Moneyand Banking

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Money and Banking
Chapter · November 2018
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List of Contributors
Nwogwugwu Uche Collins Associate Professor Department of

Economics Nnamdi Azikiwe
Univesrity, Awka
Rev. Sr. Maria C. Uzonwanne Ph.D Lecturer, Department of Economics

Nnamdi Azikiwe Univesrity, Awka
Obi, Kenneth Onyebuchi Associate Professor Department of

Univesrity, Awka
Ezenekwe, Uju Regina Ph.D Lecturer, Department of Economics

Chris, Kalu U Lecturer, Department of Economics

Okeyika, Kenechukwu Okezie Lecturer, Department of Economics

Maduka Olisaemeka Denis Lecturer, Department of Economics

Metu, Amaka G. Lecturer, Department of Economics

Eze, A. Eze Lecturer, Department of Economics

Nwokoye, Ebele Stella Ph.D\ Senior Lecturer, Department of

Univesrity, Awka
MONEY AND BANKING
Maria Chinecherem Uzonwanne
3.1 Introduction
To help us understand this chapter well, the following were discussed
(a) Money: Barter system. Evolution of money. Qualities of good money. Advantages of using
money. Functions of money, Kinds of money, and Value of money (b) Demand and Supply of
money (c) Quantity Theory of Money (d) Financial Institution: Traditional financial institution,
Modern financial institution, Money market, Capital market, Central bank. Commercial banks and
other Liquidity financial institution (e) Interest: Definition and Determinants of Interest Rate.
3.2 Money
3.2.1 The Barter System
Before the evolution of money, exchange was done on the basis of direct exchange of goods
and services. This is known as barter. Barter involves the direct exchange of one good for some
quantities of another good. For example, a horse may be exchanged for a cow, or three sheep or
four goats. Hence, for a transaction to take place there must be a double coincidence of wants. For
instance, if the horse-owner wants a cow, he has to find out a person who not only possesses the
cow but wants to exchange it with the horse. In other cases, goods are exchanged for services. A
doctor may be paid in kind as payment for his services. For example, he may be paid a cock, or
some wheat or rice or fruit. Thus a barter economy is a moneyless economy. It is also a simple
economy where people produce goods either for self-consumption or for exchange with other
goods which they want. Bartering was found in primitive societies. But it is still practiced at places
where the use of money has not spread much. Such non-monetized areas are to be found in many
rural areas of under-developed countries.
3.2.2 Difficulties of Barter System
The barter system is the most inconvenient method of exchange. It involves loss of much
time and effort on the part of people in trying to exchange goods and services. As a method of
exchange, the barter system has the following difficulties and disadvantages:
I. Lack of Double Coincidence of Wants: The functioning of the barter system requires
double coincidence of wants on the part of those who want to exchange goods or services.
It is necessary for a person who wishes to trade his good or service for another, find some
other person who is not only willing to buy his good or service, hut also possesses that
good which the former wants. For example, suppose a person possesses a horse and wants
to exchange it for a cow. In the barter system, he has to find out a person who not only
possesses a cow but also wants a horse. The existence of such a double coincidence of
wants is a remote probability. For it is a very laborious and time-consuming process to find
out a person who wants the other's goods. Often times, the horse-owner would have to
carry through a number of intermediary transactions. He might have to trade his horse for
some sheep, sheep for some goats and goats for the cow he wants. To be successful, the
barter system involves multilateral transactions which are not possible practically.
Consequently, if the double coincidence of wants is not matched exactly, no trade is
possible under barter. Thus a barter system is time-consuming and is a great hindrance to
the development and expansion of trade.
II. Lack of a Common Measure of Value: Another difficulty under the barter system relates
to the lack of a common unit in which the value of goods and services should be measured.
Even if the two persons who want each other's goods meet by coincidence, the problem
arises as to the proportion in which the two goods should be exchanged. There being no
common measure of value, the rate of exchange will be arbitrarily fixed according to the
intensity of demand for each other's goods. Consequently, one party is at a disadvantage in
the terms of trade between two goods.
Moreover, under the barter system the value of each good is required to be stated in as
many quantities as there are types and quantities of other goods and services. The exchange
rate formula given by Prof. Culbertson is n (n - l)/2. For example, if there are 100 different
types of goods in a barter economy, then there would be 4950 exchange rates for it to
function smoothly, i.e. 100(100 – 1)/2 – 100 x 99/2 or 9900/2 = 4950. This makes
accounting impossibilities because a balance sheet would consist of a long physical
inventory of the various types and quantities of goods owned and owed. Similarly, it is
difficult to draw and interpret the profit and loss accounts of even a small shop. That is
why the existence of the barter system is associated with a small primitive society confined
to a local market.
III. Indivisibility of Certain Good: The bailer is based on the exchange of goods with other
goods. It is difficult to fix exchange rates for certain goods which are indivisible. Such
indivisible goods pose a real problem, under barter. A person may desire a horse and the
other a sheep and both may be willing to trade. The former may demand more than four
sheep for a horse but the other is not prepared to give five sheep and thus there is no
exchange. If a sheep had been divisible, a payment of four and a half sheep for a horse
might have been mutually satisfactory. Similarly, if the man with the horse wants only two
sheep, then how will he exchange his horse for two sheep. As it is not possible to divide
his horse, no trade will be possible between the two persons. Thus indivisibility of certain
goods makes the barter system inoperative.
IV. Difficulty in Store Value: Under the barter system, it is difficult to store value. Anyone
wanting to save real capital over a long period would be faced with the difficulty that during
the intervening period the stored, commodity may become obsolete or deteriorate in value.
As people trade in cattle, grains and other such perishable commodities, it is very expensive
and often difficult to store and to prevent their deterioration and loss over the long period.
V. Difficulty in Making Deferred Payments: In a barter economy, it is difficult to make
payments in future. As payments are made in goods and services, debt contracts are not
possible due to disagreements on the part of the two parties on following grounds. It would
often invite controversy as to the quality of the goods or services to be repaid. The two
parties would often be unable to agree on the specific commodity to be used for repayment.
Both parties would run the risk that the commodity to be repaid would increase or decrease
seriously in value over the duration of the contract. For example, wheat might rise
markedly in value in terms of other commodities, to the debtor's regret, or decrease
markedly in value, to the creditor's regret. Thus it is not possible to make just payment
involving future contracts under the baiter system.
VI. Lack of Specialization: Another difficulty of the baiter system is that it is associated with
a production system where each person is a jack-of-all-trades. In other words, a high degree
of specialization is difficult to achieve under the barter system. Specialization and
interdependent in production is only possible in an expanded market system based on the
money economy. Thus no economic progress is possible in a barter economy due to lack
of specialization. The above mentioned difficulties of barter have led to the evolution of
money.
3.2.3 The Evolution of Money
The word, "money" is derived from the Latin word, "Moneta" which was the surname of
Roman Goddess Juno in whose temple at Rome, money was coined. The origin of money is lost
in antiquity. Even the primitive man had some sort of money. The type of money in every age
depended on the nature of its livelihood. In a hunting society, the skins of wild animal were used
as money. The pastoral society used livestock, whereas the agricultural society used grains and
food stuffs as money. The Greeks used coins as money.
Therefore, the development of money was to overcome the various ••difficulties of trade
by barter. Money is, therefore, anything that is generally acceptable as a means of exchange.
This general acceptability is the most important requirement of money. No matter how precious a
material is, if it is not generally acceptable by the people as a means of exchange, it will not qualify
as money.
3.2.4. Stages in the Evolution of Money;
The evolution of money has passed through the following five stages depending upon the progress
of human civilization at different times and places:
I. Commodity Money: Various types of commodities have been used as money from the
beginning of human civilization. Stones, spears, skins, bows and arrows and axes were
used as money in the hunting society. The pastoral society use cattle as money. The
agricultural society used grains as money. The Romans used cattle and salt as money at
different times. The Mongolians used squirrel skins as money. Precious stones, tobacco,
tea, shells, fishhooks, and many other commodities served as money depending upon time,
place and economic standard of society.
The use of commodity as money had the following defects: (a) All commodities were not
uniform in quality, such as cattle, grains, etc. Thus lack of standardization made pricing
difficult, (b) Difficult to store and prevent loss of value in case of perishable commodities,
(c) Supplies of such commodities were uncertain, (d) They lacked in portability and hence
were difficult to transfer from one place to another, (e) There was the problem of
indivisibilities in the case of such commodities as cattle.
II. Metallic Money: With the spread of civilization and trade relations by land and sea metallic
money took the of commodity money. Many nations started using silver, gold, copper, tin,
etc. as money. But metal was an inconvenient thing to accept, weigh, divide and assess in
quality. Accordingly, metal was made into coins of predetermined weight. Thus innovation
is attributed to king Midas of Lydia in the eighth century B.C. But gold coins were in use
in India many centuries earlier than in Lydia. Thus coins came to be accepted as convenient
method of exchange. But some ingenious person started debasing the coins by clipping a
thin slice of the edge of coins. This led to the hoarding of full-bodied coins with the result
that debased coins were found in circulation. This led to the minting of coins with a rough
edge. As the price of gold began to rise, gold coins were melted in other to earn more by
selling them as metal. This led the government to mixed copper or silver in gold coins so
that their intrinsic value might be more than their first value. As gold became dearer and
scarce, silver coins were used, first in their pure form and later on mixed with alloy or some
other metal. However, metallic had the following defect: (a) It was not possible to change
its supply according to the requirements of the nation both for internal and external use. (b)
Being heavy, it was not possible to carry large sums of money in the form of coins from
one place, to another by merchants, (c) It was unsafe and inconvenient to carry precious
metals for trade purposes over long distances, (d) Metallic money was very expensive
because the use of coins led their debasement and their minting and exchange as the mint
cost a lot to the government.
III. Paper Money: The development of paper money started with goldsmiths who kept strong
safes to store their gold. As goldsmiths were thought to be honest merchants, people started
keeping their gold with them for safe custody. In return, the goldsmiths gave the depositors
a receipt promising to return the gold on demand. These receipts of the goldsmiths were
given to the sellers of commodities by the buyers. Thus the receipts of the goldsmiths were
a substitute for money. Such paper money was backed by gold and was convertible on
demand into gold. This ultimately led to the development of bank notes.
The bank notes are issued by the central bank of the country. As the demand for gold and
silver increased with the rise in their prices, the convertibility of bank notes into gold and
silver was gradually given up during the beginning and after the First World War in all the
countries of the world. Since then the bank money has ceased to be representative money
and is simply fiat money which is inconvertible and is accepted as money because it is
backed by law.
IV. Credit Money: Another stage in the evolution of money in the modem world is the use of
the cheque as money. The cheque is like a bank note in that it performs the same function.
It is a means of transferring money or obligations from one person to another. But a cheque
is different from a bank note. A cheque is made for a specific sum, and it expires with a
single transaction. But a cheque is not money. It is simply a written order to transfer money.
However, large transactions are made through cheques these days and bank notes are used
only for small transactions.
V. Near Money: The final stage in the evolution of money has been the use of bills of
exchange, treasury bills, bonds, debentures, savings certificates, etc. They are known as
"near money". They are close substitutes for money and are liquid assets. The final stage
of its evolution money has become intangible. Its ownership is now transferable simply by
book entry. Thus the evolution of money has been through various stages: from commodity
money to metallic money, and to paper money, and from credit money to near money.
3.2.5 Qualities of Good Money
Nowadays, when we talk of money, we generally think of notes and coins such as Naira and Kobo
in Nigeria, Cedis and Pesewa in Ghana and Leone and Cents in Sierra Leone. However, it is
important to know that in the past, many things had been used as money in West Africa. The most
important one that comes to mind is the Cowry, which dominated West African trade as a common
medium of exchange in the nineteenth century. Cowries and other things that were used suffered
a number of problems, such as being too heavy to carry and being subjected to intense depreciation.
However, since they were then generally acceptable as a medium of exchange, they qualified as
money.
For anything to serve satisfactorily as money, that thing must fulfill the following
requirements.
(i). Divisibility: Money must be easily divisible into smaller units to facilitate both big and
small transaction.
(ii). Portability: Money must be easy to carry around to long and short distances.
(iii). Acceptability: Money must be legal tender. Money is legal lender when it has the backing
of law, in which case it cannot be refused in payment or settlement of debt within a defined
territory. Such money is said to be generally acceptable.
(iv). Durability: Money must not wear easily or suffer undue mutilation.
(v). Scarcity: Money must be relatively scarce, but not too scarce. Gold and diamond are too
scarce; hence they do not meet this requirement.
(vi). Standardized Unit: The various unit of money must be homogeneous. There must be no
disagreement about value and identity.
(vii). Stability: The value must be relatively stable over time. Money whose value is very
unstable may cease to be generally acceptable.
3.2.6 Advantages of Using Money
The use of money provides the following advantages;
(i). Access to a variety of Goods and Services: Money enables the owner to obtain a variety
of goods and services that could give him maximum satisfaction. If a man has N10, for
example, he can distribute this N10 to buy a number of goods and services that will give
him full satisfaction. Under trade by barter, if a man has a goat he might give up the whole
goal only to obtain a few yams in exchange.
(ii). Division of Labour: Exchange is an important condition for division of labour. Without
the use of money, division of labour would have been unreasonable. It is only when money
is used that it makes sense for people to specialize. If you cannot exchange part of what
you produce with other goods produced by others, it would be better to produce all that
you will need.
(iii). Easy Facility for Loans: The use of money facilitates the making of loans. When you loan
someone a hundred naira, you collect back a hundred naira later. Without the use of money,
it would have been difficult to operate this system as disagreements might occur over the
identity of objects after a few years interval.
(iv). Deferred Spending: The use of money makes it possible to save now and spend later.
Without money, saving would have been difficult. Living things might die and objects
might depreciate or rot.
3.2.7 Functions of Money
Money performs four main functions:
(i). A Medium of Exchange: Money facilitates the exchange of goods and services. This was
probably the earliest function of money. Without money, we will probably have trade by
barter with all the disadvantages which we mentioned earlier.
(ii). A Unit of Account and a Measure of Value: Money serves as a common unit which is
used to measure the relative value of goods and services. We use kilometer to measure
distance, so we can compare distance from one locality to another. In like manner, we use
money to express the value of one commodity in terms of other commodities, say rice in
terms of shoes, house, chairs, books, etc. Certainly, exchange would have been extremely
complicated without the use of money.
(iii). A Store of Value: Money makes it possible to save now for later use. Goods and services
are difficult to store. Farmers cannot store if their goods are perishable. Many producers
cannot even store their products at all. A teacher, for example, cannot save what he
produces since they are intangible. A doctor cannot save his production, i.e. what he
produces because it is direct service which is produced and consumed simultaneously. By
selling their services for money, the value received can be stored for future use.
(iv). A Standard of Deferred Payment: Deferred payment means settlement of debts at a later
date. Money makes it possible for payment to be deferred -from now till a later date. It also
facilitates future contracts to be carried out. When we buy goods on credit, we promise to
pay the money value of the goods at a later date. Without money, it would have been
impossible to record debts and settle them at a later date.
Kinds of Money
(i). Commodity Money: Commodity money that is generally acceptable as a medium of
exchange. Such a commodity has a money value as well as an intrinsic value of its own.
The history of money shows that many commodities have been used as money in different
places and at different periods. Pastoral tribes have, for example, used cattle and some still
do. The problem was that cattle are neither divisible nor uniform in size and quality. Some
common articles of trade, such as tobacco, salt, skin, had also been used provided they
were not perishable and were easy to handle. In West Africa, cowries were for very long
time used as a medium of exchange.
(ii). Gold and Silver: Gold and silver will come under the category of commodity money. In
some countries, mostly in Britain and other European countries, gold and silver had been
used as money for many years. Gold and silver were fairly generally desired for their own
sake. They were durable, divisible and homogeneous and not too heavy to carry. They
therefore, met most of the quality requirements of money. But since they were exchanged
against goods without been coined, everybody who received gold or silver as payment had
to satisfy himself as to their weights and fineness. They were also too scarce.
(iii). Metal Coin: A coin is a piece of metal whose weight and fineness have been standardized
by the maker. The invention of coins eliminated the problems of everybody certifying the
standard and fineness of gold and silver. Different countries developed different coins, and
labeled them differently.
(iv). Bank Note: This is paper money called currency. Originally, the bank note developed as a
promise to pay gold on demand. In other words, it developed as convertible currency. If a
bank note can be exchanged on demand for gold or silver coins, it is said to be convertible.
The earliest bank notes had to be convertible because people were willing to use only a
medium of exchange which was of value for its own sake. It was long before people
accepted, as money, something that has no intrinsic value by itself. Therefore, the bank
note at that time was not, strictly speaking, money but a substitute for money. The bank
note is called token money because the commodity worth of such money or its face value
is greater than the paper itself. Moreover, it is inconvertible. That is to say, no government
or bank promises to change it to gold or silver or anything else. Yet, it serves its main
purpose very well. Everybody is willing to accept it because they know they can use it to
pay for goods and services or to settle debts.
(v). Bank Deposits: The final stage in the development of money is the use of bank deposits.
The bank deposit is the process whereby an individual deposits his money in the bank and
then uses cheques as a means of payment. In countries where cheques are widely used,
most large payments are made by cheque.
In the developed countries, similarly, most big transactions are settled by cheques.
However, cheques are more widely accepted and used in the more advanced countries than in West
African countries. For reasons we may not bother with here, many people and institutions,
including government agencies and departments, are refusing private cheques as a means of
making payment. For example, the West African Examination Council (WAEC) insists on
certified cheques (i.e. cheques certified by the bank) for the payment of registration fees.
A certified cheque is the bank's own cheque which is rewritten to replace the customer's
cheque. It is a device to guarantee against fraud. It is important to note that it is the bank deposit
that is considered as money and not the cheque. The cheque is merely "an order from the owner of
a bank deposit to the banker to transfer a certain sum, to the payee named on the cheque".
The validity of a cheque, therefore, depends on whether the drawer of the cheque has
sufficient money in his current/deposit account to meet the cheque. If he writes a cheque for N10,
when his bank account shows that he has only N2 left, the bank will dishonor the cheque. That is,
the bank will refuse to pay. If this happens, we say the cheque has bounced. Cheques are, therefore,
not legal tender and anybody has a right to refuse to accept this method of payment.
3.2.9 The Value of Money
People want money not for its sake but to enable them buy goods and services. The value
of money is the quantity of goods and services that money can buy. This is what is called the
"purchasing power" of money. If prices are high, a given quantity of money will buy less than
when prices are low. For example, it used to cost 50 kobo to buy a big exercise book and 10 kobo
to buy a biro pen. Now, an exercise book costs about N20 and a biro pen N10. We can say that the
value of the naira has fallen.
Therefore, the value of money is inversely related to the price level. The higher the price level, the
smaller the quantity of goods and services that a given amount of money can buy and, therefore,
the lower the value of money. Conversely, [he lower the general price level, the greater the quantity
of goods and services money can buy and the higher the value of money
3.2.10 Effects of Changes in the Value of Money
Changes in the value of money have different effects on production and 'distribution of income.
These effects include:
Effect on Level of Production: When prices are rising, business activities will be stimulated. High
prices would encourage expansion of business. Since all costs do not generally increase
immediately as prices begin to rise, profit would be greater for businessmen. On the other hand, if
prices are falling, although there might be increased demand for some goods and services, the
profit of entrepreneur is likely to fall. This is so because not all costs will fall immediately. The
entrepreneur will, therefore, be less optimistic and may restrict production.
Effect on Distribution of Income: Price changes bring about changes in the value of money which
will have different effects on the incomes of different groups of people. Now, let us examine three
groups of people:
Those who derive their income from profit
Salary and wages earners
Those who receive fixed income (e.g. Pensioners)
a. Those who derive their income from profit. These are entrepreneurs/business people. When
prices are rising, they benefit most as profits become larger. When prices are falling they
suffer as profits decline.
b. Salary and wage earners. Wages and salaries tend to lag behind prices. That is, wages do
not generally rise immediately following high prices. Therefore, when prices are rising,
wage and salary earners suffer as the value of their wages falls. When prices are falling,
wages and salaries again lag behind. We say wages are downward strictly, meaning that it
is difficult to reduce wages. In the period of falling prices, wage and salary earners benefit
although there may be a reduced demand for labour.
c. Those who receive fixed income. Typical examples of the group are the pensioners. During
periods of rising prices, all people on fixed incomes fine their real income decline. They
can buy less goods and services with their fixed income. When prices are falling, the value
of their income, increases. They will be able to buy more goods and services with their
income.
It can be seen that those who gain when prices are rising are the ones who lose when prices are
falling and vice versa. On balance, the advantage lies with those who gain when price are rising.
This is so because the tendency has always been for price increase rather than price falling. As a
result, all debtors gain and all creditors lose during the period of price increases. During the period
of a declining price level, the reverse so is the case. Therefore, changes in the value of money,
reflected by changes in the prices, lend to unequally redistribute income among groups of people.
3.3 DEMAND AND SUPPLY OF MONEY
3.3.1 Definition of demand for money
Demand for money refers to the total amount of money balances that people want to hold
for certain purposes. Nominal money balances (MD0) are measured in monetary units, while real
money balances (MD0/P0) are measured in terms of the purchasing power of the quantity of money
demanded.
3.3.2 Motives of Demand for Money
According to John Maynard Keynes there are 3 motives for demanding money: the transaction,
precautionary and speculative motives.
a. The Transactions motive: Money is held tor the purchase of goods and services because
of the non-synchronization of the periods of income receipts and their disbursements. This
is determined directly by the level of income.
b. Precautionary Motive: Money is also demanded to cater for emergencies and
contingencies or to provide for unexpected expenditures. This is also directly dependent
on the income level.
c. Speculative Motive: This has to do with money held for the purpose of avoiding capital
losses in a declining securities market. This arises out of uncertainty. Due to changing or
fluctuating interest rates, the individual may decide to hold money in cash or in bond or in
equities, etc. this varies inversely with the rate of interest.
If we represent transactions and precautionary demand as M1 and speculative demand as M2 then
the total demand for money is shown as
M = M1 + M2
= M1 (Y) + M2 (r)
= f (Y, r)
Figure below shows demand for money curve.
Interest
rate
Md
Demand for Money

Figure 3.1: Demand for money curve
3.3.3 Determinants of Money Demand
Apart from the factors identified by Keynes, other factors were later identified by Professor Milton
Friedman in his modern quantity Theory of money. These include the price level, the rate of change
of prices or inflation, real permanent income or wealth and return on bonds and equities. Therefore,
the determinants of money could be seen as:
a. Income: demand for money varies directly with the level of income, that is, the higher the
level of income the higher the level of money demand.
b. Interest rate: demand for money varies inversely with interest rate.
c. Price level: there is direct positive relationship between money demand and the price level.
d. The rate of price changes: inflation rate varies inversely with money demand. This is a
weak determinant of money.
e. Real permanent income: Real permanent income or wealth varies directly with money
demand.
f. Return on bonds and equities: The higher the return on bonds and equities the lower the
demand for money.
3.4 Money Supply
3.4.1 Money Supply and Its Component
The problem of defining money supply is still associated with a considerable degree of
controversy. Generally, however, money supply is taken as the total amount of money (e.g.
currency and demand deposits) in circulation in a country at any given time. Currency in
circulation is made up of coins and notes, while demand deposits or checking current account are
those obligations which are not associated with any interest payments (in Nigeria before January,
1990) and accepted by the public as a means of exchange drawn without notice by means of
cheques.
Money supply can be defined narrowly or broadly. Narrow money can be defined as those
assets which represent immediate purchasing power in the economy, and hence function as a
medium of exchange.
Narrow money supply can be defined as those assets which represent immediate
purchasing power in the economy, and hence function as a medium of exchange. In Nigeria, the
narrow money supply (M1) is defined as currency outside banks plus demand deposit of
commercial banks plus domestic deposit with the Central Bank, less Federal Government deposit
at commercial banks. In simple terms, M1 is defined as M1 = C + D.
Where Ml = narrow money supply
C = currency outside banks
D = demand deposits
Ajayi (1978) contends that M1 is the appropriate definition of money in Nigeria. In the
U.K, narrow money includes M0 M1 and M2 defined variously as: MO includes only notes and
coins' in circulation and in banks tills; MI includes notes and coins in circulation and sight deposits
with the bank; and M^ includes not only notes and coins and bank current accounts, hut also 7
days bank deposits and some building society deposits.
Broad money on the other hand includes narrow money assets but in addition, includes
those assets which have the quality of liquidity. They can be quickly and readily converted to cash
and the conversion is achieved with little or no less in terms of either interest penalty or capital
loss through forced sale. In the Nigeria context, broad money (M2) is defined as M1 plus quasi-
money. Quasi-money as used here is defined as the sum of savings and time deposits with the
commercial banks. Thus, M2 is symbolically shown as:
M2 = C + D + T + S
Where:
M2 = broad money
C = currency in circulation
D = demand deposits
T = time deposits
S = savings deposits
Time deposits as used here are those obligations of the banks on which interest is paid and which
at least potentially or formally, can be made available to the depositors after some delays and
notice. In the U.K., broad money is primarily represented by M3 plus M4 and M5 – M3 consists of
M1 plus private sector, sterling bank deposits and private sector holdings of sterling certificates of
deposit; M4 includes bank deposit accounts which may readily be used for transactional purpose
with minimal interest loss penalty but does not include building society share accounts which are
a very close substitute for bank deposit accounts, and include national savings (other than National
Savings Certificates, SAYE, and long-term deposits).
It is important to note that narrow money could be preferred because they exclude
investment balance which distorts the usefulness of broad definitions, and they can usually be
calculated more quickly. But broad money has two main advantages over narrow money. It
includes funds which, while not themselves a medium of exchange, can be rapidly converted to
transactional money, and it is more stable since increase in interest rates tend to cause people to
manage their cash and current account balance more carefully, causing a fall in the narrow money
which in no way may reflect a change in transactional balance.
We also have nominal and real money supply, Nominal money supply is measured in monetary
units and it is assumed that the monetary authorities control only the nominal amount of money
exogenous supply of money which will be available to the community. This exogenous money
supply curve is shown in figure below.
MS
Rate of
interest
0
Fig 3.2: Exogenous Money Supply Curve
On the other hand, real money supply is measured in units of constant purchasing power, i.e. the
purchasing power of the existing money stock. The real money supply changes as the nominal
money supply remains constant at the level Ms0 and the price level (P0) declines by 50 percent, i.e.
from P0 to (1/2)P0 then real money supply will increase by 100 percent, i.e. from Ms0/P0. If we
assume exogeneity of money supply, the real money supply can be shown in figure 1.1b as follows:
M𝑠 0 M𝑠1 0 M𝑠2 0
P0 P0 P0
Interest
rate (r)
0
Fig 3.3: Real Money Supply Curve
Alternatively we can get the real money supply by deflating the nominal money supply by price
index. For example, if the nominal money supply in a country was N10,000m in 1970 and 12,000m
in 1979 while the index of retail price for 1979 is N240 (1970 = 100 or base year); then the real
money supply in 1979 is
Index of Retail Price 100
×
Nominal Money Supply 1
240 100
× = N2m
12000 1
In this case, even though the nominal money supply increased by N2000m, the real money supply
increased by N2m over the period.
3.4.2 Determinants of Money Supply
It is normally assumed that nominal money supply is exogenously determined, i.e. it is supplied
monetary authority or the central bank. But the real money supply is endogenously determined
since the price level variation cannot be fixed. In other words, it is determined by the following
factors: the Central bank behaviour, the behaviour of the non-bank public and the behaviour of the
commercial banks. Specifically, money supply is influenced by the following factors:
a. Total reserves supplied by the Central Bank:
If the total reserve supplied by the Central Bank is high, money supply will be high.
b. Reserve requirement:
If the reserve requirement (percentage of commercial banks' deposits legally required to be
kept with the Central bank) is high, money supply will be low.
c. Demand for currency:
If the non-bank public increases its demand for currency, money .supply will increase.
d. Demand for time deposits:
If the non-bank public increases its demand for time deposits, money supply will increase.
e. Demand for excess reserves:
If commercial banks demand for excess reserves increases; money supply increases.
f. Interest rates:
There is a positive relationship between money supply and interest rate. That is the higher
the interest rate the higher the money supply.
g. The bank rate:
If the rate at which commercial banks borrow from the Central bank or discount bill rises,
money supply falls.
Below is an illustration of an Endogenous Money Supply Curve.
rd Ms
0 Ms
Figure 3.4 endogenous money supply curve
Thus, the money supply equation can be stated summarily as:
1+C
M𝑠 = R
rd + rt + t + e
Where Ms is money supply, C is the desired currency ratio determined by the non-bank public, rd
is the reserve requirement percentage against demand deposits and set by the Central Bank, rt is
the reserve requirement percentage against commercial banks time deposits and is also set by the
Central bank, rt is the desired excess reserve ratio, determined by the commercial bank system, e
is the desired time deposit ratio which is determined by the non-bank public, and R is the quantity
of total reserves supplied to the commercial banking system by the Central Bank.
The Central Bank can control the size of the money supply by controlling R, rd and rt but
the other factors are functionally related to interest rates and other variable for example, currency
ratio, c, is said to be inversely related to national income while the public's desired time deposit
ratio, t, varies inversely with market-determined rates of interest and directly with the interest rate
which commercial banks are allowed to pay on time deposits.
On the other hand, the commercial banking system's desired excess reserve ratio, e, varies
inversely with market rates of interest and positively with the discount rate. These are as
summarized in the money supply equation above. Determinants of money supply can also be
alternatively summarized in a fairly simplified and complete money supply function as follows:
Ms = f(c, r, d, q, rd, rt, R)
Where Ms = the money supply
c = currency as demanded by the non-bank public
r = market rate of interest
d = the discount rate
q = time deposit rate
rd = reserve requirement on demand deposits
rt = reserve requirement on time deposits
R = quantity of total reserves supplied by the Central Bank
Thus, we recapitulate that money supply is determined jointly by the behaviour of the non-banking
public, the Central Banking authority, and the commercial banking system.
3.5 The Elementary Quantity Theory of Money
In the seventeenth century, it was discovered that there was connection between the
quantity of money (M) and the general level of prices (P). This the connection led to the
formulation of the Quantity Theory of Money. In its simplest form, the quantity theory of money
stated that an increase in the quantity of money (M) would bring about a proportionate rise in
prices.
Later, Professor Irving Fisher introduced a new concept to describe the relationship
between M and P. This new concept is called the "velocity of circulation of money" written as "V".
Money circulates from hand to hand. Let us illustrate that Musa, the farmer, spent N10 to buy ice
cream, the ice cream boy spent the same N10 to pay for the lunch in a nearby restaurant, while the
restaurant attendant spent the same N10 to buy vegetables from Musa. The N10 was returned to
where it was before the first transaction took place. In this case, the same currency has been used
for four separate transactions. That is to say that N10 did the work of N40. In the course of a year,
each unit of money is used many times. If one unit of money is used to serve four transactions, as
in our example, this is equivalent to four units of money, each being used in only one transaction.
Velocity of circulation of money can, therefore, be defined as the rate at which the stock of money
is turning over per year to consummate income transactions.
If the stock of money is turning over very slowly so that its rate of naira income spending
per year is low, then V will be low. If people spend as quickly as they earn, then V will be high.
With the introduction of the velocity of circulation of money, the quantity theory came to be
expressed by a new identity called the Quantity Equation of Exchange.
MV = PT
The symbol M represents the local amount of money in existence (i.e. coins, bank notes
and bank deposits). The symbol V represents the velocity of circulation. MV, therefore, represents
the amount of money used in a given period, P stands for the general price level, that is, some kind
of average of the prices of all kinds of commodities. The symbol T represents the total of all the
transactions that have taken place with money during the period.
The equation of exchange shows that the price level and the value of money can be influenced not
only by the quantity of money, M, but also by (i) the rate at which money circulates, V, and (ii)
the output of goods and services.
Therefore, prices could rise without any change in the quantity of money if a rise occurs in
the velocity of circulation. On the other hand prices might remain unchanged even though there
has been an increase in the quantity of money. This is possible where there has been a
corresponding increase in the output of goods and services.
3.6 Financial Institution
Financial institution is defined as an organized way or system of managing money.
Financial institutions can be classified into two broad headings:
(i) Traditional Financial Institutions, and
(ii) Modern Financial Institutions
3.6.1 Traditional Financial Institutions
The traditional financial institutions will include all arrangements for the management of
money before the development of the banking system. This was the system of borrowing and
lending that existed before the development of modern financial institutions.
A typical example of a traditional financial institution in Nigeria is called Esusu. It was
devised as a means to encourage savings. Under this system, a group of people agree to make
regular contributions of some amount as some specified regular intervals, sometimes daily,
sometimes weekly and sometimes monthly. The amount each participant agrees to contribute
depends on his ability. Usually, an officer is appointed called "collector". His primary function is
to go round members and collect their contributions. When contributions are made by several
individuals, the amount so generated could be quite large.
Varying arrangements exist for the distribution of the funds generated. The most common
arrangement is one in which the amount collected at the end of, say every month, is given to the
participants according to a previously agreed order. However, the system is flexible enough to
recognize people that are hard pressed for funds, such as the death of a member's father or mother,
which would require unexpected expenses for burial.
Apart from the system of Esusu, there is another traditional financial institution that was
common in Africa before the development of the banking system. The system is often referred to
as "money lender". A money lender is one who has lendable funds. He operates these funds on
purely commercial basis. In this case, he usually charges very high interest rates; in some cases,
close to a hundred percent. The factors that influence the interest rates include:
(i). The degree of need: When the degree is high, in which case the borrower is in dire need,
the rate is usually very high.
(ii). The timing of repayment: The longer the timing of repayment, the higher the interest rate.
(iii). Creditworthiness of the borrower: When is creditworthy, that is, he has some property
which could be confiscated, the rates are usually higher than when he is a poor stuff.
Advantages of Traditional Financial Institutions
(i). The institutions make funds available for various purposes.
(ii). Arrangements, for borrowing are simple. It is not a complicated system
(iii). System encourages thrift and saving habit.
Disadvantages of Traditional Financial Institutions
Among the various problems arising from the operation of the traditional financial institutions are:
(i). The system involves some elements of trade by barter. It is not easy to find people who
have money and willing to lend out money.
(ii). There is no protection against the loss of money contributed into Esusu. For example, if a
member who has collected the contributions made by others dies, there is no way of
recovering the money he has collected.
(iii). The fixing of interest rate, in the case of a money lender, is arbitrary and sometimes
inhuman.
(iv). Sometimes, the inability to repay loan leads to an arrangement whereby the son or daughter
of the loan defaulter is handed over to the creditor. The son or daughter would continue to
work for the creditor until the debtor settles his debt. The arrangement is like sending those
children into slavery.
3.6.2 Modern Financial Institutions
In the earlier chapter, an institution for buying and selling things, either commodities or
labour, was called a market. Since financial institutions deal with the lending and borrowing of
money, they are generally called financial markets. Banks, which we examined in the last chapter,
are financial markets and, therefore, one of the modern financial institutions. Also included under
financial markets are development banks, insurance companies, building societies and the stock
exchange.
Modern financial markets can be classified into two:
(i). Money Market, and
(ii). Capital Market.
3.6.2.1 The Money Market
Money market refers to a collection or group of financial institutions or exchange system set up
for dealing in short-term credit instruments of high quality, such as treasury bills, treasury
certificates, call money, commercial paper, Bankers' Unit Fund, certificates, ways and means
advances, as well as the dealing in gold and foreign exchange. These short-term instrument involve
a small risk due to loss, because they are issued by obligors of the highest credit rating and they
mature within one year.
The Nigerian Financial System
Federal Ministry of
finance and Economic
Development
Central Bank of Nigeria
Securities and Exchange Banking Non-Bank

Commission Financial
Capital Money Money
Insurance Building
Industries Societies
Ways and Development Mortgage
Debenture
Means Banks Institutions
Bonds
Advances
Shares Merchant
Treasury
Government Call Money Commercial

Securities
Provident
Certificate of Institutions
Deposit e.g. NPF and
Pension
Funds
Banker’s Unit
Commercial
While denoting trading in money and other short-term financial assets, the money they money
market comprises all the facilities of the country for the purchase and sale of money for
intermediate and deferred delivery and for the borrowing and lending of money for short periods
of time it is manifestation of dealing in short-term financial instruments (their sale and purchase,
as also borrowing and lending for short periods) on the one hand, and a collection of the dealers in
these assets on the other. H is thus a collection of financial institutions set up for granting of short-
term loans and dealing in short-term loans and dealing in short-term securities, gold and foreign
exchange.
Advantages of & Well-Developed Money Market:
The existence of a well-developed and a sensitive money market is necessary for the smooth
operation of monetary policy of the Central Bank. This is because, through the money market the
Central Bank can influence the short and long term structure of interest rates, and thus make an
impact on other rates as well.
The existence of an efficient money market enables commercial banks to conduct their
operations with smaller cash reserve ratios. That is, the money market imparts an element of
efficiency to the working of the banks.
With the existence of a bill market, the money market helps in financial trade and business
activities and hence promotes competition and trade generally.
Thus the money market is able to provide genuine trade activities and meet their varying
financial needs, while providing a lever in the hands of the authorities to implement their credit
controls more effectively
Also, the money market serves the business and trade by providing huge sums of money
according to its requirements and changing the supply there of as need be
In addition, the money market provides a mechanism whereby huge sums of money can
change quickly and safely.
Features of a Developed Money Market:
A developed money market refers to one which is comparatively efficient in the sense that it is
responsive to changes in demand for and supply of funds in any of its segments, and effects
initiated in any part of it quickly spread to others without significant time lags. To meet this
definition, a money market should possess these features:
a Presence of a Central Bank:
A Central Bank with adequate legal powers, sufficient relevant information and expertise,
must exist as a lender of last resort and as the initiator and executor of monetary policy in
a whole
b Presence of a developed Commercial Banking System:
A well-developed money-market should be characterized by the presence of a developed
commercial banking system, along with a wide-spread banking habit on the part of the
public.
c Adequate Supply of a Variety and quantity of financial assets:
In a well-developed money market, there should be an adequate supply of a variety and
quantity of short-term financial assets or instruments such as trade bills, treasury bills, etc.
d Presence of well-developed sub-markets:
The existence of a well-developed sub-markets and their adequate responsiveness to small
changes in interest and discount rates make room for a well-developed money market. If
the demand and supply of certain instruments dominate, the interaction between different
interest rates will be limited.
e Existence of Specialized institutions:
For competitiveness and efficiency, there must exist specialized institutions in particular
types of assets, e.g. specialized discount houses, acceptance houses specializing in
accepting bills, or specialized dealers in government securities.
f Existence of Contributory Legal and Economic Factors:
For the money market to well-developed, there must exist appropriate legal provisions to
reduce transaction costs, protect against default in payment, while prerequisite economic
forces such as speedy and cheap transmission of information, cheap fund remittance, and
adequate volume of trade and commerce, must exist.
Reasons for the establishment of the Nigerian money market:
a To provide the machinery needed for government short-term financing requirement,
b As an essential step on the path to independent nationhood, it was part of a modem financial
and monetary system to enable a nation to establish the monetary autonomy as a part and
parcel of the workings of an independent, modern state.
c To nationalize the credit base by providing local investment outlet for the retention of funds
in Nigeria and for the investment of funds repatriated from abroad as a result of government
persuasions to that effect.
d To perform for the country all the functions which money market traditionally performs,
such as the provision of the basis for operating and executing an effective monetary policy.
e To effectively mobilize resources for investment purposes.
Functions of the money market:
a It provides the basis for operating and executing an effective monetary policy.
b To promote an orderly flow of short-term funds.
c To ensure supply of the necessary means of expanding and contracting credits.
d It is a central pool of liquid financial resources upon which the banking system can drew
when it is in need of additional funds, and into which it can make payment when it holds
funds surplus to its needs.
e It provides the mechanism through which the liquidity of banking system is maintained at
the desired level.
f To provide banks to basic financial instruments for effective management of their
resources. Thus helps them to diversify their assets holdings by providing a forum for
investment of their surplus case.
g To provide the machinery needed for government short-term financing requirement, hence
achieving even seasonal variation in the normal flow of revenue.
h Mobilization of funds from savers (lenders) and the transmission of such funds to
borrowers (investors).
i It provides channel for the injection of Central Bank cash into the system r the economy.
j To maintain stable cash and liquidity ratios as a base for the operation.
k It helps commercial banks to lower cash reserves through the provision of a first line of
defence for cash in the form of call money, while providing second line of defence for cash
shortages through bills. If banks are threatened with cash shortages and if their cash
balances at the central Bank falls below the statutory minimum, the can draw on call money
and if need be they discount bill, for cash, including balances at the Central Bank.
The Instruments of the Nigeria Money Market:

1. Treasury Bills (TBS)
These are money-market (short-term) securities issued by the federal government of
Nigeria. 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 borrowing cash. 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 April l960) was provided for under the Treasury Ordinance of I 959, It was issued
in Nigeria in multiples of N2000 later reduced to N100 in order to expand the coverage of holders
for 91 days and at fixed discount. TBS outstanding average N34.421.8 million in 1989 with
N10.879.5 million issued between 1992, and 1995, it averaged N2585.05 million.
2. Treasury Certificate (TCS)
These are similar to TBS but are issued at par or face value and pay fixed interest rates.
These fixed 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. At the end of 1990, treasury certificates outstanding had risen to N34214.6
million. This further rose to N36554.32 in 1993. N37342.7 million in 1994 but declined to
N23596.5 million in 1995. Thus, between 1990 and 1995 it averaged N39230.2 million. The main
holders of treasury certificates are the commercial banks with the CBN ranking second.
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. They
act as a cushion which absorbs the immediate shock of liquidity pressures in the market. 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 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 then
invented the funds in the treasury bills.
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 efficiency
with which the banks managed their cash balances while helping to reduce the degree of
dependence of the banks on overseas money market facilities.
4. Commercial Papers or Commercial Bills
These are short-term promissory notes issued by the CBN and their maturities vary from
50 to 270 days, with varying denominations (sometimes N50.000 or more). They are debts that
arise in the course of commerce. Commercial papers may also be sold by major companies (blue-
chips-large, old, sale, 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 instalment 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. In 1968, CBN took over the
responsibility for the marketing Board crop finance and hence, the demise of the bill market. What
remains today of the commercial paper market, following the disappearance of produce bills are
import and domestic trade bills. By 1968, commercial paper outstanding way N5.1 million falling
from N36.4 million in 1967. However, in 1989, commercial paper outstanding averaged N868.8
million. Between 1990 and 1995, it averaged N2219.05 million recorded in 1990.
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 NCOs are
re-discountable 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. It was introduced in Nigeria by
the CBN in 1975. They are issued to fellow-bankers within that maturity period, as one of the
deposits they accept.
6. Bankers Unit Fund (BUF)
This was introduced by CBN in 1975 and initially meant to mop up excess liquidity in the
banking system. It was also designed for sweeten the market for Federal Government Stock. To
this end commercial bank holding of the stock are accepted as a part of their specified liquid assets
and are repayable on demand, under the BUF, Federal Government stocks of not more than three
years to maturity were thus designated eligible development stock (HDS) For the purpose of
meeting the banks’ specified liquid assets requirements. This placed the banks in a position to earn
long-term rates of interest on what is essentially a short-term investment. Though, initially
designed to mop up excess liquidity in the banking system by conferring on instruments cash-
substitute status repayable on demand or acceptable in meeting reserve requirements, the capability
of the bank for credit expansion was unaffected.
In effect, the BUF was intended to provide avenue for the commercial and merchant banks
and other financial institutions to invest part of their liquid fund in a money market asset linked to
Federal Government Stocks, Participants in the scheme invested in multiples of N10,000 and the
fund is in turn invested in available Government stocks of various maturities. The operation of the
scheme was subject to the availability of stocks. Interest is payable every 12 months from the date
of initial investment of funds in the scheme (Oyido, 1986). At the end of 1975, total CDs, BUF
and EDS outstanding stood at N49.8 million constituting only 5.1 per unit of the total money
market assets then. This went up to N258.2 million in 1985. However, in 1989 BUF alone
outstanding averaged N3.9 million while EDS outstanding averaged N23 million.
7. Stabilisation securities
These were issued since 1976 by the CBN ideally to mop up idle cash balances of
participating banks. Participation was mandatory for banks with savings deposits of N50 million
and above. The amount they are required to invest in stabilization securities is fixed at 50 percent
of the increase in saving deposits over the level of the preceding year. The savings deposit relates
to individual accounts not exceeding N20,000 each. In 1976 when the scheme was introduced
interest rate paid was 4 percent annum and revised to 5 percent by 1979.
8. Ways And Means Advances
Section 34 of the CBN Act 1998 (Cap 30 as amended I962-1969) empowers the CBN to
grant temporary advances in the form of ‘Ways and Means’ to the federal government up to 25
percent of estimated recurrent budget revenue. Ways and Means advances averaged about N1
million yearly between I960 and 1962. The Federal Government did not use this facility from 1963
to 1966 except on two occasions only. December 1961 and January 1966 when relatively small
amounts of N400,000 and N240,000 respectively were borrowed.
However, the financial pressures arising from the prosecution of the civil war led to
increased set of the instrument by the Government. Therefore, from N1.9 million in 1967 ways
and means advances rose to a monthly average of N54.5 million in 1969, falling marginally to
N44.5 million at the end of the war in 1970. The instrument was not used between 1971 and 1976
following Government’s unprecedented revenue from oil. However, the reemergence of financial
pressures in 1977 led to the rise in Ways and Means to a hard-core level of over N1 billion in 1977
and 1978. By 1979, Ways and Means advances outstanding was N65.4 million while the average
monthly amount outstanding in 1987 was N739.9 million, rising to N5,278.0 million in 1988 and
to N5,794.4 in 1989.
Conclusively, we may state that these money market instruments (readily marketable or
convertible into cash, with maturities ranging between a few days and one or two or three years)
are the evidences of debt originating in financial transactions in which purchasing power is
transferred from surplus spending units (buyers) to deficit spending units (sellers) while the claims
contribute a liability to those units issuing them an asset to the holders who can dispose of them
before or at maturity in order finance consumable goods.
3.6.2.2 Capital Market
The capital market is the arm of the financial markets for rising long-term funds to finance
productive investments. The market comprises the primary segment, for rising new capital, and
the secondary market, otherwise known as the stock exchange, in which existing securities are
traded.
The Nigerian Stock Exchange (NSE) is the prime operational institution in the Nigerian
capital market. The NSE was originality established in 1961 as the Lagos Stock Exchange. It was
reconstituted as the Nigerian Stock Exchange in 1977. It has presently six trading floors in Lagos,
Port Harcourt, Kaduna, Kano, Onitsha and Ibadan.
The Securities and Exchange Commission, formally called Capital Issues Commission, is
the apex regulatory organ of the market, it has responsibility for ensuring orderliness, fair play and
transparency in market operation. The Central Bank of Nigeria (CBN), as the apex institution in
the Nigeria financial system, monitors activities and developments in the market.
The capital market as we have said earlier, involves only individuals and institutions
dealing with medium and long-term loans. Some of the institutions such as commercial banks,
which deal mainly with short-term loans, also deal with the capital market because they provide
finance for investment. However, some institutions are specifically established to provide long-
term investment capital. Typical examples of institutions for capital market in Nigeria are the
Nigerian Industrial Development Bank (NIDB) and the Nigerian Bank for Commerce and Industry
(NBCI), now merged to become the new Bank for industry, and the Nigerian Agricultural and
Cooperative Bank merged with the Peoples Bank to become the Nigerian Agricultural Cooperative
and Rural Development Bank (NACRDB). In Ghana, it would include the National Bank of
Ghana. The main business of the capital market is to provide industry with permanent capital.
Development of Capital Market Institutions in West Africa
The demand for long-term loans is a function of bankable investment opportunities. The
greater the opportunities for investment, the greater the demand for long-term loans. Investors need
capital for investments, particularly for new investments. These investors could be individuals,
groups of individuals, institutions or government. An individual may want to build an industry; a
government may want to build an inter-state express road or a dam. Such investment requires large
sum of money and a longer period over which the loan is repayable. The best source of such fund
is the capital market which specializes in such long-term loans.
The development of the capital market in West Africa has been relatively recent. The
developments of certain institutions have influenced the rapid development of the capital market
in Africa, in general, and Nigeria in particular.
(i). The Recent Development of the Central Banks: In most West Africa countries, central
banks were established only after each country's independence. Therefore, bonds, which
are a type of security with a fixed interest rate, could only come into use after the
establishment of central banks. Although these bonds are usually sold to the public, they
are bought mainly by institutional investors like the development banks and insurance
companies.
(ii). Savings Certificates and Savings Stamps: the development of these institutions enables
the smaller saver to save. Pulling together smaller savings by large number of savers could
provide large capital which could be used for long-term investment. The most typical of
such savings in Nigeria is the post office savings which provides an important source of
long-term finance for government.
(iii). Development banks: Development Banks are established specifically to provide capital
for long-term investments, usually in identified priority areas. Such banks are the Nigerian
Industrial Development Banks (NIDB) in Nigeria; the National Development Bank of
Sierra Leone and the Ghana National Investment Bank. Usually, the operating capital of
these banks is provided by government. The banks use such capital to provide revolving
loans to corporate and individual investors.
(iv). Building Societies: building societies accept savings from customers. From the savings
made, they provide long-term loans to build or buy houses and in some cases to buy land.
In Nigeria such specialized institutions includes the Nigeria Building society and several
state-owned Housing Corporations. In Ghana there is First Ghana Building Society.
(v). Insurance Companies: Insurance companies accumulate a large volume of money by
collecting premium from individuals, institutions and government that have taken up a
variety of insurance policies with the companies. Such policies may include life, accident,
fire, theft and educational endowment of children. The large sum of premium so collected
is available for investment in the capital market.
(vi). Merchant Banks: Merchant Banks are also called investment banks because they provide
finance to the capital market. They obtain charges for discounting hills and by underwriting
and issuing of shares, i.e. by guaranteeing to buy unsold shares. Examples of merchant
banks are ICON limited, in Nigeria and the National Finance and Merchant Bank of Ghana.
(vii). Provident Funds: To provide social security, especially for employees in the private sector
of the economy, many countries in West Africa provide what they call Provident funds.
The arrangement requires the contribution by the employees of specified amount into the
pool. The funds have been in existence for several years and have accumulated
considerable amount of money which the governments of the various countries have
invested.
(viii). The Stock Exchange: The establishment of the stock exchange has provided one of the
most important institutions for long-term investment. The issue of new security for sale,
by joint-stock companies, is the most important source of long-term capital.
The objectives for establishing the Nigerian capital market are:
i. To mobilize long-term funds from surplus units for on-lending; - • . • ii,
ii. To ensure efficient allocation of scarce financial resources;
iii. To reduce over-reliance on the money market for industrial financing;
iv. To provide a solvent, efficient and competitive financial sector; and
v. To provide long-term finance and promote a healthy stock market culture.
The instruments available in the market includes: (i) equity or ordinary shares and (ii) government
stocks and company bonds/debentures.
Participating institutions in the capital market include:
i. Issuing houses;
ii. Commercial (deposit money banks) and Merchant banks;
iii. Development banks;
iv. Stockbrokers
v. Insurance companies;
vi. Pension fund; and
vii. Other financial intermediaries.
Growth of the Nigerian Capital Market
The Nigerian stock market has experienced remarkable growth over the years. The numbers of
quoted securities as well as the number of stock brokerage firms have increased tremendously.
Market capitalization has also risen.
The growth of the stock market has been made possibly by a number of factors, namely;
i. The income Tax Management Act, 1961 required Pension and Provident Funds to invest a
substantial proportion of their funds in government stocks.
ii. The Trustee Investment Act, 1962 required trustees to invest in government stocks and
industrial securities.
iii. The insurance (Miscellaneous Provisions) Act, 1964 required insurance companies to
invest a stipulated percentage of their premium in government securities.
iv. The Nigerian Enterprises Promotion Decree of 1970 required foreigners to relinquish
sizable proportions of their equity interest in local enterprises to members of the Nigerian
public.
v. The deregulation of interest rates.
vi. The privatization and commercialization policy of government.
Problems Facing the Capital Market
Despite the observed growth of the Nigerian capital market, the growth has been described as
unsatisfactory when compared with contemporary markets elsewhere. The following factors have
been said to be responsible for the unsatisfactory situation of the market.
i. Inadequate securities for trading.
ii. Low level of market automation and awareness
iii. Lack of timely and easy access to information
iv. Poor infrastructural facilities
v. Restriction on foreign ownership of assets.
Second-Tier Securities Market (SSM)
Second-Tier Securities Market (SSM) was established in April 1985 to encourage small and
medium-scale enterprises to avail themselves of the resources of the stock market by making
listing requirements and conditions less stringent for this category of enterprises. The aim is to
increase the volume of securities in the market.
As part of capital market reforms, the Nigerian Stock Exchange (NSE) introduced the
central Securities Clearing System (CSCS). The CSCS is an automated clearing, settling and
delivery system aimed at easing transactions and fostering investors' confidence in the market.
Other reform measures include the repeal of the indigenization legislation of the 1970s,
which limited foreign participation in the capital market, and the promulgation of the Nigerian
Investment Promotion Commission (NIPC) Decree in 1995 to liberalize the investment climate in
Nigeria. The decree allows unrestricted foreigner and residents the same rights, privileges and
opportunities of investment in the Nigerian capital market.
In 1996, the Federal Government set up the Dennis Odife Panel to review the structure,
conduct and performance of the capital market. The panel discovered that the market was operating
within many outdated laws regulations and that there was no basis for retaining the "monopoly"
status of the NSE.
The panel recommended, among other things, the establishment in Abuja, which would set
the standard against which other stock exchange in the country should compete.
Comparison of Money Market and Capital Market
The money market and capital market can be conveniently compared under three items:
i. Purpose or objectives;
ii. Types of instrument used; and
iii. Types of institutions involved.
Money Market Capital Market
Purpose Short-term loans and Medium and long-term loans
investment and investment
Instrument used Treasury Bills, Loans and investment through:
Commercial Bills, (i). Stock and Shares
Money at call, (ii). Company Bonds
Bill of Exchange, (iii). Government Bonds
Institution Commercial Banks, Building Societies,
Acceptance Houses, Insurance Companies,
Cooperative Credit societies, Development Banks,
Discount Houses, Finance Corporations,
Central Banks. Merchant Banks,
Savings Banks,
Investment Trusts,
Stock Exchange.
3.7 CENTRAL BANK

Central Banks: Each country has a central bank such as the Central Bank of Nigeria, the Bank of
Ghana, the bank of Sierra Leone and the Central of Gambia.
3.7.1 Development of Central Banking
A central bank is the apex of all banking institutions in a country. It controls the activities
of all the commercial banks. Before the independence of most English-speaking West African
countries, there was only one coordinating authority for the whole territory on currency matters.
This was called the West African Currency Board. Since it was the creation of the colonial
authorities, it had its headquarters in London. However, its functions of the central banks are much
more than the issuing of notes.
As soon as each country gained or approached political independence, it established its
own central bank. A central bank was established in Ghana in 1957, in Nigeria in 1959, in Sierra
Leone in 1964 and in the Gambia 1971. At these periods, the countries wanted to have control over
the activities of their commercial banks.
3.7.2 Functions of Central Bank
(i). The Government's Bank: The central bank is the government's own bank, it keeps the
account of the government. It keeps all revenues from taxation and makes all payment out
of it on behalf of the government. Just as a commercial bank lends to its customers, the
central bank lends to the government. More importantly, it manages the national debt, i.e.
the government's external and internal borrowings.
(ii). The Issue of Currency: The central bank is the only authority empowered by law to issue
all paper money and coins, usually called currency in any country.
(iii). Bankers Bank: The central bank serves as a bank to commercial banks. This means that
the commercial banks keep accounts with the central bank. The deposits which the
commercial banks keep with the central bank are treated as cash and are regarded as part
of the proportion of the deposits that commercial banks should, by law, keep as cash. The
central bank serves as the clearing house for the settlement of inter-bank cheques.
(iv). Lender of Last Resort: The central bank lends money to the commercial banks in serious
need. For example, the central banks make advances available to commercial banks and
acceptance houses to enable them, particularly, commercial banks, satisfy their customers'
demand for cash and thus avoid cash crisis in the country.
(v). Adviser to the Government: The central bank is an adviser to the government on monetary
matters. It advises government on the methods of raising loans, particularly foreign loans.
It manages the national debt by servicing it as well as arranging for its repayment.
(vi). Foreign Monetary Transactions: The central bank holds and manages the foreign
exchange reserves and advises government on the trends. It establishes contacts with the
central banks of other countries of the world, as well as international financial institutions
such as the International Monetary Fund (IMF) and the International Bank for
Reconstruction and Development (IBRD) which is also known as the World Bank.
(vii). Promoting Economic Development: The central bank also has responsibility of promoting
development. It does this in several ways. It controls the activities of the commercial banks
to promote industrial, agricultural and commercial growth. It promotes the establishment
and development of institutions essential for rapid economic growth such as the Nigerian
Ban for Commerce and Industry (NBCI) and the Nigerian Industrial Development Bank
(NIDB).
3.8 COMMERCIAL (DEPOSIT MONEY BANK) BANKS
In each of the West African countries, there are several commercial banks. Most of these
banks are jointly owned by the government and private investors. In Nigeria, such banks include
Access Bank, First Bank of Nigeria, Guaranty Trust Bank, Union Bank, United Bank for Africa,
Wema Bank, Zenith Bank, and a host of others.
3.8.1 Functions of Commercial Banks
(i). Acceptance of Deposits: Acceptance of deposits from customers is the oldest function of
commercial banks. In the early, commercial banks used to charge customers some amount
for the safe-keeping of their money. Nowadays, the banks pay some interest to customers
for saving their money in the bank. These are the different types of account that can be kept
at a bank.
a. Current account: This is also called demand deposit. Money saved or deposited in this
account can be withdrawn any time only by means of a cheque without giving any
noticed to the bank. Current account holders do not receive any interest on their
deposits; rather, the bank makes some charges for the safe-keeping of the money.
b. Fixed deposit account: Money saved in this account is for a stated period of time, say
nine months, one year etc. It is therefore not subject to withdrawal by cheque because
it cannot be withdrawn just any time. It earns some interests. These interests are usually
higher than the interest payable on savings accounts.
c. Savings account: Savings account makes it possible for smaller savers to keep money
without the need of cheque. The savings that are made are recorded in a "passbook"
which is generally taken to the bank, either to deposit or to withdraw. Because savings
cannot be withdrawn by cheques, a small interest is earned on the balance in the
account.
(ii). Acting as Agents far Payments: Commercial banks honour cheques and effect payments.
The cheques have become the principal method of payment and it has the following
advantages:
a. There is no need to carry large sums of money around,
b. They are generally safer to carry than cash,
c. They can be written for any amount needed,
d. They provide a form of receipts. A cleared cheque is an evidence that payment has been
made and it cannot be denied.
e. Money can be paid over long distances without the need for personal contact; and
f. Cheque stubs provide a record of payments made.
(iii). Currying Out Standing Orders: Sometimes a bank is given a standing order to make
regular payments, such as payment of school fees and monthly payment of insurance
premiums.
(iv). Lending to Customers: The most profitable business of the commercial bank is lending.
Lending to customers is also one of the most important functions. The commercial bank
performs its lending functions to customers in the following ways.
a. By means of Loans: This is done by crediting the account of the borrower with the
amount of the loan. The account is usually a current account. An arrangement is made
for the borrower to repay the loan in fixed installments over an agreed period of time.
The borrower pays interest on the full amount borrowed.
b. By means of Overdrafts: An overdraft is the credit facility that is extended by bank to
a customer who operates a current account to overdraw his account up to an agreed
maximum amount. If a customer is given an overdraft, he is allowed to withdraw more
than he has in his account up to the limit of the overdraft. He pays interest only on the
amount he has actually overdrawn in his account. Overdraft is the easiest and most
convenient method of borrowing money from the banks opened to businessmen.
c. By discounting bill of Exchange: Discounting a bill of exchange literally means
payment on behalf of the customer. Thus, when bank discounts a bill of exchange for
a customer, it means the bank makes payment to someone (creditor) who sells some
goods to his customer on the promise that the customer will later repay the bank. This
system thus enables the creditor to receive immediate payment. At the same time, it
provides the debtor (the bank's customer) credit over a given period of time, it is
therefore, other types of bank lending,
d. By buying Treasury bills: Commercial banks regularly buy treasury bills. By
government treasury bills, we mean a form of public short-term, usually 90 days, and
loans. It is a legal document or instrument expressing the promise of the treasury to pay
to the holder of such a document a stated principal sum and the interest that is specified
on the principal.
(v). Agent of Government: Commercial banks, either through the Central Bank or through
direct directives from the Ministry of Finance, serve as agents for implementing
government monetary policy, such as assisting identified sectors of the economy. Such a
policy may be to promote agricultural production or to stimulate export products.
(vi). Other Services: Many other services of a general nature are performed by commercial
banks. They serve as trustees or executors of wills. They transact foreign exchange
business, i.e. buy foreign exchange from the Central Bank and sell to customers. They issue
bank drafts and traveler's cheques. They also provide safe places for the keeping of
valuables, such as jewelries and documents.
Differences between a Commercial Bank and a Central Bank
One main difference between a commercial bank and a central bank is that commercial bank is
usually joint-stock companies, i.e. owned by shareholders. As commercial ventures, they aim at
making profit. A central bank, on the other hand, is owned entirely by the central government.
While individuals, group of individuals federal and state governments can and do own commercial
banks, only the national or federal government can own a central bank.
4.0 Other Liquidity Financial Institutions
1. Savings and loan Associations: They are operated by individuals by collecting their savings
in mutual association. They covert their savings funds into mortgage loans.
2. Mutual Savings Banks: They operate like savings and loan associations. The only difference
is that they are established on the basis of co-operation by employees of some company, trade
unions or other institutions.
3. Co-operative credit Societies: The members of credit societies purchases shares of co-
operative societies, deposit their savings with them and borrow from them.
4. Mutual Funds: Mutual funds sell their shares to individuals and firms and invest their
proceeds in various types of assets. Some mutual funds, known as money market mutual funds,
invest in short-term safe assets such as Treasury Bills, Certificates of deposit of banks etc.
5. Insurance Companies: Insurance companies protect individuals and firms against risks. The
premium they receive from individuals by insuring their lives, they invest the same in
advancing loans for long-term assets, mortgages, construction of houses, etc. on the other hand,
the premium received by them for insuring against loss from fire, theft, accident, etc. of trucks,
cars, buildings etc. is invested in short-term assets.
6. Pension Funds: Private and government corporate, and central, state and local governments
deposit some amount in pension funds by deducting a certain amount from the salaries of their
employees. Pension funds, institutions or corporate invest these funds in long-term assets.
7. Brokerage Firms: Brokerage firms link buyers and seller of financial assets. As such, they
function as intermediaries and earn a fee for each transaction, known as brokerage. They
operate only in the secondary debt market and equity market.
8. Mortgage Banks: A mortgage bank is a type of bank specifically established to provide long-
term loans for the development of houses. An example of a mortgage bank is the Federal
Mortgage Bank of Nigeria. The initial capital of the bank is usually provided by government.
The bank provides long-term loans, for the purpose of building houses, called mortgage. Loans
are granted for viable housing projects after inspection by the bank's staff. The size of loans
granted to any applicant depends on the estimated cost of such houses. Mortgage loans are
usually available for private houses, but it not unusual to obtain mortgage loans for the building
of estates.
The repayment of mortgage loans is made over a longer period, depending on agreement. The rate
of interest on such loans depends on whether the building is for private lodging or for commercial
purposes, like letting to tenants. Government can also reduce or increase the rate of interest in
accordance with its monetary policy.
5.0 INTEREST RATE
Interest is the price paid for the use of money. It is the price that borrowers need to pay lenders for
transferring purchasing power from the present to the future. It can be thought of as the amount of
money that must be paid for the use of N1 for 1 year.
Interest is stated as a percentage. Interest is paid in kind, meaning that the borrower pays for the
loan of money with money (interest). For that reason, interest is typically stated as a percentage of
the amount of money borrowed rather than as a dollar amount. It is less clumsy to say that interest
is “12 percent annually” than to say that interest is “N120 per year per N1000.” Also, stating
interest as a percentage makes comparison of the interest paid on loans of different amounts easier.
By expressing interest as a percentage, we can immediately compare an interest payment of, say,
N432 per year per N2880 with one of N1800 per year per N12,000. Both interest payments are 15
percent per year, which is not obvious from the actual dollar figures. This interest of 15 percent
per year is referred to as a 15 percent interest rate.
5.1 Types of Interest Rate
Nominal and Real Interest Rates
The nominal interest rate is the rate of interest expressed in dollars of current value.
The real interest rate is the rate of interest expressed in purchasing power minus Naira of inflation-
adjusted value.
For example: Suppose the nominal interest rate and the rates of inflation are both 10 percent. If
you borrow N100, you must pay back N110 a year from now. However, because of 10 percent
inflation, each of these 110 Naira will be worth 10 percent less. Thus, the real value or purchasing
power of your N110 at the end of the year is only N100. In inflation-adjusted dollars you are
borrowing N100 and at year's end you are paying back N100. While the nominal interest rate is 10
percent, the real interest rate is zero. We determine the real interest rate by subtracting the 10
percent inflation rate from the 10 percent nominal interest rate. It is the real interest rate, not the
nominal rate that affects investment and R&D decisions.
5.2 Factors that Influences Interest Rate
1. Amount of Loan: Interest rate has a negative relationship with loan. A higher loan attracts
lower Interest rate and vice versa.
2. Duration of the Loan: Long term loans attract higher interest rate since they won't be repaid
immediately and vice versa.
3. Nature of Security: The movable collateral like gold attracts lower interest rate while
immovable securities like land attract high interest rates.
4. Credit Worthiness of borrowers: Being credit worthy also affects the rates of interest and also
the ability to pay one's loan as at when due attracts lower interest rate and vice versa.
5. Market Imperfection: Banks vary in their own interest rate. Not only banks give out loans,
other financial institutions like insurance companies give out loans. Thus rates could be higher
or low depending on the instruction.
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Nwogwugwu Uche Collins Associate Professor Department of

Rev. Sr. Maria C. Uzonwanne Ph.D Lecturer, Department of Economics

Obi, Kenneth Onyebuchi Associate Professor Department of

Ezenekwe, Uju Regina Ph.D Lecturer, Department of Economics

Chris, Kalu U Lecturer, Department of Economics

Okeyika, Kenechukwu Okezie Lecturer, Department of Economics

Maduka Olisaemeka Denis Lecturer, Department of Economics

Metu, Amaka G. Lecturer, Department of Economics

Eze, A. Eze Lecturer, Department of Economics

Nwokoye, Ebele Stella Ph.D\ Senior Lecturer, Department of

Demand for Money

Central Bank of Nigeria

Securities and Exchange Banking Non-Bank

Capital Money Money

Government Call Money Commercial

The Instruments of the Nigeria Money Market:

3.7 CENTRAL BANK

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