standards were said to operate in an automatic way?

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SOLUTION TO SAQ 1.1
i. Countries were able to increase the stock of standard money.

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ii. Countries established a mint ratio for the two metals in their use as money.
iii. The metal that the mint ratio overvalues (in terms of the market ratio) will be left in the
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monetary system.
iv. Different countries may establish different mint ratios resulting in the flow of one metal
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to one country, and of the other metal to another country.
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SOLUTION TO SAQ 1.2

i. Because the monetary authorities had no discretion over the money supply.
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ii. Because the money supply changed in fixed proportion to the availability of gold.
iii. Because the production of the monetary metal was turned off and on in response to
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changes in the cost of its production.

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iv. Because a country could experience dramatic changes in its stock of the money metal as a
result of its export to and its import from other countries.

1.9 MUITIPLE-CHOICE QUESTIONS

1) A virtue of a metallic standard is that:
a. It reduces the need to rely on gold stocks.
b. It maintains long-run stability in the price level.
c. In is easy to expand the money supply.
d. It ensures full employment.

2) Under an international commodity standard where each country defines its monetary unit
of account in terms of gold
 a. The relationship between the various countries' currencies is fixed.
b. The relationship between the various countries' currencies is flexible.
c. There is no relationship between the various countries' currencies.
d. International trade is reduced.

3) A monetary system in which the value of the monetary unit is kept equal to a specified quantity
of a particular commodity is called
a. A fiat-money standard.
b. A gold standard.
c. A commodity standard.
d. Bimetallism.

4) Because it is a unit of account, money

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a. Reduces transaction costs.

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b. Reduces the number of prices that need to be calculated.
c. (a) and (b) only
d. Does not earn interest.

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5) Currency includes
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a. Paper money and coins.
b. Paper money, coins, and cheques.
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c. Paper money and cheques.
d. Paper money, coins, cheques, and savings deposits.
E
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6) A person's chequing deposits are part of her

a. Money.
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b. Income.
c. Wealth.
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d. Only (A) and (C) of the above.

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7) Which of the following are true statements?

a. Wealth is the total collection of pieces of property that are a store of value.
b. Income is a flow and wealth is a stock.
c. Money is a stock variable.
d. All of the above are true.

8) Which of the following are true statements?

a. Money lowers the costs spent trying to exchange goods and services.
b. Because money lowers transaction costs, it promotes economic efficiency.
c. Compared to a barter economy, an economy with money eliminates the
requirement for a double coincidence of wants.
d. All of the above are true.
9) Which function of money eliminates the requirement of a "double coincidence of wants"
that exists in a barter economy?
a. Store of value.
b. Standard of value.
c. Medium of exchange.
d. Standard of deferred payment.

10) Which of the following sequences accurately describes the evolution of the payments
system?
a. Barter, coins made of precious metals, paper currency, cheques, electronic funds
transfers.
b. Barter, coins made of precious metals, cheques, paper currency, electronic funds

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transfers.

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c. Barter, cheques, paper currency, coins made of precious metals, electronic funds
transfers.
d. Barter, cheques, paper currency, electronic funds transfers

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11) Credit cards are
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a. Not money, but a way of transferring money.
b. Money since they act as a medium of exchange.
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c. A store of value.
d. Identical to debit cards in every way.
E
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12) Money is
a. Central Bank of Nigeria notes only.
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b. Coins only.
c. Bank deposits only.
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d. Any commodity that serves as a medium of exchange.

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13) The difference between money and income is that:

a. Money is a flow and income is a stock.
b. Money is a stock and income is a flow.
c. There is no difference-money and income are both stocks.
d. There is no difference-money and income are both flows.
14) Which of the following statements is correct?
a. Money serves as a unit of account.
b. Money serves as a medium of exchange and means of payment.
c. Money serves as a store of value.
d. All of the above.

15) A fiat currency:

a. is also known as a commodity currency
b. is a currency that is based on some form of precious metal
 c. must have some other significant non-monetary uses
d. has no intrinsic value

16) The metallist fallacy states that:

a. all money must be fiat money
b. the value of money is derived from its non-monetary uses, independent of its role
as medium of exchange
c. both fiat and commodity money can circulate as money at the same time
d. all money is intrinsically useless

17) Which of the following is an example of a barter transaction?

a. An individual pays her electric bill with a check.
b. An individual pays her electric bill with currency.
c. An individual provides three light bulbs to her neighbor in exchange for two gallons of

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milk.

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d. An individual deposits three twenty-dollar bills in her checking account.

18) Which of the following is least liquid?

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a. Foreign currency. AP
b. Nigerian Treasury bonds.
c. Rare coins.
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d. Savings deposit.
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19) Which of the following assets is the most liquid?

a. Consumer loans.
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b. Provincial and municipal securities.

c. Physical capital.
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d. Nigerian government securities.

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20) Which function of money conveniently allows a way of placing value on goods and
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services?
a. Medium of Exchange
b. Unit of account
c. Store of value
d. Standard of Deferred Payment.

21) Under a barter system, it is difficult to store purchasing power, because many goods
deteriorate over time. If money was introduced, which function of money would
eliminate this problem?
a. Medium of Exchange
b. Unit of account
c. Store of value
d. Standard of Deferred Payment.
 22) Under a system of barter:
a. Currency is accepted for purchases, but personal checks are not
b. Only agricultural goods may be traded
c. Each individual trades output directly with another
d. Goods may be traded for money, but money may not be traded for goods.

23) The U.S. government is introducing new $100, $50, $20, $10, $5, and new quarters
which represent the 50 states. If the new “money” confuses people, which desirable
property of money is the U.S. government violating?
a. Standardised quality
b. Valuable relative to its weight
c. Durable
d. Divisible

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24) When the CBN defined the M2 definition of the money supply, what approach do they
use?

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a. The transaction approach
b. The liquidity approach
AP
c. The medium of exchange approach
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d. The unit of account approach.
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25) Early economists' faith in the neutrality of money led them to believe that
a. absolute prices were determined in the real part of the economy
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b. the allocation of resources was determined by the quantity of money and not by the
forces of supply and demand
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c. relative prices have no role in the real allocation of resources

d. a change in the quantity of money would change the price level but would not
M

change relative prices

BA

26) Which of the following is NOT a function that money serves?

a. Acts as a means of payment in settling a debt
b. Ensures that the double coincidence of wants is satisfied in barter trades
c. Serves as a measure for stating the prices of goods and services
d. Stores value for later exchange of goods and services

SOLUTION TO MUITIPLE-CHOICE QUESTIONS

Questions 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Answers b A C c a D d d c a a d b d d

Questions 16 17 18 19 20 21 22 23 24 25 26
Answers b C C d b C c a b d b

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AP
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ID
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 STUDY SESSION 2
THE QUANTITY THEORY OF MONEY

2.0 INTRODUCTION
We begin by presenting a framework to highlight the link between the value of money and price
level. We think it is extremely important and useful to understand the value of money and know
how is generally defined in economics. The value of money is another important concept that is
often misunderstood by students of business and economics. Also in this session, you will
attempt to explain the idea behind the quantity theory of money, which says that the supply of
money in an economy determines the level of prices and changes in the money supply result in
proportional changes in prices.

Learning Outcomes for Study Session 2

At the end of this study Session, you should be able to:

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2.1 define the concept of the quantity theory of money (SAQ 2.1)

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2.2 explain effectively the equation of exchange (SAQ 2.2)
2.3 differentiate between Fisher's quantity theory of money and Cambridge version quantity

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theory of money (SAQ 2.3)
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2.4 provide the critiques of Fisher's quantity theory of money and Cambridge quantity theory of
money (SAQ 2.4)
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2.5 explain the superiority of Cambridge version quantity theory of money over Fisher's quantity
theory of money (SAQ 2.5)
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2.1 THE CONCEPT OF THE QUANTITY THEORY OF MONEY

In 1802, economist Henry Thornton published "An Enquiry into the Nature and Effects of the
Paper Credit of Great Britain" in which he gave an account of his theory regarding the central
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bank's ability to control price level. According to his theory, the central bank could control the
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currency in circulation through book keeping. This control could allow the central bank to gain a
command of the money supply of the country. This ultimately would lead to the central bank's
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ability to control the price level. His introduction of the central bank's ability to influence the
price level was a major contribution to the development of the quantity theory of money (QTM).

Thornton (1802) assume that more money equals more inflation and that an increase in money
supply does not necessarily mean an increase in economic output. Here we look at the
assumptions and calculations underlying the QTM, as well as its relationship to monetarism and
ways the theory has been challenged.

The theory was challenged by Keynesian economics, but updated and reinvigorated by the
monetarist school of economics. While mainstream economists agree that the quantity theory
holds true in the long run, there is still disagreement about its applicability in the short run.
Critics of the theory argue that money velocity is not stable and, in the short-run, prices are
sticky, so the direct relationship between money supply and price level does not hold.
In monetary economics, the quantity theory of money states that there is a direct relationship
between the quantity of money in an economy and the level of prices of goods and services sold.
For example, if the currency in circulation increased, there would be a proportional increase in
the price of goods. According to QTM, if the amount of money in an economy doubles, price
levels also double, causing inflation (the percentage rate at which the level of prices is rising in
an economy). The consumer therefore pays twice as much for the same amount of the good or
service.

Another way to understand this theory is to recognize that money is like any other commodity:
increases in its supply decrease marginal value (the buying capacity of one unit of currency). So
an increase in money supply causes prices to rise (inflation) as they compensate for the decrease

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in money's marginal value.

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2.2 MEANING OF THE VALUE OF MONEY

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What gives money value? We know that intrinsically, a naira note is just worthless paper and
AP
ink. However, the purchasing power of a naira note is much greater than that of another piece of
paper of similar size. From where does this power originate?
R
Like most things in economics, there is a market for money. The supply of money in the money
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market comes from the monetary authority. The monetary authority has the power to adjust the
money supply by increasing or decreasing the number of bills in circulation. Nobody else can
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make this policy decision. The demand for money in the money market comes from consumers.
ID

The determinants of money demand are infinite. In general, consumers need money to purchase
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goods and services. If there is an ATM nearby or if credit cards are plentiful, consumers may
demand less money at a given time than they would if cash were difficult to obtain. The most
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important variable in determining money demand is the average price level within the economy.
If the average price level is high and goods and services tend to cost a significant amount of
money, consumers will demand more money. If, on the other hand, the average price level is low
and goods and services tend to cost little money, consumers will demand less money.

Figure 1: Sample Money Market

The value of money is ultimately determined by the intersection of the money supply, as
controlled by the monetary authority, and money demand, as created by consumers. Figure 1

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depicts the money market in a sample economy. The money supply curve is vertical because the

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monetary authority sets the amount of money available without consideration for the value of
money. The money demand curve slopes downward because as the value of money decreases,

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consumers are forced to carry more money to make purchases because goods and services cost
AP
more money. Similarly, when the value of money is high, consumers demand little money
because goods and services can be purchased for low prices. The intersection of the money
supply curve and the money demand curve shows both the equilibrium value of money as well as
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the equilibrium price level.
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Figure 2: Sample Shift in the Money Market

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ID
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The value of money, as revealed by the money market, is variable. A change in money demand
or a change in the money supply will yield a change in the value of money and in the price level.
Notice that the change in the value of money and the change in the price level are of the same
magnitude but in opposite directions. An increase in the money supply is depicted in Figure 2.
Notice that the new intersection of the money supply curve and the money demand curve is at a
lower value of money but a higher price level. This happens because more money is in
circulation, so each bill becomes worth less. It takes more bills to purchase goods and services,
and thus the price level increases accordingly.
For example: if V is the value of Money, and P the price level, then V = 1/P. when the price level
rises, the value of money falls and vice versa. The shows that the relation between the value of
money and price level in an inverse one.

The quantity theory of money is based directly on the changes brought about by an increase in
the money supply. The quantity theory of money states that the value of money is based on the
amount of money in the economy. Thus, according to the quantity theory of money, when the
monetary authority increases the money supply, the value of money falls and the price level
increases.

Nominal versus the Real Value of Money

The nominal value of money is in terms of money itself as the measuring unit. The real value of
money is in terms of its purchasing power over commodities. Thus, the nominal value of a ₦100

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note is 100 – and that of a ₦200 note is 200. The real value of money is the amount of goods and

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services one unit of money can buy and is the reciprocal of the price level of commodities traded
in the economy. It equals 1/P where P is the average price level in the economy. The real value

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of money is what we usually mean when we use the term ―the value of money.‖
AP
Question: Can you explain the value of money steadily declines?
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Solution: Inflation is when the value of money steadily declines over time. Once people expect
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that prices will rise, they are more likely to buy now, before prices go higher. This increases
demand, which tells producers they can safely pass on more costs. This drives prices up more,
EL

and inflation becomes a self-fulfilling prophecy. That's why the CBN watches inflation like a
hawk, and will reduce the money supply to curb inflation. However, a healthy economy can
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sustain a core inflation rate of 2%. Core inflation is the price of everything except those volatile
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food and gas prices. Inflation is measured by the

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Question: When does the value of money increases?

Solution: Deflation is when the value of money increases. That sounds like a great thing, but it is
actually worse for the economy than inflation. When there was massive deflation, prices can
drop more than 20%, and many people could not sell their things.

2.3 FISHER'S QUANTITY THEORY OF MONEY

The Quantity Theory was first developed by Irving Fisher in the inter-war years, and is a basic
theoretical explanation for the link between money and the general price level. Quantity theory
of money states that money supply and price level in an economy are in direct proportion to one
another. When there is a change in the supply of money, there is a proportional change in the
price level and vice-versa.
The theory rests on what is sometimes known as the Fisher identity (The Cash Transactions
Approach) or the equation of exchange. This is an identity which relates total aggregate
demand to the total value of output (GDP).

Fisher has explained his theory in terms of his equation of exchange:

MV = PT (2.1)
Where P = price level, or 1/P = the value of money;
M = the total quantity of legal tender money;
V = the velocity of circulation of M
T = the total amount of goods and services exchanged for money or transactions performed by
money.

Money supply (M) multiplied by the velocity of circulation (V) = the value of national output

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(price level (P) x volume of transactions (T))

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Velocity of circulation represents the number of times that a unit of currency (E.g. a £10 note) is

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used in a given period of time when used as a medium of exchange to buy goods and services
Velocity of circulation can be calculated by dividing the money value of national output by the
AP
money supply.
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In the basic theory of monetarism expressed using the equation of exchange, we assume that the
velocity of circulation of money is predictable and therefore treated as a constant. We also make
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an assumption that the real value of GDP is not influenced by monetary variables. For example
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the growth of a country’s productive capacity might be determined by the rate of productivity
growth or an increase in the capital stock. We might therefore treat T (real GDP) as a constant
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too.
If V and T are treated as constants, then changes in the rate of growth of the money supply will
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equate to changes in the general price level. Monetarists believe that the direction of causation is
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from money to prices.

This equation equates the demand for money (PT) to supply of money (MV). The total volume
of transactions multiplied by the price level (PT) represents the demand for money. According to
Fisher, price level (P) multiplied by quantity bought (Q) by the community (S) gives the total
demand for money. This equals the total supply of money in the community consisting of the
quantity of actual money M and its velocity of circulation V plus the total quantity of credit
money M’ and its velocity of circulation V’. Thus the total value of purchases (PT) in a year is
measured by MV. Thus the equation of exchange is PT = MV. In order to find out the effect of
the quantity of money on the price level or the value of money, we write the equation as
MV
P (2.2)
T
The velocity of money is a measure of how rapidly (on average) these naira notes change hands
in the economy. It is calculated by dividing nominal spending by the money supply, which is the
total stock of money in the economy:

nominal spending nominal GDP

velocity of money= = (2.3)
money supply money supply

If the velocity is high, then for each naira, the economy produces a large amount of nominal
GDP.
Using the fact that nominal GDP equals real GDP × the price level, we see that

price level  real GDP

velocity of money  (2.4)
money supply

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And if we multiply both sides of this equation by the money supply, we get the quantity

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equation, which is one of the most famous expressions in economics:

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Money Supply × Velocity of Money = Price Level × Real GDP.
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Let us see how these equations work by looking at 2013. In that year, nominal GDP was about
₦13 trillion in Nigeria. The amount of money circulating in the economy was about ₦6.5 trillion.
If this money took the form of 6.5 trillion naira notes changing hands for each transaction that we
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count in GDP, then, on average, each bill must have changed hands twice during the year (13/6.5
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= 2). So the velocity of money was 2 in 2013.

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The truth of this proposition is evident from the fact that if M are doubled, while V and T remain
constant, P is also doubled, but the value of money (1/P) is reduced to half.
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Assumptions of the Theory:

M

Fisher’s theory is based on the following assumptions:

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i. P is passive factor in the equation of exchange which is affected by the other factors.
ii. V are assumed to be constant and are independent of changes in M.
iii. T also remains constant and is independent of other factors such as M and V.
iv. It is assumed that the demand for money is proportional to the value of transactions.
v. The supply of money is assumed as an exogenously determined constant.
vi. The theory is applicable in the long run.
vii. It is based on the assumption of the existence of full employment in the economy.

Criticisms of the Theory:

The Fisherian quantity theory has been subjected to severe criticisms by economists on the
ground of these points below (see Jhingan for more explanation)
1) Truism
2) Other things not equal
 3) Constants Relate to Different Time
4) Fails to Measure Value of Money
5) Weak Theory
6) Neglects Interest Rate:
7) Unrealistic Assumptions:
8) V not Constant
9) Neglects Store of Value Function:
10) Neglects Real Balance Effect

In its modern form, the quantity theory builds upon the following definitional relationship.
M VT   ( pi  qi )  pT q (2.5)
i

where

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M is the total amount of money in circulation on average in an economy during the period, say a

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year.

VT is the transactions velocity of money, that is the average frequency across all transactions with

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which a unit of money is spent. This reflects availability of financial institutions, economic
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variables, and choices made as to how fast people turn over their money.
pi and qi are the price and quantity of the i-th transaction.
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p is a column vector of the pi and the superscript T is the transpose operator.
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q is a column vector of the qi

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Mainstream economics accepts a simplification, the equation of exchange:

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M VT  PT  T (2.6)
where
M

PT is the price level associated with transactions for the economy during the period
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T is an index of the real value of aggregate transactions.

The previous equation presents the difficulty that the associated data are not available for all
transactions. With the development of national income and product accounts, emphasis shifted to
national-income or final-product transactions, rather than gross transactions.

Economists may therefore work with the form

M V  P  Q (2.7)
where
V is the velocity of money in final expenditures
Q is an index of the real value of final expenditures
As an example, M might represent currency plus deposits in checking and savings accounts held
by the public, Q real output (which equals real expenditure in macroeconomic equilibrium) with
P the corresponding price level, and P  Q the nominal (money) value of output. In one empirical
formulation, velocity was taken to be ―the ratio of net national product in current prices to the
money stock.

Thus far, the theory is not particularly controversial, as the equation of exchange is an identity. A
theory requires that assumptions be made about the causal relationships among the four variables
in this one equation. There are debates about the extent to which each of these variables is
dependent upon the others. Without further restrictions, the equation does not require that a
change in the money supply would change the value of any or all of P , Q , or P  Q . For example,
a 10% increase in M could be accompanied by a change of 1/(1 + 10%) in V , leaving P  Q

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unchanged. The quantity theory postulates that the primary causal effect is an effect of M on P .

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QUESTION AND SOLUTION: Thus if an economy has N3million, and those N3million were
spent five times in a month, total spending for the month would be N15million.

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2.4 THE CAMBRIDGE EQUATIONS
The Cambridge equation formally represents the Cambridge Cash-Balance Theory, an
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alternative approach to the classical quantity theory of money. Both quantity theories, Cambridge
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and classical, attempt to express a relationship among the amount of goods produced, the price
level, amounts of money, and how money moves. The Cambridge equation focuses on money
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demand instead of money supply. The theories also differ in explaining the movement of money:
In the classical version, associated with Irving Fisher, money moves at a fixed rate and serves
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only as a medium of exchange while in the Cambridge approach money acts as a store of value
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and its movement depends on the desirability of holding cash.

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Economists associated with Cambridge University, including Alfred Marshall, A.C. Pigou, and
John Maynard Keynes (before he developed his own, eponymous school of thought) contributed
to a quantity theory of money that paid more attention to money demand than the supply-
oriented classical version. The Cambridge economists argued that a certain portion of the money
supply will not be used for transactions; instead, it will be held for the convenience and security
of having cash on hand. This portion of cash is commonly represented as k , a portion of nominal
income (the product of the price level and real income) ( P  Y ). The Cambridge economists also
thought wealth would play a role, but wealth is often omitted from the equation for simplicity.
The Cambridge equation is thus:

M d  k  P Y (2.8)
Assuming that the economy is at equilibrium ( M d  M ), Y is exogenous, and k is fixed in the
short run, the Cambridge equation is equivalent to the equation of exchange with velocity equal
to the inverse of k:
1
M   P Y (2.9)
k
The supply of money is exogenously determined at a point in time by the banking system.
Therefore, the concept of velocity circulation is altogether discarded in the cash-balances
approach because it obscures the motives and decisions of people behind it. On the other hand,
the concept of demand for money plays the crucial role in the determination of the value of
money. The demand for money is the demand to hold cash balance for transactions and
precautionary motives. According to Marshall illustration, "To give definiteness to this notion,
let us suppose that the inhabitants of a community…find it just worthwhile to keep by them on

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the average ready purchasing power to the extent of a tenth part of their annual income, together

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with a fiftieth part of the property, then the aggregate value of the currency of the country will
tend to be equal to the sum of these amounts. By implication, the cash balances approach

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considers the demand for money not as a medium of exchange but as a store of value.
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Marshall's Equation: Marshall did not make effort to put his theory in equation form and it was
for his followers to explain it algebraically. Friedman has explained Marshall's views thus: "As a
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first approximation, we may suppose that the amount one wants to hold bears some relation to
one's income, since that determines the volume of purchases and sales in which one is engaged.
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We then add up the cash balances held by all holders of money in the community and express the
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total as a fraction of their total income. Thus we can write: M = kPY where M stands for the
exogenously determined supply of money, k is the fraction of the real money income (PY) which
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people wish to hold in cash and demand deposits, P is the price level, and Y is the aggregate real
M
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income of the community. Thus the price level P  or the value of money (the reciprocal of
kY
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price level) is;

1 kY
 (2.10)
P M
Pigou's Equation: Pigou was the first Cambridge economist to express the cash balances
approach in the form of an equation:

kR
P (2.11)
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where P is the purchasing power of money or the value of money (the reciprocal of the price
level), k is the proportion of total real resources or income (R) which people wish to hold in the
form of titles to legal tender, R is the total resources (expressed in terms of wheat), or real
income, and M refers to the number of actual units of legal tender money. The demand for
money, according to Pigou, consists not only of legal money or cash but also bank notes and
bank balances. In order to include bank notes and bank balances in the demand for money, Pigou
modifies his equation as;

P
kR
c  R(1  c) (2.12)
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where c is the proportion of total real income actually held by people in legal tender including
token coins, (1-c) is the proportion kept in bank notes and bank balances, and h is the proportion
of actual legal tender that bankers keep against the notes and balances held by their customers.

Robertson's Equation: To determine the value of money or its reciprocal the price level,
Robertson formulated an equation similar to that of Pigou. The only difference between the two

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being that instead of Pigou's total real resources R, Robertson gave the volume of total

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transactions T. The Robertsonian equation is;
M
M = PkT or P  (2.13)
kT

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where P is the price level, M is the total quantity of money, k is the proportion of the total
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amount of goods and services which people wish to hold in the form of cash balances, and T is
the total volume of goods and services purchased during a year by the community.
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E

2.5 TRANSACTION ARRROACH VS CASH BALANCE APPROACH

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Similarities:
i. Same Conclusion, The Fisherian and Cambridge versions lead to the same conclusion
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that there is a direct and proportional relationship between the quantity of money and the
price level and an inverse proportionate relationship between the quantity of money and
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the value of money.

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ii. Similar Equations. The two approaches use almost similar equations. Fisher's equation
MV M
P is similar to Robertson’s equation P  .
T kT
iii. Money as the Same Phenomenon. The different symbols given to the total quantity of
money in the two approaches refer to the same phenomenon. As such MV + MV of
Fisher's equation, M of the equations of Pigou and Robertson, and n of Keynes' equation
refer to the total quantity of money.

Differences in Two Theories

i. Functions of Money. The two versions emphasize on different functions of money. The
Fisherian approach lays emphasis on the medium of exchange function while the
Cambridge approach emphasises the store of value of function of money.
 ii. Flow and Stock. In Fisher's approach money is a flow concept while in the Cambridge
approach it is a stock concept. The former relates to a period of time and the latter to a
point of time
iii. Fisher's approach emphasizes the supply Emphasis on Supply and Demand for Money of
money, whereas the Cambridge approach emphasizes both the demand for money and the
supply of money.

Superiority of Cash Balances Approach over Transactions Approach

i. Basis of Liquidity Preference Theory of Interest. The cash balances approach emphasises
the importance of holding cash balances rather than the supply of money which is given
at a point of time.
ii. Complete Theory. The cash balances version of quantity theory is superior to the
transactions version because the former determines the value of money in terms of the

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demand and supply of money.

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iii. Discards the Concept of Velocity of Circulation. The cash balances approach is superior
to the transactions approach because it altogether discards the concept of the velocity of

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circulation of money which 'obscures the motives and decisions of people behind it.'
iv.
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Related to the Short Period. Again the cash balances version is more realistic than the
transactions version of the quantity theory, because it is related to the short period while
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the latter is related to the long period.
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Summary
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According to Irving Fisher, "Other things remaining unchanged, as the quantity of money in
circulation increases, the price level also increases in direct proportion and the value of money
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decreases and vice versa. In an attempt to provide alternative to Fisher's quantity theory of
money, Cambridge economists Marshall, Pigou, Robertson and Keynes formulated the cash
M

balances approach and argued that the value of money is determined by demand and supply of
BA

money.

The Fisherian and Cambridge versions lead to the same conclusion that there is a direct and
proportional relationship between the quantity of money and the price level and an inverse
proportionate relationship between the quantity of money and the value of money. The two
versions of the theory emphasize on different functions of money. The Fisherian approach lays
emphasis on the medium of exchange function while the Cambridge approach emphases the
store of value of function of money.

The cash balances version of quantity theory is superior to the transactions version because the
former determines the value of money in terms of the demand and supply of money and thus lay
foundation for other theories.
2.6 SELF-ASSESSMENT QUESTIONS
2.1 Which of the following are true statements?
i. Wealth is the total collection of pieces of property that are a store of value.
ii. Money is a stock: it is a certain amount at a given point in time.
iii. Income is a flow of earnings per unit of time.
iv. Money is frequently confused with income.
2.2 Can you explain the difference between the internal value of money and External value of
money
2.3 How do you explain the value of money in the Nigerian economy?
2.4 How does the value of money affect you?

SOLUTION TO SAQ 2.1

i. Wealth is the total collection of pieces of property that are a store of value. True

L
ii. Money is a stock: it is a certain amount at a given point in time. True

EA
iii. Income is a flow of earnings per unit of time. True
iv. Money is frequently confused with income. True

H
SOLUTION TO SAQ 2.2
AP
Internal value of money: The internal value of money refers to the purchasing power of money
R
over domestic goods and services.
External value of money. The external value of money refers to the purchasing power of money
E

over foreign goods and services.

EL

SOLUTION TO SAQ 2.3

The value of money in the Nigerian economy is measured by the value of the naira. The naira is
ID

valued in three ways. The first is against its value to other countries' currencies, through the
M

exchange rate. This fluctuates daily. Second, the naira value is measured by Treasury notes,
which can be converted easily into naira, and are auctioned daily. Third, the naira value is
BA

measured by foreign currency reserves. This is the amount of naira held by foreign governments.
No matter how measured, the naira's value has been declining.

SOLUTION TO SAQ 2.4

You notice the value of money most directly at the gas pump and at the grocery store. That's
because the prices of gas and food are inelastic. This means that you pretty much have to buy gas
and food every week, so producers know they can pass on increased costs and you'll buy it at that
price for a while before reducing your demand for that item. When the price of gas or food goes
up, you are experiencing the reduced value of money.

2.7 MUITIPLE-CHOICE QUESTIONS

 1. The quantity theory of money allows monetarists to obtain a number of economic
predictions by assuming a constant
a. velocity of money
b. nominal output
c. overall price level
d. stock of money

2. A fall in the level of prices

a. Does not affect the value of money.
b. Has an uncertain effect on the value of money.
c. Increases the value of money.
d. More than doubles the value of money.

L
EA
3. Consider an economy with an initial price level (P0) of 100 and a rate of inflation of 20
percent per year. What will the value of money for this economy be in the third year?

H
a. 1/172.8.
b. 1/184.6. AP
c. 1/165.4.
d. 1/152.8.
R

The following situation concerns questions 4 and 5. The consumer price index for the end of
E

1980 was set at 100. In 2010 the consumer price index was 352.
EL

4. Consider the above information. If a family spent ₦250 a week on their typical purchases
in 1980, how much would those purchases cost in 2010?
ID

a. ₦1,150.
b. ₦980.
M

c. ₦910.
BA

d. ₦880.
5. Consider the above information. If your salary in 2010 was ₦30,000 a year, what would
be the real value of that salary in terms of 1980 dollars?
a. ₦11,150.
b. ₦9,830.
c. ₦8,523.
d. ₦10,880.
6. The consumer price index for 1950 was 100. In 2003 the consumer price index was 821.
From 1950 to 2003, the real value of money declined by
a. 96.25%.
b. 87.82%.
c. 84.37%.
d. 75.94%.
7. If the price level doubles, the value of money
a. Doubles.
b. More than doubles, due to scale economies.
c. Rises but does not double, due to diminishing returns.
d. Falls by 50 percent.

8. The purchasing power of money is equal to

a. The inverse of the price level.
b. The price level.
c. — p , where p is the inflation rate.
d. — p / (1 + p )

L
EA
9. The opportunity cost of holding a certain quantity of money is
a. The quantity of goods and services that can be bought with the amount of money.

H
b. The cost of the wallet in which the money is kept.
c. The amount of interest foregone.
AP
d. The amount by which the real value of money decreases due to inflation.
R

10. The quantity theory of money implies that a given percentage change in the money
E

supply will cause

EL

a. An equal percentage change in nominal GDP

b. A small percentage change in nominal GDP
ID

c. A larger percentage change in nominal GDP

d. An equal percentage change in real GDP
M
BA

11. Which of the following statements is/are true about the classical quantity theory of
money
a. the equation of exchange is MV = PQ
b. the classical economists assumed that V would rise when real interest rates rise
c. the classical economists concluded that increases in the money supply cause
increases in real GDP and nothing else
d. all of the above

12. The velocity of money is defined as________

PM
V 
a. Y
 PY '
V 
b. M
PY
V 
c. M
PY
V 
d. M'

13. The fundamental difference between the Fisher’s quantity theory of money and the
Cambridge Versions of the theory lies in ___________________________
a. their consideration of demand for money
b. their consideration of function of money
c. their consideration of supply of money

L
d. their consideration of equilibrium in money market

EA
14. Fisher’s quantity theory of money focuses attention on money as a medium of change

H
while Cambridge Versions of the theory focuses on
AP
a. Money as standard of deferred payment
b. Money as a unit of account
c. Money as store of value
R
d. Money as purchasing power
E
EL

15. While Fisher’s quantity theory of money considers quantity of money in circulation as
the so determinant of value of money, Cambridge Versions of the theory considers
ID

_________ as the determinants of value money.

a. Demand of money
M

b. Demand and supply of money

BA

c. Supply of money
d. None of the above

16. If the money supply is N2 trillion and velocity is 5, then nominal GDP is
a. N1 trillion
b. N2 trillion
c. N5 trillion
d. N10 trillion

17. Which of these is not a criticism of Fisher’s quantity theory of money

a. It fails to measure value of money
b. It neglects interest Rate
 c. It emphases the supply and demand for money
d. It neglects other factors
18. The cash transactions approach is not substantially different from cash balance approach
because the two theories conclude that___________________
a. there is a direct and proportional relationship between the quantity of money and
the price level
b. there is an inverse relationship between the quantity of money and the price level
c. there is indirect relationship between the quantity of money and the price level
d. there is no relationship between the quantity of money and the price level

19. Which of the following has not been considered as a reason why cash balance approach is
superior to cash transactions approach?

L
a. It serves as a basis of liquidity preference theory of interest

EA
b. It is a complete theory
c. It emphases supply and demand for Money

H
d. It emphases the importance of interest rate a determinant of money demand
AP
SOLUTION TO MUITIPLE-CHOICE QUESTIONS 2.7
R
Questions 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19

Answers A C A D C B D A C A A C B C B D C A D
E
EL
ID

Suggestion for further reading

Monetary Economics by M.L Jhingan 7th Edition Published By Vrinda Publication (P) Ltd
M
BA
 STUDY SESSION 3
THE DEMAND FOR MONEY THEORIES

3.0 INTRODUCTION
There are various motives of money demand. The demand for money is basically different from
the demand for commodities. The demand for money arises from two important functions of
money, namely (i) money acts as a medium of exchange, and (ii) money acts as a store of value.
In economics, the demand for money is generally equated with the desire and willingness to hold
cash or bank demand deposits. In this session examine the various approaches to the demand for
money these includes, classical approach, the Liquidity preference theory, the Tobin‟s Portfolio
and Baumol‟s Inventory Approaches and Friedman‟s modern Theory of Demand for Money.

L
Learning Outcomes for Study Session 3

EA
At the end of this study Session, you should be able to:
At the end of this study session, you should be able to

H
3.1 define correctly the concept of demand for money (SAQ 3.1)
3.2 discuss in detail the quantity theory of money using the transactions motive (SAQ 3.2)
AP
3.3 explain the Keynes‟ liquidity preference theory (SAQ 3.3)
3.4 discuss the portfolio selection model of Tobin (SAQ 3.4)
R
3.5 explain the inventory theoretic model of Baumol (SAQ 3.5)
3.6 Friedman‟s modern theory of demand for money (SAQ 3.6)
E
EL

3.1 THE CONCEPT OF DEMAND FOR MONEY

In economics, the demand for money is generally equated with cash or bank demand deposits.
ID

Generally, the nominal demand for money increases with the level of nominal output and
decreases with the nominal interest rate. The demand for money is the desired holding of
M

financial assets in the form of money: that is, cash or bank deposits. It can refer to the demand
BA

for money narrowly defined as M1 (non-interest-bearing holdings), or for money in the broader
sense of M2 or M3.

Money in the sense of M1 is dominated as a store of value by interest-bearing assets. However,

money is necessary to carry out transactions; in other words, it provides liquidity. This creates a
trade-off between the liquidity advantage of holding money and the interest advantage of holding
other assets. The demand for money is a result of this trade-off regarding the form in which a
person's wealth should be held. In macroeconomics motivations for holding one's wealth in the
form of money can roughly be divided into the transaction motive and the asset motive. These
can be further subdivided into more micro-economically founded motivations for holding
money.
Generally, the nominal demand for money increases with the level of nominal output (price level
times real output) and decreases with the nominal interest rate. The real demand for money is
defined as the nominal amount of money demanded divided by the price level. For a given
money supply the locus of income-interest rate pairs at which money demand equals money
supply is known as the LM curve.

The magnitude of the volatility of money demand has crucial implications for the optimal way in
which a central bank should carry out monetary policy and its choice of a nominal anchor.
Conditions under which the LM curve is flat, so that increases in the money supply have no
stimulatory effect (a liquidity trap), play an important role in Keynesian theory. This situation
occurs when the demand for money is infinitely elastic with respect to the interest rate.

A typical money-demand function may be written as

L
M d  P  L ( R, Y )

EA
(3.1)
where M d is the nominal amount of money demanded, P is the price level, R is the nominal
interest rate, Y is real output, and L () is real money demand. An alternate name for L ( R , Y ) is

H
the liquidity preference function.the amount of money held in easily convertible sources (cash,
AP
bank demand deposits). Specific to the liquidity function, L ( R , Y ) is the nominal interest rate and
Y is the real output.
R

Money is necessary in order to carry out transactions. However inherent to the holding of money
E

is the trade-off between the liquidity advantage of holding money and the interest advantage of
EL

holding other assets. When the demand for money is stable, monetary policy can help to stabilize
an economy. However, when the demand for money is not stable, real and nominal interest rates
ID

will change and there will be economic fluctuations.

M

3.2 CLASSICAL" TRANSACTION APPROACH

BA

The transactions motive for money demand results from the need for liquidity for day-to-day
transactions in the near future. This need arises when income is received only occasionally (say
once per month) in discrete amounts but expenditures occur continuously.

Quantity Theory of Money Demand

The most basic "classical" transaction motive can be illustrated with reference to the Quantity
Theory of Money. According to the Fisher (1911), equation of exchange MV = PY, where M is
the stock of money, V is its velocity (how many times a unit of money turns over during a period
of time), P is the price level and Y is real income. Consequently PY is nominal income (GDP) or
in other words the number of transactions carried out in an economy during a period of time. In
fact, the quantity theory of money is a theory of the demand for money. We can see this by
dividing both sides of the exchange by V, thus rewriting it as (Rearranging the above identity and
giving it a behavioral interpretation as a demand for money we have)
 Y 1
Md  P or M d  PY (3.2)
V V
or in terms of demand for real balances
Md Y
 (3.3)
P V

Hence in this simple formulation demand for money is a function of prices and income, as long
as its velocity is constant.

When the money market is in equilibrium, the quantity of money M that people hold equals
the quantity of money demand M d , so we can replace M in the equation by M d using k to

L
represent the quantity 1/V, we can rewrite the equation as

EA
Md =k×PY (3.4)

H
Because k is a constant, the level of transaction generated by a fixed level of nominal income PY
determines the quantity of money Md that people demand. Therefore, Fisher‟s quantity theory of
AP
money suggests that the demand for money is purely a function of income, and interest rates
have no effect on the demand for money. Fisher believed that people hold money only to
R
conduct transactions and have no freedom of action in terms of the amount they want to hold,
so he came to above conclusion. The demand for money is determined (1) by the level of
E

transactions generated by the level of nominal

EL

The equation of exchange is transformed into the classical quantity theory of money by the
ID

addition of two assumptions.

 First, the classical economists believed that the velocity of circulation of money could be
M

viewed as constant and independent of the money supply in the short run, i.e. V  
BA

though it may vary over the long run. The rationale for this assumption is that
institutional changes and technological innovations that might alter the transactions
behaviour of individuals seem to occur very slowly over time, so that in the short run it
seem reasonable to assume that the rate of turnover of money does not change, even if
the quantity of money changes.
 Second, the classical economists believed that real economic activity, i.e. real GDP is not
affected by changes in the quantity of money, and that on average, real GDP is at the so
called full employment level" where the economy is using all of resources as efficiently
as possible. Let us denote this full employment level of real GDP by Y classical
economists thought that GDP would be at or close to this level of GDP because they
believed that prices and wages were very quick to adjust. So for example, if there were
unemployed resources (workers, factories, etc.) wages would fall quickly so as to restore
 the economy to a situation where it was producing the Y* (full employment) level of
GDP.

With these two assumptions, V= ν and Y=Y* , the equation of exchange is transformed into the
quantity theory of money which says that a change in the quantity of money leads to an equal
proportional change in the level of prices. To understand why this statement is true, let us use our
two assumptions in the equation of exchange: MV  PY
V
Rearranging, we have: P = M (3.5)
Y

If ̅ and Y* are roughly constant and independent of changes in the money supply, then,
according to the quantity theory, a change in the quantity of money, M (which represents the

L
difference in the money supply at two dates, i.e. M t  M t 1 will lead only to a change in the level

EA
of prices, P( Pt  Pt 1 ) :
V

H
P = M (3.6)
Y AP
If we divide equation (2) by equation (1) we obtain:
R
P M
 (3.7)
P M
E
EL

This equation summarizes the classical quantity theory prediction: The percentage change in the
price level ΔP/P ) is equal to the percentage change in the money supply ( ΔM/M ).
ID

Velocity: While the relationship between money supply, money demand, the price level, and the
M

value of money presented above is accurate, it is a bit simplistic. In the real world economy,
these factors are not connected as neatly as the quantity theory of money and the basic money
BA

market diagram present. Rather, a number of variables mediate the effects of changes in the
money supply and money demand on the value of money and the price level.

The most important variable that mediates the effects of changes in the money supply is the
velocity of money. Imagine that you purchase a hamburger. The waiter then takes the money that
you spent and uses it to pay for his dry cleaning. The dry cleaner then takes that money and pays
to have his car washed. This process continues until the bill is eventually taken out of circulation.
In many cases, bills are not removed from circulation until many decades of service. In the end, a
single bill will have facilitated many times its face value in purchases.

Velocity of money is defined simply as the rate at which money changes hands. If velocity is
high, money is changing hands quickly, and a relatively small money supply can fund a
relatively large amount of purchases. On the other hand, if velocity is low, then money is
changing hands slowly, and it takes a much larger money supply to fund the same number of
purchases.

As you might expect, the velocity of money is not constant. Instead, velocity changes as
consumers' preferences change. It also changes as the value of money and the price level change.
If the value of money is low, then the price level is high, and a larger number of bills must be
used to fund purchases. Given a constant money supply, the velocity of money must increase to
fund all of these purchases. Similarly, when the money supply shifts due to Fed policy, velocity
can change. This change makes the value of money and the price level remain constant.

The relationship between velocity, the money supply, the price level, and output is represented
by the equation M * V = P *Y where M is the money supply, V is the velocity, P is the price
level, and Y is the quantity of output. P *Y, the price level multiplied by the quantity of output,

L
gives the nominal GDP. This equation can thus be rearranged as V = (nominal GDP) / M.

EA
Conceptually, this equation means that for a given level of nominal GDP, a smaller money
supply will result in money needing to change hands more quickly to facilitate the total

H
purchases, which causes increased velocity.
AP
The equation for the velocity of money, while useful in its original form, can be converted to a
percentage change formula for easier calculations. In this case, the equation becomes (percent
R
change in the money supply) + (percent change in velocity) = (percent change in the price level)
+ (percent change in output). The percentage change formula aids calculations that involve this
E

equation by ensuring that all variables are in common units.

EL

The velocity equation can be used to find the effects that changes in velocity, price level, or
ID

money supply have on each other. When making these calculations, remember that in the short
run, output (Y), is fixed, as time is required for the quantity of output to change.
M
BA

Let's try an example. What is the effect of a 3% increase in the money supply on the price level,
given that output and velocity remain relatively constant? The equation used to solve this
problem is (percent change in the money supply) + (percent change in velocity) = (percent
change in the price level) + (percent change in output). Substituting in the values from the
problem we get 3% + 0% = x% + 0%. In this case, a 3% increase in the money supple results in a
3% increase in the price level. Remember that a 3% increase in the price level means that
inflation was 3%.

In the long run, the equation for velocity becomes even more useful. In fact, the equation shows
that increases in the money supply by the Fed tend to cause increases in the price level and
therefore inflation, even though the effects of the Fed's policy is slightly dampened by changes in
velocity. This results a number of factors. First, in the long run, velocity, V, is relatively constant
because people's spending habits are not quick to change. Similarly, the quantity of output, Y, is
not affected by the actions of the Fed since it is based on the amount of production, not the value
of the stuff produced. This means that the percent change in the money supply equals the percent
change in the price level since the percent change in velocity and percent change in output are
both equal to zero. Thus, we see how an increase in the money supply by the Fed causes
inflation.

Let's try another example. What is the effect of a 5% increase in the money supply on inflation?
Again, we being by using the equation (percent change in the money supply) + (percent change
in velocity) = (percent change in the price level) + (percent change in output). Remember that in
the long run, output not affected by the Fed's actions and velocity remains relatively constant.
Thus, the equation becomes 5% + 0% = x% + 0%. In this case, a 5% increase in the money
supply results in a 5% increase in inflation.

L
The velocity of money equation represents the heart of the quantity theory of money. By

EA
understanding how velocity mitigates the actions of the Fed in the long run and in the short run,
we can gain a thorough understanding of the value of money and inflation.

H
Question
AP
Suppose nominal GDP (PY) is N9 trillion and the velocity of circulation of money, V, is 2.5. By
R
the equation of exchange, the quantity of money, M, must be N 9 trillion / 2.5 = N3.6 trillion.
Now suppose the quantity theory of money holds. If the money supply increases by 11% (i.e.
E

M = M = 11). What is the new quantity of money and the new level of nominal GDP?
EL

Solution
ID

The new quantity of money is 11% higher and equal to N3.6 × 1.11 = N3.996 trillion. The
quantity theory prediction is that nominal GDP will be 11% higher because the price level P will
M

have increased by 11% (with no change in real GDP, Y). If the new quantity of money is N3.996
BA

trillion, and V remains constant at 2.5 as the quantity theory assumes, then PY must now be
N3.996 × 2.5 = N9.99 trillion. This figure represents an increase of 11% in nominal GDP: [(N
9:99- N9)/N9] = 11.

Cambridge Approach to Money Demand

While fisher was developing his quantity theory approach to the demand for money, a group of
classical economists at Cambridge University Cambridge, England, which included Alfred
Marshall and A.C. Pigou, D. H.Robertson and also J. M. Keynes were studying the same topic.
Although their analysis led them to an equation identical to Fisher‟s money demand equation,
their approach differed significantly. Instead of studying the demand for money by looking
solely at the level of transactions and the institutions that affect the way people conduct
transactions as the key determinants. In Cambridge model, individuals are allowed some
flexible in their decisions to hold money and are not completely bound by institutional
constraints such as whether they can use credit cards to make purchases. Accordingly, the
Cambridge approach did not rule out the effects of interest rates on the demand for money.

The classical Cambridge economists thought that two properties of money make people want
to hold it: (1) its utility as a medium of exchange (2) its utility as store of wealth. Cambridge
economists agreed with Fisher that demand for money would be related to the level of
transactions and there would be a transactions component of money demand proportional to
nominal income. As far as money functions as a store of wealth, the Cambridge economists
suggest that the level of people‟s wealth also affects the demand for money. They believed that
wealth in nominal terms is proportional to nominal income, they also believed that wealth
component of money demand is proportional to nominal income. The Cambridge quantity theory
of money is a significant improvement over the classical quantity theory of money. According
to the Cambridge version of quantity theory of money, price level is effective only by that part

L
of money which people hold in form of cash for transaction purpose, not only by the total MV

EA
as suggested by the classical theory.

H
According to the neoclassical economists individuals hold money or demand money for
AP
transaction purposes. Some money is also held for security and for meeting the unexpected
obligations. People do not hold their entire income in the form of money. They hold only an
optimum amount of money because as Pigou said, “Currency held in the hands yields no
R
income.” The optimum amount of money people hold is not precisely defined. However
E

neoclassical economics hypothesized that income earners strike a balance between the
EL

convenience and security that money provides and the loss of income results from money
holding. In the ultimate analysis they postulated that people hold only a certain proportion of
ID

their money income for transaction purposes. Cambridge economist stated their hypothesis in the
form of an equation and also expressed the demand for money function as
M

M d  k  PQ (3.8)
BA

where M d is demand for money, P is price, Q is real income and k is proportion of money.
The term k is called „Cambridge k‟ and PQ  Y that is money value of real income. Equation
reads that the M d equals to k proportion of the real income. The neoclassical economist held that
is fairly stable and that at equilibrium level stock of money ( M ) equals demand for money ( M d
). That is, M  M d  kPQ

At equilibrium, therefore,
M  kPQ or, M (1/ k )  PQ (3.9)

It is important to note that in 1/k is same as V in Fisher‟s equation, this means that Cambridge k
is reciprocal of Fisher‟s V. that is k=1/V and V=1/k . Thus, k and V are reciprocals of one
another.

3.3 KEYNES’ LIQUIDITY PREFERENCE THEORY

In his famous 1936 book The General Theory of Employment, Interest, and Money, Keynes
developed a theory of money demand which he called liquidity preference theory. Keynes
abandoned the classical view that velocity was a constant, emphasized the importance of interest
rates. He postulated that there are three motives behind the demand for money: the transactions
motive, the precautionary motive, and the speculative motive.

Transactions Motive: Keynes emphasized that this component of the demand for money is
determined primarily by the level of people‟s transactions. The transactions demand for money
arises from the lack of synchronization of receipts and disbursements. In other words, people

L
aren‟t likely to get paid at the exact instant you need to make a payment, so between pay checks

EA
people keep some money around in order to buy stuff. Keynes believed that these transactions
were proportional to income, like the classical economists, he considered the transactions

H
component of the demand for money to be proportional to income.
AP
Precautionary Motive: Keynes also recognized people hold money not only to carry out
current transactions, but also as cushion against an unexpected need. Because people are
R
uncertain about the payments the might want, or have, to make. If people don‟t have money
with which to pay, they will incur a loss. When you are holding precautionary money balances,
E

you can take advantages of the sale. Keynes believed that the amount of precautionary money
EL

balances people want to hold is determined primarily by the level of transactions that they
expected to make in the future and that these transactions are proportional to income. So he
ID

considered the demand for precautionary money balances to be proportional to income.

M

Speculative Motive: The transactions motive and the precautionary motive for money emphasized
BA

medium of-exchange function of money, for each refers to the need to have money on hand to
make payments. Keynes agreed with the classical Cambridge economists that money is a store of
wealth and called this reason for holding money the speculative motive. He also considered that
wealth is tied to closely to income, the speculative component of money demand would be
related to income. Keynes believed that interest rates have an important role to play in
influencing the decisions regarding how much money to hold as a store of wealth.

Keynes divided the assets that can be used to store wealth into two categories: money and
bonds. He also asked why individuals would decide to hold their wealth in the form of money
rather than bonds. Keynes assumed that the expected return on money was zero in his time,
unlike today. For bonds, there are two components of the expected return: the interest payment
and the expected rate of capital gains. As we know, when interest rates rise, the price of a
bond falls. If you expected interest rates to rise, you expect the price of the bond to fall and
suffer negative capital gains. In this case, people would want to store their wealth as money
because its expected return is higher; its zero return exceeds the negative return on the bond.

Keynes assumed that individuals believe that interest rates gravitate to some normal value. When
interest rate are below the normal value, people expect the interest rate on bonds to rise in the
future and so expect to suffer capital loss on them. Therefore, people will be more likely to
hold their wealth as money rather bonds, and the demand for money will be high. And
contrariwise, they will be more likely to hold bonds than money, and the demand for money
will be quite low. Therefore, money demand is negatively related to the level of interest rates.

Keynes carefully distinguished between nominal quantities and real quantities. He reasoned that
people want to hold a certain amount of real money balances (an amount that the three
motives indicated would be related to real income Y and to interest rates i. Keynes developed

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the following demand for money equation, known as the liquidity preference function, which

EA
says that the demand for real money balances M d /P is a function of i and Y .
Md

H
 f (i, Y ) (3.10)
P - 
AP
Where the minus sign below i in the liquidity preference function means that the demand for real
money balances is negatively related to the interest rate, and plus sign below Y means that the
R
demand for real money balances and real income Y are positively related. Keynes thought that
the demand for money is related not only to income, but also to interest rates. Because the
E

transactions motive and precautionary motive demand for money is positively related to real
EL

income Y , speculative motive demand for money is negatively related to interest rate i the
demand for real money balances M d /P can be rewritten as
ID

Md
 L1 (Y )  L2 (i ) (3.11)
P
M

where L1 means the transactions demand for money; L 2 means the speculative demand for
BA

money. By deriving the liquidity preference function for velocity PY/M , we can see that Keynes‟s
theory of the demand for money implies that velocity is not constant but instead fluctuates with
movements in interest rates. The liquidity preference equation can be rewritten as

P 1
d
 (3.12)
M f (i, Y )

Multiplying both sides of this equation by Y and recognizing that M d can be replaced by M
because they must be equal in money market equilibrium, we solve for velocity:

PY Y
V  (3.13)
M f (i, Y )
Keynes‟s liquidity preference theory of the demand for money indicates that velocity has
substantial fluctuations as well.

The Total Demand for Money:

According to Keynes, money held for transactions and precautionary purposes is primarily a
function of the level of income, LT = f (Y), and the speculative demand for money is a function
of the rate of interest, Ls = f (i). Thus the total demand for money is a function of both income
and the interest rate:

LT  LS  f (Y )  f (i )
or
L  f (Y )  f (i ) or L  f (Y , i ) (3.14)

L
EA
Where L represents the total demand for money.
Thus the total demand for money can be derived by the lateral summation of the demand
function for transactions and precautionary purposes and the demand function for speculative

H
purposes, AP
By introducing speculative demand for money, Keynes made a significant departure from the
R
classical theory of money demand which emphasized only the transactions demand for money.
However, as seen above, Keynes‟ theory of speculative demand for money has been challenged.
E
EL

The main drawback of Keynes‟ speculative demand for money is that it visualises that people
hold their assets in either all money or all bonds. This seems quite unrealistic as individuals hold
ID

their financial wealth in some combination of both money and bonds.

M

This gave rise to portfolio approach to demand for money put forward by Tobin, Baumol and
Freidman. The portfolio of wealth consists of money, interest-bearing bonds, shares, physical
BA

assets etc. Further, while according to Keynes‟ theory, demand for money for transaction
purposes is insensitive to interest rate, the modem theories of money demand put forward by
Baumol and Tobin show that money held for transaction purposes is interest elastic

3.4 TOBIN’S PORTFOLIO APPROACH TO DEMAND FOR MONEY

An American economist James Tobin, in his important contribution explained that rational
behaviour on the part of the individuals is that they should keep a portfolio of assets which
consists of both bonds and money. In his analysis he makes a valid assumption that people prefer
more wealth to less.

According to him, an investor is faced with a problem of what proportion of his portfolio of
financial assets he should keep in the form of money (which earns no interest) and interest-
bearing bonds. The portfolio of individuals may also consist of more risky assets such as shares.
According to Tobin, faced with various safe and risky assets, individuals diversify their portfolio
by holding a balanced combination of safe and risky assets. According to Tobin, individual‟s
behaviour shows risk aversion. That is, they prefer less risk to more risk at a given rate of return.
In the Keynes‟ analysis an individual holds his wealth in either all money or all bonds depending
upon his estimate of the future rate of interest.

But, according to Tobin, individuals are uncertain about future rate of interest. If a wealth holder
chooses to hold a greater proportion of risky assets such as bonds in his portfolio, he will be
earning a high average return but will bear a higher degree of risk. Tobin argues that a risk
averter will not opt for such a portfolio with all risky bonds or a greater proportion of them.

On the other hand, a person who, in his portfolio of wealth, holds only safe and riskless assets
such as money (in the form of currency and demand deposits in banks) he will be taking almost

L
zero risk but will also be having no return and as a result there will be no growth of his wealth.

EA
Therefore, people generally prefer a mixed diversified portfolio of money, bonds and shares,
with each person opting for a little different balance between riskiness and return.

H
It is important to note that a person will be unwilling to hold all risky assets such as bonds unless
AP
he obtains a higher average return on them. In view of the desire of individuals to have both
safety and reasonable return, they strike a balance between them and hold a mixed and balanced
R
portfolio consisting of money (which is a safe and riskless asset) and risky assets such as bonds
and shares though this balance or mix varies between various individuals depending on their
E

attitude towards risk and hence their trade-off between risk and return.
EL

Tobin‘s Liquidity Preference Function:

ID

Tobin derived his liquidity preference function depicting relationship between rate of interest and
demand for money (that is, preference for holding wealth in money form which is a safe and
M

“riskless” asset. He argues that with the increase in the rate of interest (i.e. rate of return on
BA

bonds), wealth holders will be generally attracted to hold a greater fraction of their wealth in
bonds and thus reduce their holding of money.

That is, at a higher rate of interest, their demand for holding money (i.e., liquidity) will be less
and therefore they will hold more bonds in their portfolio. On the other hand, at a lower rate of
interest they will hold more money and less bonds in their portfolio.

This means, like the Keynes‟s speculative demand for money, in Tobin‟s portfolio approach
demand function for money as an asset (i.e. his liquidity preference function curve) slopes
downwards, where on the horizontal axis asset demand for money is shown. This downward-
sloping liquidity preference function curve shows that the asset demand for money in the
portfolio increases as the rate of interest on bonds falls.
In this way Tobin derives the aggregate liquidity preference curve by determining the effects of
changes in interest rate on the asset demand for money in the portfolio of individuals. Tobin‟s
liquidity preference theory has been found to be true by the empirical studies conducted to
measure interest elasticity of the demand for money.

As explained by Tobin through his portfolio approach, these empirical studies reveal that
aggregate liquidity preference curve is negatively sloped. This means that most of the people in
the economy have liquidity preference function similar to the one explained by curve Md

Tobin‟s approach has done away with the limitation of Keynes‟ theory of liquidity preference for
speculative motive, namely, individuals hold their wealth in either all money or all bonds. Thus,
Tobin‟s approach, according to which individuals simultaneously hold both money and bonds
but in different proportion at different rates of interest yields a continuous liquidity preference

L
curve.

EA
Further, Tobin‟s analysis of simultaneous holding of money and bonds is not based on the

H
erroneous Keynes‟s assumption that interest rate will move only in one direction but on a simple
fact that individuals do not know with certainty which way the interest rate will change.
AP
It is worth mentioning that Tobin‟s portfolio approach, according to which liquidity preference
R
(i.e. demand for money) is determined by the individual‟s attitude towards risk, can be extended
to the problem of asset choice when there are several alternative assets, not just two, of money
E

and bonds.
EL
ID

3.5 BAUMOL’S INVENTORY APPROACH TO TRANSACTIONS DEMAND FOR

MONEY
M

Instead of Keynes‟s speculative demand for money, Baumol concentrated on transactions

BA

demand for money and put forward a new approach to explain it. Baumol explains the
transaction demand for money from the viewpoint of the inventory control or inventory
management similar to the inventory management of goods and materials by business firms.

As businessmen keep inventories of goods and materials to facilitate transactions or exchange in

the context of changes in demand for them, Baumol asserts that individuals also hold inventory
of money because this facilitates transactions (i.e. purchases) of goods and services.

In view of the cost incurred on holding inventories of goods there is need for keeping optimal
inventory of goods to reduce cost. Similarly, individuals have to keep optimum inventory of
money for transaction purposes. Individuals also incur cost when they hold inventories of money
for transactions purposes.
They incur cost on these inventories as they have to forgone interest which they could have
earned if they had kept their wealth in saving deposits or fixed deposits or invested in bonds.
This interest income forgone is the cost of holding money for transactions purposes. In this way
Baumol and Tobin emphasised that transaction demand for money is not independent of the rate
of interest.

It may be noted that by money we mean currency and demand deposits which are quite safe and
riskless but carry no interest. On the other hand, bonds yield interest or return but are risky and
may involve capital loss if wealth holders invest in them.

However, saving deposits in banks, according to Baumol, are quite free from risk and also yield
some interest. Therefore, Baumol asks the question why an individual holds money (i.e. currency
and demand deposits) instead of keeping his wealth in saving deposits which are quite safe and

L
earn some interest as well.

EA
According to him, it is for convenience and capability of it being easily used for transactions of

H
goods that people hold money with them in preference to the saving deposits. Unlike Keynes
both Baumol and Tobin argue that transactions demand for money depends on the rate of
AP
interest.
People hold money for transaction purposes “to bridge the gap between the receipt of income
R
and its spending.” As interest rate on saving deposits goes up people will tend to shift a part of
their money holdings to the interest-bearing saving deposits.
E
EL

Individuals compare the costs and benefits of funds in the form of money with the interest-
bearing saving deposits. According to Baumol, the cost which people incur when they hold funds
ID

in money is the opportunity cost of these funds, that is, interest income forgone by not putting
them in saving deposits.
M
BA

3.6 FRIEDMAN’S MODERN THEORY OF DEMAND FOR MONEY

A noted monetarist economist Friedman put forward demand for money function which plays an
important role in his restatement of the quantity theory of money and prices. Friedman believes
that money demand function is most important stable function of macroeconomics. He treats
money as one type of asset in which wealth holders can keep a part of their wealth. Business
firms view money as a capital good or a factor of production which they combine with the
services of other productive assets or labour to produce goods and services.

Thus, according to Friedman, individuals hold money for the services it provides to them. It may
be noted that the service rendered by money is that it serves as a general purchasing power so
that it can be conveniently used for buying goods and services. His approach to demand for
money does not consider any motives for holding money, nor does it distinguishes between
speculative and transactions demand for money. Friedman considers the demand for money
merely as an application of a general theory of demand for capital assets.

Like other capital assets, money also yields return and provides services. He analyses the various
factors that determine the demand for money and from this analysis derives demand for money
function. Note that the value of goods and services which money can buy represents the real
yield on money. Obviously, this real yield of money in terms of goods and services which it can
purchase will depend on the price level of goods and services.

Besides money, bonds are another type of asset in which people can hold their wealth. Bonds are
securities which yield a stream of interest income, fixed in nominal terms. Yield on bond is the
coupon rate of interest and also anticipated capital gain or loss due to expected changes in the
market rate of interest. Equities or Shares are another form of asset in which wealth can be held.

L
The yield from equity is determined by the dividend rate, expected capital gain or loss and

EA
expected changes in the price level. The fourth form in which people can hold their wealth is the
stock of producer and durable consumer commodities.

H
AP
These commodities also yield a stream of income but in kind rather than in money. Thus, the
basic yield from commodities is implicit one. However, Friedman also considers an explicit yield
from commodities in the form of expected rate of change in their price per unit of time.
R
E

The demand for money is a function of the resources available to individuals and expected returns
on other assets relative to the expected return on money. Friedman regarded his model of the
EL

nominal demand function ( M d ) for money as follows:

ID

Md
 f (Yp , rb , rm , re ,  e , w, u ) or f (Yp , rb - rm , re - rm ,  e - rm  e - rm )
M

(3.10)
P  - - -
BA

where M d /P denote demand for real balances, Y p is the permanent income (the expected
long-run average of current and future income), that is the real GDP-production as a proxy to
capture transactions and precautionary demand for money, Price Level (P): Price level also
determines the demand for money balances. A higher price level means people will require a
larger nominal money balances in order to do the same amount of transactions, that is, to
purchase the same amount of goods and services.

If income (Y) is used as proxy for wealth (W) which, as stated above, is the most important
determinant of demand for money, then nominal income is given by Yp which becomes a
crucial determinant of demand for money.
Here Y stands for real income (i.e. in terms of goods and services) and P for price level. As the
price level goes up, the demand for money will rise and, on the other hand, if price level falls, the
demand for money will decline. As a matter of fact, people adjust the nominal money balances (
M d ) to achieve their desired level of real money balances ( M d /P ).

Rates of Interest or Return ( rb , rm , re ): Friedman considers three rates of interest, namely rb is the
expected rate of return on bonds, rm is the expected return on money, re is the expected return
on equity. Note that money kept in the form of currency and demand deposits does not earn any
interest. But money held as saving deposits and fixed deposits earns certain rates of interest and
it is this rate of interest which is designated by rm in the money demand function. Given the other
rates of interest or return, the higher the own rate of interest, the greater the demand for money.

L
In deciding how large a part of his wealth to hold in the form of money the individual will

EA
compare the rate of interest on money with rates of interest (or return) on bonds and other assets.
As mentioned earlier, the opportunity cost of holding money is the interest or return given up by

H
not holding these other forms of assets. As rates of return on bond ( rb ) and equities ( re ) rise, the
AP
opportunity cost of holding money will increase which will reduce the demand for money
holdings. Thus, the demand for money is negatively related to the rate of interest (or return) on
bonds, equities and other such non-money assets.
R

 e is the expected inflation rate (proxy for rate of return on physical assets). If people expect a
E

higher rate of inflation, they will reduce their demand for money holdings. This is because
EL

inflation reduces the value of their money balances in terms of its power to purchase goods and
services. If the rate of inflation exceeds the nominal rate of interest, there will be negative rate of
ID

return on money. Therefore, when people expect a higher rate of inflation they will tend to
convert their money holdings into goods or other assets which are not affected by inflation. On
M

the other hand, if people expect a fall in the price level, their demand for money holdings will
BA

increase.

w is the ratio of human to nonhuman wealth. The major factor determining the demand for
money is the wealth of the individual (w) In wealth Friedman includes not only non-human
wealth such as bonds, shares, money which yield various rates of return but also human wealth
or human capital. By human wealth Friedman means the value of an individual‟s present and
future earnings. Whereas non-human wealth can be easily converted into money, that is, can be
made liquid. Such substitution of human wealth is not easily possible. Thus human wealth
represents illiquid component of wealth and, therefore, the proportion of human wealth to the
non-human wealth has been included in the demand for money function as an independent
variable.
Individual‟s demand for money directly depends on his total wealth. Indeed, the total wealth of
an individual represents an upper limit of holding money by an individual and is similar to the
budget constraint of the consumer in the theory of demand.

u is other factors influencing demand for money e.g. institutional factors such as mode of wage
payments and bill payments also affect the demand for money. Several other factors which
influence the overall economic environment affect the demand for money. For example, if
recession or war is anticipated, the demand for money balances will increase. Besides, instability
in capital markets, which erodes the confidence of the people in making profits from investment
in bonds and equity shares will also raise the demand for money. Even political instability in the
country influences the demand for money. To account for these institutional factors Friedman
includes the variable u in his demand for money function.

L
The demand for an asset is positively related to wealth, money demand is positively related to

EA
Friedman’s wealth concept (permanent income). Permanent income has much smaller short-
run fluctuations because many movements of income are transitory. Friedman regarded

H
permanent income as a determinant of the demand for money is that the demand for money will
AP
not fluctuate much with business cycle movements. Friedman categorized them into three types
of assets: bonds, equity, and goods. The incentives for holding these assets rather than money
are represented by the expected return on each of these assets relative to the expected return on
R
money. The expected return on money rm is influenced by (1) the services provided by banks
E

on deposits; (2) the interest payments on money balances.

EL

In Friedman’s money demand function, the rb  rm and re  rm mean the expected return on bonds
ID

and equity relative to money; when they rise, the relative expected return on money falls, and
the demand for money falls.  e  rm means the expected return on goods relative to money.
M

When it rises, the expected return on goods relative to money rises, and the demand for money
BA

falls.

Summary
In economics, the demand for money is generally equated with cash or bank demand deposits.
The transactions motive for money demand results from the need for liquidity for day-to-day
transactions in the near future. The most basic "classical" transaction motive can be illustrated
with reference to the Quantity Theory of Money. According to the Fisher (1911), equation of
exchange MV = PY, where M is the stock of money, V is its velocity (how many times a unit of
money turns over during a period of time), P is the price level and Y is real income. While fisher
was developing his quantity theory approach to the demand for money, a group of classical
economists at Cambridge University Cambridge, England, which included Alfred Marshall and
A.C. Pigou, D. H.Robertson and also J. M. . Cambridge economist stated their hypothesis in the
form of an equation and also expressed the demand for money function as M d  k  PQ where
M d is demand for money, P is price, Q is real income and k is proportion of money.

Keynes abandoned the classical view that velocity was a constant, emphasized the importance of

L
interest rates. He postulated that there are three motives behind the demand for money: the

EA
transactions motive, the precautionary motive, and the speculative motive. Also, Friedman put
forward demand for money function which plays an important role in his restatement of the

H
quantity theory of money and prices. Friedman believes that money demand function is most
AP
important stable function of macroeconomics. Friedman regarded his model of the nominal
demand function ( Md ) for money as follows:
R
Md
 f (Yp , rb , rm , re ,  e , w, u ) or f (Yp , rb - rm , re - rm ,  e - rm  e - rm ) .
P  - - -
E
EL
ID
M

3.7 SELF-ASSESSMENT QUESTIONS

3.1 Consider the following information about a hypothetical economy. This year, the GDP is
BA

₦500, the price level is ₦120, and the quantity of money is ₦6000. Suppose that the
quantity theory of money holds for this economy. Calculate the velocity of money
3.2 Suppose that the quantity of money increases by 2%. What happens to the aggregate supply-
aggregate demand model for this economy?
3.3 Suppose the Nigeria Government wants to increase its expenditure by ₦200b but does not
have this much money so it sells 5-year government bonds to the CBN on the open market.
Then it deposits the ₦200b in a commercial bank for future use. Assume that all commercial
banks have the same reserve ratio (RR) requirement of 5% and that they lend out all extra
reserves as loans. Further assume that all borrowers do not keep the loans in the form of
currencies but deposit them in some banks for later use.
I. What is the money multiplier for this economy?
II. How much does the total money supply increase because of this open market
operation?
 III. Suppose the demand for money does not change. Will this open market operation
increase or decrease equilibrium interest rate?
IV. If the original level of money stock in the economy is ₦1000b, and the original
equilibrium price level in the economy is 2, what will the equilibrium price level be in
the long run after this monetary shock? (Assume the Quantity Theory of Money is
true!)

SOLUTION TO SAQ 3.1

Nominal GDP equals real GDP times the price level, or 500 x 120 = 60,000
The velocity of circulation equals nominal GDP divided by the quantity of money, or 60,000
1 6,000 = 10. On average, each dollar must change hands 10 times to buy the final goods
and services in this country's GDP.

L
The assumptions of the quantity theory of money are that the quantity of money does NOT

EA
affect either potential GDP or the velocity of circulation. The quantity theory of money
implies that long-run changes in the price level (for example, inflation) are caused by

H
changes in the quantity of money. So the long-run fundamental source of inflation is the
growth of the money supply, not the growth of potential GDP
AP
SOLUTION TO SAQ 3.2
R
An increase in the quantity of money would increase aggregate demand. So the aggregate
demand curve would shift rightward. The amount of this shift, measured by the vertical
E

distance between the old and new aggregate demand curves, would be 2%.
EL

SOLUTION TO SAQ 3.3

ID

I. What is the money multiplier for this economy?

1 1 1
M

The money multiplier is = = = 20

RR 5% 0.05
BA

II. How much does the total money supply increase because of this open market operation?
D M = D D* Money multiplier = ₦200 * 20 = ₦4000

III. Suppose the demand for money does not change. Will this open market operation
increase or decrease equilibrium interest rate?
Increase in money supply will decrease the equilibrium interest rate.

IV. If the original level of money stock in the economy is ₦1000b, and the original
equilibrium price level in the economy is 2, what will the equilibrium price level
be in the long run after this monetary shock? (Assume the Quantity Theory of
Money is true!)
 The quantity theory of money says that in the long run, percentage change in equilibrium
price will equal the percentage change in money stock. Hence, the money supply increase
of 400% (from ₦1000b to ₦5000b) will lead to a 400% increase in equilibrium price, which
means the equilibrium price will finally be 8.

3.8 MUITIPLE-CHOICE QUESTIONS

1) Liquidity preference (LP) function defines the relationship between
a. interest rate and bond prices
b. inflation and bond prices
c. interest rate and financial assets
d. demand for money and the price level
e. demand for money and the rate of interest

L
2) When there is an excess demand for money balances, equilibrium is established by a

EA
process that DOES NOT involve:
a. people trying to sell bonds
b. the opportunity cost of holding money falling

H
c. interest rates rising
d. the price of bonds falling
AP
e. movement up the money demand function
3) Assume there are only two assets available, money and bonds. Given a level of wealth of
R
an individual we can expect the following:
a. Bond prices will decrease as the interest rate decreases.
E

b. An individual will hold more money when the current interest rate is very low.
EL

c. An individual will not hold money as long as bonds pay a positive rate of interest.
d. An individual will hold lots of money even at very high interest rates.
ID

e. An individual will hold less money when the current interest rate is very low
4) When households and businesses substitute Treasury bills, commercial paper, and repurchase
M

agreements for short-term bank deposits in their portfolios, they are

BA

a. sacrificing liquidity for return

b. sacrificing return for liquidity
c. increasing both their liquidity and return
d. decreasing both their liquidity and return
e. none of the above
5) Suppose that during the Christmas season people decide to hold more cash and less
demand deposits to facilitate their shopping. This action will
a. decrease the money supply in the economy because all the cash will be spent
b. decrease the money supply because banks loss reserves, thereby affecting their
ability to create money
c. increase the money supply in the economy because of reduced savings
d. increase the supply of money in the economy because of the multiplier effect
e. have no effect on the money supply since demand deposits are another form of
cash
SOLUTION TO MUITIPLE-CHOICE QUESTIONS 3.8
Questions 1 2 3 4 5
Answers E B B A B

Main References
Frederic S. Mishkin, The Economics of Money, Banking, Financial Markets, Sixth Edition
Keynes, J. M. 1936, The General Theory of Employment, Interest, and Money, Macmillan
Friedman, M. ed.1956. Studies in the Quantity Theory of Money, The University of Chicago
Press,

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Supriya Guru, Theories of Demand of Money: Tobin‟s Portfolio and Baumol‟s Inventory

EA
Approaches

H
AP
R
E
EL
ID
M
BA
 STUDY SESSION 4
THE SUPPLY OF MONEY

INTRODUCTION
In session 1 we discussed the concepts and evolution of money and session 2 we the discussed
the value of money and know how is generally defined in economics. In session 3 we analysed
the factors that determine how much money individuals, and economies as a whole, demand. In
this chapter we will discuss how money, credit money in particular, is created and what
determines the supply of money. As we shall see in later chapters, the supply of money is
hugely important since a change in the money supply can lead to changes in the price level and
inflation but also to changes in real variables such as output and unemployment. By affecting
the money supply, the monetary authorities can „control‟ or at least help limit the fluctuations
of these variables.

L
EA
Learning Outcomes for Study Session 4
At the end of this study Session, you should be able to:

H
At the end of this study session, you should be able to
AP
4.1 define correctly the concept of money supply (SAQ 4.1)
4.2 state the factors influencing the supply of money (SAQ 4.2)
R
4.3 explain how the monetary authorities can control the total money supply by changing the
monetary base (SAQ 4.3)
E

4.4 differentiate between exogenous versus endogenous money supply (SAQ 4.4)
EL

4.5 derive correctly the narrow and broad money multipliers (SAQ 4.5)
ID

4.1 THE CONCEPT OF MONEY SUPPLY

In economics, the money supply or money stock, is the total amount of monetary assets available
M

in an economy at a specific time. There are several ways to define "money supply," but standard
BA

measures usually include currency in circulation and demand deposits (depositors' easily
accessed assets on the books of financial institutions). Generally, at any moment money supply is
the total amount of money in the economy and these comprises of all safe assets that households
and businesses can use to make payments or to hold as short-term investments.

Modern monetary theory distinguishes among different ways to measure the money supply,
reflected in different types of monetary aggregates, using a categorization system that focuses on
the liquidity of the financial instrument used as money. The various types of money in the money
supply are generally classified as "M"s such as M0, M1, M2 and M3, according to the type and
size of the account in which the instrument is kept or incorporated in definition and the
classification is country and research specific. Not all of the classifications are widely used, and
each country may use different classifications.
The most commonly used monetary aggregates (or types of money) are conventionally
designated M1, M2 and M3. These are successively larger aggregate categories: M1 is currency
(coins and bills) plus demand deposits (such as checking accounts); M2 is M1 plus savings
accounts and time deposits under ₦100,000; and M3 is M2 plus larger time deposits and similar
institutional accounts. M1 includes only the most liquid financial instruments, and M3 relatively
illiquid instruments. M2 included M1 and, in addition, short-term time deposits in banks and
certain money market funds. M1, and M2 are referred to as monetary base. The monetary base is
defined as the sum of currency in circulation and reserve balances (deposits held by banks and
other depository institutions in their accounts at the Central Bank of Nigeria). M1 is defined as
the sum of currency held by the public and transaction deposits at depository institutions (which
are financial institutions that obtain their funds mainly through deposits from the public, such as
commercial banks, savings and loan associations, savings banks, and credit unions). M2 is
defined as M1 plus savings deposits, small-denomination time deposits and retail money market

L
mutual fund shares.

EA
M0 is another measure of money, is also used; unlike the other measures, it does not represent

H
actual purchasing power by firms and households in the economy. M0 is base money, or the
AP
amount of money actually issued by the central bank of a country. It is measured as currency
plus deposits of banks and other institutions at the central bank. M0 is also the only money that
can satisfy the reserve requirements of commercial banks. M0 and M1, for example, are also
R
called narrow money and include coins and notes that are in circulation and other money
E

equivalents that can be converted easily to cash.

EL

More specifically, money supply can be described as the entire stock of currency and other liquid
instruments in a country's economy as of a particular time. The money supply can include cash,
ID

coins and balances held in checking and savings accounts. Money supply data are recorded and
M

published, usually by the government or the central bank of the country. Public and private
sector analysts have long monitored changes in money supply because of its effects on the price
BA

level, inflation, the exchange rate and the business cycle.

That relation between money and prices is historically associated with the quantity theory of
money. There is strong empirical evidence of a direct relation between money-supply growth and
long-term price inflation, at least for rapid increases in the amount of money in the economy. For
example, a country such as Zimbabwe which saw extremely rapid increases in its money supply
also saw extremely rapid increases in prices (hyperinflation). This is one reason for the reliance
on monetary policy as a means of controlling inflation.

The nature of this causal chain is the subject of contention. Some heterodox economists argue
that the money supply is endogenous (determined by the workings of the economy, not by the
central bank) and that the sources of inflation must be found in the distributional structure of the
economy.
In addition, those economists seeing the central bank's control over the money supply as feeble
say that there are two weak links between the growth of the money supply and the inflation rate.
First, in the aftermath of a recession, when many resources are underutilized, an increase in the
money supply can cause a sustained increase in real production instead of inflation. Second, if
the velocity of money, i.e., the ratio between nominal GDP and money supply changes, an
increase in the money supply could have either no effect, an exaggerated effect, or an
unpredictable effect on the growth of nominal GDP.

An increase in the supply of money typically lowers interest rates, which in turns generates more
investment and puts more money in the hands of consumers, thereby stimulating spending.
Businesses respond by ordering more raw materials and increasing production. The increased
business activity raises the demand for labour. The opposite can occur if the money supply falls
or when its growth rate declines.

L
EA
The different types of money are typically classified as "M"s. The "M"s usually range from M0
(narrowest) to M3 (broadest) but which "M"s are actually focused on in policy formulation
depends on the country's central bank. The typical layout for each of the "M"s is as follows:

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Table 4.1: Types of Money
AP
Type of Money M0 MB M1 M2 M3 MZM
R
Notes and coins in circulation (outside Central
Banks and the vaults of depository institutions) ✓ ✓ ✓ ✓ ✓ ✓
E

(currency)
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Notes and coins in bank vaults (Vault Cash) ✓

Central Bank credit (required reserves and

ID

✓
excess reserves not physically present in banks)
M

Traveller‟s cheques of non-bank issuers ✓ ✓ ✓ ✓

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Demand deposits ✓ ✓ ✓ ✓

Other chequeable deposits (OCDs), which

consist primarily of Negotiable Order of
Withdrawal (NOW) accounts at depository ✓ ✓ ✓ ✓
institutions and credit union share draft
accounts.

Savings deposits ✓ ✓ ✓

Time deposits less than ₦1,000,000 and money-

✓ ✓
market deposit accounts for individuals

Large time deposits, institutional money market ✓

funds, short-term repurchase and other larger
liquid assets

All money market funds ✓

 M0: In some countries, such as the United Kingdom, M0 includes bank reserves, so M0
is referred to as the monetary base, or narrow money.
 MB: is referred to as the monetary base or total currency. This is the base from which
other forms of money (like checking deposits, listed below) are created and is
traditionally the most liquid measure of the money supply.
 M1: Bank reserves are not included in M1.
 M2: Represents M1 and "close substitutes" for M1.[14] M2 is a broader classification of
money than M1. M2 is a key economic indicator used to forecast inflation.
 M3: M2 plus large and long-term deposits. Since 2006, M3 is no longer published by the

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US central bank.[16] However, there are still estimates produced by various private

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institutions.
 MZM: Money with Zero Maturity. It measures the supply of financial assets redeemable

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at par on demand. Velocity of MZM is historically a relatively accurate predictor of
inflation.
AP
The ratio of a pair of these measures, most often M2 / M0, is called an (actual, empirical) money
multiplier.
R
E

Question:
Can you explain what we happen If a bank customer transferred ₦100 million from his or
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her checking account to his or her savings account, which of the following would happen?
ID

Solution:
M

Explanation: The monetary aggregate M1 includes deposits in checking accounts, but not
deposits in savings accounts. So, when a bank customer moves ₦100 million from his or
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her checking to his or her savings account, M1 falls by ₦100 million. However, because
M2 includes both checking and savings accounts, M2 is unchanged. That is, M1 would fall
by ₦100 and M2 would stay constant

Money Supply and Money Stock: Money is a good, which, just like other goods, is demanded
and supplied by economic agents in the economy. There are a number of determinants of the
demand and supply of money. The most important of the determinants of money demand are
national income, the price level and interest rates, while that of money supply is the behaviour of
the central bank of the country which is given the power to control the money supply and bring
about changes in it. The equilibrium amount in the market for money specifies the money stock,
as opposed to the money supply, which is a behavioural function specifying the amount that
would be supplied at various interest rates and income levels. The equilibrium amount of money
is the amount for which money demand and money supply are equal
Money supply is a stock as well as a flow concept. When money supply is viewed, at a point of
time, it is a stock of money held by the public at a moment of time. It refers to the (i) currency
money, i.e. currency notes and coins issued by the Central Bank or the Central Government and
circulating in the country, and (ii) demand deposits (subject to withdrawal by cheques) with the
commercial banks held by the public.

When money supply is viewed over a period of time, it becomes a flow concept. A unit of money
may be spent several times during a given period of time, passing from one hand to another. The
average number of times a unit of money changes/passing from one hand to another during a
given period is called the 'velocity of circulation of money'. The flow of money supply is
measured by multiplying a given stock of money held by the public with the velocity of
circulation of money. In Fisher's equation, PT = MV; MV refers to the flow of money supply

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over a period of time, where M is the stock of money held by the public and

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V is the velocity of circulation of money.
4.2 MONEY SUPPLY DETERMINATION

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There are two basic assumptions that govern the determination of money supply ( Ms ). (1)
AP
Exogenous money supply: The money supply may be determined by the monetary authority or
central bank. That is, disregarding the interest rate the money supply is fixed. (2) Endogenous
R
money supply: The money supply may be also determined by forces such the level of interest
rate. That is, the money supply ( Ms ) and the interest rate is positively related as the financial
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agents will find it profitable to expand the volume of loans. It is a function of interest rate. In
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practice, the money supply is partly endogenous and partly exogenous. However, to make thing
simple, we assume the Ms as exogenous (I.e. in accordance with the change in central monetary
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authority's policy).
M

The determination of money supply are both exogenous and endogenous, several major
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participants are involved in its determination. They are:

1 The central bank, which, among its other policies, determines the monetary base and the
reserve requirements for the commercial banks, and sets its discount rate. When the Central Bank
is „easing‟ the money supply increases and when it is „tightening‟ the money supply decreases. In
the condition of easing more liquid money is available for the private banks. During the
condition of tightening the liquid money is pulled out of the private banking sector. The Central
Bank also creates new reserves that let the banks lend out more money. Then through the process
of „money multiplier‟ the loans and bank reserves increase.
2 The commercial banks, which, for a given required reserve ratio, determine their actual
demand for reserves as against their demand deposit liabilities.
3 The public, which determines its currency holdings relative to its demand deposits.
Required Reserve Ratio: There is considerable interaction between the behaviour of the central
bank, the public and the commercial banks in the money supply process. This interaction is
important in studying the behaviour of the central bank which, as a policy-making body deciding
on the total amount of money desirable for the economy, must take into account the responses of
the public and of the commercial banks to its own actions. The behaviour of the central bank in
the money-supply process becomes a distinctive topic of study.

The Bank retained the use of reserve requirements or required reserve (RR) (minimum cash
reserve ratio (CRR) and Liquidity Ratios (LQR) in the review period to complement OMO and
other instruments of liquidity management. The Central Bank may require Deposit Money Banks
(commercial banks) to hold a fraction (or a combination) of their deposit liabilities (reserves) in
their tills or 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

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that Deposit Money Banks generally maintain a stable relationship between their reserve

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holdings and the amount of credit they extend to the public. This instrument is used by the
central bank to influence the level of bank reserves and hence, their ability to grant loans or

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determine the supply of money. Reserve requirements are lowered in order to free reserves for
AP
banks to grant loans and thereby increase money supply in the economy. On the other hand, they
are raised in order to reduce the capacity of banks to provide loans thereby reducing money
R
supply in the economy.
E

An increase in the required reserved ratio reduces the supply of money with commercial banks
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and a decrease in the required reserved ratio increases the money supply. The required reserve is
the ratio of cash to current and time deposit liabilities which is determined by law. Required
reserve (RR) are determined by the required reserve ratio (RRr or RR/D) and the level of
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deposits (D) of a commercial bank: RR = RRr  D. But it is the excess reserves (ER) which are
M

important for the determination of the money supply. Excess reserves are the difference between
total reserves (TR) and required reserves (RR). ER = TR – RR, while excess reserves ratio is
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given as ER/D or ERr

Question: What effect would an increase in excess reserves held by banks have on money
supply?

Solution: Cause money supply to decrease. Recall that the money multiplier is given by (cd +
1)/(cd +rd), where cd is the currency to deposit ratio and rd is the ratio of reserves to deposits.
Assume for simplicity cd=0, then the multiplier is 1/rd. If excess reserves increase, then rd
increases, hence 1/rd declines. That is the money multiplier falls in value. Hence the money
supply decreases.
A commercial bank advances loans equal to its excess reserves which are important component
of the money supply. To determine the supply of money with a commercial bank, the central
bank influences its reserves by adopting open market operation and discount rate policy. Open
market operations is the buying and selling of government securities in the open market (primary
or secondary) in order to expand or contract the amount of money in the banking system. By
purchasing securities, the central bank injects money into the banking system and stimulates
growth whereas by selling securities it absorbs excess money. Thus, if there is excess liquidity in
the system, the central bank will in a bid to reduce the money supply sell the government
securities such as Treasury Bills. On the other hand, in periods of liquidity shortages, the central
bank buys government securities so as to increase money supply. Instruments commonly used
for this purpose include treasury bills, central bank bills, or prime commercial paper (see CBN,
2011, 2013).

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Free reserve hypothesis: Free reserves for a bank are those it wants to hold in addition to its

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required reserves and borrowed reserves. Free reserves must be distinguished from excess
reserves, which are actual holdings of cash reserves in excess of the sum of required, borrowed

H
and free reserves. Excess reserves are ones that the bank wants to eliminate either immediately or
AP
gradually. The hypothesis for the determination of free reserves is known as the free reserve
hypothesis. Required reserves and free reserves depend upon the required reserve ratio or
R
differential ratios imposed by the central bank. Banks usually hold reserves in excess of those
required to meet the required reserve ratio. Banks also borrow from other banks or the central
E

bank. Reserves held in excess of the sum of required and borrowed reserves are referred to as
free reserves – that is, at the bank‟s disposal for use if it so desires. (See Jagdish Handa, 2nd
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Edition)
ID

Demand for Currency and Deposits by the Public: Fluctuations in the public‟s demand for
M

currency relative to its holdings of demand deposits are a significant source of fluctuations in the
money supply. If people are in the habit of keeping less in cash and more in deposit with the
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commercial banks, the money supply will be large. This is because banks can create more money
with larger deposits. But if people do not have banking habit and prefer to keep their money
holding in cash, credit creation by banks will be less and the money supply will be at a low level.

The closest substitute – and a fairly close one at that – to currency holdings (C) is demand
deposits (D), so that most studies on the issue examine the determinants of the ratio Cr = C/D, or
of the ratio of currency to the total money stock (C/M1), rather than directly the determinants of
the demand for currency alone. The C/D ratio varies considerably, with a procyclical pattern over
the business cycle and over the long term. The desired C/D ratio depends upon the individual‟s
preferences in the light of the costs and benefits of holding currency relative to demand deposits.
Some of these costs and benefits are non-monetary and some are monetary. Other factors that
determines money supply e.g. interest rate, income.
4.3 MECHANICAL THEORIES OF THE MONEY SUPPLY: MONEY SUPPLY
IDENTITIES
Mechanical theories of the money supply are so called because they use identities, rather than
behavioral functions, to calculate the money supply. The money-supply equations resulting from
such an approach can be easily made more or less complex, depending upon the purpose of the
analysis. We specify below several such equations, starting with the most elementary one.

An Elementary Demand Deposit Equation

Assume that the ratio of reserves held by the banks against demand deposits is given by:

BR = ρD (4.1)

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where:

EA
BR = reserves held by banks
D = demand deposits in banks
ρ = reserve ratio

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If ρ equals the required reserve ratio, set by the central bank for the banking system, and BR
AP
represents the reserves exogenously supplied to it, profit-maximizing banks will create the
amount of deposits given by:
R

D = (1/ρ)BR 4.2)
E

This equation is the elementary deposit creation formula for the creation of deposits by banks on
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the basis of the reserves held by them. It suffers from a failure to take note of the behaviour of the
banks and the public in the deposit expansion process, so that a more elaborate approach to the
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money supply is preferable.

M

The Relationship between Money Supply, Monetary Base and Money Multiplier: Common
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Money-Supply Formulae
Friedman and Schwartz (1963) used a money-supply equation that not only takes account of the
reserve/deposit ratio of banks but also of the ratio of currency to deposits desired by the public.
These two determinants together are called the monetary base (MB) or the high powered money.
High powered money is the sum of commercial bank reserves and currency (notes and coins)
held by the public. The supply of money varies directly with changes in the monetary base and
inversely with the currency and reserve ratios. The use of monetary base or high powered
money consists of the demand of commercial banks for the legal limit or required reserves with
the central bank and excess reserves and the demand of the public for currency. Thus, monetary
base money MB = C + RR + ER. The formal relation between money supply and monetary base
money is derived simply from the accounting identities:

Thus, the money supply equation is given as;

M=C+D (4.3)

The monetary base (MB) that is controlled by the Central Bank or the high powered money
equation is given as;
MB = C + RR + ER (4.4)
where:
C = currency in the hands of the public
D = commercial bank demand deposits
RR = required reserves
ER = excess reserves of commercial banks
MB = monetary base
The relationship between money supply Ms and monetary base can be expressed as the ratio of
Ms to MB. So divide equation (4.3) by (4.4)

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Ms CD


EA
(4.5)
MB C  RR  ER
Divide the numerator and denominator of the right hand side of equation (4.5) by demand

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deposit (D) AP
C D

Ms D D

R
(4.6a)
MB C  RR  ER
D D D
E
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or
C
s 1
ID

M D
 (4.6b)
MB C RR ER
 
M

D D D
By substituting Cr for C/D (Reflects the preferences of households), RRr for RR/D (Is
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determined by the business policies of banks and laws regulating banks) and ERr for ER/D. all
are defined as exogenous variables, then equation (4.6b) becomes

Ms 1  Cr
 (4.7)
MB Cr  RRr  ERr
Thus, Monetary Base is;
Cr  RRr  ERr
MB  Ms (4.8)
1  Cr
And Money Supply is;

1  Cr
Ms   MB (4.9)
Cr  RRr  ERr
Equation (4.9) defines money supply in terms of monetary base. It expresses the money supply
in terms of four determinants, MB, Cr, RRr and ERr. The equation states that the higher the MB,
the higher the money supply. Further, the lower the currency ration (Cr), the reseve ratio (RRr)
and the excess reserve ratio (ERr).

Monetary Base Multiplier

Equation (4.9) separates the basic determinants of the money stock into changes in the monetary
base and changes in the “monetary base multiplier,” defined as (M s /MB) or the monetary base.
This multiplier is itself determined by C/D, the currency ratio, RRD, the reserve ratio and ER/D, the
excess reserve ratio. Of these, the reserve ratio reflects the required reserve ratio and the banks‟
demand for free reserves. The currency ratio reflects the public‟s behavior in its demand for
currency. Hence, the four determinants of the money stock emphasized by (4.9) are the monetary

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base, the currency and the reserve and excess reserve ratios.

EA
We have designated (M s /MB) the monetary base multiplier, so that it captures the impact

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of changes in the monetary base on the money supply. Some other authors call it the money
AP
multiplier. The quotient of equation (4.9) is the money multiplier (m). Thus

1  Cr
R
m (4.10)
Cr  RRr  ERr
E

So the relationship between the money supply and monetary base of equation (4.9) becomes
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M s  mMB (4.11)
ID

Equation (4.11) expresses money supply as a function of money multiplier (m) and monetary
base (MB). In other word, the money supply is determined by money multiplier (m) and
M

monetary base (MB) (See Jhingan, 2008)

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More explicitly, the change in money supply can be better expressed as the product of the
change in monetary base or high-powered money and in the value of the multiplier
M s  mMB  MBm (4.12)

Another version of the money-supply formula is:

1
Ms  MB (4.13)
 C RR C RR 
 s   
M D Ms D 
Using this equation, Cagan (1965) examined the contributions of the three elements MB, C/Ms
and RR/D, to M2 over the business cycle and in the long term. He found that the dominant
factor influencing the long-term growth in the money stock was the growth in the monetary base.
Changes in the two ratios contributed little to the secular change in M2. However, for cyclical
movements in the money stock the changes in the C/M ratio were the most important element,
whereas the reserve ratio had only a minor impact and changes in the monetary base exerted only
an irregular influence.

The currency demand deposit – and hence the currency–money ratio – is influenced strongly by
changes in economic activity and especially by changes in the rate of consumer spending. As we
have explained in earlier sections, this ratio varies in the same direction as nominal national
income – hence, pro-cyclically – so that a rise in spending in cyclical upturns increases currency
holdings, which lowers the money supply.

4.4 EXOGENOUS VERSUS ENDOGENOUS MONEY SUPPLY

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Endogenous Money occupies a central place in Post Keynesian economics. Within the Post

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Keynesian schema, the money supply is endogenously determined via the demand for bank
credit. For the last decade, the Post Keynesian approach to endogenous money has become

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bogged down in a debate between what have become labelled the "accommodationist" and
AP
"structuralist" approaches (Pollin, 1991). Accommodationists argue that the money supply is
exclusively credit driven, with the monetary authority setting the interest rate and being forced to
R
accommodate any increase in demand for reserves caused by increased bank lending.
Structuralists also maintain that the money supply is influenced by the demand for credit and the
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reaction of the monetary authorities, but they argue that the money supply also depends on the
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asset and liability management practices of banks. Even if the monetary authority refused to
accommodate any increase in the demand for reserves, banks would still be able to partially
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accommodate an increase in loan demand through their own initiatives. Then one of the
controversial issues in monetary economics is the debate over the concept of exogenous and
M

endogenous money. The debate has been going on since the 17th century and has its theoretical
roots as well as its policy implications.
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Exogenous money supply along with the stable money demand function is an important element
in the Monetarists„model that asserts the effectiveness of monetary policy. On the other hand,
post-Keynesians advocate the concept of endogeneity of money supply since the ultimate goal of
the economic activity is to create money. The debate over the exogenous and endogenous money
supply concepts has become in recent years an empirical issue. The history of modern monetary
economics has witnessed the emergence of two opposing views concerning the role of central
bank in managing the supply of money and (indirectly) the level of economic activities in an
economy.
The first group of economists known as Monetarists, under the influence of Milton Friedman,
contends that money supply in an economy is exogenously determined. This view is based on the
premise that money supply equals the money multiplier times the monetary base. Since the
central bank can change this base, it can control the supply of money in the economy.

The second group of economists labelled as Post Keynesians, posits that money supply is
endogenous rather than exogenous. Money supply is said to be endogenous or endogenously
determined if money creation occurs within the monetary system of an economy – rather than
being determined by external forces. What today has come to be known as Post Keynesian
economics is actually macroeconomics in a

Underlying Theory: Endogenous money is a major component of Post Keynesian economics. It

refers to the theory that the existence of money in an economy is driven by the requirements of
the real economy – that market forces combine with the central bank in establishing the money
supply (Pollin, 1991). The banking system reserves then, expand and contract as needed in order
to accommodate the demand for credit at prevailing interest rates. According to Palley (1992) the

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theory of endogenous money, maintain that money supply is endogenously determined by the

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joint actions of the monetary authority, the asset and liability management decisions of
commercial banks, the portfolio decisions of the non-bank public, and the demand for bank

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loans”. Further, underlines that the theory of endogenous money consists of five propositions:

i.
AP
The causality between money and income in the Quantity Theory of Money is reversed.
The supply of money is a function of profit expectation. The causality runs from profit
R
expectation (PE) – the expected (or desired) income of firms – to the demand for credit
(DC). It is the demand for credit that leads to the creation of money (MC). The creation
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of money through loans leads to the creation of effective demand (ED). The flow of
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causality can then be summarised as follows: PE → DC → MC → ED

ii. The causality between reserves (R), deposits (D) and loans (L) is reversed (see also
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Pollin, 1991: Lavoie, 1992): L →D → R. Being endogenous, bank reserves have no

causal influence on loans. This suggests the rejection of the money multiplier model.
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iii. The causality between savings and investment is reversed (see also Davidson, 1993;
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Shapiro, 2005). In other words, savings cannot cause investment (Lavoie, 1992).
Investment cannot be financed by savings because in a world of endogenous money it is
the creation of income resulting from an increase in investment that creates savings.
iv. The rate of interest is exogenous (see also Lavoie, 1996). Interest rate is not determined
by the market mechanism – it is determined neither by the supply of and the demand for
savings nor the supply of and the demand for money. The nominal interest rate is
exogenous because it is set by the central bank. Interest rate is exogenously determined
according to internal and external economic objectives.
v. The money supply is „demand-determined and credit driven.‟ Money which is primarily a
flow exists as a result of the demand for credit that allows firms to fulfil their expenditure
plans. Being endogenous, the supply of credit is determined by decision of commercial
banks
1.5 DERIVATION OF NARROW AND BROAD MONEY MULTIPLIERS
The total money supply is usually measured not in terms of Ms but as M1 , M 2 and M 3 . Therefore
the derivation of money multipliers of the first two M1 and M 2 of the total money supply and the
relationship of each with the monetary base or high powered money are shown below.

Narrow Money Definition ( M1 ) Measure of Money Supply

The narrow money supply equation is given as;
M1  D  C (4.14)
The monetary base or the high powered money equation is given as;
MB  RR  C (4.15)
The relationship between money supply M1 and monetary base can be expressed as the ratio of

L
M1 to MB. So divide equation (4.14) by (4.15)

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M1 DC
 (4.16)
MB C  RR

H
Divide the numerator and denominator of the right hand side of equation (4.16) by demand
deposit (D)
AP
R
D C

M1
 D D (4.17a)
E

MB RR  C
D D
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or
C
ID

1
M1 D
 (4.17b)
M

MB RR C

D D
BA

By substituting Cr for C/D and RRr for RR/D, equation (4.17b) becomes
M1 1  Cr
 (4.18)
MB RRr  Cr

Thus, Monetary Base is;

RRr  Cr
MB   M1 (4.19)
1  Cr

And Money Supply is;

1  Cr
M1   MB (4.20)
RRr  Cr
Equation (4.20) defines narrow money supply in terms of monetary base. It expresses the money
supply in terms of four determinants, MB, Cr and RRr.

Monetary Base Multiplier

The quotient of equation (4.20) is the money multiplier (m1), defined as (M1/MB) . Thus
1  Cr
m1  (4.21)
RRr  Cr
So the relationship between the money supply and monetary base of equation (4.20) becomes
M 1  m1MB (4.22)
Equation (4.21) expresses money supply as a function of money multiplier (m) and monetary base
(MB). The higher the value of the multiplier, the lower will be the reserve ratio (RRr) an\d the

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cash currency ratio (Cr).

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Broad Money Definition (M2) Measure of Money Supply

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M 2 is define as M1 plus Time Deposits (TD)
The money supply equation is given as; AP
M 2  D  C  TD (4.23)
The monetary base or the high powered money equation is given as;
R
MB  RR  ER  C (4.24)
E

The relationship between money supply M 2 and monetary base can be expressed as the ratio of
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M 2 to MB. So divide equation (4.23) by (4.24)

M2 D  C  TD

ID

(4.25)
MB RR  ER  C
Divide the numerator and denominator of the right hand side of equation (4.25) by demand
M

deposit (D)
BA

D C TD
 
M2 D D D
 (4.26)
MB RR ER C
 
D D D
By substituting Cr for C/D, Td for TD/D, RRr for RR/D and ERr for ER/D equation (4.26)
becomes
M2 1  Cr  Td
 (4.27)
MB RRr  ERr  Cr

Thus, Monetary Base is;

RRr  ERr  Cr
MB   M2 (4.28)
1  Cr  Td
And Broad Money Supply is;
1  Cr  Td
M2   MB (4.29)
RRr  ERr  Cr
Equation (4.29) defines broad money supply in terms of monetary base. It expresses the M 2 in
terms of four determinants, MB, Cr, RRr, Td and ERr.

Monetary Base Multiplier

The quotient of equation (4.29) is the broad money multiplier ( m2 ), defined as (M 2 /MB) . Thus
1  Cr  Td
m2  (4.30)
RRr  ERr  Cr

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So the relationship between the money supply and monetary base of equation (4.29) becomes

EA
M 2  m2 MB (4.31)
The value of the m2 multiplier is higher than that of m1 multiplier, because it leads to greater

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increase in the monetary base (MB). The higher the value of the multiplier ( m2 ), the lower will be
AP
the rate of Cr, RRr and ERr
R
Summary
E

In economics, the money supply or money stock, is the total amount of monetary assets available
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in an economy at a specific time. There are several ways to define "money supply," but standard
measures usually include currency in circulation and demand deposits (depositors' easily
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accessed assets on the books of financial institutions). The various types of money in the money
supply are generally classified as "M"s such as M0, M1, M2 and M3, according to the type and
M

size of the account in which the instrument is kept or incorporated in definition and the
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classification is country and research specific.

Exogenous money supply along with the stable money demand function is an important element
in the Monetarists„ model that asserts the effectiveness of monetary policy. On the other hand,
post-Keynesians advocate the concept of endogeneity of money supply since the ultimate goal of
the economic activity is to create money. Endogenous money is a major component of Post
Keynesian economics. It refers to the theory that the existence of money in an economy is driven
by the requirements of the real economy

4.6 SELF-ASSESSMENT QUESTIONS

4.1 If a bank holds 10% of its deposits in reserves, and if the currency to deposit ratio is 1%,
assuming that total monetary base is $1000, what will be the money supply for this
economy?
4.2 What effect would an increase in purchases of government securities by the CBN have on
money supply?
4.3 Determine whether the statements are true or false, if the CBN lowers the discount rate:
i. banks will tend to increase loans
ii. banks will squeeze their excess reserve holdings
iii. the money multiplier will increase
iv. the money supply will increase

SOLUTION TO SAQ 4.1

Recall that money supply is given by: M = B(cd + 1)/(cd + rd), where B = base, cd = currency to
deposit ratio, rd = reserve to deposit ratio. Hence in this example, M = 1000*(.01+1)/(.01+.1) =
9182.

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SOLUTION TO SAQ 4.2

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Increase the money supply. When the CBN either sells or buys government securities, the money
supply is affected. A sale of bonds will lower money supply since the CBN is in effect trading
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bonds for money, which is then being withdrawn from circulation. A purchase of bonds by the
CBN increases money, since the CBN is trading money for bonds
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SOLUTION TO SAQ 4.3

E

i. true
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ii. true
iii. true
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iv. true
A reduction in discount rates, will allow banks to expand lending. They will do this by
M

borrowing from the CBN. In addition, they will hold less excess reserves, since the penalty
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associated with reserves falling below the required minimum will be smaller. The reduction in
excess reserves will raise the value of the money multiplier, and in conjunction with increased
lending by banks, money supply will increase.

4.7 MUITIPLE-CHOICE QUESTIONS

1) Which of the following statements is correct:
a. the money supply does not play a role in sustained inflation
b. the CBN is “accommodating” when they decrease the money supply after the
government has increased G
c. inflation initiated by an increase in aggregate demand is referred to as demand-
pull inflation
 d. in order to avoid “crowding-out” after the government has increased G, the CBN
often decreases the money supply in order to lower the interest rates

2) The main reason the CBN cannot control the real interest rate is that?
a. M1 fluctuates too widely to allow interest rates to be easily controlled.
b. M2 fluctuates too widely to allow interest rates to be easily controlled.
c. it cannot control individual rates of time preference.
d. the real interest rate is mainly determined by the relative solvency of banks

3) The quantity of M1 demanded tends to vary inversely with market interest rates because
a. higher market interest rates lead the public to demand more money to make
investments with

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b. high interest rates discourage investments in fixed capital

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c. market interest rates represent the opportunity cost of holding M1
d. high interest rates encourage banks to make more loans

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AP
4) What is the principal means by which the central bank of Nigeria (CBN) attempts to
change the monetary base?
a. Discount loans
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b. Open market operations
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c. Changes in the required reserve ratio

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d. Moral suasion

5) The M1+ measure of money includes

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a. Small denomination time deposits.

M

b. Money market deposit accounts.

c. Demand deposits.
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d. Electronic funds transfers

6) Which of the following statements is correct:

a. the money supply does not play a role in sustained inflation
b. the CBN is “accommodating” when they decrease the money supply after the
government has increased G
c. inflation initiated by an increase in aggregate demand is referred to as demand-
pull inflation
d. in order to avoid “crowding-out” after the government has increased G, the CBN
often decreases the money supply in order to lower the interest rates

7) Which of the following assets would not be included in a theoretical definition of the
money supply?
 a. Gold coins.
b. Checking account deposits.
c. Currency.
d. All of the above.

8) Economists who prefer the M1+ measure of the money supply tend to emphasize which
function of money?
a. The medium of exchange function.
b. The standard of value function.
c. The store of value function.
d. The unit of account function.

9) If the Treasury buys $5 million in gold, the monetary base will

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a. fall by $5 million

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b. rise by $5 million
c. rise by $5 million times the money multiplier

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d. be unchanged because we are no longer on a gold standard
AP
10) The money supply in Canada is measured using M1, M2, M3 and M2+. The reason there
are so many measurements of the money supply is because
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a. money has many uses, which are reflected in the different measurements
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b. the money supply is too large to have only one measurement

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c. only the newer and broader measurements are correct but the older measurements
are still used so that historical comparisons are possible
d. the Bank of Canada wants to confuse the general public
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11) Monetary equilibrium occurs when the

a. growth in the money supply is zero
BA

b. existing supply of money is willingly held by households and firms in the

economy at the current rate of interest
c. nominal rate of interest equals the real rate of interest
d. growth of the money supply is proceeding at a constant rate

12) The CBN would tend to increase the money supply by

a. raising the bank rate
b. selling foreign currency reserves in the international market
c. selling government bonds on the open market
d. transferring government accounts from the CBN to the commercial banks

13) Reserves equal

a. deposits with the CBN plus holdings of Nigeria government securities
 b. currency in circulation plus vault cash
c. deposits with the CBN plus vault cash
d. currency outstanding plus currency in circulation

14) Why do banks avoid holding excess reserves?

a. The CBN levies a 10% penalty on any reserves held above the required level.
b. The CBN does not pay interest on reserves.
c. Savers are often reluctant to place their deposits with banks that hold excess
reserves.
d. The Office of the Comptroller of the Currency monitors excess reserves more
closely than any other bank asset.

15) The most frequently used tool for controlling the money supply is (are):

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a. regulation

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b. discount rates
c. reserve requirements

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d. open market operations
AP
16) The monetary aggregate M2 measures:
R
a. notes and coins in circulation
E

b. notes and coins in circulation + notes and coins in bank vaults

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c. notes and coins in circulation + demand deposits

d. notes and coins in circulation + demand deposits + savings deposits + small
denomination time deposits
ID
M

17) If the CBN sells government bonds from the public, money supply:
a. will decrease
BA

b. will increase
c. will be unaffected
d. will change, but the direction of this change will be unclear

SOLUTION TO MUITIPLE-CHOICE QUESTIONS 4.8

Questions 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

Answers C C C B C C A A B A B D C B D D A

RECOMMENDED BOOKS
Anyanwu, J.C (1993), “Monetary Economics, Theory, policy and institutions”
Jhingan, M.L. (2008), “Monetary Economics” 6th Edition

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 STUDY SESSION 5
THEORIES OF INTEREST RATES

INTRODUCTION

In this study session we shall discuss some of the important theories of interest rate such as the
classical and the loanable funds theory of interest rate, the Keynesian and the modern theory of
interest. To the classicalists, the rate of interest is basically determined by the supply of and
demand for capital. To the contrary, the loanable funds theorists who have been considered as
neo-classicalists explain the determination of interest rate in terms of demand and supply of
loanable funds or credit. Also, Keynes defined interest rate is as the reward of not hoarding but
the reward for parting with liquidity for the specified period. Keynesian sense, interest rate is
determined by the demand for and the supply of money.

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EA
Learning Outcome for Study Session 1
At the end of this study session, you should be able to
5.1 Define and use correctly all the key words printed in bold. (SAQ1)

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5.2 Explain the key issues in classical theory of interest rate and loanable funds theory. (SAQ2)
AP
5.3 Identify the difference between classical theory of interest rate and loanable funds theory.
(SAQ3)
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5.4 Provide the critique of the theories. (SAQ4)
5.5 Draw policy inference from the two theories. (SAQ5)
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5.6 Identify point of departure of Keynesian theory of interest rate from the classical theory of
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interest(SAQ6)
5.7 Provide a critique of Keynesian theory of interest rate (SAQ7)
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5.8 Explain IS and LM model in modern theory of interest. (SAQ8)

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BA

5.1 CLASSICAL THEORY OF INTEREST RATE

Classical theory asserts that rate of interest is determined by the supply of and demand for
capital. While supply of capital is governed by the time preference, the demand for capital is
guided by the expected productivity of capital. However, the two variables (time preference and
expected productivity of capital) depend upon saving or thrift habit of the society. The theory is,
therefore, sometime considered in the literature as the supply and demand theory of saving.

Demand of capital
The reasons for the demand for capital can be classified into two which include the demand for
productive reasons and the demand for consumptive purposes. Basically, capital is demanded by
the investors because it is productive. However, the productivity of capital is subject to the law
of variable proportions. This implies that additional units of capital are not as productive as the
earlier units. Thus, there will be period when the employment of an additional unit of capital in
the business fails to payback.

Supply of capital
The supply of capital is determined by savings, rather upon the will to save and the power to
save of the community. Some people just want to save irrespective of the prevailing rate of the
interest. There are others people who save because the current rate of interest is enough to induce
them to save. They would reduce their savings if the rate of interest fell below this level. Still
there are the potential savers who would be induced to save if the rate of interest were raised. To
the last two categories of savers, saving involves a sacrifice, abstinence or waiting when they
forgo present consumption in order to earn interest. The higher the rate of interest, the larger will
be the community savings and the more will be the supply of funds. The supply curve of capital

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or the saving curve thus moves upward to the right.

EA
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AP S
S1
d s
Rate of Income

R1
R

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E
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R3 d1
s1
ID

l
0
M

Q
Fig 5.1: Saving and
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Investment
Demand for capital and Supply of capital Intersection.
Let assume a given level of income in the society, the rate of interest is determined by the
interaction of the demand curve and the supply curve of saving. This is shown in Figure 1 where
I and S curves intersect at E which is the equilibrium point when OQ quantity of capital is
demanded and supplied at R rate of interest. If at any time the rate of interest rises above R, the
demand for investment funds will fall and the supply of savings will increase. Since the supply
of savings is more than the demand (R1s>R1 d), the rate of interest will come down to the
equilibrium level OR. The reverse will be the case if the rate of interest falls to R, The demand
for investment funds is greater than the supply of savings rate of interest will rise to R
Weakness of Classical Theory of Interest Rate
I. Income not Constant but Variable. Income of any society is not constant as assumed by
 theory
II. Saving-Investment Schedules not Independent. According to Keynes, the saving curve
and investment curve are not independent of one another.
III. Neglects the Effects of Investment on Income. The classical theory neglects the effect of
investment on the level of income.
IV. Neglects other Sources of Savings. The theory include savings out of current income in
the supply schedule of savings which makes it inadequate.

5.2 LOANABLE FUND THEORY OF INTEREST

The loanable funds theory explains the determination of interest in terms of demand and supply
of loanable funds or credit. The theorists assert that, the rate of interest is the price of credit,
which is determined by the demand and supply for loanable funds (Loanable funds is the sum
total of all the money people and entities in an economy has decided to save and lend out to

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borrowers as an investment rather than use for personal consumption). The concept was

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formulated by Knut Wicksell Swedish economist.

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Demand for Loanable Fund.
AP
The demand for loanable funds has primarily three sources, they are government, businessmen
and consumers who need them for purposes of investment, hoarding and consumption.
Households borrow to consume at the expense of lower future consumption. A rise in interest
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rates will mean that a larger amount of future consumption will be forgone for any given amount
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of borrowing. Therefore, the higher the interest rates, the lower the demand for loanable funds by
households. Similarly, Firms borrow to invest and a rise in interest rates will lead to higher costs
EL

of borrowing and hence less profitable planned investments. Therefore, the higher the interest
rates, the lower the demand for loanable funds by firms. Also, government borrows to finance a
ID

budget deficit. This is done through issuing securities such as bonds and bills.
M

Supply of Loanable Fund

BA

Basically, we can look at supply of loanable fund in term of household savings and retained
profit from firms. Households save to increase their future consumption. A rise in interest rates
will mean that a larger amount of future consumption will be made available for any given
amount of savings. Therefore, the higher the interest rates, the higher the supply of loanable
funds by households. Also, firms save when they retain a part of the profits that they make.
However, this does not depend so much on interest rates. Rather, firms make decisions regarding
retained profits based on factors such as the economic outlook, investment opportunities, etc.

Equilibrium
The law of supply and demand is applicable in the market for loanable funds. We can consider
the interest rate a lender earns or a borrower must pay as the price for the loan. Supply, as we
have stated above, is simply the amount of savings in the market that provides the money to fund
the loans. Demand is the level of investment seeking financing. As the interest rate on loanable
 funds increases, it becomes more expensive to borrow and the quantity of funds demanded will
decrease. On the other hand, as the interest rate for loanable funds increase, the supply of
loanable funds also increases because higher interests rates makes saving more financially
attractive.

Eventually, the interest rate for loanable funds will reach equilibrium where demand for loanable
funds equal the supply of loanable funds offered for investment. If the interest rate is lower than
the interest rate at equilibrium, then the amount of loanable funds available is less than the
demand for them. As a result, lenders will increase the interest they charge on loans until the rate
reaches the equilibrium point as the supply of funds increases due to increasing interest rates, and
the demand decreases because of the increased lending costs.

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Fig.5.2
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Weakness of Loanable Funds

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I. Equilibrium Rate reflects Unstable Equilibrium. The demand and supply schedules for
loanable funds determine the equilibrium rate of interest OR which does not equate each
component on the supply side with the corresponding component on the demand side
II. Hansen criticises the loanable funds theory as not providing us with a determinate
solution to the problem of rate of interest because the rate of interest cannot be known
unless the level of income is known; and the level of income cannot be known unless the
rate of interest is known.
III. The theory is an exaggeration of the functional relationship between the rate of interest
and savings. Critics argue that people usually save not for the sake of interest but out of
precautionary motives, where propensity to save is interest- inelastic.

Loanable Funds and Classical Theory Compared.

 I. The classical theory is a real theory of interest and neglects monetary influences on
interest. With the inclusion of real as well as monetary factors, the loanable funds theory
becomes superior to the classical theory.
II. The classicists neglect the role of bank credit as a constituent of money supply
influencing the rate of interest which is an important factor in the loanable funds theory.
III. The classicists also do not consider the role of hoarding. By including the desire to hoard
money in the demand for loanable funds, the loanable funds theory becomes more
realistic and brings us nearer to Keynes's liquidity preference theory.

5.3 KEYNESS LIQUIDITY PREFERENCE THEORY OF INTEREST

According to Keynes interest is purely a monetary phenomenon because rate of interest is
calculated in terms of money. It is a monetary phenomenon in the sense that rate of interest is
determined by the supply of and demand for money, Keynes defined interest as the reward for

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parting with liquidity for specified time.

EA
Meaning of liquidity preference

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Thus according to Keynes interest is the price paid for surrendering their liquid assets. Greater
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the liquidity preference higher shall be the rate of interest. The liquidity preference constitutes
the demand for money. According Keynes rate of interest is determined by supply of and
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demand for money. The rate of interest on the demand side is governed by the liquidity
preference of the community arises due to the necessity of keeping cash for meeting certain
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requirements.
EL

The demand for liquidity arises due to three motives.

(i) The transaction motive: An individual for his day to day transaction demand money. A man
ID

has to buy food and medicines in his day to day life. For this purpose people want to keep some
M

cash with them. The amount of cash which an individual will require to keep in his possession
depends on two factors (i) the size of personal income and (ii) the length of the time between
BA

pay-days. The richer a community the greater the demand for transaction motive.

(ii) The precautionary motive: People demand to hold money with them to meet the unforeseen
contingencies. An individual may become unemployed; he may fall sick or may meet serious
accident. For all these misfortune, he demands money to hold with him. The amount of money
under the precautionary motive depends on the individual's condition, economic as well as
political which he lives. Thus the demand for money under this motive depends on size of
income, nature of the person and farsightedness.

(iii) Speculative motive: Under speculative motive people want to keep each with them to take
advantage of the charges in the price of bonds and securities. People under speculative motive
hold money in order to secure profit from the future speculation of the bond market. In such a
situation the demand to hold cash diminishes. Thus liquidity preference will be more at lower
interest rates. According to Keynes, it is expectations about changes in bond prices or in the
current market rate of interest that determine the speculative demand for money. The speculative
demand for money is a decreasing function of the rate of interest.

Total Demand for Money

Money under the above three motives constitute the demand for money. An increase in the
demand for money leads to a rise in the late of interest, a decrease in the demand for money leads
to a fall in the rate of interest. According to Keynes the first two motives for liquidity preference
namely the transaction and precautionary are interest inelastic. That is why the speculative
motive is important in the sense that speculative motive is interest elastic.

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Supply money

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Supply of Money: The supply of money refers to the total quantity of money in the country.
Though the supply of money is a function of the rate of interest to a certain degree, yet it is

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considered to be fixed by the monetary authorities. Hence the supply curve of money is taken as
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perfectly inelastic represented by a vertical straight line.

Determination of the Rate of Interest:

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Like the price of any product, the rate of interest is determined at the level where the demand for
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money equals the supply of money. In the following figure, the vertical line QM represents the
supply of money and L the total demand for money curve. Both the curves intersect at E2 where
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the equilibrium rate of interest OR is established.

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M
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Fig 5.3

Weaknesses of Keynes theory of Interest Rate

1. It has been pointed out that the rate of interest is not purely a monetary phenomenon. It
has been argued that real forces like productivity of capital and thriftiness or saving by
the people also play an important role in the determination of the rate of interest.
 2. The liquidity preference theory does not explain the existence of different rates of
interest prevailing in the market at the same time.
3. The Keynesian theory only explains interest in the short-run. It gives no clue to the rates
of interest in the long run.
Liquidity Preference Theory of Interest and the Loanable Funds Theory Compared
I. The Keynesian theory is a stock analysis. It is a statement about stocks or quantities of
money at a point of time, while the loanable funds theory is a statement about certain
flows or quantities of money per time period.
II. The liquidity preference theory is more realistic than the loanable funds theory because it
is more akin to the behaviour of interest rate in the business world.
III. All the variables in the loanable funds theory like saving, investment, hoarding,
dishoarding are in terms of partial equilibrium analysis while the demand for and supply
of money in the Keynesian system have been treated as a part of the general determinate

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system.

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5.4 MODERN THEORY OF INTEREST AP
In general, it has been observed that no single theory of interest rate is adequate and determinate.
An adequate theory to be determinate must take into consideration both the real and monetary
R
factors that influence the interest rate. Consequently, Hicks utilized the Keynesian tools
demonstrate that productivity, thrift, liquidity preference and money supply are all necessary
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elements in a comprehensive and determinate interest theory. In the words of Hansen, "An
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equilibrium condition is reached when the desired volume of cash balances equals the quantity of
money, when the marginal efficiency of capital is equal to the rate of interest and finally, when
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the volume of investment is equal to the normal or desired volume of saving.

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To provide synthesis of loanable funds theory with the liquidity preference theory, four
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variables of the two formulations have been combined to construct two new curves, the IS curve
which represent flow variable of the loanable funds formulation (or the real factors of the
classical theory) and the LM curve representing the stock variables of liquidity preference
formulation. The equilibrium between IS and LM curves provides a determinate solution.

The IS Curve
IS, is a curve which explains the relationship between a family of saving schedules and
investment schedules. In other words, this curve shows the equality of saving and investment at
various combinations of the levels of income and the rates of interest. It was from derived from
the loanable funds formulation. In Figure 8 (A), the saving curve S in relation to income is drawn
in a fixed position, since the influence of interest on saving is assumed to be negligible. The
saving curve shows that saving increases as income increases, viz., saving is an increasing
function of income. Investment, on the other hand, depends on the rate of interest and the level of
income.

Given a level of interest rates, the level of investment rises with the level of income, at a 5 per
cent rate of interest, the investment curve is I2. If the rate of interest is reduced to 4 per cent, the
investment curve will shift upward to I3. The rate of investment will have to be raised to reduce
the marginal efficiency of capital to equality with the lower rate of interest. Thus the investment
curve I3 shows more investment at every level of income. Similarly when the interest rate is
raised to 6 per cent, the investment curve will shift downward to l1.The reduction in the rate of
investment is essential to raise the marginal efficiency of capital to equality with the higher
interest rate.

Similarly, in Figure 8 (B), IS curve is derived by marking the level of income at various interest

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rates. Each point on this IS curve represents a level of income at which saving equals investment

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at various interest rates. The rate of interest is represented on the vertical axis and the level of
income on the horizontal axis. If the rate of interest is 6 per cent, the lS curve intersects the I1

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curve at E. From this income level which equals N 100 a dashed line is drawn downward to
intersect the extended line from 6 per cent at point A. At interest rate 5 percent, the lS curve
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intersects the I2 curve at E2 so as to determine OY2 income N 200. Also in the in the graph, point
B corresponds to 5 per cent interest rate and N 200 income level. Similarly, the point C
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corresponds to the equilibrium of lS and I3 at 4 per cent interest rate. By connecting these points
A, B and C with a line, we get the IS curve. The IS curve slopes downward from left to right
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because as the interest rate falls, investment increases and so does income.
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(A)
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BA Saving and Investment

S
E3

E2 I3 (r =4%)

E1 I2 (r = 5%)

I1 (r=6%)

0 Y1 Y2 Y3 Income
Interest Rate

(B)
6 A
B
5
C
IS
4
Y1 Y2 Y3
100 200 300
The LM Curve
The LM curve shows all combinations of interest rates and levels of income at which the demand
for and supply of money are equal. The LM curve is derived from the Keynesian formulation of
liquidity preference schedules and the schedule of supply of money. A family of liquidity
preference curves L1Y1, L1Y2 and L3Y3 is drawn at income levels of N100, N 200 and N300
respectively in Figure 9 (A). These curves together with the perfectly inelastic money supply

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curve MQ give us the LM curve. The LM curve consists of a series of points, each point

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representing an interest-income level at which the demand for money (L) equals the supply of
money (M). If the income Level is Y1 , the demand for money (L1Y1) equals tie money supply

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(QM) at interest rate OR1 . At the (N200) income level, the L2,Y2 and the QM curves equal at
OR2 interest rate. Similarly at the Y3 (N 300 ) income level, the L3Y3 and QM res equal at OR3
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interest rate. The supply of money, the liquidity preference, the level of income and the rate of
interest provide information for the LM curve town in Figure 9 (B).
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Suppose the level of income is Y1 (N 100 ), as marked out on the income axis in Figure 9 (B).
The income of N100 generates a demand for money represented by the liquidity preference curve
E

L1Y1. From the point E1 where the L1Y1curve intersects the MQ curve, extends a dashed line
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horizontally to the right so as to meet the line drawn upward from Y1, at K in Figure 9 (B).
Points S and T can also be determined in a similar manner. By connecting these points K, S and
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T with a line, we get the LM curve. This curve relates different income levels to various interest
rates, but it does not show what the rate of interest will be.
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The LM curve slopes upward from left to right because given the quantity of money, an
increasing preference for liquidity manifests itself in a higher rate of interest. It also becomes
gradually perfectly inelastic shown as the vertical portion from T above on the LM curve in
Panel (B) of Figure 5.5 . This is because at higher income levels the demand for transaction and
precautionary motives increases so that little is left to satisfy the demand for speculative motive
out of a given supply of money.

(A)
(B)

L2 L3
LM
L1
Interest Rate

E3
T
R1
E2
Y3 (300)
S
R2
Y2 (200) K
R3
E1 Y1 (100)
 Fig.5.5

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Determination of the Rate Of Interest

EA
The IS and LM curves relate to income levels and interest rates. Taken by themselves they
cannot tell us either about the level of income or the rate of interest. It is only their intersection
that determines the rate of interest. This is illustrated in Figure 10 where the LM and IS curves

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intersect at point E and OR rate of interest is determined corresponding to the income level OY.
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The income level and the interest rate lead to simultaneous equilibrium in the real (saving-
investment) market and the money (demand and supply of money) market. This general
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equilibrium position persists at a point of time. If there is any deviation from this equilibrium
position, certain forces will act and react in such a. manner that the equilibrium will be restored.
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ID
M

LM
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B D
Interest Rate

R1
E
R

R2 C
A
IS
0 Y1 Y Y2 Income
Fig.5.6

Weaknesses
 I. Static Theory. It is a static theory that explains the short-run behaviour of the economy.
Thus it fails to explain how the economy behaves in the long run
II. Interest Rate not Flexible. The theory is based on the assumption that the interest rate is
flexible and varies with changes in LM or/and IS curves. But it may not always happen if
the interest rate happens to be rigid because the adjustment mechanism will not take place
III. Investment not Interest Elastic. The theory assumes that investment is interest elastic. But
if investment is interest inelastic, as is generally the case in practice, then the Hicks-
Hansen theory does not hold good
IV. Price Level Exogenous Variable. The price level is treated as an exogenous variable in
this model. This is unrealistic because price changes play an important role in the
determination of income and interest rates in an economy.

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Summary

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Classical theory asserts that rate of interest is determined by the supply of and demand for
capital. While supply of capital is governed by the time preference, the demand for capital is

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guided by the expected productivity of capital.
AP
According to loanable theorists ,there are three sources of demand for loanable funds which
are; government, businessmen and consumers who need them for purposes of investment,
hoarding and consumption.
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The supply of capital is determined by savings, rather upon the will to save and the power to
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save of the community

The loanable funds theory explains the determination of interest in terms of demand and
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supply of loanable funds or credit.

Loanable funds is the sum total of all the money people and entities in an economy has
ID

decided to save and lend out to borrowers as an investment rather than use for personal
M

consumption.
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5.5 Self-Assessment Question

1. If the current market interest rate for loanable funds is below the equilibrium level, then
the quantity of loanable funds (SAQ1)
a) demanded will exceed the quantity of loanable funds supplied and the interest rate will
rise
b) supplied will exceed the quantity of loanable funds demanded and the interest rate will
rise.
c) demanded will exceed the quantity of loanable funds supplied and the interest rate will
fall.
d) supplied will exceed the quantity of loanable funds demanded and the interest rate will
fall
2. What would happen in the market for loanable funds if the government were to decrease
the tax rate on interest income? (SAQ2)
a. The supply of and demand for loanable funds would shift right.
b. The supply of and demand for loanable funds would shift left.
c. The supply of loanable funds would shift right and the demand for loanable funds
would shift left.
d. None of the above is correct.
3. If the quantity of loanable funds supplied is greater than the quantity demanded, then
(SAQ3)
a. there is a shortage of loanable funds and the interest rate will fall.
b. there is a shortage of loanable funds and the interest rate will rise.
c. there is a surplus of loanable funds and the interest rate will fall.
d. there is a surplus of loanable funds and the interest rate will rise.

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4. If at some interest rate the quantity of money demanded is greater than the quantity of

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money supplied, people will desire to (SAQ4)
a. sell interest bearing assets causing the interest rate to decrease.

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b. sell interest bearing assets causing the interest rate to increase.
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c. buy interest bearing assets causing the interest rate to decrease.
d. buy interest bearing assets causing the interest rate to increase
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5. In the loanable funds theory of interest determination, an increase in the productivity of
capital equipment should lead to: (SAQ5)
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a. Higher interest rates

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b. A reduction in the amount of saving

c. Higher prices
d. More employment
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e. A reduction in interest rates

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6. If there is excess money supply, people will (SAQ6)

a. deposit more into interest bearing accounts, and the interest rate will fall.
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b. deposit more into interest bearing accounts, and the interest rate will rise.
c. withdraw money from interest bearing accounts, and the interest rate will fall.
d. withdraw money from interest bearing accounts, and the interest rate will rise
7. Changes in the interest rate bring the money market into equilibrium according to
(SAQ7)
a. both liquidity preference theory and classical theory.
b. neither liquidity preference theory nor classical theory.
c. liquidity preference theory, but not classical theory.
d. classical theory, but not liquidity preference theory
8. In the open-economy macroeconomic model, the market for loanable funds identity can
be written as (SAQ8)
a. S=I
 b. S = NCO
c. S = I + NCO
d. S + I = NCO

9. Other things the same, a higher real interest rate raises the quantity of (SAQ9)
a. domestic investment.
b. net capital outflow.
c. loanable funds demanded.
d. loanable funds supplied.
10. The supply of loanable funds comes from(SAQ10)
a. national saving.
b. national saving and domestic investment.
c. domestic investment and net capital outflow.

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d. national saving, domestic investment, and net capital outflow

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11. If savers decide to save more, ceteris paribus, the loanable funds theory predicts:
a. A fall in the exchange rate

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b. A reduction in interest rates and more investment
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c. A reduction in investment and interest rate
d. Higher economic growth
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e. An increase in investment and interest rates
12. According to the liquidity preference theory of interest, an increase in uncertainty, other
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things being equal, will:

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a. Raise interest rate

b. Reduce the supply of money
c. Decrease output and employment
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d. Increase risk aversion

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e. Reduce the demand for money

13. In Keynesʹs liquidity preference framework, individuals are assumed to hold their wealth
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in two forms:
a. money and gold.
b. real assets and financial assets.
c. stocks and bonds.
d. money and bonds
e. No of the above
14. The liquidity preference theory distinguishes between __________
a. Nominal and real quantities
b. Money and financial assets
c. Buying goods and earning interest income
d. All of the above
e. None of the above
 15. According to liquidity preference theory, an increase in the price level would
__________.
a. Increase the demand for real money balances
b. Decrease the supply of real money balances
c. Decrease the real interest rate
d. All of the above

Solutions:
Questions 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Answers A A C C A A A A D D B B D A

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Suggestion for further reading

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 Monetary Economics by M.L Jhingan 7th edition published by Vrinda Publication (P) Ltd
 Money And Banking By E. Narayanan Nadar Phi Learning Pvt. Ltd., Jun 21, 2013

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 Mishkin, Frederic S. The economics of money, banking, and financial markets / Frederic
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S. Mishkin.—7th ed.
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ID
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 STUDY SESSION 6
THE CONCEPT OF INFLATION
INTRODUCTION
Inflation is a very old problem and the problem still persists till today in fact, some countries
have been reported to experience rates as high as 40 percent per month in recent times.
Generally, Inflation is described as a persistent rise in the general price level not in the price of a
particular commodity. And, It can result from either an increase in aggregate demand—demand-
pull inflation—or a decrease in aggregate supply—cost-push inflation. Why does inflation occur
and how do our expectations of inflation influence the economy. These and many more will be
the focus of this study session.

Learning Outcome for Study Session Nine

At the end of this study session, you should be able to

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6.1 Define and use correctly all the key words printed in bold, (SAQ1)

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6.2 Explain the concept of inflation.(SAQ2)
6.3 Determine inflation rate.(SAQ3)

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6.4 Explain types of inflation.(SAQ4)
6.5 Identify the causes of inflation(SAQ5).
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6.1 Definition of Inflation
In economics literature Inflation has been considered as a phenomenon of continuous rise in the
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general price level of goods and services. Inflation is not a rise in the prices of one or just few
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goods, and it is also not a just one-time rise in the prices of most commodities. During
inflationary periods, prices of few goods may fall, but prices of most goods rise. Inflation can
also be defined as a decline in the value or purchasing power of money. Combining these two
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definitions, Inflation can simply be defined as a process in which the price level is rising and
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money is losing value. Inflation is a very important macroeconomic variable and several reasons
have been put forward as the likely cause depending on the school of taught involves. Majorly,
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Inflation maybe as a result of increasing money supply without corresponding increase in supply
of goods and services and a continuous fall in supply of goods and services due to continuous
rise in cost of production. Thus, an increase in money supply can be a reason of inflation or
increase in cost of production.

6.2 Causes of Inflation

Inflation can result from either an increase in aggregate demand— demand-pull inflation—or a
decrease in aggregate supply—cost-push inflation.
Demand-Pull Inflation
Demand-pull inflation is an inflation that results from an initial increase in aggregate demand
over available output. But why does aggregate demand rise? Classical economists attribute this
rise in aggregate demand to increase in money supply. In other words, when people have more
money to buy things, but there aren't enough of the things people want to buy. Therefore,
according to the predictions of the Supply and Demand model, this will cause an increase in the
price of the goods suffering a shortage. This is due to the scarcity of the goods relative to the
increase in the amount of money in the hands of consumers who wish to purchase them (demand
exceeds supply --> shortage --> an increase in price). On the other hand Keynesians argued that
there can be autonomous increase in aggregate demand or spending with no increase in money
supply.

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Fig. 6.1
From figure 7.1, AD1 is the initial aggregate demand curve that intersects the aggregate supply
curve AS at point E1. Thus the price level is determined at OP1. As the aggregate demand curve
shift to AD2, price level rises to OP2. In conclusion, an increase in aggregate demand at the full
employment stage leads to increase in price level only, rather than the level of output.

Cost-Push Inflation
Cost -push inflation: This type of inflation occurs as a result of increase in cost of production
which shifts the aggregate supply leftward. Cost of production may rise due to increase in the
price of raw materials, wages e.t.c. Cost -push inflation are caused by supply-side factor. For
example, if prices of some key inputs like oil rise, producers will have to either adjust output
supply or translate the higher costs into higher output prices. When output declines because of
cost pressure on producers there will be a shortage in output markets and prices will rise as a
result, ceteris paribus. Prices may also rise as a result of uncertainty about future market
condition.

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Fig 6.2
Intersection point (E1) of AD and SARA1 curves determined the price level, now there is a
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leftward shift of aggregate supply curve to SRAS2. With no change in aggregate demand, this
causes price level to rise to OP2 and output to OY2.
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6.3 Types of inflation

Inflation can be classified using the intensity or speed. Based on that, we have the following type
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of inflation
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 Creeping inflation: If the speed of upward thrust in prices is very low then we have
creeping inflation. What speed of annual price rise is a creeping has not been stated by
the economists? But some economists have considered inflation rate of 2% to 3% as
creeping inflation.
 Walking Inflation: If the rate of annual price increase lies between 3% to 4% then we
have a situation walking inflation. It emerges principally due to failure to maintain
creeping inflation. But the two types of inflation (Creeping and Walking) can be regarded
as moderate inflation.
 Galloping and Hyperinflation: This is an extreme form of inflation when an economy
gets shattered. When inflation turns double or triple digit inflation percent a year it is
considered galloping inflation.

6.4 How Inflation is Measured and the Inflation Rate Calculated

For measuring inflation, an aggregate representation of prices of commodities is needed. Such a
general price level is represented through a price index; GDP deflator is one such price index.
There are other price indices also, most notably the Consumer Price Index (CPI) and the
Producer Price Index (PPI).

GDP Deflator
GDP Deflator is the ratio of the value of aggregate final output at current market prices
(Nominal GDP) to its value at the base year prices (Real GDP). In effect the basket of goods for
the construction of this price index includes all the final output produced within the geographic
boundaries of the country. GDP Deflator can be considered the most comprehensive measure of
inflation since a wide array of goods and services are included in its construction. But it may not
reflect the full impact of inflation on consumer welfare because it does not include imported

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goods and services that constitute a significant portion of what people buy.

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GDP Deflator = Nominal GDP/ Real GDP

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Note


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Nominal GDP is the sum value of all produced goods and services at current prices.
 Real GDP is the sum value of all produced goods and services at constant prices. The
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prices used in the computation of real GDP are gleaned from a specified base year
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The first step to calculating real GDP is choosing a base year.

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Example
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In year 1 Country N produced 5 bananas worth N1 each and 5 bags of cocoa worth N6 each. In
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year 2 Country N produced 10 bananas worth N1 each and 7 bag of cocoa worth N6 each. . In
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year Country N produced 10 bananas worth N 2 each and 9 bag of cocoa worth N6 each.
Calculate the GDP deflator for Country N in year 3 using year 1 as the base year.

In order to find the GDP deflator, we first must determine both nominal GDP and real GDP in
year 3.

Nominal GDP in year 3 = (10 X N2) + (9 X N6) = N74

Real GDP in year 3 (with year 1 as base year) = (10 X N1) + (9 X N6) = N64
The ratio of nominal GDP to real GDP is ( N 74 / N 64 ) = 1.156

We can estimate inflation rate from GDP deflator by multiplying our GDP deflator by 100.
1.156* 100 = 115.6
This means that the price level rose approximately 16% from year 1, the base year, to year 3,
thus, there prevailing inflation rate in the economy is 16%. The formula and the procedures are
the same for any price index, the only difference among different price indices is the items that
go into the market basket.

CONSUMER PRICE INDEX (CPI)

We can described CPI is the cost of purchasing a market basket of consumption goods by a final
consumer during a given period of time usually a month, relative to the cost of purchasing the
same market basket in the base year. We can demonstrate the method of computing CPI with a
hypothetical example in Table 5.1 below.

Table 5.1: Construction of Price Index

Monthly Market 1985 1996 Cost of market basket Cost of market basket

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Basket Prices(N) Prices(N) in 1985(N) in 1996(N)

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60 gala 1.60 3.20 96.00 192.00

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4 T-shirts 10.00 18.00 40.00 72.00

2 jeans 24.00 24.00

AP 48.00 48.00
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1 compact disc 16.00 12.00 16.00 12.00

Total Cost of Basket 200.00 324.00

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CPI 100 162

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Let 1985 be the base year. When constructing a price index, its value is normalized to 100 in the
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base year. Then, the value of price index in any year t can be calculated as:
Cost of market basket in Year t
PI t 
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x100
Cost of market basket in Base Year

We can estimate CPI in 1996 as follow:

CPI = (324/200)*100 = 162,
This implies that the general price level increased by 62 percent during the 11-year period from
1985 to 1996. The above is a general formula for calculation of any price index. In CPI the
market basket consists of only the consumption goods, because the objective is to measure the
effect of inflation on households.

PROBLEMS WITH CPI AS MEASUREMENT OF INFLATION

 Since the CPI represents the expenditure of the ‗average‘ household, inevitably it will be
inaccurate for the ‗non-typical‘ household.
  Single people have different spending patterns from households that include children,
young from old, male from female, rich from poor and minority groups.
 We all have our own ‗weighting‘ for goods and services that does not coincide with that
assigned for the consumer price index.

INFLATION MEASUREMENT
Generally, inflation in any year t (πt) is measured as the percentage change in price index from
the previous period:

PI t  PI t 1
(Equation 2) t  x100%
PI t 1

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Calculation of Inflation Rate

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Year Price Index Inflation Rate, %
1990 100 -

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1991 110 {(110-100/100}*100=11%
1992 121 {(121-110)/110}*100=10%
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6.5 Effect of inflation
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 Transactions costs. People spend money more rapidly when they anticipate high inflation
and so transact more frequently, thereby incurring more transactions costs.
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 Tax consequences. Inflation reduces the after-tax return from saving, which decreases
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capital accumulation and long-term economic growth.

 Increased uncertainty. A high inflation rate increases uncertainty, which makes long-
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term planning for investment more difficult and leads people to spend time forecasting
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inflation rather than undertaking more productive activities.

 Inflation lowers the real wage rate and employers gain at the expense of workers.
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 If the inflation rate is unexpectedly high, borrowers gain but lenders lose

6.6 Control of Inflation

Causes of inflation are many and varied but its management can basically be traced to policies
that slow down the growth of AD ( Demand management policy) and policies that boost the rate
of growth of aggregate supply AS ( supply side policy). Demand side policy can take the form
of either fiscal policy or monetary policy or both.
 Fiscal policy:

a. Controlling aggregate demand is important if inflation is to be controlled. If the

government believes that AD is too high, it may choose to ‗tighten fiscal policy‘
by reducing its own spending on public and merit goods or welfare payments
b. It can choose to raise direct taxes, leading to a reduction in real disposable income
 c. The consequence may be that demand and output are lower which has a negative
effect on jobs and real economic growth in the short-term

 Monetary policy:
a. A ‗tightening of monetary policy’ involves the central bank introducing a period
of higher interest rates to reduce consumer and investment spending
b. Higher interest rates may cause the exchange rate to appreciate in value bringing
about a fall in the cost of imported goods and services and also a fall in demand
for exports (X)
 Supply side economic policies:

Supply side policies seek to increase productivity, competition and innovation –

all of which can maintain lower prices. The following measures constitute supply

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side policies

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 A reduction in company taxes to encourage greater investment

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 A reduction in taxes which increases risk-taking and incentives to work –
a cut in income taxes can be considered both a fiscal and a supply-side
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policy
 Policies to open a market to more competition to increase supply and
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lower prices.
 The prices of some utilities such as water bills are subject to regulatory
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control – if the price capping regime changes, this can have a short-term
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effect on the rate of inflation

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6.7 Theories of inflation

Several theories of inflation exist in economics literature but they can be sharply divided along
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monetarists‘ theory of inflation and Keynesian theory of inflation.

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Monetarists’ Theory of Inflation

The monetarist emphasise the importance of money as the major cause of inflation. They argue
that inflation is always a monetary phenomenon. The simplest explanation is contained in
quantity theory of money.

Where M is the supply of money, V stands for velocity of circulation, P is the general price level
and Q is the level of output in the economy.
Let us assume that V and Q are constant, the price level P varies proportionately with the supply
of money (M). Given that the economy as at full employment due to the assumption of flexible
wage rate. The capital stock, labour force and technology can only change gradually overtime.
The implication of this is that, the amount of money spent would not affect the real output in the
economy so that doubling of quantity of money would only result in doubling of the price level.
The price level would continue to rise until it rises just in the same with quantity of money as
individual and firms would have excess cash which they would spend if the price level still falls
below that level.
According to Friedman, ‗‗inflation is always and everywhere a monetary phenomenon that arises
from a more rapid expansion in the quantity in the quantity of money than in total output‘‘. He
argues that changes in the quantity of money will work through to cause changes in nominal
income and people will continue to spend their excess cash balances since the demand for money
is fairly stable. This excess spending will result to inflation.

Keynesian Theory of Inflation

The Keynesian approach does not offer much insight into movements of the price level. The
simplest variant of it that will do so is based on the view that inflation arises entirely from
attempts to buy more goods and services than can be supplied—i.e., more than can be produced

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at the ―full employment‖ level of activity. If, for example, government expenditure is higher than

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the difference between production and consumption at the level corresponding to full
employment, there is an ―inflationary gap.‖ The market process closes this gap by bidding up of

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prices to the point at which the difference between income and consumption, in money terms, is
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big enough to accommodate the government expenditure. (In an economy open to foreign trade,
the gap may be closed wholly or in part by the creation of an import surplus). The theory fails to
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account for the experience in the decades after World War II of continuous inflation in
conditions that do not suggest the existence of an inflationary gap.
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Summary of the Study Session

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.Inflation is not a rise in the prices of one or just few goods, and it is also not a just one-
time rise in the prices of most commodities. Inflation is a phenomenon of continuous rise
in the general price level of goods and services. Generally, inflation in any year t (πt) is
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measured as the percentage change in price index from the previous period:
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PI  PI t 1
t  t x100%
PI t 1
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Causes of inflation are many and varied but its management can basically be traced to policies
that slow down the growth of AD (Demand management policy) and policies that boost the rate
of growth of aggregate supply AS (supply side policy).Several theories of inflation exist in
economics literature but they can be sharply divided along monetarists‘ theory of inflation and
Keynesian theory of inflation.

6.8 Self-Assessment Question

1. Inflation can defined as (SAQ1)
a) persistant rise in general price level
b) persistant fall in general price level
c) an Increase purchasing power
d) . increase in Value of money
2. What will be likely to cause inflation in an economy?(SAQ2)
a) decrease in the cost of production
b) a decrease in total expenditure
c) An increase in productivity
d) An increase in the average wage level

3. Demand pull inflation is caused by (SAQ3)

a) Aggregate supply exceeds aggregate demand
b) Aggregate Demand exceeds aggregate supply
c) Aggregate demand and aggregate supply change in same direction.
d) Fall in equilibrium price

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4. Cost push inflation is caused by (SAQ4)

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a) An increase in the price of raw- materials, wage rate, rent
b) A reduction in aggregate demand

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c) An increase Aggregate supply
d) An increase in factors of production
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5. Which of the following is the most obvious sign of inflation? (SAQ5)
a) An increase in imports
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b) A rise in the national debts

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c) A rise in the rate of interest

d) A rise in retail prices
6. Fiscal policy deals with (SAQ5)
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a) Import and export

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b) Taxation and public expenditure

c) Public expenditure and money supply
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d) Taxation and interest rate

7. To reduce the rate of inflation, the government should(SAQ7)
a) Increase public expenditure
b) Encourage consumer spending
c) Increase income tax
d) Reduce interest rate.
8. If the price level was 100 in 1999 and 102 in 2000, the inflation rate was(SAQ8)
 (a) 102%.
(b) 20%.
(c) 2%.
(d) 0.2%.
9. If the CPI was 132.5 at the end of 2003 and 140.2 at the end of 2004, the inflation rate
over these two years was (SAQ9)
a) 7.7 percent.
b) 5.4 percent.
c) 4.4 percent.
d) 5.8 percent.
10. The technique currently used to calculate the CPI implicitly assumes that over time
consumers buy (SAQ10)

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a) relatively more of goods whose relative prices are rising.

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b) relatively less of goods whose relative prices are rising.
c) the same relative quantities of goods as in a base year.

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d) goods and services whose quality improves at the rate of growth of real income

Solutions:
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Questions 1 2 3 4 5 6 7 8 9 10
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Answers A D B A D B C C A C
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Suggestion for further reading

Monetary Economics by M.L Jhingan 7th edition published by Vrinda Publication (P) Ltd
ID

Money And Banking By E. Narayanan Nadar Phi Learning Pvt. Ltd., Jun 21, 2013
Mishkin, Frederic S. The economics of money, banking, and financial markets / Frederic S.
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Mishkin.—7th ed.
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 STUDY SESSION 7
CENTRAL BANKING: HISTORY, FUNCTIONS AND OPERATIONS

INTRODUCTION
This session take a wider look at Central Banking from a wider perspective. Central banking
is not unique or peculiar to Nigeria. All over the world, countries have their own central
banks. A central bank has the responsibility of managing the volume of money in circulation
and by implication it can also influence the general level of prices in the economy. So, all
over the world, Central Banks are charged with the control and protection of the nation‟s
currency as well as their external values. Central Banking all over the world is primarily non-
profit making ventures. Also, in this session, the Central Bank of Nigeria will be further
examined in terms of its establishment, its objectives, the management, and its economic
functions.

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LEARNING OUTCOMES FOR STUDY SESSION 7

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At the end of this study Session, you should be able to:
At the end of this study session, you should be able to
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7.1 understand correctly the meaning of a bank (SAQ 7.1)
7.2 define correctly the concept “Central Banking” (SAQ 7.2)
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7.3 explain and outline the history and evolution of central bank (SAQ 7.3)
7.4 discuss the different functions of the central bank (SAQ 7.4)
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7.5 understand how central banks conduct monetary policy(SAQ 7.5)

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7.6 understand the main monetary policy instruments of the central bank (SAQ 7.6)
7.7 explain the independence of central banks (SAQ 7.7)
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7.8 explain what the Central Bank of Nigeria (CBN) is all about (SAQ 7.8)
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7.1 MEANING OF A BANK

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The term „Bank‟ has been defined in different ways by different economists. A few definitions
are: According to Walter Leaf “A bank is a person or corporation which holds itself out to
receive from the public, deposits payable on demand by cheque.” Horace White has defined a
bank, “as a manufacture of credit and a machine for facilitating exchange.” According to Prof
Kinley, “A bank is an establishment which makes to individuals such advances of money as may
be required and safely made, and to which individuals entrust money when not required by them
for use.” The Banking Companies Act of India defines Bank as “A Bank is a financial institution
which accepts money from the public for the purpose of lending or investment repayable on
demand or otherwise withdrawable by cheques, drafts or order or otherwise.” Thus, we can say
that a bank is a financial institution which deals in debts and credits. It accepts deposits, lends
money and also creates money. It bridges the gap between the savers and borrowers. Banks are
not merely traders in money but also in an important sense manufacturers of money.
According to Crowther, "The banker's business is to take the debts of other people to oiler his
own in exchange, and thereby create money”. A similar definition has been given by Kent who
defines a bank as "an organisation whose principal operations are concerned with the
accumulation of the temporarily idle money of the general public for the purpose of advancing to
others for expenditure. Sayers, on the other hand, gives a still more detailed definition of a bank
thus: "Ordinary banking business consists of changing cash for bank deposits and hank deposits
for cash; transferring bank deposits from one person or corporation (one 'depositor') to another;
giving bank deposits in exchange for bills of exchange, government bonds, the secured or
unsecured promise of businessmen ID repay, etc. Thus a bank is an institution which accepts
deposits from the public and in turn advances loans by creating credit. It is different from other
financial institutions in that they cannot create credit though they may be accepting deposits and
making advances (see Jhingah, 2008)

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Banks also serve often under-appreciated roles as payment agents within a country and between

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nations. Not only do banks issue debit cards that allow account holders to pay for goods with the
swipe of a card, they can also arrange wire transfers with other institutions. Banks essentially

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underwrite financial transactions by lending their reputation and credibility to the transaction; a
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check is basically just a promissory note between two people, but without a bank's name and
information on that note, no merchant would accept it. As payment agents, banks make
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commercial transactions much more convenient; it is not necessary to carry around large
amounts of physical currency when merchants will accept the checks, debit cards or credit cards
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that banks provide.

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Broadly speaking, banks can be classified into central bank and commercial banks (financial
institutions). Commercial banks are those which provide banking services for profit. The central
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bank has the function of controlling commercial banks and various other economic activities.
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There are many types of commercial banks (financial institutions) such as deposit banks,
industrial banks, savings banks, agricultural banks, exchange banks, and miscellaneous banks.
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7.2 DEFINITION OF CENTRAL BANKING

A central bank, reserve bank, or monetary authority is an institution charged with the
responsibility of regulating or that manages a state's currency, money supply, and interest rates.
The Central Bank of a country is regarded as the apex regulatory institution of the financial
system of that country. Central banks also usually oversee the commercial banking system of
their respective countries. In contrast to a commercial bank, a central bank possesses a monopoly
on increasing the amount of money in the nation, and usually also prints the national currency,
which usually serves as the nation's legal tender. Examples include the European Central Bank
(ECB), the Federal Reserve of the United States and Central Bank of Nigeria.

There is no standard terminology for the name of a Central Bank, but many countries use the
"Bank of Country" form (for example: Bank of England (which is in fact the central bank of the
United Kingdom as a whole), Bank of Canada, Central Bank of Nigeria, Bank of Mexico; But
the Bank of India is a (government-owned) commercial bank and not a central bank). Some are
styled "national" banks, such as the National Bank of Ukraine, although the term national bank is
also used for private commercial banks in some countries. In other cases, central banks may
incorporate the word "Central" (for example, European Central Bank, Central Bank of Ireland,
Central Bank of Brazil); but the Central Bank of India is a (government-owned) commercial
bank and not a central bank. The word "Reserve" is also often included, such as the Reserve
Bank of India, Reserve Bank of Australia, Reserve Bank of New Zealand, the South African
Reserve Bank, and U.S. Federal Reserve System. Other central banks are known as monetary
authorities such as the Monetary Authority of Singapore, Maldives Monetary Authority and
Cayman Islands Monetary Authority. Many countries have state-owned banks or other quasi-
government entities that have entirely separate functions, such as financing imports and exports.

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In some countries, particularly in some Communist countries, the term national bank may be

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used to indicate both the monetary authority and the leading banking entity, such as the Soviet
Union's Gosbank (state bank). In other countries, the term national bank may be used to indicate

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that the central bank's goals are broader than monetary stability, such as full employment,
industrial development, or other goals.
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7.3 HISTORICAL DEVELOPMENT OF CENTRAL BANKING
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As the first public bank to "offer accounts not directly convertible to coin", the Bank of
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Amsterdam established in 1609 is considered to be the precursor to modern central banks. The
central bank of Sweden was founded in Stockholm from the remains of the failed bank
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Stockholms Banco in 1664 and answered to the parliament. One role of the Swedish central bank
was lending money to the government.
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The establishment of the Bank of England in 1694, the model on which most modern central
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banks have been based, was devised by Charles Montagu, 1st Earl of Halifax, in 1694, to the
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plan which had been proposed by William Paterson three years before, but had not been acted
upon. He proposed a loan of £1.2M to the government; in return the subscribers would be
incorporated as The Governor and Company of the Bank of England with long-term banking
privileges including the issue of notes. The Royal Charter was granted on 27 July through the
passage of the Tonnage Act 1694.

Although some would point to the 1694 establishment Bank of England as the origin of central
banking, it did not have the functions as a modern central bank, namely, to regulate the value of
the national currency, to finance the government, to be the sole authorised distributor of
banknotes, and to function as a 'lender of last resort' to banks suffering a liquidity crisis. The
modern central bank evolved slowly through the 18th and 19th centuries to reach its current
form.
Although the Bank was originally a private institution, by the end of the 18th century it was
increasingly being regarded as a public authority with civic responsibility toward the upkeep of a
healthy financial system. The currency crisis of 1797, caused by panicked depositors
withdrawing from the Bank led to the government suspending convertibility of notes into specie
payment. The bank was soon accused by the bullionists of causing the exchange rate to fall from
over issuing banknotes, a charge which the Bank denied. Nevertheless, it was clear that the Bank
was being treated as an organ of the state.

Henry Thornton, a merchant banker and monetary theorist has been described as the father of the
modern central bank. An opponent of the real bills doctrine, he was a defender of the bullionist
position and a significant figure in monetary theory, his process of monetary expansion
anticipating the theories of Knut Wicksell regarding the "cumulative process which restates the
Quantity Theory in a theoretically coherent form". As a response 1797 currency crisis, Thornton

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wrote in 1802 An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, in

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which he argued that the increase in paper credit did not cause the crisis. The book also gives a
detailed account of the British monetary system as well as a detailed examination of the ways in

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which the Bank of England should act to counteract fluctuations in the value of the pound.
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Until the mid-nineteenth century, commercial banks were able to issue their own banknotes, and
notes issued by provincial banking companies were commonly in circulation. Many consider the
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origins of the central bank to lie with the passage of the Bank Charter Act of 1844. Under this
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law, authorisation to issue new banknotes was restricted to the Bank of England. At the same
time, the Bank of England was restricted to issue new banknotes only if they were 100% backed
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by gold or up to £14 million in government debt. The Act served to restrict the supply of new
notes reaching circulation, and gave the Bank of England an effective monopoly on the printing
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of new notes. The Bank accepted the role of 'lender of last resort' in the 1870s after criticism of
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its' lacklustre response to the Overend-Gurney crisis.

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7.4 FUNCTION OF A CENTRAL BANK

The primary function of a Central Bank is to manage the nation's money supply (monetary
policy), through active duties such as managing interest rates, setting the reserve requirement,
and acting as a lender of last resort to the banking sector during times of bank insolvency or
financial crisis. Central Banks usually also have supervisory powers, intended to prevent bank
runs and to reduce the risk that commercial banks and other financial institutions engage in
reckless or fraudulent behavior. Central banks in most developed nations are institutionally
designed to be independent from political interference. Still, limited control by the executive and
legislative bodies usually exists. The chief executive of a central bank is normally known as the
Governor, President or Chairman.
Functions of a central bank may include:
i. implementing monetary policies
ii. determining Interest rates
 iii. controlling the nation's entire money supply
iv. the Government's banker and the bankers' bank ("lender of last resort")
v. managing the country's foreign exchange and gold reserves and the Government's stock
register
vi. setting the official interest rate – used to manage both inflation and the country's
exchange rate – and ensuring that this rate takes effect via a variety of policy mechanisms
vii. regulating and supervising the banking industry. In some countries a central bank through
its subsidiaries controls and monitors the banking sector. It examines the banks' balance
sheets and behaviour and policies toward consumers. Apart from refinancing, it also
provides banks with services such as transfer of funds, bank notes and coins or foreign
currency. Thus it is often described as the "bank of banks"

In other countries banking supervision is carried out by a government department such as the UK

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Treasury, or an independent government agency (for example, UK's Financial Conduct

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Authority). Many countries such as the United States will monitor and control the banking sector
through different agencies and for different purposes, although there is usually significant

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cooperation between the agencies. For example, money center banks, deposit-taking institutions,
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and other types of financial institutions may be subject to different (and occasionally
overlapping) regulation. Some types of banking regulation may be delegated to other levels of
government, such as state or provincial governments.
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7.5 GOALS OF MONETARY POLICY OF THE CENTRAL BANKS

Central banks implement a country's chosen monetary policy. At the most basic level, this
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involves establishing what form of currency the country may have, whether a fiat currency, gold-
backed currency (disallowed for countries with membership of the International Monetary Fund),
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currency board or a currency union. When a country has its own national currency, this involves
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the issue of some form of standardized currency, which is essentially a form of promissory note:
a promise to exchange the note for "money" under certain circumstances. Historically, this was
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often a promise to exchange the money for precious metals in some fixed amount. Now, when
many currencies are fiat money, the "promise to pay" consists of the promise to accept that
currency to pay for taxes.

A Central Bank may use another country's currency either directly (in a currency union), or
indirectly (a currency board). In the latter case, exemplified by Bulgaria, Hong Kong and Latvia,
the local currency is backed at a fixed rate by the central bank's holdings of a foreign currency.

The expression "monetary policy" may also refer more narrowly to the interest-rate targets and
other active measures undertaken by the monetary authority.

Full Employment: It is the desire of government to provide ample job opportunities for the
citizenry. The government wish that all those who are willing and able to work find job. In a
similar situation, employment increase in money stock will bring interest rate down which in
turn raise effective demand through the multipliers effect thereby enhancing employment,
income and output. However, once full employment is reached, further increases in output would
raise prices. This is what full employment is all about.
However, it should be noted that full employment does not mean that one hundred percent
(100%) of the labour force must be employed. At any point in time there must be some level of
unemployment co-existing with unfilled vacancies in the economy.
As Keynes puts it, full employment is all about absence of involuntary unemployment. Keynes
labeled any jobs that would be created by a rise in wage-goods (i.e., a decrease in real-wages) as
involuntary unemployment: Men are involuntarily unemployed if, in the event of a small rise in
the price of wage-goods relatively to the money-wage, both the aggregate supply of labour
willing to work for the current money-wage and the aggregate demand for it at that wage would

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be greater than the existing volume of employment. (See John Maynard Keynes, The General

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Theory of Employment, Interest and Money)

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Price stability: Inflation is defined either as the devaluation of a currency or equivalently the
rise of prices relative to a currency. Since inflation lowers real wages, Keynesians view inflation
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as the solution to involuntary unemployment. However, "unanticipated" inflation leads to lender
losses as the real interest rate will be lower than expected. Thus, Keynesian monetary policy
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aims for a steady rate of inflation.
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Economic growth: Economic growth can be enhanced by investment in capital, such as more or
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better machinery. A low interest rate implies that firms can loan money to invest in their capital
stock and pay less interest for it. Lowering the interest is therefore considered to encourage
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economic growth and is often used to alleviate times of low economic growth. On the other
hand, raising the interest rate is often used in times of high economic growth as a contra-cyclical
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device to keep the economy from overheating and avoid market bubbles.
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Balance of Payment Equilibrium: The goal of monetary policy has been to maintain
equilibrium in the balance of payments. The achievement of this objectives has been necessitated
by the phenomenal growth of international liquidity. Also, it is recognised that deficit in the
balance of payment will retard the attainment of other objectives. This is because a deficit I the
balance of payment leads to a sizeable outflow of gold (Mishkin 1992). Balance of payment is
widely designed into current and capital account.
Currency issuance: Similar to commercial banks, central banks hold assets (government bonds,
foreign exchange, gold, and other financial assets) and incur liabilities (currency outstanding).
Central banks create money by issuing interest-free currency notes and selling them to the public
in exchange for interest-bearing assets such as government bonds. When a central bank wishes to
purchase more bonds than their respective national governments make available, they may
purchase private bonds or assets denominated in foreign currencies.
The European Central Bank remits its interest income to the central banks of the member
countries of the European Union. The US Federal Reserve remits all its profits to the U.S.
Treasury. This income, derived from the power to issue currency, is referred to as seigniorage,
and usually belongs to the national government. The state-sanctioned power to create currency is
called the Right of Issuance. Throughout history there have been disagreements over this power,
since whoever controls the creation of currency controls the seigniorage income.

Interest rate interventions: Typically a central bank controls certain types of short-term interest
rates. These influence the stock- and bond markets as well as mortgage and other interest rates.
The European Central Bank for example announces its interest rate at the meeting of its
Governing Council; in the case of the U.S. Federal Reserve, the Federal Reserve Board of
Governors.

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Both the Federal Reserve and the ECB are composed of one or more central bodies that are
responsible for the main decisions about interest rates and the size and type of open market

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operations, and several branches to execute its policies. In the case of the Federal Reserve, they
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are the local Federal Reserve Banks; for the ECB they are the national central banks.

Limits on policy effects: Although the perception by the public may be that the "central bank"
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controls some or all interest rates and currency rates, economic theory (and substantial empirical
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evidence) shows that it is impossible to do both at once in an open economy. Robert Mundell's
"impossible trinity" is the most famous formulation of these limited powers, and postulates that it
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is impossible to target monetary policy (broadly, interest rates), the exchange rate (through a
fixed rate) and maintain free capital movement. Since most Western economies are now
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considered "open" with free capital movement, this essentially means that central banks may
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target interest rates or exchange rates with credibility, but not both at once. Goals frequently
cannot be separated from each other and often conflict. Costs must therefore be carefully
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weighed before policy implementation.

Question: What are the goals of Monetary Policy?

Solution: The ultimate goals of monetary policy are basically to control inflation, maintain a
healthy balance of payment position in order to safeguard the external value of national currency
and promote adequate and sustainable level of economic growth and development. These goals
are achieved by controlling money supply in order to enhance price stability (low and stable
inflation) and economic growth.

7.6 CENTRAL BANKS MONETARY POLICY INSTRUMENTS

The main monetary policy instruments available to central banks are open market operation,
bank reserve requirement, interest rate policy, re-lending and re-discount (including using the
term repurchase market), and credit policy (often coordinated with trade policy). While capital
adequacy is important, it is defined and regulated by the Bank for International Settlements, and
central banks in practice generally do not apply stricter rules.

To enable open market operations, a central bank must hold foreign exchange reserves (usually
in the form of government bonds) and official gold reserves. It will often have some influence
over any official or mandated exchange rates: Some exchange rates are managed, some are
market based (free float) and many are somewhere in between ("managed float" or "dirty float").

Interest Rates: By far the most visible and obvious power of many modern central banks is to
influence market interest rates; contrary to popular belief, they rarely "set" rates to a fixed
number. Although the mechanism differs from country to country, most use a similar mechanism
based on a central bank's ability to create as much fiat money as required.

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The mechanism to move the market towards a 'target rate' (whichever specific rate is used) is
generally to lend money or borrow money in theoretically unlimited quantities, until the targeted

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market rate is sufficiently close to the target. Central banks may do so by lending money to and
borrowing money from (taking deposits from) a limited number of qualified banks, or by
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purchasing and selling bonds. It is also notable that the target rates are generally short-term rates.
The actual rate that borrowers and lenders receive on the market will depend on (perceived)
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credit risk, maturity and other factors
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A typical central bank has several interest rates or monetary policy tools it can set to influence
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markets.
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 Marginal lending rate (In the USA this is called the discount rate).
 Main refinancing rate (It is also known as minimum bid rate and serves as a bidding floor
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for refinancing loans

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 Deposit rate, generally consisting of interest on reserves and sometimes also the rates
parties receive for deposits at the central bank.

These rates directly affect the rates in the money market, the market for short term loans.

Open Market Operations: Through open market operations, a central bank influences the
money supply in an economy. Each time it buys securities (such as a government bond or
Treasury bill), it in effect creates money. The central bank exchanges money for the security,
increasing the money supply while lowering the supply of the specific security. Conversely,
selling of securities by the central bank reduces the money supply.
Open market operations usually take the form of:
i. Buying or selling securities ("direct operations") to achieve an interest rate target in the
interbank market
 ii. Temporary lending of money for collateral securities ("Reverse Operations" or
"repurchase operations", otherwise known as the "repo" market). These operations are
carried out on a regular basis, where fixed maturity loans (of one week and one month for
the ECB) are auctioned off.
iii. Foreign exchange operations such as foreign exchange swaps.
All of these interventions can also influence the foreign exchange market and thus the exchange
rate.

Capital Requirements: All banks are required to hold a certain percentage of their assets as
capital, a rate which may be established by the central bank or the banking supervisor. Partly due
to concerns about asset inflation and repurchase agreements, capital requirements may be
considered more effective than reserve requirements in preventing indefinite lending: when at the
threshold, a bank cannot extend another loan without acquiring further capital on its balance

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sheet.

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Reserve Requirements: Historically, bank reserves have formed only a small fraction of

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deposits, a system called fractional reserve banking. Banks would hold only a small percentage
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of their assets in the form of cash reserves as insurance against bank runs. Over time this process
has been regulated and insured by central banks. Such legal reserve requirements were
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introduced in the 19th century as an attempt to reduce the risk of banks overextending
themselves and suffering from bank runs, as this could lead to knock-on effects on other
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overextended banks (See also money multiplier).

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Loan activity by banks plays a fundamental role in determining the money supply. The central-
bank money after aggregate settlement – "final money" – can take only one of two forms:
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 physical cash, which is rarely used in wholesale financial markets,

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 central-bank money which is rarely used by the people

The currency component of the money supply is far smaller than the deposit component.
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Currency, bank reserves and institutional loan agreements together make up the monetary base,
called M1, M2 and M3.

Exchange Requirements: To influence the money supply, some central banks may require that
some or all foreign exchange receipts (generally from exports) be exchanged for the local
currency. The rate that is used to purchase local currency may be market-based or arbitrarily set
by the bank. This tool is generally used in countries with non-convertible currencies or partially
convertible currencies. The recipient of the local currency may be allowed to freely dispose of
the funds, required to hold the funds with the central bank for some period of time, or allowed to
use the funds subject to certain restrictions. In other cases, the ability to hold or use the foreign
exchange may be otherwise limited.
In this method, money supply is increased by the central bank when it purchases the foreign
currency by issuing (selling) the local currency. The central bank may subsequently reduce the
money supply by various means, including selling bonds or foreign exchange interventions.

Margin Requirements and other Tools: In some countries, central banks may have other tools
that work indirectly to limit lending practices and otherwise restrict or regulate capital markets.
For example, a central bank may regulate margin lending, whereby individuals or companies
may borrow against pledged securities. The margin requirement establishes a minimum ratio of
the value of the securities to the amount borrowed.
Central banks often have requirements for the quality of assets that may be held by financial
institutions; these requirements may act as a limit on the amount of risk and leverage created by
the financial system. These requirements may be direct, such as requiring certain assets to bear
certain minimum credit ratings, or indirect, by the central bank lending to counterparties only

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when security of a certain quality is pledged as collateral.

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Question: What is the primary instrument of monetary policy under the market-based approach
to monetary management? AP
Answer: The Open Market Operations (OMO) is the primary instrument of monetary policy
under the market-based approach to monetary management in Nigeria, but it is being
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complemented by reserve requirements, discount window operations, foreign exchange market
intervention, and movement of public sector deposits in and out of the domestic money banks
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(DMBs).
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7.7 THE INDEPENDENCE OF CENTRAL BANKS

In the 2000s there has been a trend towards increasing the independence of central banks as a
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way of improving long-term economic performance. However, while a large volume of

economic research has been done to define the relationship between central bank independence
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and economic performance, the results are ambiguous.

It is argued that an independent central bank can run a more credible monetary policy, making
market expectations more responsive to signals from the central bank. Recently, both the Bank of
England (1997) and the European Central Bank have been made independent and follow a set of
published inflation targets so that markets know what to expect. The People's Bank of China's
independence can thus be read more as independence from the USA which rules the financial
markets, than from the Communist Party of China which rules the country. The fact that the
Communist Party is not elected also relieves the pressure to please people, increasing its
independence.
Governments generally have some degree of influence over even "independent" central banks;
the aim of independence is primarily to prevent short-term interference. For example, the Board
of Governors of the U.S. Federal Reserve are nominated by the President of the U.S. and
confirmed by the Senate. The Chairman and other Federal Reserve officials often testify before
the Congress. Also, in Nigeria the Board of Governors are nominated by the Nigeria President.

International organizations such as the World Bank, the Bank for International Settlements (BIS)
and the International Monetary Fund (IMF) are strong supporters of central bank independence.
This results, in part, from a belief in the intrinsic merits of increased independence. The support
for independence from the international organizations also derives partly from the connection
between increased independence for the central bank and increased transparency in the policy-
making process. The IMF's Financial Services Action Plan (FSAP) review self-assessment, for
example, includes a number of questions about central bank independence in the transparency

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section. An independent central bank will score higher in the review than one that is not

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independent.

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Advocates of central bank independence argue that a central bank which is too susceptible to
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political direction or pressure may encourage economic cycles ("boom and bust"), as politicians
may be tempted to boost economic activity in advance of an election, to the detriment of the
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long-term health of the economy and the country, for that there is a very close relationship
between Central Banks and the Governments
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In this context, independence is usually defined as the central bank's operational and
management independence from the government. The literature on central bank independence
has defined a number of types of independence.
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i. Legal Independence: The independence of the central bank is enshrined in law. This
type of independence is limited in a democratic state; in almost all cases the central bank
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is accountable at some level to government officials, either through a government

minister or directly to a legislature. Even defining degrees of legal independence has
proven to be a challenge since legislation typically provides only a framework within
which the government and the central bank work out their relationship.
ii. Goal Independence: The central bank has the right to set its own policy goals, whether
inflation targeting, control of the money supply, or maintaining a fixed exchange rate.
While this type of independence is more common, many central banks prefer to announce
their policy goals in partnership with the appropriate government departments. This
increases the transparency of the policy setting process and thereby increases the
credibility of the goals chosen by providing assurance that they will not be changed
without notice. In addition, the setting of common goals by the central bank and the
 government helps to avoid situations where monetary and fiscal policy are in conflict; a
policy combination that is clearly sub-optimal.
iii. Operational Independence: The central bank has the independence to determine the
best way of achieving its policy goals, including the types of instruments used and the
timing of their use. This is the most common form of central bank independence. The
granting of independence to the Bank of England in 1997 was, in fact, the granting of
operational independence; the inflation target continued to be announced in the
Chancellor's annual budget speech to Parliament.
iv. Management Independence: The central bank has the authority to run its own
operations (appointing staff, setting budgets, and so on.) without excessive involvement
of the government. The other forms of independence are not possible unless the central
bank has a significant degree of management independence. One of the most common
statistical indicators used in the literature as a proxy for central bank independence is the

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"turn-over-rate" of central bank governors. If a government is in the habit of appointing

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and replacing the governor frequently, it clearly has the capacity to micro-manage the
central bank through its choice of governors.

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7.8 THE CENTRAL BANK OF NIGERIA (CBN)
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The Central Bank of Nigeria was established by the CBN Act of 1958 and commenced
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operations on July 1, 1958. The major regulatory objectives of the bank as stated in the CBN act
of 1958 is to: maintain the external reserves of the country, promote monetary stability and a
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sound financial environment, and to act as a banker of last resort and financial adviser to the
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federal government. The central bank's role as lender of last resort and adviser to the federal
government has sometimes pushed it into murky regulatory waters. After the end of imperial rule
the desire of the government to become pro-active in the development of the economy became
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visible especially after the end of the Nigerian civil war, the bank followed the government's
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desire and took a determined effort to supplement any short falls in credit allocations to the real
sector. The bank soon became involved in lending directly to consumers, contravening its
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original intention to work through commercial banks in activities involving consumer lending.
However, the policy was an offspring of the indigenisation policy at the time. Nevertheless, the
government through the central bank has been actively involved in building the nation's money
and equity centres, forming securities regulatory board and introducing treasury instruments into
the capital market

Authorizing legislation
In 1948, an inquiry under the leadership of G.D Paton was established by the colonial
administration to investigate banking practices in Nigeria. Prior to the inquiry, the banking
industry was largely uncontrolled. The G.D Paton report, an offshoot of the inquiry became the
cornerstone of the first banking legislation in the country: the banking ordinance of 1952. The
ordinance was designed to prevent non-viable banks from mushrooming, and to ensure orderly
 commercial banking. The banking ordinance triggered a rapid growth in the industry, with
growth also came disappointment. By 1958, a few number of banks had failed. To curtail further
failures and to prepare for indigenous control, in 1958, a bill for the establishment of Central
Bank of Nigeria was presented to the House of Representatives of Nigeria. The Act was fully
implemented on July 1, 1959, when the Central Bank of Nigeria came into full operation. In
April 1960, the Bank issued its first treasury bills. In May 1961 the Bank launched the Lagos
Bankers Clearing House, which provided licensed banks a framework in which to exchange and
clear checks rapidly. By July 1, 1961 the Bank had completed issuing all denominations of new
Nigerian notes and coins and redeemed all of the West African Currency Board's previous
money.

Policy implementation and criticism

The CBN's early functions were mainly to act as the government's agency for the control and

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supervision of the banking sector, to monitor the balance of payments according to the demands

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of the federal government and to tailor monetary policy along the demands of the federal budget.
The central bank's initial lack of financial competence over the finance ministry led to deferment

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of major economic decisions to the finance ministry. A key instrument of the bank was to initiate
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credit limit legislation for bank lending. The initiative was geared to make credit available to
neglected national areas such as agriculture and manufacturing. By the end of 1979, most of the
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banks did not adhere to their credit limits and favoured a loose interpretation of CBN's
guidelines. The central bank did not effectively curtail the prevalence of short term loan
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maturities. Most loans given out by commercial banks were usually set within a year. The major
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policy to balance this distortion in the credit market was to create a new Bank of Commerce and
industry, a universal bank. However, the new bank did not fulfil its mission. Another policy of
the bank in concert with the intentions of the government was direct involvement in the affairs of
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the three major expatriate commercial banks in order to forestall any bias against indigenous
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borrowers and consumers. By 1976, the federal government had acquired 40% of equity in the
three largest commercial banks. The bank's slow reaction to curtail inflation by financing huge
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deficits of the federal government has been one of the sore points in the history of the central
bank. Coupled with its failure to control the burgeoning trade arrears in 1983, the country was
left with huge trade debts totalling $6 billion.

Table 7.1: Governors of the Central Bank since Independence

Governor Previous position Term start Term end
Roy Pentelow Fenton 24 July 1958 24 July 1963
Aliyu Mai-Bornu Deputy Governor, CBN 25 July 1963 22 June 1967
Clement Nyong Isong Advisor International Monetary Fund 15 August 1967 22 September 1975
24 September
Adamu Ciroma 28 June 1977
1975
Ola Vincent Deputy Governor, CBN 28 June 1977 28 June 1982
Abdulkadir Ahmed Deputy Governor, CBN 28 June 1982 30 September 1993
Paul Agbai Ogwuma CEO, Union Bank of Nigeria 1 October 1993 29 May 1999
Joseph Oladele Sanusi CEO First Bank of Nigeria 29 May 1999 29 May 2004
Chief Executive, National Planning
Charles Chukwuma Soludo 29 May 2004 29 May 2009
Commission
Sanusi Lamido Aminu Sanusi CEO, First Bank of Nigeria 3 June 2009 20 February 2014
Deputy Governor, Central Bank of
Sarah Alade 20 February 2014 3 June 2014
Nigeria
Godwin Emefiele Chief Executive Officer, Zenith Bank 3 June 2014 to date
Central Bank of NigeriaWebsite www.cbn.gov.ng

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Monetary Policy Functions of the Central Bank of Nigeria
We have briefly discussed the key events that led to the establishment of the Central Bank of

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Nigeria. We are now going to discuss the objectives. It will be in order if you can put at the back
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of your mind that the Central Bank of Nigeria is not a profit driven organisation. It was
established for the public interest. Section 4 of the 1958 Ordinance clearly spelt out the key
functions of the Central Bank of Nigeria. The Central Bank of Nigeria like any other Central
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Bank performs certain traditional functions in addition to other functions that may be ascribed to
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it. Some of the functions of the Central Bank of Nigeria are listed below.
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1. Issuance of Legal Tender Currency Notes and coins: The Central Bank of Nigeria
engages in currency issue and distribution within the economy. Issuance of Legal Tender
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Currency. It has the sole responsibility of issuing currencies and coins, and also changing
old and worn out notes. In Nigeria a lot of transactions are done using cash instead of
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cheques. The currencies and coins issued by the CBN are distributed through the
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Commercial banks in Nigeria. Also the CBN withdraws old and mutilated currencies
through the Commercial banks.

The Bank assumed these important functions since 1959 when it replaced the West African
Currency Board (WACB) pound then in circulation with the Nigerian pound. The decimal
currency denominations, Naira and Kobo, were introduced in 1973 in order to move to the metric
system, which simplifies transactions. In 1976, a higher denomination note – N20 joined the
currency profile. In 1984, a currency exchange was carried out whereby, the colors of existing
currencies were swapped in order to discourage currency hoarding and forestall counterfeiting
(see History of Nigerian Currency).
2. Maintenance of Nigeria’s External Reserves: In order to safeguard the international
value of the legal tender currency, the CBN is actively involved in the management of the
country‟s debt and foreign exchange.
i. Debt Management: In addition to its function of mobilizing funds for the Federal
Government, the CBN in the past managed its domestic debt and services external
debt on the advice of the Federal Ministry of Finance. On the domestic front, the
Bank advises the Federal Government as to the timing and size of new debt
instruments, advertises for public subscription to new issues, redeems matured
stocks, pays interest and principal as and when due, collects proceeds of issues for
and on behalf of the Federal Government, and sensitises the Government on the
implications of the size of debt and budget deficit, among others. On external debt
service, the CBN also cooperates with other agencies to manage the country‟s
debt. In 2001, the responsibility of debt management was transferred to Debt

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Management Office (DMO).

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ii. Foreign Exchange Management: Foreign Exchange management involves the
acquisition and deployment of foreign exchange resources in order to reduce the

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destabilizing effects of short-term capital flows in the economy. The CBN
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monitors the use of scarce foreign exchange resources to ensure that foreign
exchange disbursements and utilization are in line with economic priorities and
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within the annual foreign exchange budget in order to ensure available balance of
payments position as well as the stability of the Naira.
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3. Promotion and Maintenance of Monetary Stability and a Sound and Efficient

Financial System: The effectiveness of any central bank in executing its functions
hinges crucially on its ability to promote monetary stability. Price stability is
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indispensable for money to perform its role of medium exchange, store of value, standard
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of deferred payments and unit of account. Attainment of monetary stability rests on a

central bank‟s ability to evolve effective monetary policy and to implement it effectively.
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Since June 30, 1993 when the CBN adopted the market-based mechanism for the conduct
of monetary policy, Open Market Operations (OMO) has constituted the primary tool of
monetary management supported by reserve requirements and discount window
operations for enhanced effectiveness in liquidity management. Specifically, liquidity
management by the Central Bank of Nigeria involves the routine control of the level of
liquidity in the system in order to maintain monetary stability. Periodically, the CBN
determines target growth rates of money supply, which are compatible with overall
policy goals. It also seeks to align commercial and merchant banking activities with the
overall target. The CBN through its surveillance activities over banks and non-bank
financial institutions seeks to promote a sound and efficient financial system in Nigeria.
 4. Banker and Financial Adviser to the Federal Government: The CBN as banker to the
Federal government undertakes most of Federal Government banking businesses within
and outside the country. The Bank also provides banking services to the state and local
governments and may act as banker to institutions, funds or corporation set up by the
Federal, State and Local Governments. The CBN also finances government in period of
temporary budget shortfalls through Ways and Means Advances subject to limits
imposed by law. As financial adviser to the Federal Government, the Bank advises on the
nature and size of government debt instruments to be issued, while it acts as the issuing
house on behalf of government for the short, medium and long-term debt instruments.
The Bank coordinates the financial needs of government in collaboration with the
treasury to determine appropriately the term, timing of issue and volume of instruments
to raise funds for government financing.

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5. Banker and Lender of Last Resort to Banks: another major function of the CBN is to

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act as a banker to other financial institutions. Banks, discount houses and other financial
institutions maintain accounts with the CBN. The CBN acts as a lender of last resort to

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the banks. As a banker to other banks, the CBN issues directives on cash reserve and
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liquidity ratios. This it does through the monetary policy circulars.
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The CBN maintains current account for deposit money banks. It also provides clearing house
facilities through which instruments from the banks are processed and settled. Similarly, it
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undertakes trade finance functions on behalf of banks‟ customers. Finally, it provides temporary
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accommodation to banks in the performance of its functions as lender of last resort (see CBN,
website)
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6. Banking Supervision and Examination: one major function of the CBN is to supervise
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and examine other financial institutions and ensure that they operate according to set
regulations. The supervision is done both off-site and on-site.
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Off-site supervision is done through the review of the various weekly, monthly, quarterly or
annual returns usually rendered by the financial institutions.

On-site supervision visits by CBN officials to the offices of the various financial institutions
refers to the supervision which is done through. During such visits, the CBN officials will
examine their books and their various control systems. They also examine the books to ensure
strict conformity to operational rule especially in connection with charges to customers of
financial institutions. A benefit of the supervisory function of the CBN is that it enables it to
offer advice to the financial institutions on the management of their affairs.
The supervisory function of CBN is structured into three departments, 1. Financial Policy and
Regulation, 2. Banking Supervision Department, 3. Other Financial Institutions Supervision
Department

Financial Policy and Regulation department develops and implements policies & regulations
aimed at ensuring financial system stability. It also licenses & grants approvals for banks and
other financial institutional.

Banking Supervision Department carries out the supervision of Deposit money banks and
Discount houses while Other Financial Institutions Supervision Department supervises other
financial institutions. The other financial institutions include Micro-finance Banks (MFBs),
Finance Companies (FCs), Bureaux-de-change (BDCs), Primary Mortgage Institutions (PMIs)
and Development Finance Institutions (DFI's). The supervisory process of both departments

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involves both on-site and off-site arrangements. Read more on the supervisory framework

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The Central Bank of Nigeria supervises the following categories of financial institutions:

i. Bureaux-de-Change (BDCs)
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ii. Commercial Banks
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iii. Development Finance Institutions (DFI's)
iv. Discount Houses
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v. Finance Companies (FCs)

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vi. Merchant Banks

vii. Micro-finance Banks (MFBs)
viii. Non-Interest Banks
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ix. Primary Mortgage Institutions (PMIs)

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7. Developmental Functions of the CBN: we have discussed the traditional functions of

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the CBN. The CBN in addition, performs other functions which enhance the development
of the Nigerian economy. The developmental functions are in two main areas namely:
i. Promotion of the money and capital market: the growth of the money market has
been achieved largely through the activities of the CBN which has the
responsibility of issuing Treasury Bills and certificates which are money market
instruments. The CBN also helped in the establishment of the Nigerian Stock
Exchange. It is also a major shareholder in many capital market institutions like
the Bank of Industry Limited.

ii. ii. Apart from promoting the growth of the money and capital market, the CBN
has been playing crucial roles in the establishment of specialised financial
institutions. Some of the specialised financial institutions like the Bank of
 Industry Ltd (built from the Ashes of the former Nigerian Industrial Development
Bank in which the CBN is a shareholder play leading roles in the development
and transformation of the Nigerian economy (see NOUN, MBF)
The Conduct of Monetary Policy
Over the years, the objectives of monetary policy have remained the attainment of internal and
external balance of payments. However, emphasis on techniques/instruments to achieve those
objectives have changed over the years. There have been two major phases in the pursuit of
monetary policy, namely, before and after 1986. The first phase placed emphasis on direct
monetary controls, while the second relies on market mechanisms.

Monetary Policy Performance in 2008 – 2011

The conduct of monetary policy by the Central Bank of Nigeria since 2008 has been designed to:
influence the growth of money supply consistent with the required aggregate Gross Domestic

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Product (GDP) growth rate, ensure financial stability, maintain a stable and competitive

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exchange rate of the naira, and achieve positive real interest rates.

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The conduct of monetary policy in the review period was largely influenced by the global
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financial crisis which started in 2007 in the U.S. and spread to other regions and emerging
markets including Nigeria. The crisis created liquidity crisis in the banking system, large
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quantum of non-performing credits, large capital outflows and pressure on the exchange rate,
decline in oil prices and falling external reserves, sharp drop in government revenue, huge fiscal
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injections and collapse of the capital market.

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Consequently in the wake of the global financial crisis, the Bank largely adopted the policy of
monetary easing to address the problem of liquidity shortages in the banking system from
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September 2008 to September 2010. The monetary policy easing measures taken during the
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period included:
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 Stoppage of aggressive liquidity mop-up since September 18, 2008

 Progressive reduction of monetary policy rate (MPR) from 10.25 to 6.0 per cent
 Reduction of cash reserve requirement (CRR) from 4.0 to 2.0 and 1.0 per cent
 Reduction of liquidity ratio (LR) from 40.0 to 30.0, and 25.0 per cent
 Introduction of Expanded Discount Window (EDW) to increase DMB‟s access to
facilities from the CBN, and by July 2009 was replaced with CBN Guarantee of
interbank transactions
 Reduction of Net Open Position (NOP) limit of deposit money banks from 20.00 to
10.00, 5.00 and 1.00 per cent
 Injection of N620 billion as tier 2 capital in 8 troubled banks

Following the restoration of stability and re-emergence of liquidity surfeit in the banking system,
the Bank adopted a tightening stance from September 2010 to December 2011. The monetary
policy easing measures coupled with huge fiscal expansion put much pressure on inflation,
exchange rate and external reserves. To curtail these threats the stance of monetary policy
changed from monetary easing to tightening, from September 2010 to December 2011 and the
following monetary policy actions were taken during the period:

 The Resumption of active Open Market Operations for the purpose of targeted liquidity
management
 Progressive increase in the monetary policy rate (MPR) from 6.00 to 12.00 per cent
 Increase in the Cash Reserve Requirement (CRR) from 1.00 to 2.00, 4.00 and 8.00 per
cent
 Increase in liquidity ratio (LR) from 25.00 to 30 per cent
 Introduction of reserve averaging method of computing Cash Reserve Requirement
(CRR), which was later stopped

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 Increase of Net Foreign Exchange Open Position (NOP) of banks from 1.00 to 5.00 per

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cent; but later reduced to 3.00 per cent
 Shift in the mid-point of the foreign exchange band from N150/US$1 +/-3 per cent to

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N155/US$1 +/-3 per cent
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The above policy actions taken by the CBN were within the statutory mandate of the Bank, and
in the overall interest of the Nigerian Economy. The Bank‟s monetary policy decisions
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strengthened financial system stability and supported the growth of the Nigerian economy.
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History of Nigerian Currency

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The West African Currency Board was responsible for issuing currency notes in Nigeria from
1912 to 1959. Prior to the establishment of the West African Currency Board, Nigeria had used
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various forms of money including cowries and manilas.

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On 1st July, 1959 the Central Bank of Nigeria issued the Nigerian currency notes and coins and
the West African Currency Board notes and coins were withdrawn. It was not until 1st July, 1962
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that legal tender status was changed to reflect the country‟s new status. The notes were again
changed in 1968 as a war strategy following the misuse of the country‟s currency notes.

On 31st March, 1971, the then Head of State announced that Nigeria would change to decimal
currency as from 1st January, 1973.The major currency unit would be called Naira which would
be equivalent to ten shillings: the minor unit would be called kobo; 100 of which would make
one Naira. The decision to change to decimal currency followed the recommendations of the
Decimal Currency Committee set up in 1962 which submitted its report in 1964.

The change that took place in January, 1973 was a major one and this involved both currency
notes and coins. The major unit of currency which used to be £1 ceased to exist and the one
Naira which was equivalent to 10/- become the major unit:
On 11th February, 1977 a new banknote denomination of the value of 20 Naira was issued. This
was special in two respects:

1. The N20 (Twenty Naira) banknote was the highest denomination to be introduced then,
and its issue became necessary as a result of the growth of incomes in the country; the
preference for cash transactions and the need for convenience.
2. The N20 (Twenty Naira) banknote became the first currency note in Nigeria bearing the
Portrait of a Nigerian citizen, in this case, the late Head of State, General Murtala Ramat
Muhammed (1938-1976) who was the torch bearer of the Nigerian Revolution July,
1975.

He was declared a national hero on the 1st of October,1978. The note was issued on the 1st
Anniversary of his assassination as a fitting tribute to a most illustrious son of Nigeria. On 2nd

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July, 1979, new currency notes of three denominations, namely, ( N1), (N5), and (N10) were

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introduced. These notes were of the same size i.e., 151 x 78 mm as the N20 note issued on the
11th February, 1977. In order to facilitate identification, distinctive colours which were similar to

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those of the current banknotes of the various denominations were used. The notes bore the
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portraits of three eminent Nigerians who were declared national heroes on the 1st of October,
1978. The engravings at the back of the notes reflected the cultural aspects of the country. In
1991, both the 50k and N1 Notes were coined. In response to expansion in economic activities
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and to facilitate an efficient payments system and possible by oil boom, N20, and N50 note
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denominations were added in 1977 and 1991 respectively. Considering cost effectiveness and
expansion of economic activities, higher denomination notes were issued. These are 100 Naira
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(1999); 200 Naira note (2000); 500 Naira was released in April, 2001 while the 1000 Naira note
was released in October 2005.
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On February 28th 2007, as part of the economic reforms, N50, N20, N10, and N5 banknotes as
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well as N1 and 50K coins were reissued with new designs, while a new N2 coin was introduced
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(See CBN website)

Summary
A central bank, reserve bank, or monetary authority is an institution charged with the
responsibility of regulating or that manages a state's currency, money supply, and interest rates.
The Central Bank of a country is regarded as the apex regulatory institution of the financial
system of that country. The major goals of Central Bank include full employment, price stability,
balance of payment and exchange rate stability.The main monetary policy instruments available
to central banks at its goals are open market operation, bank reserve requirement, interest rate
policy, re-lending and re-discount (including using the term repurchase market), and credit
policy (often coordinated with trade policy.
7.9 SELF-ASSESSMENT QUESTIONS
7.1 Can the Federal Government frustrate the Central Bank from pursing its monetary policy?
7.2 How does e-money affect the efficacy of Central Bank‟s monetary policy?
7.3 What are the prerequisites for successful monetary policy?

SOLUTION TO SAQ 7.1

Yes, when the Federal government exceeds its revenue the CBN finance government deficit
through Ways and Means Advances subject (in some cases) to the limits set existing regulations,
which are sometimes disregarded by the Federal Government. The direct consequence of Central
Banks financing of deficits are distortions or surges in monetary base leading to adverse effect
on domestic prices and exchange rates i.e macroeconomic instability because of excess liquidity
that has been injected into the economy.

SOLUTION TO SAQ 7.2

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The introduction of e-money poses a challenge to Central Bank‟s ability to control interest rate

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as well as increase endogenous financial instability. The challenge to interest rate control stems
from the possibility that e-money may diminish the financial system‟s demand for Central

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Bank‟s liabilities thereby rendering Central Bank unable to conduct meaningful open market
operations, while increased financial instability could emerge from the increased elasticity of
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private money production and from periodic runs out of e-money into Central Bank money that
generate liquidity crises.
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SOLUTION TO SAQ 7.3

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A successful monetary policy is a function of certain fundamental imperatives. Among others,

relevant legal and regulatory framework, deep and broad financial market, good understanding of
monetary transmission lag, and availability of timely and accurate data and information for the
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monetary authorities are crucial for successful monetary policy.

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7.10 MUITIPLE-CHOICE QUESTIONS

1) The main argument against Central Banks independence is that
a. in a democracy elected officials should make public policy
b. monetary and fiscal policy would be easier to coordinate if the Fed were not
independent
c. the Central bank has proven irresponsible on many occasions
d. congressional control of the Fed was tried during the 1960s and it worked

2) The Federal Reserve implements monetary policy in the US because

a. the Fed has better information than market participants
b. the fed has the interests of the banking public at heart at all times
c. bankers are the best-qualified people to administer monetary policy
d. the majority opinion in congress wants it that way
 3) A central bank can create money by
a. selling some of its foreign-currency reserves for domestic currency
b. issuing its own Central Bank bonds
c. selling government treasury bills to the chartered banks
d. purchasing government securities on the open market

4) The CBN would tend to increase the money supply by

a. raising the bank rate
b. selling foreign currency reserves in the international market
c. selling government bonds on the open market
d. transferring government accounts from the CBN to the commercial banks

5) The organization responsible for the conduct of monetary policy in the Nigeria is the
a. Comptroller of the Currency.

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b. National Bureau of Statistics
c. Central Bank of Nigeria

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d. Ministry of Finance

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6) One of the major functions of the CBN is to:
a. insure deposits AP
b. monitor transactions on the stock exchange
c. ensure the stability of prices
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d. provide economic statistics on various macroeconomic indicators, including
inflation, unemployment and GDP growth
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7) What is a “central bank”?

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a. Any commercial bank that is willing to make loans to other commercial banks.
b. The largest bank in a particular system
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c. A special governmental or quasi- governmental institution in the financial system

that regulates the medium of exchange
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d. Any commercial bank located in the capital of a country.

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SOLUTION TO MUITIPLE-CHOICE QUESTIONS 7.10

Questions 1 2 3 4 5 6 7
Answers A D D D C C C
 STUDY SESSION 8
COMMERCIAL BANKING

Introduction

A financial institution is an establishment that conducts financial transactions such as

investments, loans and deposits. Almost everyone deals with financial institutions on a regular
basis. Everything from depositing money to taking out loans and exchanging currencies must be
done through financial institutions. This session deals with the functions and the operations of
the major financial institution (the commercial banks) and its roles in the financial system. The
theme of this chapter therefore is a detailed examination of the creation and destruction of bank
deposits.
Learning Outcomes for Study Session 8

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At the end of this study Session, you should be able to:

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8.1 define correctly the meaning of financial institutions (SAQ 8.1)
8.2 state in absolute sense the meaning of commercial banks (SAQ 8.2)

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8.3 understand the functions of commercial banks (SAQ 8.3)
8.4 explain the sources of bank‟s income (SAQ 8.4)AP
8.5 discuss effectively the commercial banks‟ balance sheet (SAQ 8.5)
8.6 understand the difference between the unit banking and branch banking (SAQ 8.6)
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8.7 explain the process of commercial bank deposit creation (SAQ 8.7)
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8.8 define the role of commercial banks in economic development (SAQ 8.8)
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8.1 DEFINITION OF FINANCIAL INSTITUTIONS

In financial economics, a financial institution is an institution that provides financial services for
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its clients or members. Probably the greatest important financial service provided by financial
institutions is acting as financial intermediaries. Most financial institutions are regulated by the
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government.
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The economic system could not function without financial institutions. These institutions
including commercial banks, savings and loan associations, and credit unions are financial go-
betweens. They keep money flowing throughout the economy among consumers, businesses,
and government.

When people deposit money in a bank, that money does not sit in a vault. The bank lends the
money to other consumers and businesses. The naira or dollars may be loaned to consumers to
help finance new cars, homes, college tuition, and other needs. Businesses may borrow the
money for new equipment and expansion. State and local governments may borrow to build
new highways, schools, and hospitals. The interaction that financial institutions create between
consumers, businesses, and governments keeps the economy alive.
Without financial institutions, consumers would probably keep their cash under a mattress or
locked in a safe. Money could not circulate easily. The nation‟s money supply would shrink.
Funds would not be available for consumer spending. Demand for goods and services would fall.
Businesses could not get the money to modernize plants and develop new products. The economy
would slow down. Jobs would become scarce. As you can see, the economy depends on the
flow of money and the services financial institutions provide.

Broadly speaking, there are three major types of financial institutions:

1. Depositary Institutions : Deposit-taking institutions that accept and manage deposits and
make loans, including banks, building societies, credit unions, trust companies, and
mortgage loan companies
2. Contractual Institutions: Insurance companies and pension funds; and
3. Investment Institutions: Investment Banks, underwriters, brokerage firms.

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An establishment that focuses on dealing with financial transactions, such as investments, loans
and deposits. Conventionally, financial institutions are composed of organizations such as banks,

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trust companies, insurance companies and investment dealers. Almost everyone has deal with a
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financial institution on a regular basis. Everything from depositing money to taking out loans and
exchange currencies must be done through financial institutions
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Since all people depend on the services provided by financial institutions, it is imperative that
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they are regulated highly by the federal government. For example, if a financial institution were
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to enter into bankruptcy as a result of controversial practices, this will no doubt cause wide-
spread panic as people start to question the safety of their finances. Also, this loss of confidence
can inflict further negative externalities upon the economy.
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Financial institutions in most countries operate in a heavily regulated environment as they are
critical parts of countries' economies. Regulation structures differ in each country, but typically
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involve prudential regulation as well as consumer protection and market stability. Some
countries have one consolidated agency that regulates all financial institutions while others have
separate agencies for different types of institutions such as banks, insurance companies and
brokers.

8.2 MEANING OF COMMERCIAL BANKS

A commercial bank is a profit-seeking business firm, dealing in money and credit. It is a
financial institution dealing in money in the sense that it accepts deposits of money from the
public to keep them in its custody for safety. So also, it deals in credit, i.e., it creates credit by
making advances out of the funds received as deposits to needy people. It thus, functions as a
mobiliser of saving in the economy. A bank is, therefore like a reservoir into which flow the
savings, the idle surplus money of households and from which loans are given on interest to
businessmen and others who need them for investment or productive uses.

Commercial banks is a financial institution that provides services, such as accepting deposits,
giving business loans and auto loans, mortgage lending, and basic investment products like
savings accounts and certificates of deposit. The traditional commercial bank is a brick and
mortar institution with tellers, safe deposit boxes, vaults and ATMs. However, some commercial
banks do not have any physical branches and require consumers to complete all transactions by
phone or Internet. In exchange, they generally pay higher interest rates on investments and
deposits, and charge lower fees.

Commercial banks accept deposits and provide security and convenience to their customers. Part
of the original purpose of banks was to offer customers safe keeping for their money. By keeping

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physical cash at home or in a wallet, there are risks of loss due to theft and accidents, not to

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mention the loss of possible income from interest. With banks, consumers no longer need to keep
large amounts of currency on hand; transactions can be handled with checks, debit cards or credit

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cards instead.
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Commercial banks also make loans that individuals and businesses use to buy goods or expand
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business operations, which in turn leads to more deposited funds that make their way to banks. If
banks can lend money at a higher interest rate than they have to pay for funds and operating costs
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they make money. Commercial banking activities are different than those of investment banking,
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which include underwriting, acting as an intermediary between an issuer of securities and the
investing public, facilitating mergers and other corporate reorganizations, and also acting as a
broker for institutional clients.
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8.3 FUNCTIONS OF COMMERCIAL BANKS

Commercial banks have to perform a variety of functions which are common to both developed
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and developing countries. These are known as „General Banking‟ functions of the commercial
banks. The modern banks perform a variety of functions. These can be broadly divided into two
categories: (a) Primary functions and (b) Secondary functions.

Figure 8.1: Commercial Bank Functions

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A. Primary Functions

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Primary banking functions of the commercial banks include:
1. Acceptance of deposits AP
2. Advancing loans
3. Creation of credit
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4. Clearing of cheques
5. Financing foreign trade
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6. Remittance of funds
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1. Acceptance of Deposits: Accepting deposits is the primary function of a commercial bank

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mobilise savings of the household sector. Banks generally accept three types of deposits viz., (a)
Current Deposits (b) Savings Deposits, and (c) Fixed Deposits.
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a) Current Deposits: These deposits are also known as demand deposits. These deposits can
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be withdrawn at any time. Generally, no interest is allowed on current deposits, and in

case, the customer is required to leave a minimum balance undrawn with the bank.
Cheques are used to withdraw the amount. These deposits are kept by businessmen and
industrialists who receive and make large payments through banks. The bank levies
certain incidental charges on the customer for the services rendered by it.
b) Savings Deposits: This is meant mainly for professional men and middle class people to
help them deposit their small savings. It can be opened without any introduction. Money
can be deposited at any time but the maximum cannot go beyond a certain limit. There is
a restriction on the amount that can be withdrawn at a particular time or during a week. If
the customer wishes to withdraw more than the specified amount at any one time, he has
to give prior notice. Interest is allowed on the credit balance of this account. The rate of
interest is greater than the rate of interest on the current deposits and less than that on
fixed deposit. This system greatly encourages the habit of thrift or savings.
 c) Fixed Deposits: These deposits are also known as time deposits. These deposits cannot be
withdrawn before the expiry of the period for which they are deposited or without giving
a prior notice for withdrawal. If the depositor is in need of money, he has to borrow on
the security of this account and pay a slightly higher rate of interest to the bank. They are
attracted by the payment of interest which is usually higher for longer period. Fixed
deposits are liked by depositors both for their safety and as well as for their interest. In
India, they are accepted between three months and ten years.

2. Advancing Loans: The second primary function of a commercial bank is to make loans and
advances to all types of persons, particularly to businessmen and entrepreneurs. Loans are made
against personal security, gold and silver, stocks of goods and other assets. The most common
way of lending is by:
i. Overdraft Facilities: In this case, the depositor in a current account is allowed to draw

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over and above his account up to a previously agreed limit. Suppose a businessman has

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only ₦30,000/- in his current account in a bank but requires ₦60,000/- to meet his
expenses. He may approach his bank and borrow the additional amount of ₦30,000/-.

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The bank allows the customer to overdraw his account through cheques. The bank,
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however, charges interest only on the amount overdrawn from the account. This type of
loan is very popular with the Indian businessmen.
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ii. Cash Credit: Under this account, the bank gives loans to the borrowers against certain
security. But the entire loan is not given at one particular time, instead the amount is
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credited into his account in the bank; but under emergency cash will be given. The
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borrower is required to pay interest only on the amount of credit availed to him. He will
be allowed to withdraw small sums of money according to his requirements through
cheques, but he cannot exceed the credit limit allowed to him. Besides, the bank can also
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give specified loan to a person, for a firm against some collateral security. The bank can
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recall such loans at its option.

iii. Discounting Bills of Exchange: This is another type of lending which is very popular
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with the modern banks. The holder of a bill can get it discounted by the bank, when he is
in need of money. After deducting its commission, the bank pays the present price of the
bill to the holder. Such bills form good investment for a bank. They provide a very liquid
asset which can be quickly turned into cash. The commercial banks can rediscount, the
discounted bills with the central banks when they are in need of money. These bills are
safe and secured bills. When the bill matures the bank can secure its payment from the
party which had accepted the bill.
iv. Money at Call: Bank also grant loans for a very short period, generally not exceeding 7
days to the borrowers, usually dealers or brokers in stock exchange markets against
collateral securities like stock or equity shares, debentures, etc., offered by them. Such
advances are repayable immediately at short notice hence, they are described as money at
call or call money.
 v. Term Loans: Banks give term loans to traders, industrialists and now to agriculturists also
against some collateral securities. Term loans are so-called because their maturity period
varies between 1 to 10 years. Term loans, as such provide intermediate or working capital
funds to the borrowers. Sometimes, two or more banks may jointly provide large term
loans to the borrower against a common security. Such loans are called participation
loans or consortium finance.
vi. Consumer Credit: Banks also grant credit to households in a limited amount to buy some
durable consumer goods such as television sets, refrigerators, etc., or to meet some
personal needs like payment of hospital bills etc. Such consumer credit is made in a lump
sum and is repayable in instalments in a short time. Un-der the 20-point programme, the
scope of consumer credit has been extended to cover expenses on marriage, funeral etc.,
as well.
vii. Miscellaneous Advances: Among other forms of bank advances there are packing credits

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given to exporters for a short duration, export bills purchased/discounted, import finance-

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advances against import bills, finance to the self-employed, credit to the public sector,
credit to the cooperative sector and above all, credit to the weaker sections of the

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community at concessional rates.
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3. Creation of Credit: A unique function of the bank is to create credit. Banks supply money to
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traders and manufacturers. They also create or manufacture money. Bank deposits are regarded
as money. They are as good as cash. The reason is they can be used for the purchase of goods
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and services and also in payment of debts. When a bank grants a loan to its customer, it does not
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pay cash. It simply credits the account of the borrower. He can withdraw the amount whenever
he wants by a cheque. In this case, bank has created a deposit without receiving cash. That is,
banks are said to have created credit. Sayers says “banks are not merely purveyors of money, but
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also in an important sense, manufacturers of money.”

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4. Promote the Use of Cheques: The commercial banks render an important service by providing
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to their customers a cheap medium of exchange like cheques. It is found much more convenient
to settle debts through cheques rather than through the use of cash. The cheque is the most
developed type of credit instrument in the money market.

5. Financing Internal and Foreign Trade: The bank finances internal and foreign trade through
discounting of exchange bills. Sometimes, the bank gives short-term loans to traders on the
security of commercial papers. This discounting business greatly facilitates the movement of
internal and external trade.

6. Remittance of Funds: Commercial banks, on account of their network of branches throughout

the country, also provide facilities to remit funds from one place to another for their customers
by issuing bank drafts, mail transfers or telegraphic transfers on nominal commission charges.
As compared to the postal money orders or other instruments, bank drafts have proved to be a
much cheaper mode of transferring money and has helped the business community considerably.

B. Secondary Functions
Secondary banking functions of the commercial banks include: Agency Services and General
Utility Services. These are discussed below.
1. Agency Services: Banks also perform certain agency functions for and on behalf of their
customers. The agency services are of immense value to the people at large. The various agency
services rendered by banks are as follows:
a. Collection and Payment of Credit Instruments: Banks collect and pay various
credit instruments like cheques, bills of exchange, promissory notes etc., on
behalf of their customers.
b. Purchase and Sale of Securities: Banks purchase and sell various securities like

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shares, stocks, bonds, debentures on behalf of their customers.

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c. Collection of Dividends on Shares: Banks collect dividends and interest on shares
and debentures of their customers and credit them to their accounts.

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d. Acts as Correspondent: Sometimes banks act as representative and correspondents
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of their customers. They get passports, traveller‟s tickets and even secure air and
sea passages for their customers.
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e. Income-tax Consultancy: Banks may also employ income tax experts to prepare
income tax returns for their customers and to help them to get refund of income
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tax.
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f. Execution of Standing Orders: Banks execute the standing instructions of their

customers for making various periodic payments. They pay subscriptions, rents,
insurance premia etc., on behalf of their customers.
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g. Acts as Trustee and Executor: Banks preserve the „Wills‟ of their customers and
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execute them after their death.

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2. General Utility Services: In addition to agency services, the modern banks provide many
general utility services for the community as given.
a. Locker Facility: Bank provide locker facility to their customers. The customers
can keep their valuables, such as gold and silver ornaments, important documents;
shares and debentures in these lockers for safe custody.
b. Traveller‟s Cheques and Credit Cards: Banks issue traveller‟s cheques to help
their customers to travel without the fear of theft or loss of money. With this
facility, the customers need not take the risk of carrying cash with them during
their travels.
c. Letter of Credit: Letters of credit are issued by the banks to their customers
certifying their credit worthiness. Letters of credit are very useful in foreign trade.
 d. Collection of Statistics: Banks collect statistics giving important information
relating to trade, commerce, industries, money and banking. They also publish
valuable journals and bulletins containing articles on economic and financial
matters.
e. Acting Referee: Banks may act as referees with respect to the financial standing,
business reputation and respectability of customers.
f. Underwriting Securities: Banks underwrite the shares and debentures issued by
the Government, public or private companies.
g. Gift Cheques: Some banks issue cheques of various denominations to be used on
auspicious occasions.
h. Accepting Bills of Exchange on Behalf of Customers: Sometimes, banks accept
bills of exchange, internal as well as foreign, on behalf of their customers. It
enables customers to import goods.

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i. Merchant Banking: Some commercial banks have opened merchant banking

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divisions to provide merchant banking services.

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C. Fulfillment of Socio-Economic Objectives AP
In recent years, commercial banks, particularly in developing countries, have been called upon
to help achieve certain socio-economic objectives laid down by the state. For example, the
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nationalized banks in India have framed special innovative schemes of credit to help small
agriculturists, village and cottage industries, retailers, artisans, the self-employed persons
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through loans and advances at concessional rates of interest. Under the Differential Interest
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Scheme (D.I.S.) the nationalized banks in India advance loans to persons belonging to
scheduled tribes, tailors, rickshaw-walas, shoe-makers etc. at the concessional rate of 4 per cent
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per annum. This does not cover even the cost of the funds made available to these priority
sectors. Banking is, thus, being used to sub-serve the national policy objectives of reducing
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inequalities of income and wealth, removal of poverty and elimination of unemployment in the
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country.

It is clear from the above that banks help development of trade and industry in the country. They
encourage habits of thrift and saving. They help capital formation in the country. They lend
money to traders and manufacturers. In the modern world, banks are to be considered not
merely as dealers in money but also the leaders in economic development

8.4 SOURCES OF BANKS’ INCOME

A bank is a business organisation engaged in the business of borrowing and lending money. A
bank can earn income only if it borrows at a lower rate and lends at a higher rate. The difference
between the two rates will represent the costs incurred by the bank and the profit. Bank also
provides a number of services to its customers for which it charges commission. This is also an
important source of income. The followings are the various sources of a bank‟s profit:
1. Interest on Loans: The main function of a commercial bank is to borrow money for the
purpose of lending at a higher rate of interest. Bank grants various types of loans to the
industrialists and traders. The yields from loans constitute the major portion of the income of a
bank. The banks grant loans generally for short periods. But now the banks also advance call
loans which can be called at a very short notice. Such loans are granted to share brokers and
other banks. These assets are highly liquid because they can be called at any time. Moreover,
they are source of income to the bank.
2. Interest on Investments: Banks also invest an important portion of their resources in
government and other first class industrial securities. The interest and dividend received from
time to time on these investments is a source of income for the banks. Bank also earn some
income when the market prices of these securities rise.

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3. Discounts: Commercial banks invest a part of their funds in bills of exchange by discounting

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them. Banks discount both foreign and inland bills of exchange, or in other words, they purchase
the bills at discount and receive the full amount at the date of maturity. For instance, if a bill of

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₦1000 is discounted for ₦975, the bank earns a discount of ₦25 because bank pays ₦975 today,
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but will get ₦1000 on the due date. Discount, as a matter of fact, is the interest on the amount
paid for the remaining period of the bill. The rate of discount on bills of exchange is slightly
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lower than the interest rate charged on loans and advances because bills are considered to be
highly liquid assets.
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4. Commission, Brokerage, etc.: Banks perform numerous services to their customers and charge
commission, etc., for such services. Banks collect cheques, rents, dividends, etc., accepts bills of
exchange, issue drafts and letters of credit and collect pensions and salaries on behalf of their
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customers. They pay insurance premiums, rents, taxes etc., on behalf of their customers. For all
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these services banks charge their commission. They also earn locker rents for providing safety
vaults to their customers. Recently the banks have also started underwriting the shares and
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debentures issued by the joint stock companies for which they receive underwriting commission.

Commercial banks also deal in foreign exchange. They sell demand drafts, issue letters of credit
and help remittance of funds in foreign countries. They also act as brokers in foreign exchange.
Banks earn income out of these operations.

8.5 BALANCE SHEET OF COMMERCIAL BANKS

The balance sheet of a commercial bank is a statement of its assets and liabilities. Assets are
what others owe the bank, and what the bank owes others constitutes its liabilities. The business
of a bank is reflected in its balance sheet and hence its financial position as well. The balance
sheet is issued usually at the end of every financial year of the bank
The balance sheet of the bank comprises of two sides; the assets side and the liabilities side. The
assets and liabilities that banks hold determine the amount of profit that can be made, and they
also determine the solvency of the bank. The profit of the bank is primarily derivable in the form
of interest on its earning assets: investments and loans. It is therefore reasonable to expect banks
to carry in their portfolio a sizeable proportion of loans and investments, since these carry the
highest rates of return. There is danger in doing so. This is due to the fact that most of the
liabilities of commercial banks are payable on demand, A bank that has invested too much in
interest-bearing assets may find itself incapable of paying back its depositors' money when
requested. In order to continue in the business of banking, a bank has to maintain liquidity
adequate for safety. The problem facing commercial banks is that a conflict usually exists
between the need for liquidity and safety on the one hand, and the need for profits on the other.
In general, assets that have the highest returns are the least liquid, while those, which are most
liquid, have the lowest yields.

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In the process of managing their portfolios, a number of requirements are necessarily borne in
mind by commercial banks. The first is that the portfolio must contain enough cash, or access to

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cash, to meet customers' demand for cash withdrawals. The second is that, in addition to being
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solvent, commercial banks must make some profit to pay for operating costs and services to
customers. Third, banks have the important responsibility of meeting the financial needs of the
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community in which they are located. The ability of the bank to meet this responsibility is, of
course, dependent on the nature as well as the quality of the assets that it holds. The nature of the
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assets that banks may acquire, as well as the amount in certain cases, is regulated by banking
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legislation.

It is customary to record liabilities on the left side and assets on the right side. The following is
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the preformat of a balance sheet of the bank.

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Table 8.1: Balance Sheet of Commercial Banks

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Liabilities Assets
1 Capital 1 Cash
a. Authorised capital a. Cash on hand
b. Issued capital b. Cash with central bank and other
c. Subscribed capital banks
d. Paid-up capital
2 Reserve fund 2 Money at call and short notice
3 Deposits 3 Bills discounted
4 Borrowings from other banks 4 Bills for collection
5 Bills payable 5 Investments
6 Acceptance liabilities 6 Loans and advances
7 Contingent liabilities 7 Acceptance and endorsement
8 Profit and loss account 8 Fixed assets
9 Bills for collection

Liabilities
Liabilities are those items on account of which the bank is liable to pay others. They denote
other‟s claims on the bank. Now we have to analyse the various items on the liabilities side.

1. Capital: The bank has to raise capital before commencing its business. Authorised capital is
the maximum capital up to which the bank is empowered to raise capital by the Memorandum of

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Association. Generally, the entire authorised capital is not raised from the public. That part of

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authorised capital which is issued in the form of shares for public subscription is called the
issued capital. Subscribed capital represents that part of issued capital which is actually

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subscribed by the public. Finally, paid-up capital is that part of the subscribed capital which the
subscribers are actually called upon to pay.
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2. Reserve Fund: Reserve fund is the accumulated undistributed profits of the bank. The bank
maintains reserve fund to tide over any crisis. But, it belongs to the shareholders and hence a
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liability on the bank. In India, the commercial bank is required by law to transfer 20 per cent of
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its annual profits to the Reserve fund.

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3. Deposits: The deposits of the public like demand deposits, savings deposits and fixed deposits
constitute an important item on the liabilities side of the balance sheet. The success of any
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banking business depends to a large extent upon the degree of confidence it can install in the
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minds of the depositors. The bank can never afford to forget the claims of the depositors. Hence,
the bank should always have enough cash to honour the obligations of the depositors.
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4. Borrowings from Other Banks: Under this head, the bank shows those loans it has taken from
other banks. The bank takes loans from other banks, especially the central bank, in certain
extraordinary circumstances.

5. Bills Payable: These include the unpaid bank drafts and telegraphic transfers issued by the
bank. These drafts and telegraphic transfers are paid to the holders thereof by the bank‟s
branches, agents and correspondents who are reimbursed by the bank.

6. Acceptances and Endorsements: This item appears as a contra item on both the sides of the
balance sheet. It represents the liability of the bank in respect of bills accepted or endorsed on
behalf of its customers and also letters of credit issued and guarantees given on their behalf. For
rendering this service, a commission is charged and the customers to whom this service is
extended are liable to the bank for full payment of the bills. Hence, this item is shown on both
sides of the balance sheet.

7. Contingent Liabilities: Contingent liabilities comprise of those liabilities which are not known
in advance and are unforeseeable. Every bank makes some provision for contingent liabilities.

8. Profit and Loss Account: The profit earned by the bank in the course of the year is shown
under this head. Since the profit is payable to the shareholders it represents a liability on the
bank.

9. Bills for Collection: This item also appears on both the sides of the balance sheet. It consists of
drafts and hundies drawn by sellers of goods on their customers and are sent to the bank for
collection, against delivery documents like railway receipt, bill of lading, etc., attached thereto.

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All such bills in hand at the date of the balance sheet are shown on both the sides of the balance

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sheet because they form an asset of the bank, since the bank will receive payment in due course,
it is also a liability because the bank will have to account for them to its customers.

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Assets
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According to Crowther, the assets side of the balance sheet is more complicated and interesting.
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Assets are the claims of the bank on others. In the distribution of its assets, the bank is governed
by certain well defined principles. These principles constitute the principles of the investment
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policy of the bank or the principles underlying the distribution of the assets of the bank. The
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most important guiding principles of the distribution of assets of the bank are liquidity,
profitability and safety or security. In fact, the various items on the assets side are distributed
according to the descending order of liquidity and the ascending order of profitability.
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Now, we have to analyse the various items on the assets side.

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1. Cash: Here we can distinguish cash on hand from cash with central bank and other banks cash
on hand refers to cash in the vaults of the bank. It constitutes the most liquid asset which can be
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immediately used to meet the obligations of the depositors. Cash on hand is called the first line
of defence to the bank. In addition to cash on hand, the bank also keeps some money with the
central bank or other commercial banks. This represents the second line of defence to the bank.
2. Money at Call and Short Notice: Money at call and short notice includes loans to the brokers
in the stock market, dealers in the discount market and to other banks. These loans could be
quickly converted into cash and without loss, as and when the bank requires. At the same time,
this item yields income to the bank. The significance of money at call and short notice is that it is
used by the banks to effect desirable adjustments in the balance sheet. This process is called
„Window Dressing‟. This item constitutes the „third line of defence‟ to the bank.
3. Bills Discounted: The commercial banks invest in short term bills consisting of bills of
exchange and treasury bills which are self-liquidating in character. These short term bills are
highly negotiable and they satisfy the twin objectives of liquidity and profitability. If a
commercial bank requires additional funds, it can easily rediscount the bills in the bill market
and it can also rediscount the bills with the central bank.
4. Bills for Collection: As mentioned earlier, this item appears on both sides of the balance sheet.
5. Investments: This item includes the total amount of the profit yielding assets of the bank. The
bank invests a part of its funds in government and non-government securities.
6. Loans and Advances: Loans and advances constitute the most profitable asset to the bank. The
very survival of the bank depends upon the extent of income it can earn by advancing loans. But,
this item is the least liquid asset as well. The bank earns quite a sizeable interest from the loans
and advances it gives to the private individuals and commercial firms.
7. Acceptances and Endorsements: As discussed earlier, this item appears as a contra item on
both sides of the balance sheet.
8. Fixed Assets: Fixed assets include building, furniture and other property owned by the bank.
This item includes the total volume of the movable and immovable property of the bank. Fixed

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assets are referred to as „dead stocks‟. The bank generally undervalues this item deliberately in

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the balance sheet. The intention here is to build up secret reserves which can be used at times of
crisis.

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Balance sheet of a bank acts as a mirror of its policies, operations and achievements. The
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liabilities indicate the sources of its funds; the assets are the various kinds of debts incurred by a
bank to its customers. Thus, the balance sheet is a complete picture of the size and nature of
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operations of a bank.
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8.6 UNIT BANKING VS BRANCH BANKING

The banking system in different countries vary substantially from one another. Broadly speaking,
however, there are two important types of banking systems, viz., unit banking and branch
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banking.
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A. Unit Banking
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„Unit banking‟ means a system of banking under which banking services are provided by a
single banking organisation. Such a bank has a single office or place of work. It has its own
governing body or board of directors. It functions independently and is not controlled by any
other individual, firm or body corporate. It also does not control any other bank. Such banks can
become member of the clearing house and also of the Banker‟s Association. Unit banking system
originated and grew in the U.S.A. Different unit banks in the U.S.A. are linked with each other
and with other financial centres in the country through “correspondent banks.”
Advantages of Unit Banking
Following are the main advantages of unit banking:
1. Efficient Management: One of the most important advantages of unit banking system is that it
can be managed efficiently because of its size and work. Co-ordination and control becomes
effective. There is no communication gap between the persons making decisions and those
executing such decisions.
2. Better Service: Unit banks can render efficient service to their customers. Their area of
operation being limited, they can concentrate well on that limited area and provide best possible
service. Moreover, they can take care of all banking requirements of a particular area.
3. Close Customer-banker Relations: Since the area of operation is limited the customers can
have direct contact. Their grievances can be redressed then and there.
4. No Evil Effects Due to Strikes or Closure: In case there is a strike or closure of a unit, it does
not have much impact on the trade and industry because of its small size. It does not affect the
entire banking system.
5. No Monopolistic Practices: Since the size of the bank and area of its operation are limited, it is
difficult for the bank to adopt monopolistic practices. Moreover, there is free competition. It will
not be possible for the bank to indulge in monopolistic practices.

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6. No Risks of Fraud: Due to small size of the bank, there is stricter and closer control of

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management. Therefore, the employees will not be able to commit fraud.
7. Closure of Inefficient Banks: Inefficient banks will be automatically closed as they would not

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be able to satisfy their customers by providing efficient service.
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8. Local Development: Unit banking is localised banking. The unit bank has the specialised
knowledge of the local problems and serves the requirement of the local people in a better
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manner than branch banking. The funds of the locality are utilised for the local development and
are not transferred to other areas.
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9. Promotes Regional Balance: Under unit banking system, there is no transfer of resources from
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rural and backward areas to the big industrial and commercial centres. This tends to reduce
regional imbalance.
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Disadvantages of Unit Banking

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1. No Economies of Large Scale: Since the size of a unit bank is small, it cannot reap the
advantages of large scale viz., division of labour and specialisation.
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2. Lack of Uniformity in Interest Rates: In unit banking system there will be large number of
banks in operation. There will be lack of control and therefore their rates of interest would differ
widely from place to place. Moreover, transfer of funds will be difficult and costly.
3. Lack of Control: Since the number of unit banks is very large, their co-ordination and control
would become very difficult.
4. Risks of Bank‟s Failure: Unit banks are more exposed to closure risks. Bigger unit can
compensate their losses at some branches against profits at the others. This is not possible in case
of smaller banks. Hence, they have to face closure sooner or later.
5. Limited Resources: Under unit banking system the size of bank is small. Consequently its
resources are also limited. Hence, they cannot meet the requirements of large scale industries.
6. Unhealthy Competition: A number of unit banks come into existence at an important business
centre. In order to attract customers they indulge in unhealthy competition.
7. Wastage of National Resources: Unit banks concentrate in big metropolitan cities whereas
they do not have their places of work in rural areas. Consequently there is uneven and
unbalanced growth of banking facilities.
8. No Banking Development in Backward Areas: Unit banks, because of their limited resources,
cannot afford to open uneconomic branches in smaller towns and rural areas. As such, these
areas remain unbanked.
9. Local Pressure: Since unit banks are highly localised in their business, local pressures and
interferences generally disrupt their normal functioning.

B. Branch Banking System

It means a system of banking in which a banking organisation works at more than one place. The
main place of business is called head office and the other places of business are called branches.
The head office controls and co-ordinates the work at branches. The day-to-day operations are

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performed by the branch manager as per the policies and directions issued from time to time by

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the head office. This system of banking is prevalent throughout the world. In India also, all the
major banks have been operating under branch banking system.

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Advantages of Branch Banking
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1. Better Banking Services: Such banks, because of their large size can enjoy the economies of
large scale viz., division of work and specialisation. These banks can also afford to have the
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specialised services of bank personnel which the unit banks can hardly afford.
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2. Extensive Service: Branch banking can provide extensive service to cover large area. They can
open their branches throughout the country and even in foreign countries.
3. Decentralisation of Risks: In branch banking system branches are not concentrated at one
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place or in one industry. These are decentralised at different places and in different industries.
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Hence the risks are also distributed.

4. Uniform Rates of Interest: In branch banking, there is better control and co-ordination of the
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central bank. Consequently interest rates can be uniform.

5. Better Cash Management: In branch banking there can be better cash management as cash
easily be transferred from one branch to another. Therefore, there will be lesser need to keep the
cash idle for meeting contingencies.
6. Better Training Facilities to Employees: Under branch banking the size of the bank is quite
large. Therefore, such banks can afford to provide better training facilities to their employees.
Almost every nationalised bank in India has its separate training college.
7. Easy and Economical Transfer of Funds: Under branch banking, a bank has a widespread of
branches. Therefore, it is easier and economical to transfer funds from one branch to the other.
8. Better Investment of Funds: Such bank can afford the services of specialised and expert staff.
Therefore they invest their funds in such industries where they get the highest return and
appreciation without sacrificing the safety and liquidity of funds.
9. Effective Central Bank Control: Under branch banking, the central bank has to deal only with
a few big banks controlling a large number of branches. It is always easier and more convenient
to the central bank to regulate and control the credit policies of a few big banks, than to regulate
and control the activities of a large number of small unit banks. This ensures better
implementation of monetary policy.
10. Contacts with the Whole Country: Under branch banking, the bank maintains continual
contacts with all parts of the country. This helps it to acquire correct and reliable knowledge
about economic conditions in various parts of the country. This knowledge enables the bank to
make a proper and profitable investment of its surplus funds.
11. Greater Public Confidence: A bank, with huge financial resources and number of branches
spread throughout the country, can command greater public confidence than a small unit bank
with limited resources and one or a few branches.

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Disadvantages of Branch Banking

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Following are the disadvantages of branch banking:
1. Difficulties of Management, Supervision and Control: Since there are hundreds of branches of

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a bank under this system, management, supervision and control became more inconvenient and
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difficult. There are possibilities of mismanagement in branches. Branch managers may misuse
their position and misappropriate funds. There is great scope for fraud. Thus there are
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possibilities of fraud and irregularities in the financial management of the bank.
2. Lack of Initiative: The branches of the bank under this system suffer from a complete lack of
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initiative on important banking problems confronting them. No branch of the bank can take
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decision on important problems without consulting the head office. Consequently, the branches
of the bank find themselves unable to carry on banking activities in accordance with the
requirements of the local situation. This makes the banking system rigid and inelastic in its
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functioning. This also leads to “red-tapism” which means “official delay.”

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3. Monopolistic Tendencies: Branch banking encourages monopolistic tendencies in the banking

system. A few big banks dominate and control the whole banking system of the country through
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their branches. This can lead to the concentration of resources in the hands of a small number of
men. Such a monopoly power is a source of danger to the community, whose goal is a socialistic
pattern of society.
4. Regional Imbalances: Under the branch banking system, the financial resources collected in
the smaller and backward regions are transferred to the bigger industrial centres. This encourages
regional imbalances in the country.
5. Continuance of Non-profitable Branches: Under branch banking, the weak and unprofitable
branches continue to operate under the protection cover of the stronger and profitable branches.
6. Unnecessary Competition: Branch banking is delocalised banking, under branch banking
system, the branches of different banks get concentrated at certain places, particularly in big
towns and cities. This gives rise to unnecessary and unhealthy competition among them. The
branches of the competing banks try to tempt customers by offering extra inducements and
facilities to them. This naturally increases the banking expenditure.
7. Expensiveness: Branch banking system is much more expensive than the unit banking system.
When a bank opens a number of branches at different places, then there arises the problem of co-
ordinating their activities with others. This necessitates the employment of expensive staff by the
bank.
8. Losses by Some Branches Affect Others: When some branches suffer losses due to certain
reasons, this has its repercussions on other branches of the bank.
Thus branch banking system as well as unit banking system suffer from defects and drawbacks.
But the branch banking system is, on the whole, better than the unit banking system. In fact, the
branch banking system has proved more suitable for backward and developing countries like
India. Branch banking is very popular and successful in India. A comparison between unit
banking and branch banking is essentially a comparison between small-scale and large-scale

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operations.

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8.7 THE PROCESS OF COMMERCIAL BANK CREDIT CREATION

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The money supply narrowly defined is made up of currency outside banks plus demand
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deposits. Hence, the factors that determine the volume of deposits in existence also determine the
supply of money. Banking operations play a vital part in creating deposits as well as destroying
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deposits. An important function performed by the commercial banks is the creation of credit. The
process of banking must be considered in terms of monetary flows, that is, continuous depositing
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and withdrawal of cash from the bank. It is only this activity which has enabled the bank to
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manufacture money. Therefore the banks are not only the purveyors of money but manufacturers
of money.
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Basis of Credit Creation

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The basis of credit money is the bank deposits. The bank deposits are of two kinds‟ viz., (1)
Primary deposits, and (2) Derivative deposits.
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1. Primary Deposits: Primary deposits arise or formed when cash or cheque is deposited by
customers. When a person deposits money or cheque, the bank will credit his account. The
customer is free to withdraw the amount whenever he wants by cheques. These deposits are
called “primary deposits” or “cash deposits.” It is out of these primary deposits that the bank
makes loans and advances to its customers. The initiative is taken by the customers themselves.
In this case, the role of the bank is passive. So these deposits are also called “passive deposits.”
These deposits merely convert currency money into deposit money. They do not create money.
They do not make any net addition to the stock of money. In other words, there is no increase in
the supply of money.

2. Derivative Deposits: Bank deposits also arise when a loan is granted or when a bank discounts
a bill or purchase government securities. Deposits which arise on account of granting loan or
purchase of assets by a bank are called “derivative deposits.” Since the bank play an active role
in the creation of such deposits, they are also known as “active deposits.” When the banker
sanctions a loan to a customer, a deposit account is opened in the name of the customer and the
sum is credited to his account. The bank does not pay him cash. The customer is free to withdraw
the amount whenever he wants by cheques. Thus the banker lends money in the form of deposit
credit. The creation of a derivative deposit does result in a net increase in the total supply of
money in the economy, Hartly Withers says “every loan creates a deposit.” It may also be said
“loans make deposits” or “loans create deposits.” It is rightly said that “deposits are the children
of loans, and credit is the creation of bank clerk‟s pen.”

Granting a loan is not the only method of creating deposit or credit. Deposits also arise when a
bank discounts a bill or purchase government securities. When the bank buys government
securities, it does not pay the purchase price at once in cash. It simply credits the account of the

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government with the purchase price. The government is free to withdraw the amount whenever it

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wants by cheque. Similarly, when a bank purchase a bill of exchange or discounts a bill of
exchange, the proceeds of the bill of exchange is credited to the account of the seller and

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promises to pay the amount whenever he wants. Thus asset acquired by a bank creates an
equivalent bank deposit. It is perfectly correct to state that “bank loans create deposits.” The
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derivate deposits are regarded as bank money or credit. Thus the power of commercial banks to
expand deposits through loans, advances and investments is known as “credit creation.”
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Thus, credit creation implies multiplication of bank deposits. Credit creation may be defined as
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“the expansion of bank deposits through the process of more loans and advances and
investments.”
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The process of deposit creation

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It is well known among bank experts that banks can create money. This process of credit creation
can be illustrated with a simple example. To explain the phenomenon of how a cash deposit of
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₦l,000, for example, can be made to support ₦10,000 in bank deposits, we make a number of
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assumptions:

(1) There are many banks in the system and each with different sets of depositors.
(2) The legal reserve ratio is 10 per cent. This is the amount of cash reserve that is assumed
to be held against deposit liabilities. In other words, every bank has to keep 10 % of
cash reserves, according to law
(3) All banks in the system have made loans up to the limit set by reserve requirement before
the receipt of the additional cash.
(4) All funds loaned by, and cheques drawn on, one bank are deposited in the same or
another bank.
(5) A member of the banking system receives ₦2,000 in cash.
(6) There is no cash drain on the system. The public is willing to borrow as much as banks
are able and willing to lend.
The process may be described as follows. For example, Suppose, a person deposits ₦1,000 cash
in United Bank for African (UBA), on receiving the ₦1,000, places N100 in reserves and
proceeds to lend ₦900. This is lent to a customer, who later writes a cheque to a creditor for
₦900. The receiver of the cheque then deposits it in a Zenith Bank. Then Zenith Bank proceeds
to keep ₦90 and to lend out ₦810. This money comes into the possession of somebody else,
when it is spent by the borrower, and the cheque deposited in a Guarantee Trust Bank (GTB).
Then GTB keeps ₦81 as reserves and lends out ₦729. The Sum of ₦729 is then deposited in a
Wema bank when the borrower spends it, and again 10 per cent is kept as reserves and the rest is
lent out

As can be seen from the above illustration, the banking system was able through repeated use of
funds to expand deposits to ten times the amount of newly acquired cash. The process of credit
(deposit) creation comes to an end when no bank has any excess reserves to lend.

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The balance sheet of the bank is as follows:

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Table 8.2: Balance Sheet of Bank A
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Liabilities ₦ Assets ₦
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New deposit 1,000 New Cash 1,000
Total 1,000 1,000
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Under the double entry system, the amount of ₦1,000 is shown on both sides. The
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deposit of ₦1,000 is a liability for the bank and it is also an asset to the bank. UBA has to keep
only 10% cash reserve, i.e., ₦100 against its new deposit and it has a surplus of ₦900 which it
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can profitably employ in the assets like loans. Suppose UBA gives a loan to X, who uses the
amount to pay off his creditors. After the loan has been made and the amount so withdrawn by X
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to pay off his creditors, the balance sheet of bank A will be as follows

Table 8.3: Balance Sheet of UBA

Liabilities ₦ Assets ₦
Deposit 1,000 New Cash 100
Loan to X 900
Total 1,000 1,000

Suppose X purchase goods of the value of ₦900 from Y and pay cash. Y deposits the amount
with Zenith bank. The deposits of Zenith bank now increase by ₦900 and its cash also increases
by ₦900. After keeping a cash reserve of ₦90, Zenith bank is free to lend the balance of ₦810 to
anyone. Suppose Zenith bank lends ₦810 to Z, who uses the amount to pay off his creditors. The
balance sheet of Zenith bank will be as follows:

Table 8.4: Balance Sheet of Zenith Bank

Liabilities ₦ Assets ₦
Deposit 900 Cash 90
Loan to Z 810
Total 900 900

Suppose Z purchases goods of the value of ₦810 from S and pays the amount. S deposits the
amount of ₦810 in Guarantee Trust Bank (GTB) now keeps 10 % as reserve (₦81) and
lends ₦729 to a merchant. The balance sheet of \GTB will be as follows:

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Table 8.5: Balance Sheet of Bank GTB
Liabilities ₦ Assets ₦
Deposit 810 Cash 81

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AP Loan 729
Total 810 810
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Table 8.6: Thus looking at the banking system as a whole, the position will be as follow
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Name of bank Deposits, ₦ Cash reserve, ₦ Loan ₦

UBA 1,000 100 900
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Zenith 900 90 810

GTB 810 81 728
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Total 2,710 271 2,439

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It is clear from the above that out of the initial primary deposit, UBA advanced ₦900 as a
loan. It formed the primary deposit of Zenith which in turn advanced ₦810 as loan. This sum
again formed, the primary deposit of GTB, which in turn advanced ₦729 as loan. Thus the
initial primary deposit of ₦1,000 resulted in bank credit of ₦2439 in three banks. There will
be many banks in the country and the above process of credit expansion will come to an
end when no bank has an excess reserve to lend. In the above example, there will be 10
fold increase in credit because the cash ratio is 10 %. The total volume of credit created in
the banking system depends on the cash ratio. If the cash ratio is 10 % there will be 10 fold
increase. If it is 20 %, there will be 5 fold increase. When the banking system receives an
additional primary deposit, there will be multiple expansion of credit. When the banking system
loses cash, there will be multiple contraction of credit. . When the original cash receipt of
₦1000 has diffused itself throughout the system, deposits will amount to ₦10,000 (ten times the
cash reserve) and loans to ₦9,000. Thus, the bank receiving a cash deposit of ₦1,000 is
immediately in a position to lend ₦9,000 (not ₦900), because the whole ₦1,000 is added to its
cash reserve.

The extent to which the banks can create credit together could be found out with the help of
the credit multiplier formula. The formula is:
1
K (8.1)
r
Where K is the credit multiplier, and r, the required reserves. If the reserve ratio is 10 % the size
of credit multiplier will be:
1 1
K   10 (8.2)
r 0.1

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It means that the banking system can create credit together which is ten times more than the

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original increase in the deposits. It should be noted here that the size of credit multiplier is
inversely related to the percentage of cash reserves the banks have to maintain. If the reserve

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ratio increases, the size of credit multiplier is reduced and if the reserve ratio is reduced, the
size of credit multiplier will increase. AP
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This process of deposit creation that is shown in Table 8.6, column 1 is the sum of a
geometric series. This can also be expressed as
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2 3 n
9 9 9 9
1, 000  1, 000    1, 000    1, 000      1, 000   (8.3)
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10  10  10  10 

Algebraically, this is
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a  ar  ar 2  ar 3    ar n (8.4)
As n approaches infinity, the value of total new deposits is
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 1 
(0  r  1)
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a (8.5)
1  r 
9
Since a = ₦1,000 and r  , we have, on substitution into (8.6)
10
 1 
N1,000 1  9   N10,000 (8.7)
 10 
 
As can be seen from the above illustration, the banking system was able through repeated use of
funds to expand deposits to ten times the amount of newly acquired cash. The process of credit
(deposit) creation comes to an end when no bank has any excess reserves to lend.

Leaf and Cannon Criticism

Walter Leaf and Edwin Cannon objected to the theory of credit creation. According to them, the
commercial bank cannot lend anything more than what it receives as cash from deposits. But the
contention of Leaf and Cannon that banks cannot create credit is wrong due to the following
reasons:

(a) A single bank may not be able to create derivative deposits in excess of its cash
reserves. But the banking system as a whole can do what a single bank cannot do.
(b) As Crowther points out that the total net deposits of commercial banks are for in
excess of their cash reserves. It means they can create credit.

Limitation on Credit Creation

The commercial banks do not have unlimited power of credit creation. Their power to

1. Amount of Cash: The power to create credit depends on the cash received by banks. If banks
receive more cash, they can create more credit. If they receive less cash they can create less
credit. Cash supply is controlled by the central bank of the country.

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2. Cash Reserve Ratio: All deposits cannot be used for credit creation. Banks must keep certain
percentage of deposits in cash as reserve. The volume of bank credit depends also on the cash
reserve ratio the banks have to keep. If the cash reserve ratio is increased, the volume of credit

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that the banks can create will fall. If the cash reserve ratio is lowered, the bank credit will
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increase. The Central Bank has the power to prescribe and change the cash reserve ratio to be
kept by the commercial banks. Thus the central bank can change the volume of credit by
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changing the cash reserve ratio.
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3. Banking Habits of the People: The loan advanced to a customer should again come back into
banks as primary deposit. Then only there can be multiple expansion. This will happen only
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when the banking habit among the people is well developed. They should keep their money in
the banks as deposits and use cheques for the settlement of transactions.
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4. Nature of Business Conditions in the Economy: Credit creation will depend upon the nature of
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business conditions. Credit creation will be large during a period of prosperity, while it will be
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smaller during a depression. During periods of prosperity, there will be more demand for loans
and advances for investment purposes. Many people approach banks for loans and advances.
Hence, the volume of bank credit will be high. During periods of business depression, the
amount of loans and advances will be small because businessmen and industrialists may not
come to borrow. Hence the volume of bank credit will be low.

5. Leakages in Credit-Creation: There may be some leakages in the process of credit creation.
The funds may not flow smoothly from one bank to another. Some people may keep a portion of
their amount as idle cash.

6. Sound Securities: A bank creates credit in the process of acquiring sound and profitable assets,
like bills, and government securities. If people cannot offer sound securities, a bank cannot
create credit. Crowther says “a bank cannot create money out of thin air. It transmutes other
forms of wealth into money.”
7. Liquidity Preference: If people desire to hold more cash, the power of banks to create credit is
reduced.

8. Monetary Policy of the Central Bank: The extent of credit creation will largely depend upon
the monetary policy of the Central Bank of the country. The Central Bank has the power to
influence the volume of money in circulation and through this it can influence the volume of
credit created by the banks. The Central Bank has also certain powerful weapons, like the bank
rate, open market operations with the help of which it can exercise control on the expansion and
contraction of credit by the commercial bank.

8.8 COMMERCIAL BANKS AND ECONOMIC DEVELOPMENT

Commercial banks are considered not merely as dealers in money but also the leaders in
economic development. They are not only the store houses of the country‟s wealth but also the

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reservoirs of resources necessary for economic development. They play an important role in the

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economic development of a country. A well-developed banking system is essential for the
economic development of a country. The “Industrial Revolution” in Europe in the 19th century

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would not have been possible without a sound system of commercial banking. In case of
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developing countries like India, the commercial banks are considered to be the backbone of the
economy. Commercial banks can contribute to a country‟s economic development in the
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following ways:

1. Accelerating the Rate of Capital Formation: Capital formation is the most important
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determinant of economic development. The basic problem of a developing economy is slow rate
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of capital formation. Banks promote capital formation. They encourage the habit of saving
among people. They mobilise idle resources for production purposes. Economic development
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depends upon the diversion of economic resources from consumption to capital formation. Banks
help in this direction by encouraging saving and mobilising them for productive uses.
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2. Provision of Finance and Credit: Commercial banks are a very important source of finance and
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credit for industry and trade. Credit is a pillar of development. Credit lubricates all commerce
and trade. Banks become the nerve centre of all commerce and trade. Banks are instruments for
developing internal as well as external trade.

3. Monetisation of Economy: An underdeveloped economy is characterised by the existence of a

large non-monetised sector. The existence of this non-monetised sector is a hindrance in the
economic development of the country. The banks, by opening branches in rural and backward
areas can promote the process of monetisation (conversion of debt into money) in the economy.

4. Innovations: Innovations are an essential prerequisite for economic development. These

innovations are mostly financed by bank credit in the developed countries. But in
underdeveloped countries, entrepreneurs hesitate to invest in new ventures and undertake
innovations largely due to lack of funds. Facilities of bank loans enable the entrepreneurs to step
up their investment on innovational activities, adopt new methods of production and increase
productive capacity of the economy.

5. Implementation of Monetary Policy: Economic development need an appropriate monetary

policy. But a well-developed banking is a necessary pre-condition for the effective
implementation of the monetary policy. Control and regulation of credit by the monetary
authority is not possible without the active co-operation of the banking system in the country.

6. Encouragement to Right Type of Industries: Banks generally provide financial resources to the
right type of industries to secure the necessary material, machines and other inputs. In this way
they influence the nature and volume of industrial production.

7. Development of Agriculture: Underdeveloped economies are primarily agricultural

economies. Majority of the population in these economies live in rural areas. Therefore,

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economic development in these economies requires the development of agriculture and small

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scale industries in rural areas. So far banks in underdeveloped countries have been paying more
attention to trade and commerce and have almost neglected agriculture and industry. Banks must

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provide loans to agriculture for development and modernisation of agriculture. In recent years,
the State Bank of India and other commercial banks are granting short term, medium-term and
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long-term loans to agriculture and small-scale industries.
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8. Regional Development: Banks can also play an important role in achieving balanced
development in different regions of the country. They transfer surplus capital from the developed
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regions to the less developed regions, where it is scarce and most needed. This reallocation of
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funds between regions will promote economic development in underdeveloped areas of the
country.
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9. Promote Industrial Development: Industrial development needs finance. In some countries,

commercial banks encouraged industrial development by granting long-term loans also. Loan or
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credit is a pillar to development. In underdeveloped countries like India, commercial banks are
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granting short-term and medium-term loans to industries. They are also underwriting the issue of
shares and debentures by industrial concerns. This helps industrial concerns to secure adequate
capital for their establishment, expansion and modernisation. Commercial banks are also helping
manufacturers to secure machinery and equipment from foreign countries under instalment
system by guaranteeing deferred payments. Thus, banks promote or encourage industrial
development.

10. Promote Commercial Virtues: The businessmen are more afraid of a banker than a preacher.
The businessmen should have certain business qualities like industry, forethought, honesty and
punctuality. These qualities are called “commercial virtues” which are essential for rapid
economic progress. The banker is in a better position to promote commercial virtues. Banks are
called “public conservators of commercial virtues.”
11. Fulfilment of Socio-economic Objectives: In recent years, commercial banks, particularly in
developing countries, have been called upon to help achieve certain socio-economic objectives
laid down by the state. For example, nationalised bank in India have framed special innovative
schemes of credit to help small agriculturists, self-employed persons and retailers through loans
and advances at concessional rates of interest. Banking is thus used to achieve the national policy
objectives of reducing inequalities of income and wealth, removal of poverty and elimination of
unemployment in the country.

Thus, banks in a developing country have to play a dynamic role. Economic development places
heavy demand on the resources and ingenuity of the banking system. It has to respond to the
multifarious economic needs of a developing country. Traditional views and methods may have
to be discarded. “An Institution, such as the banking system, which touches and should touch the
lives of millions, has necessarily to be inspired by a larger social purpose and has to sub serve

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national priorities and objectives.” A well-developed banking system provides a firm and durable

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foundation for the economic development of the country.

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Lists of Commercial Banks in Nigeria
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The 89 Legacy Banks before Banking Consolidation in Nigeria
1 Access Bank Plc
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2 Citibank Nigeria Limited
3 Diamond Bank Plc
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4 Ecobank Nigeria Plc

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5 Enterprise Bank
6 Fidelity Bank Plc
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7 First Bank of Nigeria Plc

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8 First City Monument Bank Plc

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9 Guaranty Trust Bank Plc

10 Heritage Banking Company Ltd.
11 Key Stone Bank
12 MainStreet Bank
13 Skye Bank Plc
14 Stanbic IBTC Bank Ltd.
15 Standard Chartered Bank Nigeria Ltd.
16 Sterling Bank Plc
17 Union Bank of Nigeria Plc
18 United Bank For Africa Plc
19 Unity Bank Plc
20 Wema Bank Plc
21 Zenith Bank Plc

Summary
From the above discussion, undoubtedly, we can say that, commercial banks form the most
important part of financial intermediaries. It accepts deposits from the general public and extends
loans to the households, firms and the government. Banks form a significant part of the
infrastructure essential for breaking vicious circle of poverty and promoting economic growth.

8.9 SELF-ASSESSMENT QUESTIONS

8.1 Do bank‟s that make no loans create money?

SOLUTION TO SAQ 8.1

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Bank that make no loans create deposits but do not create money. By accepting notes and coin in

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circulation, banks, even those that make no loans, create deposits. However, they do not create
money. Take the example we covered in class, where Odior has ₦100,000, which she deposits at

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First Bank, which is a 100% reserve bank. Prior to depositing her money, total money supply in
the economy is: Money = notes and coin in circulation + demand deposits = 100 + 0 = 100 (we
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are assuming that Odior is the only individual with money holdings in this economy). After
Odior makes her deposit at First Bank, First Bank opens an account for Odior.
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Odior now has ₦100,000 deposited at the bank. So ₦100,000 of deposits have been created,
however money supply is still ₦100,000. To see this note that money supply is: Money = notes
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and coin in circulation + demand deposits = 0 + 100,000 = 100,000

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8.10 MUITIPLE-CHOICE QUESTIONS

1) Which of the following financial intermediaries is not a depository institution?
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a. A trust and mortgage loan company

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b. A commercial bank.
c. A credit union.
d. A finance company.

2) Which answer below would be a benefit in investing your funds in a financial institution,
like a bank?
a. A bank account increases investor‟s risk
b. A bank account is not a liquid investment
c. A bank account is a liquid investment
d. A bank collects information on borrowers poorly.

3) Which of the following is NOT a key financial service provided by the financial system?
a. Liquidity
b. Risk sharing
c. Profitability
 d. information

4) Bank's that make no loans:

a. create deposits but do not create money
b. create deposits and create money
c. hold no reserves
d. hold few reserves

5) A bank run involves

a. a failure by a bank to get the maximum return on its investments
b. large numbers of depositors withdrawing their deposits in a short period of
time
c. a bank being forced into receivership
d. fraud on the part of a bank‟s management

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6) If you deposit a ₦5,000 check in the bank, before the check has cleared, the change

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in your bank's balance sheet will be
a. a ₦5,000 increase in reserves and a ₦5,000 increase in checkable deposits

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b. a ₦5,000 increase in cash items in the process of collection and a ₦5,000
increase in reserves AP
c. a ₦5,000 increase in cash items in the process of collection and a ₦5,000 increase in
checkable deposits
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d. a ₦5,000 increase in cash and a ₦5,000 increase in checkable deposits
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7) Economists group commercial banks, savings and loan associations, credit unions,
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mutual funds, mutual savings banks, insurance companies, pension funds, and finance
companies together under the heading financial intermediaries. Financial intermediaries
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a. act as middlemen, borrowing funds from those who have saved and lending these
funds to others
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b. produce nothing of value and are therefore a drain on society's resources

c. help promote a more efficient and dynamic economy
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d. do only (a) and (c) of the above

8) Suppose that the banking system currently has no excess reserves and that a bank in the
system receives a deposit into a checking account of ₦20,000 in new currency. Under
current reserve requirements, and assuming all subsequent deposits are placed in
accounts requiring reserves, what is the maximum amount of deposits the entire
fractional reserve banking system can create?
a. ₦100,000
b. ₦160,000
c. ₦180,000
d. ₦200,000

9) Why is liquidity so important?

a. Stronger liquidity causes the economy to grow faster.
 b. Liquidity causes problems when converting nominal GDP into real GDP.
c. Liquidity defines the money supply for countries with sophisticated financial
markets
d. Liquidity helps the Fed in controlling the money supply.

SOLUTION TO MUITIPLE-CHOICE QUESTIONS 2.7

Questions 1 2 3 4 5 6 7 8 9
Answers D c c a b c d d C

Further Questions for Discussion

(1) What is a commercial bank? What are the main functions performed by commercial

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banks? How far are they useful for economic development?

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(2) .State the kinds of commercial banks.
(3) What do you understand by a commercial bank‟s balance sheet? What specific

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information does it convey?
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(4) What is the investment policy of a commercial bank? Explain the factors that constitute
for formulating a suitable investment policy.
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(5) What is credit creation? How banks create credit? What are the limitations of credit
creation?
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(6) State the advantages and disadvantages of unit banking system.

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(7) State the advantages and disadvantages of branch banking system.

(8) Discuss the role of banks in a developing economy.
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 STUDY SESSION 9
OTHER FINANCIAL INSTITUTIONS
Introduction
This session deals with the other major categories of financial institutions and their roles in the
financial system. First, we discuss the merchant banks and their roles in the economy; and then
we discuss some specialized banks, like the Federal Savings Bank, the Nigerian industrial
Development Bank, the Nigerian Agricultural Bank, the Nigerian Bank for Commerce and
Industry, and the Federal Mortgage Bank and finally, the non-bank financial intermediaries.
Learning Outcomes for Study Session 9
At the end of this study Session, you should be able to:
9.1 understand the function of merchant banks (SAQ 9.1)
9.2 discuss the activities of the development finance institutions (SAQ 9.2)
9.3 explain the role of non-bank financial institutions intermediaries (SAQ 9.3)

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9.1 MERCHANT BANKS
A merchant bank can be defined as a wholesale banker whose deposits are usually in large

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amounts (a minimum of ₦10, 000.00). Such deposits are fixed for a particular period; and, of
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course, they earn interest. With such large deposits its loans are inevitably and equally of large
denominations. The history of merchant banking dates from 1960, when Philip Hill (Nigeria)
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limited was established to carry out merchant banking in Nigeria. It was to dominate the scene
for the next decade.
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The sudden upsurge in merchant banking should not come as a surprise. With the structure of the
Nigerian economy changing so rapidly, and with "the pace of industrialization gathering breath-
taking momentum, there is the inevitable need for wholesale banking and for medium and long-
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term financing activities that are outside the traditional domain of commercial banks.
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What are the differences between a merchant bank and a commercial bank? A merchant bank is
essentially a wholesale banker. A commercial bank, on the other hand, is a retail banker, in the
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sense that it mobilises small and large savings throughout the economy. Whereas overdrafts form
a significant proportion of commercial bank loans and advances, they form only a small
proportion of the loans and advances of merchant banks. Since it does not provide current
account facilities, a merchant bank holds little or no cash reserves. This contrasts sharply with
commercial banks, which have to keep large cash reserves to meet customers' cash withdrawals.
Furthermore, again unlike commercial banks, merchant banks have no widespread branch
network.

This comparison can be extended to their sources and uses of funds. While a commercial bank
accepts deposits from individuals and institutions, a merchant bank obtains its funds, apart from
its share capital, from banks and corporations (both public and private). As for the utilisation of
funds, a commercial bank typically lends to a wide variety of individuals and institutions, but a
merchant bank utilises its funds by accepting bills of exchange to finance trade. Such bills are, of
course, discountable with the Central Bank.

In spite of these differences, it is obvious that merchant banks and commercial banks provide
complementary rather than competitive services; and in some areas (e.g. the provision of credit
facilities for external trade) their activities overlap.

Functions of Merchant Banks

The functions of merchant banks can be broken down into four: banking services, financial
advice to companies, investment management services, and floating of state government stocks.
Banking services: Merchant banks provide short-term finance by means of acceptance credit for
the finance of external trade. While such facilities are normally made available for a period of up
to three months, they can be offered on a revolving basis.

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Merchant banks also provide bridging loans for short periods for companies that need temporary
finance pending the conclusion of funding arrangements. The provision of finance for industrial

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re-equipment or purchase of new machinery or plant is also another area in which merchant
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banks are active. They also provide longer-term finance for the purchase of real estate and for
specialised agricultural development.
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Merchant banks also deal in foreign exchange market, and consequently they can engage in the
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purchase and sale of foreign exchange for commercial and other purposes. Merchant banks are
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involved in the leasing of equipment. Leasing is a method of financing that enables a company to
rent industrial equipment instead of buying it outright. This arrangement has some advantages.
First it enables the lessee to have the use of expensive equipment immediately without the
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necessity of finding capital for it. Secondly, in event of the obsolescence of the equipment, it can
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be replaced quickly without placing too great a strain on the lessee's capital resources.
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Financial advice for Companies: Merchant banks advise companies on the raising of capital for
expansion and development. Since they are issuing houses, they offer advice on steps to be taken
in seeking a quotation on the stock exchange. They also help to place company shares with the
general public and offer advice to the company on all preliminary actions, such as the adoption
of articles of association and, in appropriate cases, the rationalisation of the company's capital
structure, including scrip issue. They also give advice on merger, acquisitions, capital
reconstruction, and the most effective way of achieving any desired degree and structure of
corporate financing.

Government Finance: Merchant banks are also involved with government finance. As a result
of Federal Government decision permitting state government, local governments and other
parastatal bodies to approach the capital market directly, merchant banks have become involved
with the floating of state government loan stocks.

9.2 DEVELOPMENT FINANCE INSTITUTIONS (DFI'S)

Industrial Banks: Industries require a huge capital for a long period to buy machinery and
equipment. Industrial banks help such industrialists. They provide long term loans to industries.
Besides, they buy shares and debentures of companies, and enable them to have fixed capital.
Sometimes, they even underwrite the debentures and shares of big industrial concerns. The
important functions of industrial banks are:
1. They accept long term deposits.
2. They meet the credit requirements of industries by extending long term loans.
3. These banks advise the industrial firms regarding the sale and purchase of shares and

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debentures. The industrial banks play a vital role in accelerating industrial development.

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Example of industrial banks in Nigeria.

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Nigerian Bank for Commerce and Industry (NBCI): The Nigerian Bank for Commerce and
Industry (NBCI) was established 1973. It has an authorised capital of N50m. of which N10m are
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paid u The Central Bank of Nigeria and the Federal Government jointly provide the bank's share
capital, with the former providing 40 per cent and the latter 60 per cent. Insurance companies,
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banks and other financial institutions can acquire the Central Bank's proportion of 20 per cent.
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The bank has three objectives:

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i. Providing equity capital and funds through loans to indigenous persons and institutions
for medium and long-term investment in commerce and industry;
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ii. Performing all aspects of merchant banking; and

iii. Conducting other banking and commercial business.
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It is also empowered to assist indigenous businessmen in identifying vial projects, preparing

feasibility studies and advising on technical a managerial matters.
Established in the wake of the Nigerian Enterprises Promotion Decree (197 the bank has
provided reasonable medium and long-term finance for the acquisition of indigenised enterprises.
Existing enterprises have a benefited from its loans.

As can be seen, the government instituted a two-pronged approach to industrial development:

through the NIDB and the NBCI. But their non-satisfactory performances even after the
recapitalisation grant provided to these banks in March 1999 by the Federal Government led to
their demise in wake of 2000s. The two banks were merged with NERFUND in 2000 to form the
Bank of Industry (BOI).
The Bank of Industry (BOI): The BOI came into existence through the merger of the Nigerian
Industrial Development Bank (NIDB), the Nigerian Bank for Commerce and Industry (NBCI)
and the National Economic Reconstruction Fund (NERFUND). The new bank took off in the
first quarter of 2002 with an initial capital of N50 billions of 40 per cent of which was the
expected from the Central Bank of Nigeria.
The primary function of the bank is to provide financial assistance for the establishment of large,
medium and small-scale projects in addition to the expansion, diversification and modernisation
of existing enterprises; and the rehabilitation of ailing industries. The other functions of the bank
include: Mobilisation of funds -Promotion and development of enterprises -Appraisal of projects
-Financing and implementation and -Investment supervision and loan recovery.

Nigeria Industrial Development Bank (NIDB): By reconstructing the investment Company of

Nigeria Ltd, which was incorporated in 1959, the Nigerian Industrial Development Bank (NIDB)

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was established on 22 January 1964 with an initial capital of N8.50m. The NIDB is a

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development finance company, which provides both medium and long-term finance. It also
sometimes makes equity investments. As a development bank it then has two important

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functions: the banking function and the development function. The first function is the provision
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of medium and long-term finance to industrial projects, while the development function relates to
the removal of bottlenecks to development. Thus, the development activities of the NIBD
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involve investigating new investment opportunities, encouraging the interest of potential
investors and generally assessing the economic viability of industrial projects from both the
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financial and the economic points of view, Also provided are technical assistance such as
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accounting and engineering, including managerial assistance, to the projects of clients.

Five departments share the responsibilities of the bank's development activities:

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i. The Promotion and Development Department;

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ii. The Appraisal Department

iii. The Investment Supervision Department
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iv. The Management Services Department and

v. The Research Department

The banking function of the NIDB consists of making funds available for industrial investment.
There are two aspects of this function, the first consists of the approval of clients' applications for
financial assistance, and the second is the disbursements of the approved sum after the
satisfaction of the pre-disbursement requirements.
The scope of the investment is presently limited to manufacturing, non-petroleum-mining and
tourism. Tourism includes the provision of hotels of international standards. The preponderance
of the bank's investment (usually about 90 per cent and above) is concentrated on manufacturing.
Agricultural Banks: Agriculture has its own problems and hence there are separate banks to
finance it. These banks are organised on co-operative lines and therefore do not work on the
principle of maximum profit for the shareholders. These banks meet the credit requirements of
the farmers through term loans, viz., short, medium and long term loans. There are two types of
agricultural banks,
(a) Agricultural Co-operative Banks, and
(b) Land Mortgage Banks. Co-operative Banks are mainly for short periods. For long periods
there are Land Mortgage Banks
Example of Agricultural Banks in Nigeria, The Nigerian Agricultural Bank (NACB): it was
established in 1972 but did not start effective operation until 1973. It received its initial funds of
N12m. from the Federal Government. Out of this, N1m were equity capital and N11m loan
capital. It has the power to raise funds from the public.

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The main aim of the bank is the provision of funds for the development, production, storage and

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marketing of agricultural products. In the pursuit of these goals, the bank deals with a special
class of borrowers; state governments, farmers' co-operative societies and credit worthy

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individuals.
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The need to develop agriculture arises as a result of the need to increase food production, for
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food was in short supply immediately after the war. Consequently, increased food production
was thought to be a mechanism for curbing the increasing inflationary pressure. Agriculture is
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also important from another perspective. Apart from providing the food supply it can also be a
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source of supply of raw materials for the industrial projects allied to agriculture.

Federal Mortgage Bank: The Nigerian Building Society was established in 1957. It was
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reconstituted as the Nigerian Mortgage Bank in 1977, following the acceptance by the Federal
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Government of the recommendations of the Financial Review Panel. The bank has two
objectives: to provide loans to Nigerians to buy or build their own houses; and to encourage the
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habit of saving among Nigerians, so that, when they apply for loans, they will have acquired
certain savings, which they can show as evidence of their ability to manage personal finance.
With the change in structure in 1977, it is required to co-ordinate housing policy and land-
development financing in the country.

The bank provides loans to individuals to cover a part of the total cost of building a house,
including the cost of land. The repayment of loans is made by equal monthly instalments spread
over a period not exceeding twenty years. The main sources of the fund include loan from
Federal Government grants, other institutions and deposit liability plus reserves.

This followed the licensing of Primary Mortgage Institutions (PMIs) to operate at the retail end
of the mortgage finance market. The FMBN became the apex institution that regulated and
supervised these private Primary Mortgage Institutions in the country that was springing up then
in the early 1990s. It also performed wholesale mortgage finance functions.

The bank finally transferred the supervision of the primary mortgage institutions, which were
part of its obligation to the CBN in 1998. It has, since then, focused on-the coordination and
management of the National Housing Fund (NHF), which was established in 1992 and aimed at
mobilising mandatory savings by formal sector employees. It however continues its wholesale
mortgage finance business.

Savings Banks: These banks were specially established to encourage thrift among small savers
and therefore, they were willing to accept small sums as deposits. They encourage savings of the
poor and middle class people. After nationalisation most of the nationalised banks accept the
saving deposits.

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9.3 NON-BANK FINANCIAL INSTITUTIONS INTERMEDIARIES
Financial Intermediaries and Intermediation

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It is now generally agreed that money has substitutes, and these substitutes are the instruments in
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which non-bank financial intermediaries’ deal, thus very important that we study the institutions
that deal in these money substitutes, for three main reasons. First, these institutions are crucial
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channels of credit in their own rights, so that their efficient working (i.e. way in which they
allocate credit) is essential to the smooth working of financial system. Secondly, many of these
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intermediaries issue and deal in liabilities that are almost indistinguishable from money. It is in
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this se that one can refer to them as subsidiary creators of money. Thirdly, even when these
assets are not money substitutes, they sufficiently resemble money to enable their substitution for
money if the yields on them are attractive.
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What then, are financial intermediaries? The distinguishing characteristic of financial

intermediaries is that their assets consist almost exclusive; financial instruments, primarily of
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non-financial borrowers, such as business enterprises, households and governments. This is

unlike the other sector the economy, whose assets are mainly tangible assets, although they may
hold some financial assets either as liquid reserves or as sources income such as interest and
dividends.

Financial intermediaries can then be regarded as institutions that raise their funds by borrowing
and use them for lending. In the words of Goldsmith (1968), they are primary issuers of, and
dealers in, debt. In pursuance of this role, they direct the flow of financial instruments among
non-financial units and, in doing this, often transform the character of the funds involved.
How does the need for financial intermediaries arise? Their development is a feature of a modern
economy, as the discussion below demonstrates. Consider, for example, a country in which each
unit in it spends exactly as" much as its income. In such a rudimentary economy there would be
no need for external financing, as a unit's income would finance its consumption and capital
accumulation. Thus, financial intermediaries presuppose the absence of this kind of complete
financial autonomy. They also presuppose the existence of some economic units whose receipts
exceed their expenditure (financial surplus units) and of the other units whose expenditure
exceeds their receipts (financial deficit units).

The existence of financial 'surpluses and financial deficits requires the creation of instruments
with which to transfer funds from the surplus units to deficit units. It is, however, possible for the
transfer of funds to be direct. It is called direct external financing. It is called direct because the
transfer occurs directly between the surplus units and the deficit units. It is external in the sense
that the deficit units are using funds external to themselves. The development of financial
intermediaries can be traced to the idea of replacing direct financing with indirect financing, and
the main advantage in it is to be found in the convenience that it confers on both the surplus and

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the deficit units.

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The essential fact always is that financial intermediaries make the funds available to deficit units
- or more broadly to borrowers ... -in a form different from that in which they receive them from

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surplus units, or again more broadly from lenders. Financial intermediation thus involves a
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'transformation' of funds, a process that is economically though not technically equivalent to the
transformation that occurs in the production of commodities or services.
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The kind of transformation that takes place is one of debtor substitution- the substitution of
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liabilities of financial intermediaries for those of non- financial units. Lenders have preference
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for this kind of substitution, because the financial intermediaries are better known and more
creditworthy than the borrower. In addition, the issues of financial intermediaries are more liquid
than those of non-financial issues. To the borrowers financial intermediation has its own
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advantages. Intermediation introduces greater flexibility in borrowing arrangements. Such

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flexibility may be the ease with which borrowing terms can be changed.
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However, these advantages have to be obtained at a cost. In the process of intermediation, the
financial intermediaries incur costs and must in fact make profit for their owners. Hence, the rate
of interest that lenders receive from the financial intermediaries is lower than the rates paid by
the borrowers. The difference represents the profit of the intermediaries plus the cost of
intermediation.

Kinds of Non-bank financial intermediaries

Insurance Companies: Insurance companies pool risk by collecting premiums from a large
group of people who want to protect themselves and/or their loved ones against a particular loss,
such as a fire, car accident, illness, lawsuit, disability or death. Insurance helps individuals and
companies manage risk and preserve wealth. By insuring a large number of people, insurance
companies can operate profitably and at the same time pay for claims that may arise. Insurance
companies use statistical analysis to project what their actual losses will be within a given class.
They know that not all insured individuals will suffer losses at the same time or at all.

Insurance business started in Nigeria in 1921 with the establishment of the Royal Exchange
Assurance. It was to remain the only insurance company until 1949, when three others were
established. The number of companies has increased enormously over the years. In 1981 there
were 84 registered insurance companies. This number increased to 168 companies in 1998.
For a long time foreigners dominated tile insurance business, but this situation has changed in
recent years, and the number of indigenous insurance firms now exceeds the number of foreign-
owned ones. This has led the Federal Government to acquire equity participation in all the
foreign-owned companies. Its share ranges from 13 percent to 49 percent in such companies.

The Government has since handed off equity participation in insurance companies following the

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liberalisation and privatisation reform programmes of the government. By law, insurance

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companies must invest part of their reserves, which they carry for the protection of policyholders
and their surplus funds. Such funds are usually invested in stocks and shares. Insurance

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companies also grant loans and advances to different sectors of the economy (see Ajayi and Ojo,
2006)
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On January 1997, The National Insurance Commission (NAICOM) replaced the National
Insurance Supervisory Board (NISB) as the regulatory authority of the insurance industry. All
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insurance companies are required to make periodic return to NAICOM. The effective
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administration, supervision, regulation and control of insurance business in Nigeria are under the
control of NAICOM. The specific functions of NAICOM include.
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i. Establishment of standards for the conduct of insurance business;

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ii. Protection of insurance policy holders through the establishment of a bureau to which
members of the public can lodge complaints against insurance companies.
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In 1999, NAICOM implemented a new capital structure for insurance companies. The stipulated
minimum paid-up capital requirement ranged from N20 million for general insurance to N90
million for the special risk category. At the end of 2000, the 118 insurance companies in
operation complied fully with the minimum paid-up capital requirements.

Question: What Is Deposit Insurance?

Solution: Deposit Insurance is a system established by the Government to protect depositors

against the loss of their insured deposits placed with member institutions in the event a member
institution is unable to meet its obligations to depositors. Deposit Insurance ensures that the
depositor does not lose all his money in the event of a bank failure. It also engenders public
confidence in, and promotes the stability of, the banking system by assuring savers of the safety
of their funds. Deposit Insurance makes a bank failure an isolated event, hence it eliminates the
danger that unfounded rumours will start a contagious bank run.

Discount Houses: Discount houses are non-bank financial institutions designed to act between
the Central Banks and other financial institutions in provision of discount and rediscounting
facilities in government short-term securities, commercial papers and other eligible money
market instruments. Discount houses intermediate funds among banks, and invest in short-term
securities. They assist financial institutions to effectively manage their idle cash balances by
bringing together both surplus and deficit units in the money market. Discount houses play
crucial roles in successful implementation of Open Market Operation (OMO) as the main
intermediary in the money market.

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Discount houses commenced operation in Nigeria in 1993 following the transition by the CBN

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from direct monetary control to a market based indirect monetary control. It brought about the
adoption of Open Market Operation as the main instrument of monetary management in the

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economy. They collate bids from their willing dealers (commercial and merchant banks and
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members of the public) and forward them to the CBN alongside their own bidding needs. The
pattern of OMO is that periodically, the apex bank determines the excesses in the economy to be
mopped up and the type and tenor of instrument to use. A circular to that effect is then issued.
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Participants in the impending bid then submit their bids through the discount houses. The CBN
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then use this bid to determine the price and allocation of the bills to bidders. The winners pay for
their allocation through the discount houses. Discount houses also provide secondary market for
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these bills at a discount rate before maturity at which holders can sell their bill when short of
cash.
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In addition to this primary business of the discount houses, they also finance first class
commercial bills, bankers' acceptances and provide short-term liquidity adjustment services for
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banks. The dominant source of fund to the discount houses is money at call from commercial and
merchant banks. Other sources include the non-deposit liabilities of the discount houses.

Investment Banks: The stock market crash of 1929 and ensuing Great Depression caused the
United States government to increase financial market regulation. The Glass-Steagall Act of
1933 resulted in the separation of investment banking from commercial banking. While
investment banks may be called "banks," their operations are far different than deposit-gathering
commercial banks.

An investment bank is a financial intermediary that performs a variety of services for businesses
and some governments. These services include underwriting debt and equity offerings, acting as
an intermediary between an issuer of securities and the investing public, making markets,
facilitating mergers and other corporate reorganizations, and acting as a broker for institutional
clients. They may also provide research and financial advisory services to companies.

As a general rule, investment banks focus on initial public offerings (IPOs) and large public and
private share offerings. Traditionally, investment banks do not deal with the general public.
However, some of the big names in investment banking, such as JP Morgan Chase, Bank of
America and Citigroup, also operate commercial banks. Other past and present investment banks
you may have heard of include Morgan Stanley, Goldman Sachs, Lehman Brothers and First
Boston.

Generally speaking, investment banks are subject to less regulation than commercial banks.
While investment banks operate under the supervision of regulatory bodies, like the Securities
and Exchange Commission, FINRA, and the U.S. Treasury, there are typically fewer restrictions

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when it comes to maintaining capital ratios or introducing new products.

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Brokerages: A brokerage acts as an intermediary between buyers and sellers to facilitate

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securities transactions. Brokerage companies are compensated via commission after the
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transaction has been successfully completed. For example, when a trade order for a stock is
carried out, an individual often pays a transaction fee for the brokerage company's efforts to
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execute the trade.
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A brokerage can be either full service or discount. A full service brokerage provides investment
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advice, portfolio management and trade execution. In exchange for this high level of service,
customers pay significant commissions on each trade. Discount brokers allow investors to
perform their own investment research and make their own decisions. The brokerage still
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executes the investor's trades, but since it doesn't provide the other services of a full-service
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brokerage, its trade commissions are much smaller.

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Investment Companies: An investment company is a corporation or a trust through which

individuals invest in diversified, professionally managed portfolios of securities by pooling their
funds with those of other investors. Rather than purchasing combinations of individual stocks
and bonds for a portfolio, an investor can purchase securities indirectly through a package
product like a mutual fund.
There are three fundamental types of investment companies: unit investment trusts (UITs), face
amount certificate companies and managed investment companies. All three types have the
following things in common:

i. An undivided interest in the fund proportional to the number of shares held

ii. Diversification in a large number of securities
iii. Professional management
 iv. Specific investment objectives
Investment companies have been established by the various government units in the country in
the fields of agriculture, industry, housing and credit. They carry out a wide range of activities
geared to the promotion of economic development. Their activities include the provision of loans
and equity finance.

Besides these publicly owned investment companies, there are some privately owned ones. They
provide hire purchase finance, and they also invest in industry and commerce.
These privately owned investment companies are licensed and registered by the CBN and are
known as Finance companies (FCs)

Unit Investment Trusts (UITs): A unit investment trust, or UIT, is a company established
under an indenture or similar agreement. It has the following characteristics:

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i. The management of the trust is supervised by a trustee.

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ii. Unit investment trusts sell a fixed number of shares to unit holders, who receive a
proportionate share of net income from the underlying trust.

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iii. The UIT security is redeemable and represents an undivided interest in a specific
portfolio of securities.
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iv. The portfolio is merely supervised, not managed, as it remains fixed for the life of the
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trust. In other words, there is no day-to-day management of the portfolio.
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Face Amount Certificates: A face amount certificate company issues debt certificates at a
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predetermined rate of interest. Additional characteristics include:

i. Certificate holders may redeem their certificates for a fixed amount on a specified date,
or for a specific surrender value, before maturity.
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ii. Certificates can be purchased either in periodic instalments or all at once with a lump-
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sum payment.
iii. Face amount certificate companies are almost non-existent today.
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Management Investment Companies: The most common type of Investment Company is the
management investment company, which actively manages a portfolio of securities to achieve its
investment objective. There are two types of management investment company: closed-end and
open-end. The primary differences between the two come down to where investors buy and sell
their shares - in the primary or secondary markets - and the type of securities the investment
company sells.
i. Closed-End Investment Companies: A closed-end investment company issues shares in
a one-time public offering. It does not continually offer new shares, nor does it redeem its
shares like an open-end investment company. Once shares are issued, an investor may
purchase them on the open market and sell them in the same way. The market value of
the closed-end fund's shares will be based on supply and demand, much like other
 securities. Instead of selling at net asset value, the shares can sell at a premium or at a
discount to the net asset value.
ii. Open-End Investment Companies: Open-end investment companies, also known as
mutual funds, continuously issue new shares. These shares may only be purchased from
the investment company and sold back to the investment company. Mutual funds are
discussed in more detail in the Variable Contracts section.

Savings and Loan Associations: Savings and loan associations(S&L) are financial institutions
that previously only made mortgage loans and paid dividends on depositors’ savings. Today
savings and loan associations offer most of the services commercial banks do. They may be state
or federally chartered. There are two types of savings and loans.
i. Mutual savings and loan associations are owned by and operated for the benefit of their
depositors. These depositors receive dividends on their savings.

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ii. Stock savings and loan associations are owned by stockholders. Like commercial banks,

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these companies operate for profit
Savings and loan associations, also known as S&Ls or thrifts, resemble banks in many respects.

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Most consumers don't know the differences between commercial banks and S&Ls. By law,
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savings and loan companies must have 65% or more of their lending in residential mortgages,
though other types of lending is allowed.
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S&Ls emerged largely in response to the exclusivity of commercial banks. There was a time
when banks would only accept deposits from people of relatively high wealth, with references,
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and would not lend to ordinary workers. Savings and loans typically offered lower borrowing
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rates than commercial banks and higher interest rates on deposits; the narrower profit margin was
a by-product of the fact that such S&Ls were privately or mutually owned.
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Credit Unions and Co-Operative Societies: The credit and co-operative societies are small
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non-profit lending institutions. They are usually organised around some common bond of
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membership or a club. They accept deposits from members and restrict loans to their
membership. The interest charged is usually kept low. This is later shared among the members at
the end of the year as profit.

Credit unions are another alternative to regular commercial banks. Credit unions are almost
always organized as not-for-profit cooperatives. Like banks and S&Ls, credit unions can be
chartered at the federal or state level. Like S&Ls, credit unions typically offer higher rates on
deposits and charge lower rates on loans in comparison to commercial banks.

In exchange for a little added freedom, there is one particular restriction on credit unions;
membership is not open to the public, but rather restricted to a particular membership group. In
the past, this has meant that employees of certain companies, members of certain churches, and
so on, were the only ones allowed to join a credit union. In recent years, though, these
restrictions have been eased considerably, very much over the objections of banks. These
societies have increased in number tremendously in recent times and are helping in a lot of ways
to financially assist the common Nigerian.

Shadow Banks: The housing bubble and subsequent credit crisis brought attention to what is
commonly called "the shadow banking system." This is a collection of investment banks, hedge
funds, insurers and other non-bank financial institutions that replicate some of the activities of
regulated banks, but do not operate in the same regulatory environment.

The shadow banking system funnelled a great deal of money into the U.S. residential mortgage
market during the bubble. Insurance companies would buy mortgage bonds from investment
banks, which would then use the proceeds to buy more mortgages, so that they could issue more
mortgage bonds. The banks would use the money obtained from selling mortgages to write still

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more mortgages.

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Apart from the absence of regulation and reporting requirements, the nature of the operations

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within the shadow banking system created several problems. Specifically, many of these
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institutions "borrowed short" to "lend long." In other words, they financed long-term
commitments with short-term debt. This left these institutions very vulnerable to increases in
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short-term rates and when those rates rose, it forced many institutions to rush to liquidate
investments and make margin calls. Moreover, as these institutions were not part of the formal
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banking system, they did not have access to the same emergency funding facilities.
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Bureaux-de-Change (BDCs): A bureau de change is a business which, in competition with

other similar businesses, makes its profit by selling currency at a higher exchange rate than a rate
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at which it buys the same currency, as well as any commission or fee it may charge. These
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institutions were established to broaden the foreign exchange market and improve accessibility to
foreign exchange. They are licensed and regulated by the CBN. In setting its exchange rates, it
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must keep an eye on the rates quoted by competitors, and may be subject to government foreign
exchange controls and other regulations.

The exchange rates charged at bureaux are generally related to the spot prices available for large
interbank transactions, and are adjusted to ensure a profit. The rate at which a bureau will buy
currency differs from that at which it will sell it; for every currency it trades both will be on
display, generally in the shop window.

So the bureau sells at a lower rate from that at which it buys. For example a Nigerian bureau may
sell ₦140 for $1 but buy ₦160 for $1. This business model can be upset by a currency run when
there are far more buyers than sellers (or vice versa) because they feel a particular currency is
overvalued or undervalued and becomes “not worth a Continental”.
A bureau de change (plural bureaux de change, both (British English) or currency exchange
(American English) is a business where people can exchange one currency for another. Although
originally French, the term “bureau de change” is widely used throughout Europe, where it is
common to find a sign saying "exchange" or "change." Since the adoption of the euro, many
exchange offices incorporate its logotype prominently on their signage. In the United States and
English-speaking Canada the business is described as “currency exchange” and sometimes
“money exchange”, sometimes with various additions such as “foreign”, “desk”, “office”,
“counter”, “service”, etc.; for example, “foreign currency exchange office”.
A bureau de change is often located at a bank, at a travel agent, airport, main railway station or
large stores namely, anywhere there is likely to be a market for people needing to convert
currency. So they are particularly prominent at travel hubs, although currency can be exchanged
in many other ways both legally and illegally in other venues.

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Microfinance Bank
Microfinance services refer to loans, deposits, insurance, fund transfer and other ancillary

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non-financial products targeted at low-income clients. Three features distinguish
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microfinance from other formal financial products: (i) smallness of loans and savings,
(ii) absence or reduced emphasis on collateral, and (iii) simplicity of operations.
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A microfinance bank (MFB), unless otherwise stated, shall be construed to mean any company
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licensed by the CBN to carry on the business of providing financial services such as savings and
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deposits, loans, domestic fund transfers, other financial and non-financial services to
microfinance clients.
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Microfinance Bank Target Client: A microfinance bank target client shall include the
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economically active low-income earners, low income households, the un-banked and under-
served people, in particular, vulnerable groups such as women, physically challenged, youths,
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micro-entrepreneurs, informal sector operators, subsistence farmers in urban and rural areas.

Microenterprise: A Microenterprise is a business that operates with very small start-up capital.
The management is often built around the sole owner or micro-entrepreneur. It provides
employment for few people mainly the immediate family members and does not often require
formal registration to start.

The management and accounting requirements are very simple and flexible. Generally, most
micro-entrepreneurs work informally, without business licences or formal records of their
activities. The scope of economic activities of micro-enterprises typically includes primary
production and crafts, value added processing, distributive trades and diverse services.
Microfinance Loan: A microfinance loan is granted to the operators of micro-enterprises, such
as peasant farmers, artisans, fishermen, youths, women, senior citizens and non-salaried workers
in the formal and informal sectors. The loans are usually unsecured, but typically granted on the
basis of the applicant’s character and the combined cash flow of the business and household.

The tenure of microfinance loans is usually within 180 days (6 months). Tenures longer than six
(6) months would be treated as special cases. In the case of agriculture, or projects with longer
gestation period, however, a maximum tenure of twelve (12) months is permissible and in
housing microfinance, a longer tenure of twenty-four (24) months is permissible.
In line with best practice, the maximum principal amount shall not exceed ₦500,000, or one (1)
per cent of the shareholders fund unimpaired by losses and/or as may be reviewed from time to
time by the CBN. Microfinance loans may also require joint and several guarantees of one or
more persons. The repayment may be on a daily, weekly, bi-monthly, monthly basis or in

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accordance with amortization schedule in the loan contract.

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Related Party: A related party is an individual or group of individuals that is related in some

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ways to any of the Directors and Management staff of an MFB. This could include a family
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member, relative, shareholder, related company or proxy or associates.
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Permissible and Prohibited Activities in Nigeria
Permissible Activities
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An MFB shall be allowed to engage in the provision of the following services to its clients:
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i. Acceptance of various types of deposits including savings, time, target and demand
from individuals, groups and associations; except public sector deposits;
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ii. Provision of credit to its customers, including formal and informal self-help groups,
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individuals and associations;

iii. Promotion and monitoring of loan usage among its customers by providing ancillary
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capacity building in areas such as record keeping and small business management;
iv. Issuance of redeemable debentures to interested parties to raise funds from members of
the public with the prior approval of the CBN;
v. Collection of money or proceeds of banking instruments on behalf of its customers
including clearing of cheques through correspondent banks;
vi. Act as agent for the provision of mobile banking and micro insurance services to its
clients.
vii. Provision of payment services such as salary, gratuity, pension for employees of the
various tiers of government;
viii. Provision of loan disbursement services for the delivery of the credit programme of
government, agencies, groups and individual for poverty alleviation on non-recourse
basis;
 ix. Provision of ancillary banking services to its customers such as domestic remittance
of funds and safe custody;
x. Maintenance and operation of various types of account with other banks in Nigeria;
xi. Investment of its surplus funds in suitable instruments including placing such funds with
correspondent banks and in Treasury Bills;
xii. Pay and receive interests as may be agreed upon between the MFB and its clients in
accordance with existing guidelines;
xiii. Operation of micro leasing facilities, microfinance related hire purchase and arrangement of
consortium lending as well as supervision of credit schemes to ensure access of
microfinance customers to inputs for their economic activities;
xiv. Receiving of refinancing or other funds from CBN and other sources, private or public,
on terms mutually acceptable to both the provider of the funds and the recipient MFBs;
xv. Provision of microfinance related guarantees for its customers to enable them have

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better access to credit and other resources;

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xvi. Buying, selling and supplying industrial and agricultural inputs, livestock, machinery and
industrial raw materials to low-income persons on credit and to act as agent for any

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association for the sale of such goods or livestock;
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xvii. Investment in shares or equity of a body corporate, the objective of which is to provide
microfinance services to low-income persons;
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xviii. Investment in cottage industries and income generating projects for low-income persons
as may be prescribed by the CBN;
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xix. Provision of services and facilities to customers to hedge various risks relating to
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microfinance activities;
xx. Provision of professional advice to low-income persons regarding investments in small
businesses; rendering managerial, marketing, technical and administrative advice to
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customers and assisting them in obtaining services in such fields;

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xxi. Mobilize and provide financial and technical assistance and training to microenterprises;
xxii. Provision of loans to microfinance clients for home improvement, housing microfinance
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and consumer credits; and

xxiii. Performance of non-banking functions that relate to microfinance business development
services such as co-operatives and group formation activities, rural industrialization and
other support services needed by micro enterprises.
Prohibited Activities
No MFB shall undertake any business other than those permitted as stated in the preceding
paragraph or such activities as may be prescribed from time to time by the CBN. Specifically, no
MFB shall engage in the provision of the following financial services:
i. Acceptance of public sector (government) deposits except for the permissible activities
(vii) and (viii) in permissible activities
ii. Foreign exchange transactions;
iii. International commercial papers;
 iv. International corporate finance;
v. International electronic funds transfer;
vi. Clearing house activities;
vii. Collection of third party cheques and other instruments for the purpose of clearing
through correspondent banks.
viii. Dealing in land for speculative purposes;
ix. Dealing in real estate except for its use as office accommodation;
x. Provision of any facility for speculative purposes;
xi. Leasing, renting, and sale/purchase of any kind with its directors, officers, employees or
persons who either individually or in concert with their family members and beneficiaries
own five per cent (5%) or more of the equity of the MFB, without the prior approval in
writing of the CBN; and
xii. Financing of any illegal/prohibited activities such as gambling, drug-trafficking, and

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firearms.

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Licensing Requirements

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There shall be three (3) categories of MFBs:
1. Category 1: Unit Microfinance Bank
AP
A Unit Microfinance Bank is authorized to operate in one location. It shall be required to
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have a minimum paid-up capital of N20 million (twenty million Naira) and is prohibited
from having branches and/or cash centres.
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2. Category 2: State Microfinance Bank

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A State Microfinance Bank is authorized to operate in one State or the Federal Capital
Territory (FCT). It shall be required to have a minimum paid-up capital of N100 million
(one hundred million Naira) and is allowed to open branches within the same State or the
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FCT, subject to prior written approval of the CBN for each new branch or cash centre.
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3. Category 3: National Microfinance Bank

A National Microfinance Bank is authorized to operate in more than one State including
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the FCT. It shall be required to have a minimum paid-up capital of N2 billion (two billion
Naira), and is allowed to open branches in all States of the Federation and the FCT,
subject to prior written approval of the CBN for each new branch or cash centre.

Ownership and Licensing Requirements

Ownership Requirements
1. A microfinance bank may be established by individuals, group of individuals, community
development associations, private corporate entities and foreign investors.
2. No individual, group of individuals, their proxies or corporate entities and/or their
subsidiaries shall own controlling interest in more than one MFB, except as approved by
the CBN.
 3. A bank holding company that intends to set up any category of MFBs as subsidiaries
shall be required to meet the prescribed capital and other requirements stipulated in these
Guidelines.
Summary
A merchant bank can be defined as a wholesale banker whose deposits are usually in large
amounts (a minimum of ₦10, 000.00). Such deposits are fixed for a particular period; and, of
course, they earn interest. Shadow Banks: The housing bubble and subsequent credit crisis
brought attention to what is commonly called "the shadow banking system." This is a collection
of investment banks, hedge funds, insurers and other non-bank financial institutions that replicate
some of the activities of regulated banks, but do not operate in the same regulatory environment.
Savings and Loan Associations: Savings and loan associations(S&L) are financial institutions
that previously only made mortgage loans and paid dividends on depositors’ savings. Credit
Unions and Co-Operative Societies: The credit and co-operative societies are small non-profit

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lending institutions. They are usually organised around some common bond of membership or a

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club.

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9.4 SELF-ASSESSMENT QUESTIONS
AP
9.1 What are the specific objectives of the new microfinance policy in Nigeria?
9.2 Differentiate between a Derivatives and Forex and the Interbank Markets
9.3 Who are the target clients of Microfinance Banks?
R
E

SOLUTION TO SAQ 9.1

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The specific objectives of the microfinance policy are to: (a) Make financial services accessible
to a large segment of the potentially productive Nigerian population which would otherwise have
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little or no access to financial services. (b) Provide synergy and mainstreaming of the informal
sub-sector into the national financial system. (c) Enhance service delivery by microfinance
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institutions to micro, small and medium entrepreneurs (MSMEs). (d) Contribute to rural
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transformation by mobilizing savings. (e) Promote linkage programme between microfinance

institutions (MFIs), Deposit Money Banks (DMBs), Development Finance Institutions (DFIs),
specialized Funding institutions. (f) Create employment opportunities and increase the
productivity and household income of the economically active poor in the country, thus
enhancing their standard of living. (g) Promote a platform for microfinance service providers to
network, exchange view and share experience

SOLUTION TO SAQ 9.2

The derivative is named so for a reason: its value is derived from its underlying asset or assets. A
derivative is a contract, but in this case the contract price is determined by the market price of the
core asset. If that sounds complicated, it's because it is. The derivatives market adds yet another
layer of complexity and is therefore not ideal for inexperienced traders looking to speculate.
The interbank market is the financial system and trading of currencies among banks and financial
institutions, excluding retail investors and smaller trading parties. While some interbank trading
is performed by banks on behalf of large customers, most interbank trading takes place from the
banks’ accounts

The forex market is where currencies are traded. The forex market is the largest, most liquid
market in the world with an average traded value that exceeds $1.9 trillion per day and includes
all of the currencies in the world. The forex is the largest market in the world in terms of the total
cash value traded, and any person, firm or country may participate in this market.

SOLUTION TO SAQ 9.3

Answer: Microfinance Banks target client includes the following group of persons: (a) The
economically active poor. (b) Low-income households (c) The un-banked and underserved

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people, particularly vulnerable groups such as women, youths and the physically challenged. (d)

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Informal sector operators, micro-entrepreneurs and subsistence farmers.

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9.5 MUITIPLE-CHOICE QUESTIONS
AP
1) Financial intermediaries
R
a. are involved in the process of indirect finance
b. improve the lot of the small saver
E

c. exist because there are substantial information and transactions costs in the
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economy
d. do each of the above
ID

2) Changes in stock prices

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a. affect people's wealth and their willingness to spend

BA

b. affect firms' decisions to sell stock to finance investment spending

c. are characterized by considerable fluctuations
d. all of the above

3) An important financial institution that assists in the initial sale of securities in the primary
market is the
a. investment bank
b. brokerage house
c. commercial bank
d. stock exchange

4) Which answer below would be a benefit in investing your funds in a financial institution,
like a bank?
 a. A bank account increases investor’s risk
b. bank account is not a liquid investment
c. A bank account is a liquid investment
d. A bank collects information on borrowers poorly

5) What are investment banks?

a. They are identical to commercial banks.
b. They regulate the secondary markets
c. They accept checking accounts and make commercial loans
d. They help corporations and Government Issue new securities.

6) Financial markets and institutions

a. Involve the movement of huge flows of money.

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b. Affect the profits of businesses.

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c. Affect the types of goods and services produced in an economy.
d. Do each of the above.

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AP
7) Which of the following is a depository institution?
a. Life insurance Company
R
b. Credit union.
c. Pension fund.
E

d. Finance company.
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8) Which of the following is not a contractual savings institution?

ID

a. A life insurance company

b. A pension fund
M

c. A savings and loan association

BA

d. A fire and casualty insurance company

9) Which of the following is not typically considered a function of financial intermediaries?

a. Providing a payment mechanism.
b. Investing in real assets.
c. Accumulating funds from smaller investors.
d. Spreading or pooling risk among individuals.

10) In the flow of funds, the financial system is

a. The ultimate source of funds.
b. The main user of funds.
c. An intermediary between the sources and users of funds
d. The ultimate source of endowment and consumption.
 11) Deposit insurance
a. stops runs on banks completely
b. encourages banks to hold excess reserves
c. encourages depositor vigilance about bank safety and soundness
d. encourages banks to engage in riskier lending practices than without it

12) A corporation acquires new funds only when its securities are sold
a. in the primary market by an investment bank
b. in the primary market by a stock exchange broker
c. in the secondary market by a securities dealer
d. in the secondary market by a commercial bank

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13) Which of the following can be described as involving direct finance?

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a. A corporation takes out a loan from a bank.
b. People buy shares in a mutual fund.

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c. A corporation buys commercial paper issued by another corporation.
AP
d. An insurance company buys shares of common stock in the over-the-counter
markets.
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14) Which of the following can be described as involving indirect finance?
E

a. You make a loan to your neighbor.

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b. A corporation buys a share of common stock issued by another corporation.

c. You buy a U.S. Treasury bill from the U.S. Treasury.
d. You make a deposit at a bank.
ID
M

15) Which of the following can be described as involving indirect finance?

a. A corporation issues new shares of stock.
BA

b. A corporation buys commercial paper issued by another corporation.

c. A pension fund manager buys commercial paper in the secondary market.
d. D) Both (a) and (b) of the above.

SOLUTION TO MUITIPLE-CHOICE QUESTIONS 9.5

Questions 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Answers D d a c d d b c b c d A c d c

REFERENCE
Central Bank of Nigeria (2012), Revised Regulatory and Supervisory Guidelines for
Microfinance Banks (MFBS) In Nigeria
 STUDY SESSION 10
THE FINANCIAL MARKETS
INTRODUCTION
In this session, we have treated the Nigerian financial market which is a very crucial aspect of
our study. So far the financial institutions (bank and non-bank) have been discussed in isolation.
Yet, this is not a true picture of the situation. The various institutions are brought together in the
financial markets, namely, the money market and the capital market. This session deals with
such markets.

Learning Outcomes for Study Session 10

At the end of this study Session, you should be able to:
10.1 define in absolute sense the concepts in financial markets (SAQ 10.1)
10.2 distinguish between the different types of financial markets (SAQ 10.2)

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10.3 discuss the various functions of financial markets (SAQ 10.3)

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10.4 explain the basis of financial markets (SAQ 10.4)
10.5 discuss what constituents the financial markets(SAQ 10.5)

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10.6 explain why financial markets exist in an economy (SAQ 10.6)
10.7 understand the operation of Nigerian financial markets(SAQ 10.7)
AP
10.1 DEFINITION OF A FINANCIAL MARKET
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In Economics, a financial market is a market in which people and entities can trade financial
securities, commodities, and other fungible items of value at low transaction costs and at prices
E

that reflect supply and demand (such as stocks and bonds), commodities (such as precious
EL

metals or agricultural goods), and other fungible items of value at low transaction costs and at
prices that reflect the efficient-market hypothesis.
ID

A financial market is a broad term describing any marketplace where buyers and sellers
M

participate in the trade of assets such as equities, bonds, currencies and derivatives and
BA

commodities like valuable metals are exchanged at efficient market prices. Here, by efficient
market prices we mean the unbiased price that reflects belief at collective speculation of all
investors about the future prospect. The trading of stocks and bonds in the Financial Market can
take place directly between buyers and sellers or by the medium of Stock Exchange. Financial
Markets can be domestic or international. Financial markets are typically defined by having
transparent pricing, basic regulations on trading, costs and fees, and market forces determining
the prices of securities that trade.

Financial Markets are typically defined by having transparent pricing, basic regulations on
trading, costs and fees and market forces determining the prices of securities that trade. In
economics, typically, the term market means the aggregate of possible buyers and sellers of a
certain good or service and the transactions between them. The term "market" is sometimes used
for what are more strictly exchanges, organizations that facilitate the trade in financial securities,
e.g., a stock exchange or exchange in Finance, Financial Markets facilitate: The raising of capital
(in the Capital Markets), The transfer of risk (in the Derivatives Markets), The transfer of
liquidity (in the Money Markets), International trade (in the Currency Markets).

Financial markets can be found in nearly every nation in the world. Some are very small, with
only a few participants, while others - like the New York Stock Exchange (NYSE) and the forex
markets - trade trillions of dollars daily. Investors have access to a large number of financial
markets and exchanges representing a vast array of financial products. Some of these markets
have always been open to private investors; others remained the exclusive domain of major
international banks and financial professionals until the very end of the twentieth century.

10.2 TYPES OF FINANCIAL MARKETS

Within the financial sector, the term "financial markets" is often used to refer just to the markets

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that are used to raise finance: for long term finance, the Capital markets; for short term finance,

EA
the Money markets. Another common use of the term is as a catchall for all the markets in the
financial sector, as per examples in the breakdown below.

H
AP
Capital Markets: It consist of stock markets, which provide financing through the issuance of
shares or common stock, and enable the subsequent trading thereof. Bond markets, which
R
provide financing through the issuance of bonds, and enable the subsequent trading thereof.
E

The capital market, with its myriads of institutions and intermediaries and instruments mobilizes
EL

and channels long-term funds into productive investment. Instruments in the capital market have
medium and long term focus, they exceed 12 months in maturity while some long term
instruments do not carry maturity as their holder wishes e.g. equities.
ID

Capital market consists of primary market and secondary market. In primary market newly
M

issued (securities) bonds and stocks are exchanged and in secondary market buying and selling
BA

of already existing bonds and stocks take place. The transaction in primary market exists
between investors and public while secondary market it’s between investors. So, the Capital
Market can be divided into Bond Market and Stock Market. As a whole, Capital Market
facilitates raising of capital.

Capital market is that constituent of the Financial Market that facilitates the mobilization of long-
term investment capital for the financing of business enterprises as well as Government long
term investment projects. In other words, the term Capital Market refers to a specialized financial
institution that provides a channel for the borrowing and lending of long-term funds (i.e. over
one year). It is a well-organized financial institution that facilitates the transfer of financial
resources from those that have surplus funds (savers) to those that needed the use of these funds
(i.e. Government and private sector businesses) to undertake long-term investment. Thus the
Capital Market offers an opportunity for both private business people and Government to
mobilize huge amounts of financial resources from the general public through the sale of
financial securities

Liquidity is a crucial aspect of securities that are traded in secondary markets. Liquidity refers to
the ease with which a security can be sold without a loss of value. Securities with an active
secondary market mean that there are many buyers and sellers at a given point in time. Investors
benefit from liquid securities because they can sell their assets whenever they want; an illiquid
security may force the seller to get rid of their asset at a large discount.

1) Stock Markets: Stock Market provides financing by shares or stock issuance and by
share trading. Stock markets allow investors to buy and sell shares in publicly traded
companies. They are one of the most vital areas of a market economy as they provide
companies with access to capital and investors with a slice of ownership in the company

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and the potential of gains based on the company's future performance. This market can be

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split into two main sections: the primary market and the secondary market. The primary
market is where new issues are first offered, with any subsequent trading going on in the

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secondary market.
2) Bond Markets: A bond is a debt investment in which an investor loans money to an
AP
entity (corporate or governmental), which borrows the funds for a defined period of time
at a fixed interest rate. Bonds are used by companies, municipalities, countries and
R
foreign governments to finance a variety of projects and activities. Bonds can be bought
and sold by investors on credit markets around the world. This market is alternatively
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referred to as the debt, credit or fixed-income market. It is much larger in nominal terms
EL

that the world's stock markets. Bond Market provides financing by bond issuance and
bond trading.
ID

The Benefits of the Capital Markets

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i. Provision of long term funds for industrial and infrastructural development;

BA

ii. Serving as vehicle for government to execute economic programmes such as

privatization, entrepreneurial development and poverty alleviations;
iii. Provision of the mechanism for the populace to be involved in the ownership of
companies;
iv. Promotion of accountability, transparency and good governance in the corporate sector;
v. Provision of a vehicle for attracting foreign capital and funds of nationals in Diaspora
vi. Provision of alternative sources of funds to the use of ways and means of financing by
government (see Ayayi and Ojo, 2006)

Methods of Raising Funds from the Capital Market

There are a number of ways by which a firm in need of funds can raise fund from the capital
market. These are mentioned below:
i. Offer for Subscription;
 ii. Offer for sale;
iii. Offer by introduction;
iv. Private placements; and
v. Right Issue.

The Key Players in the Capital Market

The key actors in a well-organized Stock Exchange include the Dealers/Stockbrokerage Firms,
Company Registrars, Issuing Houses, Mutual Fund Managers, Investment Bankers, the Stock
Exchange, the Security and Exchange Commission (which regulates the activities of the
Exchange), the Central Security Clearing and Settlement (CSCS) system, the Investing Public,
Accountants (Auditors ) and Solicitors.

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a) Stock Brokers: A stockbroker is a licensed member of a Stock Exchange that buys and sells

EA
financial securities for their clients/customers. That is, a Stockbroker is an agent that simply buys
or sells securities on the behalf of an investor. This simply means that a Stockbroker executes

H
trade on the instruction of his/her customer. Because he/she is trading on the behalf of someone
(the investor), he/she gets his/her compensation by levying some form of tax (i.e. a commission)
AP
from the proceeds of the trade.
R
On the other hand, a dealer buys and sells financial securities on his/her own account. In other
words, a dealer enters the market as a buyer or seller of securities using his/her own financial
E

resources. Thus, his/her compensation depends on the outcome of the trade. If he/she can buy at
EL

a lower price and sells at a higher price, then he/she will make a capital gain. If the reverse holds,
then he/she is liable to make a capital loss which he/she has to bear up alone. In some cases, an
individual/institution can act in the capacity of a Stockbroker as well as a dealer in securities. In
ID

this case, the institution or individual is referred to as a Dealer-Broker. In a Dealer-Broker

M

setting, the individual can buy or sell securities for him/herself or for some other person with the
hope of making a commission.
BA

b) Registrars: Registrars are a group of operators in the capital market that are charged with the
responsibility of keeping records on the ownership of a company’s securities. They ensure that
details on the transfer of ownership of securities from one investor to another are well recorded
to avoid confusion on claims arising from benefits associated with holding such securities.
During the allotment stage of an oversubscribed issue of securities, Registrars prepare a range of
analysis on how the securities should be allotted. They also prepare the list of investors that
qualify to receive dividend from the Company’s annual dividend disbursement to shareholders.

c) Issuing Houses: An Issuing House is normally a licensed corporate body that acts as an agent
for an issuer of securities in the primary market. Marketing of the securities issued by an issuer is
very crucial in the Capital market. Issuing Houses perform this function by helping the issuer in
packaging and marketing the offer of securities to the general public. They can normally
underwrite the offer of securities by providing the issuer with the required financial resources
and eventually sell the securities to the general public. That is, instead of the issuer having to
wait until the securities are sold, an Issuing House can buy the securities at a discount thereby
making the needed funds immediately available to the issuer. Sometimes, instead of underwriting
the offer, an Issuing House can simply use its best effort in selling the securities to the general
public. In this situation, an Issuing House will not undertake any responsible for securities that
are not bought.

d) Mutual Fund Managers: Mutual Funds or Unit Trust Funds are non-bank financial
institutions that mobilize financial resources from the general public for investment in the capital
market. As a result of his/her expertise in portfolio management, a Mutual Fund Manager
reduces the risk of investors by diversifying investment from the pool of funds into various
securities. Thus by pooling resources from many individual investors and investing in various

L
securities in the capital market, a Mutual Fund Manager reduces idiosyncratic risk through

EA
portfolio diversification.

e) The Stock Exchange: A Stock Exchange is licensed non-bank financial institution that

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provides a platform for transactions involving the buying and selling of financial securities in the
AP
Secondary Market. It is a place where debts and equity securities of varying types are traded to
facilitate capital mobilization. In short, the Stock Exchange does the work of a Secondary Market
R
by facilitating a formal trading arrangement for financial securities. Some of the Stock
Exchanges in Africa include the following: Ghana Stock Exchange (GSE) in Ghana; Nairobi
E

Stock Exchange (NSE) in Kenya; Namibia Stock Exchange (NASE) in Namibia; Nigerian Stock
EL

Exchange (NISE) in Nigeria; Swaziland Stock Exchange (SSE) in Swaziland; Sierra Leone
Stock Exchange (SLSE) in Sierra Leone
ID

f) The Security and Exchange Commission (SEC): Government plays a central role in the
capital market by creating the basic institutions that regulate and supervise principal market
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participants. The Security and Exchange Commission (SEC) is the apex regulatory body of the
BA

Capital Market. In many countries with well-established Capital Markets, there is always the
need for the establishment of a body charged with the responsibility of regulating corporate and
individual capital market operators. In Sierra Leone, the Supervision Department of the Bank of
Sierra Leone is currently playing the role of SEC in an effort to establish a regulatory framework
for the Sierra Leone Capital Market until a Security and Exchange Commission is established.

g) The Central Security Clearing and Settlement (CSCS): The Central Security Clearing and
Settlement (CSCS) system is a subsidiary corporate body of a well-established Stock Exchange
that performs the role of clearing and settlement of transactions involving the buying and selling
of securities. This function is done by maintaining a record of all traded securities on behalf of
shareholders. It facilitates the delivery (i.e. transfer of shares from sellers to buyers) and
settlement (Payment) of securities transacted in a well-organized Stock Exchange.
h) Investing Public: An investor is an individual or an institution that buys financial securities
with the sole purpose of making some financial returns from the investment. Investors cannot
buy securities directly from the Stock Exchange except through a licensed stock broker. When an
investor is desirous of buying securities from the Capital Market, he/she approaches a Stock
Broker who will execute his/her mandate in the market.

i) Accountants (Auditors) and Solicitors: Accountants and Solicitors are also very important
players in the Capital Market. The full disclosure requirements for listed Companies in the
Capital market necessitated the regular publication of financial statements of listed companies.
Prior to the publication of such financial statements, certified accountants (Auditors) are required
to authenticate the extent to which such financial statements can reliably inform the true picture
of the Company’s financial position. This is meant to provide an accurate guide for investors’
decision making (see Jalloh, 2009).

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Money Markets: Money Market facilitates short-term debt financing and capital. In other words

EA
it provide short term debt financing and investment and as its name suggests, it is a market in
which money is bought and sold. The money market is a segment of the financial market in

H
which financial instruments with high liquidity and very short maturities are traded. The money
AP
market is used by participants as a means for borrowing and lending in the short term, from
several days to just under a year. Money market securities (the instruments in the money market)
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consist of negotiable certificates of deposit (CDs), banker's acceptances, Nigeria Treasury bills,
commercial paper, municipal notes, eurodollars, federal funds and repurchase agreements
E

(repos). Money market investments are also called cash investments because of their short
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maturities.

The major function of the market is to facilitate the raising of short-term funds from the surplus
ID

to the deficit sectors of the economy. The market is used by business enterprises to raise funds
for the purchase of inventories, by banks to finance temporary reserve loss, by companies to
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finance consumer credit and by government to bridge the gap between its receipts and
BA

expenditure.

Dealers in the market are individuals or institutions with excess funds and individuals or
institutions in need of funds. A commercial bank, for instance, may be accumulating cash
reserves to meet Christmas cash withdrawals, but in the meantime it may decide to invest them
in short-term interest-earning assets.

One main feature of a money market is the centralization of funds and the employment of liquid
assets of varying periods of maturity. From this one can infer that the essential prerequisite to the
development of a money market is the availability of short-term funds of which the owners are
ready to invest at relatively low yields. Also there must be a continuous and sufficient flow of
assets with varying maturities. There must also be middlemen (intermediaries), whose main task
is to bring together the pool of resources in the economy and to invest them in short-term bills.
Finally, there must be a lender of last resort (a central bank) capable of guaranteeing the liquidity
of at least some of the assets being traded.

Government treasury bills and similar securities, as well as company commercial bills, are
examples of instruments traded in the money market. A wide range of financial institutions,
including merchant banks, commercial banks, the central bank and other dealers operate in the
money market. Public as well as private sector operators make use of various financial
instruments to raise and invest short term funds which, if need be, can be quickly liquidated to
satisfy short-term needs

The money market is used by a wide array of participants, from a company raising money by
selling commercial paper into the market to an investor purchasing CDs as a safe place to park
money in the short term. The money market is typically seen as a safe place to put money due the
highly liquid nature of the securities and short maturities. Because they are extremely

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conservative, money market securities offer significantly lower returns than most other

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securities. However, there are risks in the money market that any investor needs to be aware of,
including the risk of default on securities such as commercial paper.

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AP
Derivatives markets, which provide instruments for the management of financial risk. The
derivative is named so for a reason: its value is derived from its underlying asset or assets. A
R
derivative is a contract, but in this case the contract price is determined by the market price of the
core asset. If that sounds complicated, it's because it is. The derivatives market adds yet another
E

layer of complexity and is therefore not ideal for inexperienced traders looking to speculate.
EL

However, it can be used quite effectively as part of a risk management program.

Examples of common derivatives are forwards, futures, options, swaps and contracts-for-
ID

difference (CFDs). Not only are these instruments complex but so too are the strategies deployed
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by this market's participants. There are also many derivatives, structured products and
collateralized obligations available, mainly in the over-the-counter (non-exchange) market that
BA

professional investors, institutions and hedge fund managers use to varying degrees but that play
an insignificant role in private investing.

Futures markets, which provide standardized forward contracts for trading products at some
future date; see also forward market.

Insurance markets, which facilitate the redistribution of various risks. Reforms have created
competition in the insurance sector and given the customers a wide choice not only in the
matter of insurance companies, but also in terms of insurance products. However, impact
of increased competition is yet to be felt on insurance penetration.

Commodity Markets, which facilitate the trading of commodities.

Foreign exchange interbank markets: Foreign exchange (forex) facilitate the trading of foreign
exchange. The forex market is where currencies are traded. The forex market is the largest, most
liquid market in the world with an average traded value that exceeds $1.9 trillion per day and
includes all of the currencies in the world. The forex is the largest market in the world in terms of
the total cash value traded, and any person, firm or country may participate in this market.

There is no central marketplace for currency exchange; trade is conducted over the counter. The
forex market is open 24 hours a day, five days a week and currencies are traded worldwide
among the major financial centers of London, New York, Tokyo, Zürich, Frankfurt, Hong Kong,
Singapore, Paris and Sydney.

Until recently, forex trading in the currency market had largely been the domain of large

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financial institutions, corporations, central banks, hedge funds and extremely wealthy

EA
individuals. The emergence of the internet has changed all of this, and now it is possible for
average investors to buy and sell currencies easily with the click of a mouse through online

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brokerage accounts. (For further reading, see The Foreign Exchange Interbank Market.)
AP
The interbank market is the financial system and trading of currencies among banks and financial
R
institutions, excluding retail investors and smaller trading parties. While some interbank trading
is performed by banks on behalf of large customers, most interbank trading takes place from the
E

banks' own accounts.

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Question: Can you tell us why derivative markets exist?

Solution: Derivative markets exist in order to reduce the risk of exposure to price fluctuations in
ID

cash markets.
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Question: Determine whether the statements are True or False. As compared to capital
BA

markets, money markets

i. Are usually more widely traded
ii. Trade debt instruments with shorter terms.
iii. Have smaller fluctuations in price.
Solution
i. True
ii. True
iii. True

10.3 FUNCTIONS OF FINANCIAL MARKETS

Intermediary Functions: The intermediary functions of a financial markets include the
following:
 i. Transfer of Resources: Financial markets facilitate the transfer of real economic
resources from lenders to ultimate borrowers.
ii. Enhancing income: Financial markets allow lenders to earn interest or dividend on their
surplus invisible funds, thus contributing to the enhancement of the individual and the
national income.
iii. Productive usage: Financial markets allow for the productive use of the funds borrowed.
The enhancing the income and the gross national production.
iv. Capital Formation: Financial markets provide a channel through which new savings flow
to aid capital formation of a country.
v. Price determination: Financial markets allow for the determination of price of the traded
financial assets through the interaction of buyers and sellers. They provide a sign for the
allocation of funds in the economy based on the demand and to the supply through the
mechanism called price discovery process.

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vi. Sale Mechanism: Financial markets provide a mechanism for selling of a financial asset

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by an investor so as to offer the benefit of marketability and liquidity of such assets.
vii. Information: The activities of the participants in the financial market result in the

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generation and the consequent dissemination of information to the various segments of
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the market. So as to reduce the cost of transaction of financial assets.
Financial Functions
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i. Providing the borrower with funds so as to enable them to carry out their investment
plans.
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ii. Providing the lenders with earning assets so as to enable them to earn wealth by
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deploying the assets in production debentures.

iii. Providing liquidity in the market so as to facilitate trading of funds.
iv. it provides liquidity to commercial bank
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v. it facilitate credit creation

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vi. it promotes savings

vii. it promotes investment
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viii. it facilitates balance economic growth

ix. it improves trading floors

10.4 BASIS OF FINANCIAL MARKETS (Raising Capital)

The basis of financial markets are the lenders and borrowers, financial markets attract funds from
investors and channel them to corporations they thus allow corporations to finance their
operations and achieve growth. Money markets allow firms to borrow funds on a short term
basis, while capital markets allow corporations to gain long-term funding to support expansion
(known as maturity transformation).

Without financial markets, borrowers would have difficulty finding lenders themselves.
Intermediaries such as banks, Investment Banks, and Boutique Investment Banks can help in this
process. Banks take deposits from those who have money to save. They can then lend money
from this pool of deposited money to those who seek to borrow. Banks popularly lend money in
the form of loans and mortgages. Financial institutions and financial markets help firms raise
money. They can do this by taking out a loan from a bank and repaying it with interest, issuing
bonds to borrow money from investors that will be repaid at a fixed interest rate, or offering
investors partial ownership in the company and a claim on its residual cash flows in the form of
stock.

More complex transactions than a simple bank deposit require markets where lenders and their
agents can meet borrowers and their agents, and where existing borrowing or lending
commitments can be sold on to other parties. A good example of a financial market is a stock
exchange. A company can raise money by selling shares to investors and its existing shares can
be bought or sold.

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The following table illustrates where financial markets fit in the relationship between lenders and
borrowers:

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Table 10.1: Relationship between Lenders and Borrowers
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Lenders Financial Financial Markets Borrowers
intermediaries
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Individuals Banks Interbank Individuals

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Companies Insurance Companies Stock Exchange Companies

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Pension Funds Money Market Central

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Government
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Mutual Funds Bond Market Municipalities

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Foreign Exchange Public

Corporations
Lenders
Lenders in the financial market are actually the investors, who have enough money to lend or to
give someone money from own pocket at the condition of getting back the principal amount or
with some interest or charge, is the Lender. Their invested money is used to finance the
requirements of borrowers. So, there are various types of investments which generate lending
activities. Some of these types of investments are depositing money in savings bank account,
paying premiums to Insurance Companies, investing in shares of different companies, investing
in govt. bonds and investing in pension funds and mutual funds.
Financial Market is nothing but a tool which is used to raise capital. Just like any other tool, it
can be beneficial and can be harmful too. So, the ultimate outcome solely lies in the hands of the
people who use it to serve their purpose.

Individuals & Doubles

Many individuals are not aware that they are lenders, but almost everybody does lend money in
many ways. A person lends money when he or she:
 puts money in a savings account at a bank;
 contributes to a pension plan;
 pays premiums to an insurance company;
 invests in government bonds;

For example, Companies tend to be borrowers of capital. When companies have surplus cash that

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is not needed for a short period of time, they may seek to make money from their cash surplus by

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lending it via short term markets called money markets. There are a few companies that have
very strong cash, these companies tend to be lenders rather than borrowers. Such companies may

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decide to return cash to surplus (e.g. via a share buyback.) Alternatively, they may seek to make
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more money on their cash by lending it (e.g. investing in bonds and stocks).

Borrowers
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Borrowers of the financial market can be individual persons, private companies, public
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corporations, government and other local authorities like municipalities. Individual persons
generally take short term or long term mortgage loans from banks to buy any property. Private
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Companies take short term or long term loans for expansion of business or for improvement of
the business infrastructure. Public Corporations like railway companies and postal services also
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borrow from Financial Market to collect required money. Government also borrows from
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Financial Market to bridge the gap between govt. revenue and govt. spending. Local authorities
like municipalities sometimes borrow in their own name and sometimes govt. borrows in behalf
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of them from the Financial Market.

 Individuals borrow money via bankers' loans for short term needs or longer term
mortgages to help finance a house purchase.

 Companies borrow money to aid short term or long term cash flows. They also borrow to
fund modernization or future business expansion.

 Governments often find their spending requirements exceed their tax revenues. To make
up this difference, they need to borrow. Governments also borrow on behalf of
nationalized industries, municipalities, local authorities and other public sector bodies. In
the UK, the total borrowing requirement is often referred to as the Public sector net cash
requirement .
Governments borrow by issuing bonds. In the UK, the government also borrows from
individuals by offering bank accounts and Premium Bonds. Government debt seems to be
permanent. Indeed the debt seemingly expands rather than being paid off. One strategy used by
governments to reduce the value of the debt is to influence inflation.

Municipalities and local authorities may borrow in their own name as well as receiving funding
from national governments. In the UK, this would cover an authority like Hampshire County
Council. Public Corporations typically include nationalized industries. These may include the
postal services, railway companies and utility companies. Many borrowers have difficulty raising
money locally. They need to borrow internationally with the aid of Foreign exchange markets.

Borrowers having similar needs can form into a group of borrowers. They can also take an
organizational form like Mutual Funds. They can provide mortgage on weight basis. The main

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advantage is that this lowers the cost of their borrowings.

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10.5 CONSTITUENTS OF FINANCIAL MARKETS

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Base on markets levels
Primary market: Primary market is a market for new issues or new financial claims. Hence it’s
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also called new issue market. The primary market deals with those securities which are issued to
the public for the first time. A primary market issues new securities on an exchange. Companies,
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governments and other groups obtain financing through debt or equity based securities. Primary
markets, also known as "new issue markets," are facilitated by underwriting groups, which
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consist of investment banks that will set a beginning price range for a given security and then
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oversee its sale directly to investors.

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The primary markets are where investors have their first chance to participate in a new security
issuance. The issuing company or group receives cash proceeds from the sale, which is then used
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to fund operations or expand the business.

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The secondary market is where investors purchase securities or assets from other investors,
rather than from issuing companies themselves. The Securities and Exchange Commission (SEC)
registers securities prior to their primary issuance, then they start trading in the secondary market
on the New York Stock Exchange, NASDAQ or other venue where the securities have been
accepted for listing and trading

Secondary market: It’s a market for secondary sale of securities. In other words, securities
which have already passed through the new issue market are traded in this market. Generally,
such securities are quoted in the stock exchange and it provides a continuous and regular market
for buying and selling of securities.

The secondary market is where the bulk of exchange trading occurs each day. Primary markets
can see increased volatility over secondary markets because it is difficult to accurately gauge
investor demand for a new security until several days of trading have occurred. In the primary
market, prices are often set beforehand, whereas in the secondary market only basic forces like
supply and demand determine the price of the security.
Secondary markets exist for other securities as well, such as when funds, investment banks or
entities such as Fannie Mae purchase mortgages from issuing lenders. In any secondary market
trade, the cash proceeds go to an investor rather than to the underlying company/entity directly.

The Over-The-Counter Market

The over-the-counter (OTC) market is a type of secondary market also referred to as a dealer
market. The term "over-the-counter" refers to stocks that are not trading on a stock exchange
such as the NASDAQ, NYSE or American Stock Exchange (AMEX). This generally means that
the stock trades either on the over-the-counter bulletin board (OTCBB) or the pink sheets.
Neither of these networks is an exchange; in fact, they describe themselves as providers of

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pricing information for securities. OTCBB and pink sheet companies have far fewer regulations

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to comply with than those that trade shares on a stock exchange. Most securities that trade this
way are penny stocks or are from very small companies.

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Third and Fourth Markets AP
You might also hear the terms "third" and "fourth markets." These don't concern individual
investors because they involve significant volumes of shares to be transacted per trade. These
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markets deal with transactions between broker-dealers and large institutions through over-the-
counter electronic networks. The third market comprises OTC transactions between broker-
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dealers and large institutions. The fourth market is made up of transactions that take place
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between large institutions. The main reason these third and fourth market transactions occur is to
avoid placing these orders through the main exchange, which could greatly affect the price of the
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security. Because access to the third and fourth markets is limited, their activities have little
effect on the average investor.
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Based On Security Types

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Money market: Money market is a market for dealing with financial assets and securities which
have a maturity period of up to one year. In other words, it’s a market for purely short term
funds.

Capital market: A capital market is a market for financial assets which have a long or indefinite
maturity. Generally it deals with long term securities which have a maturity period of above one
year. Capital market may be further divided into: (a) industrial securities market (b) Govt.
securities market and (c) long term loans market.

(a) Equity markets: A market where ownership of securities are issued and subscribed is
known as equity market. An example of a secondary equity market for shares is the
Bombay stock exchange.
 (b) Debt market: The market where funds are borrowed and lent is known as debt market.
Arrangements are made in such a way that the borrowers agree to pay the lender the
original amount of the loan plus some specified amount of interest.
Derivative markets: A market where financial instruments are derived and traded based on an
underlying asset such as commodities or stocks.

Financial service market: A market that comprises participants such as commercial banks that
provide various financial services like ATM. Credit cards. Credit rating, stock broking etc. is
known as financial service market. Individuals and firms use financial services markets, to
purchase services that enhance the working of debt and equity markets.

Depository markets: A depository market consist of depository institutions that accept deposit
from individuals and firms and uses these funds to participate in the debt market, by giving loans

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or purchasing other debt instruments such as treasure bills.

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Non-Depository market: Non-depository market carry out various functions in financial

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markets ranging from financial intermediary to selling, insurance etc. The various constituency
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in non-depositary markets are mutual funds, insurance companies, pension funds, brokerage
firms etc.
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Question: Which of the following statements about secondary markets is correct?
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a) They do not raise new capital.

b) They provide liquidity, without which primary issues could not be marketed.
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c) They are of great importance to an economy.

d) They are markets for previously issued financial instruments.
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Solution
All of the above are correct
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10.6 ROLE OF FINANCIAL MARKETS IN AN ECONOMY

Financial markets play an important role in the mobilization of financial resources for long term
investment through financial intermediation. The existence of money markets facilitate trading in
short-term debt instruments to meet short-term needs of large users of funds such as
governments, banks and similar institutions. Government treasury bills and similar securities, as
well as company commercial bills, are examples of instruments traded in the money market. A
wide range of financial institutions, including merchant banks, commercial banks, the central
bank and other dealers operate in the money market. Public as well as private sector operators
make use of various financial instruments to raise and invest short term funds which, if need be,
can be quickly liquidated to satisfy short-term needs. Unlike the money market, the capital
market mobilizes long-term debt and equity finance for investments in long-term assets. Capital
markets also help to strengthen corporate financial structure and improve the general solvency of
the financial system.
One of the important sustainability requisite for the accelerated development of an economy is
the existence of a dynamic financial market. A financial market helps the economy in the
following manner.

Saving mobilization: Stock exchanges provide organized market for individual as well as
institutional investors. They regulate the trading transactions with proper rules and
regulations in order to ensure investor’s protection. This helps to consolidate the confidence of
investors and small savers, thus. Stock exchanges attract small savings especially of large
number of investors in the capital market. Obtaining funds from the savers or surplus units such
as household individuals, business firms, public sector units, central government, state
governments etc. is an important role played by financial markets

Promoting Capital Formation: The funds mobilized through capital market are provided to the

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industries engaged in the production of various goods and services useful for the society.

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This leads to capital formation and development of national assets. The savings mobilized are
channelized into appropriate avenues of investment.

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Wider Avenues of Investment: Stock exchanges provide a wider avenue for the investment
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to the people and organizations with investible surplus. Companies from diverse industries like
Information Technology. Steel, Chemicals, Fuels and petroleum, Cement, Fertilizers etc. offer
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various kinds of equity and debt securities to the investors. Online trading facility has brought
the stock exchange at the doorsteps of investors through computer network. Diverse type of
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securities is made available in the stock exchanges to suit the varying objectives and notions
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of different classes of investor. Necessary information from stock exchanges available from
different sources guides the investors in the effective management of their investment
portfolios.
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Liquidity of Investment: Stock exchanges provide liquidity of investment to the investors.

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Investors can sell out any of their investments in securities at any time during trading days and
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trading hours on stock exchanges; Thus Stock exchanges provide liquidity of investment. The
on-line trading and online settlement of demat securities facilitates the investors to sell out their
investment and realize the proceeds within a day or two. Even investors can switch over their
investment from one security to another according to the changing scenario of capital market.

Investment Priorities: Stock exchanges facilitate the investors to decide his investment
priorities by providing him the basket of different kinds of securities of different industries and
companies. He can sell stock of one company and buy a stock of another company through
stock exchange whenever he wants. He can manage his investment portfolio to maximize his
wealth.
Investment Safety: Stock exchanges through their by-laws. Securities and Exchange Board of
India (SEBI) guidelines. Transparent procedures try to provide safety to the investment in
industrial securities. Government has established the National stock Exchange (NSE) and over
the counter Exchange of India (OTCEI) or investor’s safety. Exchange authorities try to curb
speculative practices and minimize the risk for common investor to preserve his confidence.
Wide Marketability to Securities: Online price quoting system and online buying and selling
facility have changed the nature and working of stock exchanges, formerly. The dealings on
stock exchanges were restricted to its headquarters. The investors across the lack of
information, but today due to Internet, on line quoting facility is available at the computers of
investors, as a result. They can keep track of prince fluctuations taking place on stock exchange
every second during the working hours. Certain T.V. channels like CNBC are fully devoted to
stock market information and corporate news. Even other channels display the on line quoting
of stocks, thus. Modern stock exchanges backed up by internet and information
technology provide wide marketability to securities of the industries.

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Financial Resources for Public and Private Sectors: Stock Exchanges make available the

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financial resources available to the industries in public and private sector through various kinds
of securities. Due to the assurance of liquidity, Marketing support. Investment safety assured
through stock exchanges. The public issues of securities by these industries receive strong

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public response (resulting in oversubscription of issue).
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Funds for Development Purpose: Stock exchanges enable the government to mobilize the funds
for public utilities and public undertakings which take up the developmental activities like power
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projects, Shipping, railways, telecommunication dams and roads constructions, etc. Stock
exchanges provide liquidity, marketability, price continuity and constant evaluation of
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government securities.
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Indicator of Industrial Development: Stock exchanges are the symbolic indicators of

industrial development of a nation. Productivity, efficiency, economic-status. A prospect of
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each industry and every unit in an industry is reflected through the price fluctuation of industrial
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on stock exchanges. The different components of financial markets help an accelerated growth of
industrial and economic development of a country, thus contributing to raising the standard of
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living and the society of well-being.

Barometer of National Economy: Stock exchanges are taken as a Barometer of the economy of
a country. Each economy is economically symbolized (indicators) by its most significant stock
exchange. New York stock Exchange, London stock Exchange, Tokyo stock Exchange and
Bombay stock Exchange are considered as barometers of U.S.A. United Kingdom, Japan,
Nigerian Stock Exchange and India respectively. At both national and international level these
stock exchanges represent the progress and conditions of their economies

10.7 THE NIGERIAN FINANCIAL MARKETS

(A) The Nigerian Capital Market and Its Institutions
The Nigerian capital market has continued to play its traditional role of mobilising medium to
long-term funds for development purposes. The Securities and Exchange Commission (SEC) is
the regulatory authority of the market and the operational institutions are the Nigerian Stock
Exchange, the issuing houses and the stock broking firms. The capital market consists of the
primary market for new issues of securities and the secondary market for trading in existing
securities. So far, trading floors exist at Kaduna, Kano, Port Harcourt, Onitsha, lbadan and
Abuja. Activities in both markets have increased tremendously over the years. One significant
development in the capital market is the establishment, in April 1985, of the Second-Tier
Securities Market (SSM). This market caters for the small to medium scale enterprises. There is
also the Unit Trust Scheme, the first of which commenced operation in December 1990. As at
the end of 1997, there were 14 unit trust schemes.

The capital market has undergone tremendous reforms in recent years. Among these is the
introduction of Central Securities Clearing System (CSCS), an automated clearing, settlement
and delivery system aimed at easing transactions and fostering investors' confidence in the

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market. Equally important is the linking of performance information on the NSE to Reuters

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International System in order to disseminate relevant market information to subscribers. The
Abacha regime promoted the establishment of another Stock Exchange, the Abuja Stock

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Exchange by Federal Government agencies. Although SEC has approved its establishment as of
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the beginning of year 2000, it had not commenced operations. There are speculations that the
project may be abandoned.
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Aim of the Nigerian Capital Market: The primary aim of the Nigerian capital market is to
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mobilize long-term funds. The Nigerian Stock Exchange (NSE) is the centre point of the capital
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market while the Securities and Exchange Commission (SEC) serves as the apex regulatory
body. It provides a mechanism for mobilizing private and public savings and makes such funds
available for productive purposes. The Exchange also provides a means for trading in existing
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securities. To enable small as well as large-scale enterprises gain access to public listing, the
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NSC operates the main Exchange for relatively large enterprises, and the Second-Tier Security
Market (SSM) where listing requirements are less stringent for small and medium-scale
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enterprises. The exchange which started with only 19 securities traded on its floors in 1961, now
has 279 securities made up of 34 Federal Government Stocks. 62 Corporate/Bonds and 183
equities all with a total market capitalization of N170 billion. The major instruments used to raise
funds in the market include equities, debentures, bonds and stocks. Capital markets are classified
into two segments, namely primary and secondary.

The primary market for new issues of securities. The mode of offer for the securities traded in
this market includes offer for subscriptions, rights issues, offer for sale, private placement etc.
while the secondary market is a market for trading in existing securities. This consists of
exchanges and over the counter deals where securities are bought and sold after their issuance in
the primary market. Activities in the secondary market have increased substantially over the
years. The number of stock brokers trading on the Exchange increased from 110 in 1991 to 140
in 1994.

The debt of the capital market has increased with the introduction of the Unit Trust Scheme for
mobilizing the financial resources of small and big savers and managing such funds to achieve
relatively high returns with minimum risks through efficient portfolio diversification. Efficiently
managed unit fund schemes offer the advantages of low costs, liquidity and high returns. The
promulgation of the Companies and Allied Matters Decree of 1990 provided the legal framework
for the establishment of unit trusts.

With the introduction of the Electronic Contributor System, the NSE is able to beam stock
market operations to the outside world via the Reuters International Information Network.

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(a) Instruments employed at the Capital Market: The major instrument used to raise fund

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at the Nigerian Capital Market includes:
i. Debt - Government Bonds (Federal, States, & Local Governments)

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ii. Equities - Ordinary Shares and Preference shares
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iii. Industrial Loans/Debenture Stocks and Bonds
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(b) The structure of the Capital Market: There are two markets within the Nigerian
Capital Market, which can be broadly classified into primary market and secondary
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market
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(c) Primary Market: This is a market where new securities are issued. The mode of offer
for the securities traded in this market includes offer for subscription, right issues, offer
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for sales, private placement.

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(d) Secondary Market: This is the market for trading in existing securities. This consists of
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exchange and over the counter market where securities are bought and sold after their
issuance in the Primary market.

(e) Major Participant in The Nigerian Capital Market: i) The Securities and Exchange
Commission (SEC), is responsible for the overall regulation of the entire market. ii.) The
Nigerian Stock Exchange (NSE), is self-regulatory organization that supervises the
operations of the formal quoted market: iii.) Market Operators consisting of the Issuing
Houses (Merchant Banks and Stock broking firms), Stockbrokers, Trustees, Registrars,
etc. iv.) Investors, Individuals, Insurance Companies, Pension Fund, and Unit Trusts
(Institutional Investors.

Nigerian Stock Exchange

The NSE provides a mechanism for mobilizing private and public savings. It also encourages
large-scale enterprises to gain access to public listing. The NSE operates the main exchange for
relatively large enterprises while the Second tier Securities Market (SSM) where listing
requirement are less stringent for small and medium scale enterprises.

The primary aim of the Nigerian Stock Exchange is to mobilize long-term funds for investment.
Another objective is to improve the efficiency of capital by providing market measure of returns
on capital.

Functions
i. Foster the growth of the domestic financial services sector and the various forms of
institutional savings such as life insurance and pension funds.

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ii. Provide an additional channel for engaging and mobilizing domestic savings for

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productive investment and represent an alternative to bank deposits, real estate
investment and the financing of consumption loans.

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iii. Improves the gearing of the domestic corporate sector and helps reduce dependence on
borrowing.
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iv. To facilitate the transfer of enterprises from the public sector to the private sector.
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v. Provide access to finance for new and smaller companies and encourage institutional
development in facilitating the setting up of Nigeria’s domestic funds, foreign funds and
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venture capital funds.

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vi. To encourage privatization by increasing the marketability of new issues.

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Nigerian Securities and Exchange Commission

Securities and Exchange Commission (SEC) was established by the SEC Act of 27th September,
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1979 and was re-enacted by the SEC Decree of 1988. It is the apex regulatory organ of the
capital market. Its major objective is the promotion of an orderly and active capital market. In
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doing this the SEC has a major function of ensuring adequate protection of the investing public.
SEC continues to maintain surveillance over the market to enhance efficiency. In 1993, the SEC
issued guidelines on the establishment of Stock Exchange in furtherance of the deregulation of
the capital market.

This first enabling act was re-enacted in 1988 to correct flaws in the first and in 1999 was
repealed and replaced with the Investment and Securities Act (ISA) of 1999. ISA charged the
SEC with the dual responsibilities of regulating and developing the capital market. All
instruments, operators/ consultants, exchanges, clearing and settlement agencies and depositors
must register with the SEC.

Functions and Responsibilities of the SEC

The following are the functions of the SEC as mandated by ISA (1999):
a) To regulate securities business in Nigeria;
b) To register and regulate securities and exchanges, capital trade points, futures, options,
and derivatives, commodity exchanges and any other recognized investment exchanges;
c) To register securities to be offered for subscriptions for sale to the public;
d) To render assistance in all aspects, including funding as may be deemed necessary to
promoters and investors wishing to establish securities exchanges and capital trade
points;
e) To regulate and register corporate and individuals capital market .operators as well as
capital market advisers and consultants such as solicitors, accountants and surveyors.
f) To facilitate the establishment of a nationwide system for securities trading in Nigeria
capital market in order to protect investors and maintain fair and orderly dealing;
g) To facilitate the linking of markets in securities through modern communication and data

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processing facilities so as to foster efficiency, competition and improved information

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availability to brokers, dealers and investors in the market;
h) To act in the public's interest having regards for the protection of investors and

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maintenance of fair and orderly market and to this end establish a nationwide trust
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scheme to compensate investors whose losses are not covered under the investors
protection funds administered by securities exchanges and capital trade points;
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i) To register and regulate central depository companies clearing and settlement companies,
custodian of securities, credit rating agencies and such other agencies and intermediaries.
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j) To review, approve and regulate mergers, acquisitions and all forms of business
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combinations;
k) To conduct research into all or any aspect of the securities industry;
l) To act as a regulatory apex body of the Nigerian capital market including the promotion
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and registration of self-regulatory organizations and capital market and trade associations
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to which it may delegate its power.

The specific regulatory roles of the SEC consist of the following:
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a) Registration of exchanges such as securities and commodity exchanges, capital trade

points and derivatives exchange;
b) Registration of market operators and professionals such as stock brokers, issuing houses,
registrars, portfolio managers, lawyers and accountants;
c) Registration of securities to be offered to the public;
d) Surveillance of trading activities at the exchanges in a bid to forestall abuses of insider
trading and preventing unfair manipulations of the market; and
e) Inspection of the books of operators, investigation of complaints and enforcement of ISA
rules and regulations of SEC.
The strategies employed by SEC for its developmental role consist of,
a) Extensive research for policy formulations;
b) Introduction of new products to broaden and deepen the capital market;
 c) General education of market participants and the public as a whole
Development Finance Institutions
These are specialised banks established to contribute to the development of specific sectors of
the economy. They consist of the (i) Nigerian Industrial (iv) Development Bank (NIDB)
established in 1964 to provide credit and other facilities to industries; (ii) Nigerian Bank for
Commerce and Industry (NBCI) established through Decree No. 22 of 1973 to develop
indigenous enterprises; (ili) Nigerian Agricultural and Co-operative Bank (NACB) established in
1973 to finance agricultural development projects and allied industries; (iv) Nigerian Education
Bank (NEB) established to replace the former Students' Loans Board and provide loans to needy
students; (v) Urban Development Bank (UDB) established through Decree No. 51 of 1992 to
provide financial resources to both the public and private sectors of the economy for the
development (v) of urban dwellings, mass transportation and public utilities; and (vi) the
Nigerian Export Import Bank (NEXIIVI) established to finance exports and imports, and to

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provide export credit guarantee and insurance to Nigerian exporters. At various times, these

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institutions have contributed to the development of the country. However, in recent years, the
operations of some of these institutions have been hampered by problems ranging from poor

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management to insufficient funds due to low capitalisation.
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Other Financial Institutions and Funds Other financial institutions and funds which perform
intermediation functions include the following.
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i. Insurance Companies (see session 9)
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ii. Finance Companies: Finance companies specialise in short-term non-bank financial

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intermediation such as financing Local Purchase Order (LPO), project financing,

equipment leasing, and debt factoring. Finance companies became prominent in Nigeria
after the 1986 financial sector liberalisation. As at end of 1997, 229 finance companies
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were in operation.
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iii. Bureau de Change (see session 9)

iv. Primary Mortgage Institutions (PMIs): The enabling law for the establishment and
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operation of PMIs is Decree No. 53 of 1989. The major function of PMIs is to mobilise
savings for the development of the housing sector. PMIs were initially supervised by the
Federal Mortgage Bank of Nigeria (FMBN) but that function has since been transferred
to the CBN. PMIs have grown over the years to about 115 in 1997 while their total
assets/liabilities stood at 146,078.9 million in the same year.

v. The National Economic Reconstruction Fund (NERFUND): NERFUND was

established under Decree No. 25 of 1988 with the broad objective of providing local and
foreign funds to small and medium-scale enterprises. The Fund draws its resources from
the Federal government, the CBN, African Development Bank and foreign governments
that provide funding by way of export credits for the scheme. Cumulative disbursements
 of N306.8 million and US$80.1 million had been made to projects under the scheme as at
the end of 1994.

vi. Nigerian Social Insurance Trust Fund (NSITF): Established by Decree No. 73 of 1993
to replace the defunct National Provident Fund (NPF), NSITF's main function is to adopt
a more comprehensive social security scheme for Nigerian private-sector employees.
Underlie scheme, Nigerian private sector employees are expected to con tribute 2.5 per
cent of their respective gross monthly income while the employer is expected to
contribute 5 per cent of gross monthly emolument.

(B) The Nigerian Money Market

The money market is a market for short-term funds: and as the name suggests, it is a market in
which money is bought and sold, the market is used by business enterprises to raise funds for the

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purchase of inventories, by banks to finance temporary reserve loss, by companies to finance

EA
consumer credit and by government to bridge the gap between its receipts and expenditure.

H
Unlike the market for textiles, for example, there is no place that one can call a money market.
Although activities in the money market cam be concentrated in a particular street. For example,
AP
all street in New York, Lombard street in London and Broad street in Lagos. Transactions in the
market are impersonal taking place mostly by telephone (Ajayi and Ojo, 1981). Thus, it is a
R
market for the collection of financial institutions set up for the granting of short-term loans and
dealing in short-term securities, gold, and foreign exchange (Anyanwu, 1993).
E
EL

Reasons for the Establishment of the Nigerian Money Market

i. To provide the machinery need for government short-term financing requirements.
ii. It is a part of a modern financial and monetary system which enables the nation to
ID

establish the monetary autonomy which is part and parcel of the workings of an
M

independent, modern state.

iii. To domesticate the credit base by providing local investment outlets for the retention of
BA

funds in Nigeria and for the investment of funds repatriated from abroad as a result of
government persuasions to that effect.
iv. It provides a good barometer to CBN, which can use it to judge the shortage of surplus of
funds in the economy.
v. The existence of the money market enables the central bank to undertake vigorous
monetary policy.

The Development of the Nigerian Money Market

No money market existed in Nigeria before the establishment of the Central Bank of Nigeria.
This is however not to say that a market for short-term funds did not exist before then. Before the
advent of commercials banking, there existed some elements of short-term lending and
borrowing based of commercial paper. The market was an integral part of the London money
market. It worked by moving funds from London to Nigeria during the season in order to finance
the export of produce. At the end of the season, the funds were moved back to London, when
there was all-season money-market activity. The establishment of the Nigerian money market
involved, on the part of the Central Bank of Nigeria, repatriating these “roving” funds to Nigeria
for the country’s economic development.
The Central Bank issued the first Treasury bills in 1960. The bills were in multiples of ₦l.000
and were issued on a monthly basis. Regular weekly issues replaced the monthly issues in 1963.
Treasury bills are now issued in multiples of ₦2, 000 and are for three months. They are issued
at a fixed rate of discount, and notice of issue is advertised each week in the newspapers. And by
2003, the Treasury bill market were issued daily in the daily Open Market Operation sessions of
the CBN. A prospective buyer must make his application through a licensed bank or acceptance
house. With the shift from direct monetary control to Market based control by the CBN in 1993,

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both individuals and licensed banks now place their application through the discount houses that

EA
intermediate between the CBN and these other parties.

The Nigerian money market activities rally around the activities of the commercial and merchant

H
banks, the inter banks fund markets and the activities in the markets for the different instruments
AP
in the money market. And the development is not unconnected with the systematic introduction
of the various instruments used in the market. Hence, discussion shall be on these instruments
R
and time of introduction. In recent periods, the instruments in the money market are:

1. Treasury Bills (TBS)

E

These are money-market (short-term) securities issued by the federal government of Nigeria.
EL

They are sold at a discount (rather than paying coupon interest), mature within 90 days of the
date of issue. They provide the government with a highly flexible and relatively cheap means of
ID

borrowing cash.
M

Thus, TBS and IOUs, are used by the federal government to borrow for short periods of about
three months pending the collection of its revenue. Their issue for the first time in Nigeria (in
BA

April 1960) was provided for under the Treasury Ordinance of 1959. It was issued in Nigeria in
multiples of ₦2000 (later reduced to ₦100 in order to expand the coverage of holders for 91 days
and at fixed discount.

2. Treasury Certificate (TCS)

These are similar to TBS but are issued at par or face value and pay fixed interest rates. These
fixed in interest rates are called coupon rates. Thus, each issue promises to pay a coupon rate of
interest and the investor collects this interest by tearing coupons off the edge of the certificate
and cashing the coupon at a bank; post office, or other specified federal office. Each coupon is
imprinted a year from the date of issue. In the Nigeria context, their rates became market-
determined like TB rates following interest rates deregulation.
Thus, treasury certificates are medium-term government securities which mature after a period of
one to two tears and are intended to bridge the gap between the Treasury bill and long term
government securities. They were first issued in 1968 at a discount of 45/8 percent for one-year
certificates and 41/2 percent for two year certificates.

3. Call Money Fund Scheme- Money at call or Short Notice

This refers to money lent by the banks on the understanding that it is repayable at the bank’s
demand or at short notice (e.g. 24 hours or over-night). Overnight loans are simply bank reserves
that are loaned from banks with excess reserves to banks with insufficient reserves. One bank
borrows money and pays the overnight interest rate to another bank in order and obtains the
lending bank’s excess reserves to hold as one-day deposits. The borrowing bank needs these one
day deposits in order to acquire the legal reserves the CBN examiners require banks to maintain.

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They act as a cushion which absorbs the immediate shock of liquidity pressures in the market.

EA
The scheme was introduced in 1962 in Nigeria. Under the scheme, fund was created at the CBN
and the participating banks had to agree to maintain a minimum balance at the CBN. Any surplus

H
above the minimum balance was then lint to the fund. The CBN administered the fund on behalf
of the banks and paid interest at a fixed rate somewhere below the Treasury bill rate. The CBN
AP
then invested the funds in the treasury bills.
R
The scheme was abolished in 1974 due to buoyant oil revenue of the federal government
consequent upon the oil boom. While the scheme lasted, it had a beneficial impact on the
E

efficiency with which the banks managed their cash balances while helping to reduce the degree
EL

of dependence of the banks on overseas money market facilities.

4. Commercial Papers or Commercial Bills

ID

These are short-term promissory notes issued by the CBN and their maturities vary from 50 to
270 days, with varying denominations (sometimes ₦50,000 or more). They are debt that arise in
M

the course of commerce.

BA

Commercial papers may also be sold by major companies (blue-chips-large, old, safe, well-
known, national companies) to obtain a loan. Here, such notes are not backed by any collateral,
rather, they rely on the high credit rating of the issuing companies. Normally, issuers of
commercial papers maintain open lines of credit (i.e. unused borrowing power at banks)
sufficient to pay back all of their commercial papers outstanding. Issuers operate in this form
since this type of credit can be obtained more quickly and easily than can bank loans.

This instrument was introduced in 1962 to finance the export-marketing operations of the then
Northern Marketing Board. Under the arrangement, the marketing boards meet their cash
requirements by drawing ninety-day bills of exchange on the marketing boards. The bills are
then discounted with the commercial banks and acceptance houses participating in the scheme.
The role of the CBN is that to provide rediscounting facilities for the bills.
5. Certificates of Deposits (CDS)
Negotiable (NCO) or Non-negotiable (NNCO) deposits are inter-bank debt instruments designed
mainly to channel commercial banks surplus funds into the merchant banks. NCO’s are
rediscountable with the CBN and those with more than 18 months tenure are eligible as liquid
assets in computing a bank’s liquidity ratio. These attributes make the instruments attractive to
banks.

Summary
The Financial Market plays an important role in promoting economic growth. By mobilizing
savings for productive investment and facilitating capital inflows, it stimulates investment in
both physical and human capital. The Financial Market also channels savings to more productive
uses by collecting and analysing information about investment opportunities. Thus, by creating

L
an efficient mechanism for transactions in long term financial instruments, it provides a wide

EA
range of wealth creating opportunities for the Government, Corporations, Private individuals,
and other financial institutions. Financial Market allows for intermediation of capital between

H
households and firms. Thus we have observed that financial market helps industrial to
perform from the following, AP
i. Determines the price of a transaction.
ii. Provides liquidity by transferring ownership of assets from one agent to the other. Performs
R
measurement and management of asset price risk.
E

iii. Some Financial Markets only allow participants that meet certain criteria, which can be
based on factors like the amount of money held, the investor’s geographical location,
EL

knowledge of the markets or the profession of the participant

ID

10.8 SELF-ASSESSMENT QUESTIONS

M

10.1 Give four examples of short-term financial instruments?

10.2 State four secondary markets known to you
BA

SOLUTION TO SAQ 10.1

1. A bankers acceptance
2. A Nigeria Treasury bill
3. A negotiable certificate of deposit
4. A six-month loan

SOLUTION TO SAQ 10.2

1. The over-the-counter stock market
2. The options markets
3. The Nigerian government bond market
4. The New York Stock Exchange

10.9 MUITIPLE-CHOICE QUESTIONS

1) Which of the following are securities?
a. A share of Texaco common stock
b. A Treasury bill
c. A certificate of deposit
d. Each of the above

2) Which of the following instruments is not traded in a money market?

a. Eurodollars and U.S. Treasury Bills
b. Banker's acceptances
c. Commercial paper
d. None of the above

3) Which of the following instruments are traded in a capital market?

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a. Banker's acceptances

EA
b. Nigeria Government agency securities
c. Negotiable bank CDs

H
d. Repurchase agreements
AP
4) What is the purpose of a financial market?
R
a. Allow banks to link buyers and sellers of financial securities
b. Buyers and sellers come together to buy and sell financial securities
E

c. Buyers and sellers come together to trade one good for another good
EL

d. Buyers and sellers are linked by a government agency. The government agency
controls the transaction.
ID

5) The bond markets are important because

M

a. they are easily the most widely followed financial markets in the United States
b. they are the markets where foreign exchange rates are determined
BA

c. they are the markets where interest rates are determined

d. of each of the above

6) Every financial market has the following characteristic:

a. It channels funds from lenders-savers to borrowers-spenders.
b. It determines the level of interest rates.
c. It allows common stock to be traded.
d. It allows loans to be made.

7) What is one method that a saver may directly lend to a borrower?

a. A saver pays an insurance premium
b. A saver buys a corporate bond.
 c. A saver opens a checking account
d. A saver opens a savings account.
8) If you buy a financial instrument/loan that has no stated interest rate on it, what kind of
financial instrument/loan is this?
a. Simple loan
b. Coupon bond
c. Discount bond.
d. Fixed-payment loan

9) What is the demand curve for bonds?

a. The demand curve shows the relationship between quantity demanded and market
price of bonds
b. The demand curve shows the relationship between quantities supplied and market

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price of bonds

EA
c. The demand curve shows the relationship between a bond’s market price and the
interest rate

H
d. The demand curve shows the relationship between the buyers and sellers of
bonds.
AP
R
10) A rising stock market index due to higher share prices
a. Increases people's wealth and as a result may increase their willingness to spend.
E

b. Increases the amount of funds that business firms can raise by selling newly-
EL

issued stock.
c. Decreases the amount of funds that business firms can raise by selling newly-
ID

issued stock.
d. Only (a) and (b) of the above.
M
BA

11) If you want to invest funds for a period greater than one year, you would most likely
invest in which market?
a. A primary market.
b. A capital market.
c. A money market.
d. An over-the-counter market.

12) Money market securities are usually:

a. More widely traded than long-term securities and so tend to be more liquid.
b. More widely traded than long-term securities and so tend to be less liquid.
c. Less widely traded than long-term securities and so tend to be more liquid.
d. Less widely traded than long-term securities and so tend to be less liquid.
13) Of the following assets, the most liquid is
a. Savings bonds.
b. Corporate bonds.
c. Stocks
d. Travellers’ cheques

14) Well-functioning financial markets promote economic efficiency by

a. Channelling funds from investors to savers.
b. Creating inflation.
c. Channelling funds from savers to investors.
d. Reducing investment.

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15) Nigerian government treasury bills

EA
a. are the safest of all money market instruments
b. sell at a discount because they are no interest payments

H
c. are the most liquid of the money market securities
d. all of the above. AP
R
16) Which of the following would be considered a real asset?
a. A corporate bond.
E

b. A machine
EL

c. Money.
d. Bank loans
ID

17) Which of the following financial assets might be least likely to have an active secondary
M

market?
a. Common stock of a large firm
BA

b. Bank loans made to smaller firms

c. Bonds of a major, multinational corporation
d. Debt issued by the United States Treasury

18) Which of the following are real assets:

a. A share of stock.
b. The balance in the firm's chequing account.
c. A factory
d. None of the above
19) The market in which securities trade is called
a. Previously issued; the primary market.
b. Newly issued; the secondary market.
 c. Previously issued; the secondary market.
d. Foreign; the unregulated primary duration market.

20) The capital market deals with assets of maturities of more than:
a. Two years.
b. One year.
c. Three years.
d. Three months.

21) A bond is
a. a promise to pay back a loan over an unspecified period
b. allows the firm to access funds with no liabilities
c. the only way a firm can raise funds

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d. a document that promises to pay back a loan under specified terms over a

EA
specified period of time

H
22) Bond prices
AP
a. are unaffected by changes in the demand for money
b. are unaffected by interest-rate changes
R
c. vary directly with interest rates
d. vary inversely with interest rates
E
EL

23) Securities are _____ for the person who buys them, but are _____ for the individual or
firm that issues them.
a. assets; liabilities
ID

b. liabilities; assets
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c. negotiable; nonnegotiable
d. nonnegotiable; negotiable
BA

24) Which of the following statements about the characteristics of debt and equity are true?
a. They can both be long-term financial instruments.
b. They can both be short-term financial instruments.
c. Debt is a claim on the issuer's assets, but equity is a claim on the issuer's income.
d. Both (a) and (b) of the above.

25) Financial markets improve economic welfare because

a. those who have such opportunities
b. they allow funds to move from those without productive investment opportunities
to
c. they allow consumers to time their purchase better
 d. they do (a) and (b) of the above

26) Which of the following are long-term financial instruments?

a. A negotiable certificate of deposit
b. A six-month loan
c. A banker’s acceptance
d. None of the above

27) Which of the following are primary markets?

a. The Nigerian government bond market
b. The options markets
c. The over-the-counter stock market
d. None of the above

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EA
28) Which of the following statements about financial markets and securities are true?
a. A debt instrument is long term if its maturity is ten years or longer.
b. The maturity of a debt instrument is the time (term) to that instrument's expiration

H
date.
AP
c. A debt instrument is intermediate term if its maturity is less than one year.
d. A bond is a long term security that promises to make periodic payments called
dividends to the firm's residual claimants.
R

29) Every financial market has the following characteristic:

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a. It channels funds from lenders-savers to borrowers-spenders

EL

b. It allows loans to be made

c. It determines the level of interest rates.
ID

d. It allows common stock to be traded.

M

30) A corporation acquires new funds only when its securities are sold
a. in the primary market by an investment bank
BA

b. in the primary market by a stock exchange broker

c. in the secondary market by a securities dealer
d. in the secondary market by a commercial bank

SOLUTION TO MUITIPLE-CHOICE QUESTIONS 10.9

Questions 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Answers d d B b c a b c a d b A d c d

Questions 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Answers b b C c c d d a a d d D a a a
 STUDY SESSION ELEVEN
GENERAL EQUILIBRIUM: IS-LM ANALYSIS
11.0 INTRODUCTION
Listening to news especially business news, you often see forecasts of GDP and interest rates
by economists. These predictions are products of a variety of economic models. One model
that has been widely put to use by economic forecasters is the IS-LM model developed by Sir
John Hicks in 1937. The IS-LM model basically explains how interest rates and total output
produced in the economy (aggregate output or, equivalently, aggregate income) are
determined, given a fixed price level. The objective of the IS-LM model is to bring the
product market and money market outcomes into a single framework as to analyse how we
can simultaneously determine the equilibrium value of national income and the interest rate.
The IS-LM model thus regards as a general equilibrium the interest rate and income level that

L
EA
generates simultaneous equilibrium in the both the product and money markets.

Learning Outcome for Study Eight

H
AP
At the end of this study session, you should be able to

11.1Define and use correctly all the key words printed in bold (SAQ1)
R

11.2 Explain the component of aggregate Demand and their determinants (SAQ2)
E

11.3Derive IS and LM curves (SAQ3)

EL

11.4Identify factors which determine the slope of the IS and LM curves (SAQ4)
ID

11.5 Explain the concept of general equilibrium using IS-LM frame work (SAQ5)
11.6 Analyse economics policies using IS-LM frame work (SAQ6)
M
BA

11.1 IS CONCEPTS

Generally, the I - S stands for investment and saving and the IS curve displays the
equilibrium in the goods and service market for various interest rates. Let us begin with the
recognition that the total quantity demanded of an economy’s output is the sum of four types
of spending: (1) consumer expenditure (C) , the total demand for consumer goods and
services (2) planned investment spending ( I ), government spending (G ) , the spending by
all levels of government on goods and services and (4) net exports ( NX) , the net foreign
spending on domestic goods and services, equal to exports minus imports. Now, let discuss
each component of the aggregate demand.

Consumption Expenditure

1
Basically, consumer expenditure is related to disposable income which is the total income
available for spending .This relationship between disposable income Y and consumer
expenditure C can be expressed as:

……………………………………………………………………..(11.1)

The term a stands for autonomous consumer expenditure, the amount of consumer
expenditure that is independent of disposable. The term mpc, the marginal propensity to
consume, is the slope of the consumption function line.

Investment Spending

There are two types of investment according to this theory. They are fixed investment and
inventory investment. While fixed investment is the spending by firms on equipment such as

L
machines, inventory investment is the spending by firms on additional holdings of raw

EA
materials, and some finished in a given time period—say a year. Given this background,

H
planned investment spending as a component of aggregate demand comprises of
AP
planned fixed investment and the amount of inventory investment planned by firms. In this
framework, there are two factors that influence planned investment spending: interest rates
R

and businesses’ expectations about the future. Modelling this in mathematical equation we
E

can say that desired investment demand depends upon the real interest rate as it can be
EL

presented as follow:

…………………………………………………………………………(11.2)
ID
M
BA

Where is the autonomous investment, r stands for the real interest rate and γ captures the
sensitivity of investment demand to changes in r. As r increases, a fall in the amount of
investment that firms wish to undertake is observed.

Government Expenditure

In the theory, it is appreciated that government spending and taxation could also affect the
position of the aggregate demand function. As reflected in the aggregate demand
equation , government spending G adds directly to aggregate demand.
Taxes, however, do not affect aggregate demand directly, as government spending does.
Instead, taxes lower the amount of income that consumers have available for spending and
affect aggregate demand by influencing consumer expenditure; that is, when there are taxes,
disposable income Y does not equal aggregate output; it equals aggregate output Y minus
2
taxes T: The consumption function can be rewritten as
follows:

………………………………………………………………(11.3)

International Trade

International trade also plays a role in determining aggregate output because net exports
(exports minus imports) are a component of aggregate demand. Now foreigners suddenly
decide to buy more of Nigerian crude this will position of our net export and by extension
aggregate output. Thus, changes in net exports can be another important factor affecting
fluctuations in aggregate output.

Aggregate Demand and Equilibrium

L
EA
The aggregation of the activities in these four components represents an economy’s output
called aggregate demand ( ). Symbolically,

H
…………………………………………………………(11.4)
AP
Where stands for aggregate demand and symbols C, I, G and NX remain as defined
R

earlier. Using our microeconomics ideas of supply and demand analysis, it is safe to conclude
E

that equilibrium would occur in the economy when total quantity of output supplied
EL

(aggregate output produced) Y equals quantity of output demanded that is:

ID

Y= ………………………………………………………………………(11.5)
M

When this equilibrium condition is satisfied producers are able to sell all of their output and
BA

have no reason to change their production. Also of great importance to this IS analysis is the
assumption of fixed price level.

11.2 IS Curve

The IS curve represents all combinations of income (Y) and the real interest rate (r) such that
the market for goods and services is in equilibrium. That is, every point on the IS curve is an
income/real interest rate pair (Y,r) such that the demand for goods is equal to the supply of
goods (where it is implicitly assumed that whatever is demanded is supplied) or, equivalently,
desired national saving is equal to desired investment. The graphical derivation of the IS
curve is given below.

3
Fig.11.1

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Consider an initial equilibrium in the goods market where r = 5% and income is equal to Y0.

EA
This equilibrium is illustrated in the graph on the right with r on the vertical axis and Y on the
horizontal axis as the big black dot (middle dot). Now suppose Y increases to Y1 (say supply

H
increases). This increase in Y shifts the desired savings curve down and right lowering the
AP
equilibrium real interest rate to 3%. The new equilibrium in the goods market with higher
income and a lower real interest rate is illustrated in the graph on the right as the big blue dot
R

(bottom dot). Similarly, if Y decreases from Y0 to Y2 then the savings curve shifts up and left
E

and the equilibrium real interest rises. The new equilibrium in the goods market with lower
EL

income and a higher real interest rate is illustrated in the graph on the right as the big red dot
ID

(top dot). Notice that as income increases (decreases) the real interest must fall (rise) in order
to maintain equilibrium in the goods market. This is the relationship that is represented in the
M

downward sloping IS curve.

BA

Every point on the IS curve represents an intersection between desired national saving and
desired investment for some income/interest rate pair (Y,r). As such the IS curve is derived
holding the determinants of saving and investment, other than Y and r, fixed. When these
factors change the IS curve will shift. Since points on the IS curve represent points where
aggregate demand is equal to aggregate supply any factor that increases the demand for goods
and services will shift the IS curve up and to the right and any factor that decreases the
demand for goods and services will shift the IS curve down and to the left. From the
savings/investment diagram it follows that any shift of the savings or investment curve that
increases the real interest rate, holding Y fixed, will shift up the IS curve. Functionally, the IS
curve is represented as

4
 ( )…………………………………………………………………(11.6)

Pluses (+) above the exogenous variables indicate that increases in the variables shift the IS
curve up and to the right (increases demand)

11.3 DERIVING THE L-M CURVE

The LM curve, "L" denotes Liquidity and "M" denotes money, is a graph of combinations of
real income, Y, and the real interest rate, r, such that the money market is in equilibrium (i.e.
real money supply = real money demand). The graphical derivation of the LM curve is
illustrated-below.

L
EA
H
AP
R
E
EL
ID

Fig.11.2
M
BA

The left-hand side of the graph illustrates money market equilibrium for a given level of Y.
For example, when Y = Y0 the equilibrium real interest rate is 5%. The right-hand-side of the
graph gives the LM curve. The LM curve is plotted with the real interest rate on the vertical
axis and real income (GDP) on the horizontal axis. Each point on the LM curve represents
money market equilibrium for a particular real interest rate and income pair (r, Y). For
example, the money market equilibrium at (r=5%, Y=Y0) is given by the black (middle) dot
on the LM curve.

At a higher level of income, Y1 > Y0, the money demand curve shifts up and right and a new
equilibrium occurs at r = 7%. This equilibrium is represented by the blue (upper) dot on the
LM curve. Similarly, at a lower level of income Y2 < Y0 the money demand curve shifts

5
down and left and a new equilibrium occurs at r = 3%. This equilibrium is given the by the
red (lower) dot on the LM curve.

The above analysis shows that the LM curve is an upward sloping curve in the graph with r
on the vertical axis and Y on the horizontal axis. Every point on the LM curve represents an
intersection between the real money supply (M/P) and real money demand (Ld). The LM
curve will shift whenever the variables we hold fixed, other than Y, in the money-
supply/money-demand diagram change. These variable are M/P and e. In particular, if M/P
increases holding expected inflation fixed then r falls in the money market and so the LM
curve shifts down and right. Similarly, if expected inflation increases real money demand
falls, lowering the interest rate, and the LM curve shifts down and to the right. Functionally,
we represent the LM curve as

L
EA
…………………………………………………………………….(11.7)

H
AP
11.4 GENERAL EQUILIBRIUM IN THE GOODS AND MONEY MARKET
R
E
EL
ID
M
BA

Fig 11.3

At r = 5% and Y = 100 the IS and LM curves intersect. At this point both the goods market
and the money market are in equilibrium. This is called a general equilibrium since more than
one market is in equilibrium simultaneously. If r = 8% and Y = 75 then the goods market is in
equilibrium (on the IS curve) but the money market is not in equilibrium (off the LM curve).
At r = 8%, Y is too low for the money market to be in equilibrium. To get to general
equilibrium, r must fall and Y must rise (holding everything else fixed).

6
11.5 IS/LM MODEL AND POLICY ANALYSIS
Monetary Policy in the IS/LM Model
An increase in the nominal money supply causes a downward shift of the LM curve

L
EA
H
AP
Fig.11.4

Assume that the economy moves to point F. Then, the labour market is no longer in
R

equilibrium. Point F gives us aggregate demand. Since AD > Y*, firms raise prices causing
E

the price level to rise. The LM curve shifts back up to the left until AD = Y* at point E.
EL

 economy is brought into equilibrium by adjustment of the price level (speed of

ID

adjustment is a matter of dispute)

M

 money is neutral - had no effect on the real variables r, Y, and the level of
BA

employment

1.1.1 Fiscal Policy In the IS/LM Model

An increase in government spending shifts the IS curve up to the right.

Fig.11.5
7
AD > Y*, so the price level rises. The LM curve shifts up to the left to restore equilibrium.

Supply Shocks.

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EA
Fig.11.6 H
AP
A temporary adverse supply shock shifts the FE line to the left. AD > Y2 *, so the price level
R

rises. The LM curve shifts up to the left. A supply shock brings a fall in output and a jump in
the inflation rate.
E
EL

Summary of the Study Session

ID

Generally, the I - S stands for investment and saving and the IS curve displays the
M

equilibrium in the goods and service market for various interest rates. The IS curve
BA

represents all combinations of income (Y) and the real interest rate (r) such that the
market for goods and services is in equilibrium. Every point on the IS curve
represents an intersection between desired national saving and desired investment for
some income/interest rate pair (Y,r).
The LM curve, "L" denotes Liquidity and "M" denotes money, is a graph of
combinations of real income, Y, and the real interest rate, r, such that the money
market is in equilibrium (i.e. real money supply = real money demand). The LM
curve is an upward sloping curve in the graph with r on the vertical axis and Y on the
horizontal axis. Every point on the LM curve represents an intersection between the
real money supply (M/P) and real money demand (Ld).

8
11.6 SELF-ASSESSMENT QUESTION

1. When a firm invest it (SAQ1)

a. Uses excess cash to purchase bonds
b. Purchases some of its outstanding common stock
c. Begins construction on a new plant, buys some new equipment or begins
construction on new housing
d. Issues stock options to its executives.

2. Which of the following is the correct definition of the IS curve? (SAQ2)

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a. The IS curve represents the combinations of output and the interest rate where the

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goods market is in equilibrium.
b. The IS curve represents the single level of output where financial markets are in
equilibrium. H
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c. The IS curve represents the combinations of output and the interest rate where the
money
R

Market is in equilibrium.
E
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d. The IS curve represents the Single level of output where the goods market is in
equilibrium.
ID

e. none of the above

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3. An increase in the interest rate causes: (SAQ2)

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a. movement along an LM curve

b. a movement along an IS curve
c. investment spending to fall and real money demand to fall
d. All of the above are correct

4. Which of the following will cause the LM curve to shift? (SAQ4)

a. A change in autonomous taxes
b. A change in government spending
c. A change in autonomous consumption spending
d. A change in the money supply

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5. Suppose an economy is in short-run equilibrium at the intersection of IS and LM
curves. The central bank decreases the money supply. What will happen to the
equilibrium interest rate and equilibrium output? (SAQ5)
a. The interest rate will rise and output will fall
b. The interest rate will fall and output rise
c. Interest rate will fall and output will fall
d. Interest rate will rise and output will rise

6. The policy mix refers to: (SAQ6)

a. the combination of policies an insurance company sells
b. the recipe used in making a cake mix

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c. the blend of aggregate gravel used in making cement

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d. the combination of fiscal and monetary policy in use at a given time
7. The variable that links the market for goods and services and the market for real
money balances in the IS-LM model is the: (SAQ7) H
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a. consumption function
R

b. interest rate
c. price level
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d. nominal money supply

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8. In the IS-LM model, a decrease in government purchases leads to a(n) ______ in

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planned expenditures, a(n) ______ in total income, a(n) ______ in money demand,
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and a(n) ______ in the equilibrium interest rate. (SAQ8)

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a. decrease; decrease; decrease; decrease

b. increases; increase; increases; increase
c. decrease; decrease; increase; increase
d. increase; increase; decrease; decrease

9. An adverse supply shock would cause the FE line to (SAQ9)

a. shift to the right.
b. shift to the left.
c. remain unchanged.
d. remain unchanged if the shock is temporary; shift to the right if the shock is
permanent.
10. A decrease in wealth would cause the IS curve to (SAQ10)

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 a. shift up and to the right.
b. shift down and to the left.
c. remain unchanged.
d. shift up and to the right only if
people face borrowing constraints

Solutions:
Questions 1 2 3 4 5 6 7 8 9 10

Answers C A D D A D B A B B

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REFERENCES

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Books
Ajayi S.I and O.O. Ojo, (2006), ―Money and Banking, Analysis and Policy in the Nigeria
Context, Second Edition
H
Anyanwu, J.C (1993), ―Monetary Economics, Theory, policy and institutions‖
AP
Frederic S. Mishkin (2004), The Economics Of Money, Banking And Financial Markets,
Seventh Edition, The Addison-Wesley Series In Economics
R

Jhingan, M.L. (2008), ―Monetary Economics‖ 6th Edition

McCallum, B. (1989) Monetary Economics, New York: Macmillan; London: Collier
E

Macmillan
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Mishkin, Frederic S. The economics of money, banking, and financial markets / Frederic S.
Mishkin.—7th ed.
ID

Monetary Economics by M.L Jhingan 7th edition published by Vrinda Publication (P) Ltd
Money And Banking By E. Narayanan Nadar Phi Learning Pvt. Ltd., Jun 21, 2013
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Journal Articles
Central Bank of Nigeria (2011), Monetary Policy Review, Garki Abuja, Nigeria
Central Bank of Nigeria (2012) Revised Regulatory and Supervisory Guidelines for
Microfinance Banks (MFBS) In Nigeria
Central Bank of Nigeria (2013), Monetary Policy Review, Garki Abuja, Nigeria
Central Bank of Nigeria, Microfinance Policy Framework for Nigeria
Central Bank of NigeriaWebsite www.cbn.gov.ng
John Maynard Keynes (1936), The General Theory of Employment, Interest and Money p11
Mohamed Jalloh, (2009), The Role Of Financial Markets In Economic Growth. WAIFEM
Regional Course on Operations and Regulation of Capital Market, Accra, Ghana.,
National Open University of Nigeria (NOUN), School Of Business and Human Resource
Management, Course Code: MBF 731, Course Title: Monetary Economics and Policy
Rahul Sawlikar, Financial Market – Its Types and Roles in Industry, National Monthly
Refereed Journal of Research in Commerce & Management Volume No.1, Issue No.8

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Supriya Guru, Theories of Demand of Money: Tobin’s Portfolio and Baumol’s Inventory
Approaches

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ID
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BA

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