The five parts of a financial system
- Money: A commodity which is used as a means of payment for exchanging goods or services. The US they use the US dollars as legal tender. In Uganda the Uganda Shilling is legal tender (as fiat money).
- Financial instruments: Financial instruments include stocks, bonds and insurance policies. These are written legal obligations between two parties where one party is obligated to transfer something of value to another party at some future date under certain conditions. These obligations usually transfer resources from savers to investors.
- Financial markets: Markets where financial assets are traded. New York Stock Exchange, and Chicago
Board of Trade, etc. - Financial institutions: Financial institutions bring together investors and sellers of financial assets; and
borrowers and lenders. They bring together the deficit spending units and surplus spending units together. The deficit spending units are the borrowers while the surplus spending units are the lenders. banks, Microfinance Deposit taking institutions (MDIs), and insurance companies. In other developed countries with a fully operation financial markets, financial institutions include securities firms. - Central bank: this is the government agency that monitors the state of the economy and implements the monitory policies on behalf of the government. In the US it is called the Federal Reserve Bank (or the Fed).
Money and Banking
Money: Money can be defined as an asset that is generally accepted as means of payment for goods and services or repayment of debt.
It can be in the form of paper, beads, or gold. It is claimed that American soldiers during World War II had not ample paper currency, where they were at war overseas, and so they often used chocolate, cigarettes and even silk stockings as mediums of exchange.In the eastern region of Africa, cowrie shells were used as money before the introduction of modern forms of money. In the South Pacific island of Yap, they used rocks of various sizes as money during that same period.
Functions of money
3 main functions: a means of payment; a unit of account; a store of value
- It is a means of payment (a medium of exchange): This is the primary characteristic of money: that it is used as a means of payment or a medium of exchange. Most buyers and sellers will use and accept money as a form of payment in their transactions. Barter (exchange of goods or services for goods or services), as form of countertrade, suffers from double coincidence of wants.
- A unit of account: As a unit of account, money is simply used to measure prices andndebts. It allows prices for all goods and services to be compared. So we use money to a unit to effect business calculations and accounting procedures. In modern economics, money as a unit of account is almost always the medium of exchange. There are few circumstances where for example the prices of antiques or racehorses that are offered for sale at an auction are expressed in guineas (even when the guinea has long ceased to be
monetary unit).
- A store of value: Money can be used as a store of value. For example, an employee who sells his labour and in turn receives money in exchange may decide to keep that money (their income) without using it to make purchases. For money to be valuable and serve as a store of value, it needs to be able to retain value overtime. It should not depreciate and lose value overtime. There are other assets that also serve as a store of value such as bonds, stocks, and savings account. Money is the most unique store of value when compared to the assets mentioned here because it highly liquid. Liquidity can be described as how easy it is to turn an asset into consumption. Because money serves as a means of payment, it has a high liquidity.
- A standard of deferred payment: Money is used to facilitate payment of debts and other transactions in the future (at a specified day & date).
Desirable characteristics for a commodity to function as money
Here we are looking at qualities of good money
- For a commodity to act as money it has to be relatively scarce; portable; durable; divisible; and uniform.
- A commodity that is easily accessible and not scarce will not serve as money. That commodity should not be heavy but portable for carrying purposes.
- Durability means that it can be kept for long.
- Money should be divided into smaller units or denominations to make it possible to purchase smaller units of commodities.
- Uniformity (homogeneity) means all transactions will be made using the same commodity as a medium of exchange. This will make it acceptable by all people using it as exchanges.
Theory of money supply
Historically money supply depended on the discoveries of gold mines and the activities of miners. With the growth of demand deposit exchange, and the development of central banks with the power to regulate the money supply which the banking system creates, the need for the theory of money supply is important. Modern theory of money supply maintains that money supply is jointly determined by the central banks, the commercial banks, and the public.
Therefore money supply (M) is the product monetary base (B) and the money multiplier (m). We can have M = mB.
Money
Determinants of money supply
There are two key determinants of the supply of money and these are monetary base and the money multiplier. These factors are presented here.
- Monetary base: monetary base refers to the supply of money available for use either as cash or reserves of the central bank. The magnitude of the monetary base (B) is the significant determinant of the size of money supply. Money supply varies directly in relation to the changes in the monetary base.
Monetary base = notes and coins and reserve deposits at the central bank (Federal Reserve in the case of USA)
- Money multiplier: Money multiplier is the second important (the first is the monetary base) determinant of money supply.
- Reserve ratio: the reserve ratio is legally fixed by the central bank.
- Currency ratio: the ratio of currency demand to demand deposits
- Value of money: the value of money in terms of other goods and services has a positive influence on the monetary base and ultimately the stock of money.
- Interest rate: has a positive influence on the money multiplier effect and hence money supply. A rise in the interest rate will reduce the reserve ratio, and this will raise the money multiplier and vice versa.
- Monetary policy: has either positive or negative influence on the money multiplier and ultimately money supply. This will depend on whether reserve requirements are raised or lowered. If the reserve requirements are raised, the value of reserve ratio will rise thereby reducing the money multiplier and thus the money supply. And vice versa.
- Seasonal factors: for example during the holidays (x-mas, Easter, Idd, Thanks giving, St. Francis Day, etc.), the currency ratio will tend to rise, thereby reducing the money multiplier and hence the money supply.
The demand for money
The willingness by an individual to hold money in cash is what can be referred to as individual demand for money. Total demand for money refers to the amount of wealth that all individuals in the economy wish to hold in cash form.
The Quantity Theory of money: According to Irwin Fisher (1911), a classical economist, demand for money primarily depends on the level of transactions – that is, that money is used as a medium of exchange. Whenever a transaction has been made, there is an exchange of money for the good, service or securities. The value money then will be equal to the value of the good, service or security for which it was exchanged. This can be illustrated by the Fisher’s equation of exchange.
Fisher’s equation of exchange
This can be illustrated by the Fisher’s equation of exchange. We explain itbelow. MV = PT Where:
M is the nominal quantity of money in circulation V is the transactions velocity of money (number of times money changes hands)
P is the average price level of the transactions
T is the number of transactions in time period T.
If we assume that V and P are constant, if T increases M would alsincrease. This would mean that the number of transactions is high; and people would demand for money to settle such transactions.
See Irwin Fisher, 1911. The Purchasing Power of Money
3 Motives for demand for money
Transaction motive: Money (cash) is required to undertake day–to –day purchase goods and services.
The transaction demand for money depends on the following:
- Real income: people with higher levels of income are more likely to require large cash balances to finance their purchases. They are assumed to spend more than the poor.
- The general price level: a rise in the price level is most likely to increase the transaction demand for money. More money will be needed to finance the same real expenditure
- Institutional factors such as how long it takes organizations to pay their employees.
- With the introduction of ‘plastic money’, it is now possible to visit an automated teller machine (ATM) any time of the day or night and access cash. That is why we now are talking about money on the bank deposit.
Precautionary motive: Individuals may hold money to meet unforeseen emergencies. Some money is kept in cash reserves to avoid unexpected demands for cash in the short term. They just take precaution. It is usual these days to hold money for precautionary motives in near money cash items – that is the form of easily realized short term investments.
Speculative motive: This is sometimes called demand to hold passive or idle money balances. This is the motive of holding money so that you can take advantage of any changes in the interest rate, or attractive investment opportunities that may arise.
Five core principles of money and banking
Time has value: People prefer to have something now than another day. So if you have to borrow some person’s money, it is necessary that the value of time is calculated – interest accrues.
Risk requires compensation: Risks lead to charging interest on financial transactions. When a lender gives money to a borrower, they take a risk. Risk must be compensated.
Information is the basis for decision making: Information is required as basis to take informed decisions. Information has to be gathered before a financial decision made. One needs information before investing is stocks or bonds, or taking up a health insurance premium.
The market sets prices and allocates resources: The financial markets, obeying the laws of demand and supply, will dictate the prices of financial assets and decide who will get these financial goods.
Stability improves welfare: The stability in a financial system is preferred by the borrowers and lenders, investors and even sellers of financial assets (issuers of securities).
Commercial Banks
Functions of Commercial Banks
- Financial intermediation: Commercial banks receive money from savers, the. depositors, and lend it to borrowers (mainly investors) at an interest rate. The interest and other costs charged on the borrowers is what the banks use to run business and pay interest to the depositors.
- Maturity transformation: They keep different accounts which help to ensure that the bank has money to meet daily financial requirements of their depositors, and at the same time continue to lend out to borrowers.
- Delegated monitoring: Individual savers would have found it expensive to individually monitor the investors’ (borrowers). This role is done by the commercial banks. According to Leland and Pyle (1977), markets are characterized by informational differences between buyers and sellers and that in financial markets, informational asymmetries are particularly pronounced.
Leland, H.E., and Pyle, D.H., (1997: 371), “Information Asymmetries, Financial Structure, and Financial Intermediation”, The Journal of Finance, Vol.32, No.2; Papers and Proceedings of the Thirty-Fifth Annual Meeting of the American Finance Association, Atlantic City, New Jersey, September 16-18, 1976 (May, 1977), pp. 371-387.)
- An efficient payment system: the key reason for most people holding a bank account is because
banks operate a payment system. When money is in the bank, on your bank account, you can use different technologies – such as cheques, withdraw slips, payment cards (e.g. ATM), etc. to spend that money. For most transactions, banking transfers are far more convenient than cash. - Offer financial advice to clients (depositors and borrowers): They advise borrowers on the potential success or failure of the project; they advise depositors on the various savings account options – including fixed deposit account.
- Provide reference on their clients’ creditworthiness: They assure their clients business partners about their creditworthiness. They give guarantees in form of bid security, performance guarantees, letter of credit, etc. to their clients.
- Custodial functions: Commercial banks keep their clients’ valuable articles and documents in safe custody (land titles, wills, academic certificates, etc.).
- Safe keeping of depositors’ money: They keep their depositors money. Money is safer in a bank than at home where it may be stolen by family members and other thieves, be burnt in fire that may destroy the house where it is kept, or be eaten by termites in poor African shelters.
CENTRAL BANK
- A central bank is the financial institution which is mandated, by law, to implement the country’s monetary policy including controlling the quantity and use of money, and manage inflation.
- It is supposed to advice government on the monetary policies – that is, whether to undertake expansionary or restrictive monetary policies.
- It controls commercial banks, credit institutions, microfinance deposit institutions, and other non-bank financial institutions.
Functions of a central bank
- It is the bank to the government: keeping government funds; paying interest on public debt; selling government securities (treasury bills, bonds);
- It acts lender of last resort to commercial banks and as clearing house for all commercial banks.
- It supervises the commercial banks, credit institutions, microfinance deposit institutions, and other non-bank financial institutions.
- It uses the tools of monetary policy to influence the level of economic activity and boost economic growth.
- It has the role of issuing and renewing national currency (coins, and notes).
- It is the custodian of foreign currencies;
- It can keep the funds of international institutions (e.g., IMF, The World Bank, etc.)
