UNIT 1: MONEY

Contents
1.0 Aims and Objectives
1.1 Introduction
1.2 Meaning of Money
1.2.1 Evolution of Money
1.2.2 Classification of Money
1.2.3 Characteristics of Good Money
1.2.4 Functions of Money
1.2.5 Significance or Role of Money
1.2.6 Defects of Money
1.3 The Demand for and Supply of Money
1.3.1 The Demand for Money
1.3.2 The Supply of Money
1.4 Summary
1.5 Answers to Check Your Progress
1.6 Key Terms

1.0 AIMS AND OBJECTIVES

At the end of this unit, you are expected to

 define money and identify the types of money
 understand the functions, characteristics, roles and defects of money
 understand the determinants of supply of money and demand for money.

1.1 INTRODUCTION

This unit focuses on money. Money is defined according to the functions it performs. As a
general rule, money performs primary functions, secondary and other functions. Money passes
through different stages and different materials were used as money.

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Money has many roles/significances and defects in the economy. Money to undertake these roles
effectively and to minimize its defects its value must be stable. The value of money becomes
stable depending upon the demand for and supply of money. These points will be discussed in
this unit.

1.2 MEANING OF MONEY

The word money is derived form the Latin word “Moneta” which was the surname of the Roman
Goddess of Juno in whose temple at Rome, money was coined. The type of money in every age
depended on the nature of its livelihood.
For example:
example: - In a hunting society – skins of wild animals used as money
The pastoral society – Livestock used as money
The agricultural society – grains and food staffs used as money
The Greeks used coins as money.
Money is anything generally accepted as a medium of exchange. It is anything used to pay for
goods and services or settle debts, or it is anything that is generally recognized and accepted as
payment in the exchange process.

Money is, therefore, any thing that is used as a means of facilitating transaction and exchange in
a given community. According to the nature of transaction or exchange, a given community’s
economy may be classified as: Barter economy and monetary economy. They can be discussed
as follows.

a) Barter Economy
A barter economy is a type of economy in which transactions or exchanges in a community
carried out without the use of money as a medium of exchange. Barter involves the direct
exchange of one good for some quantity of another good or service.

Barter is a system in which people sell goods and services in order to obtain other goods and
services through direct exchange. Thus a barter economy is a money less economy. It is also a
simple economy where people produce goods either for self-consumption or for exchange with
other goods which they want. It was found at large in a primitive societies. But it is still practiced
in modern societies. For instance, in this modern world a certain company in Ethiopia may
import a coffee processing machine in exchange for coffee. The seller sells his coffee-processing

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machine for coffee and the importer gets the coffee-processing machine in exchange for coffee.
However, the nature of this exchange is different from the barter system during the primitive
society where money was not introduced. At present the two parties weigh the value of the two
items in terms of money and exchange items only when they are not at a loss side.

As a society becomes more civilized and the complexities of economic organization begin to
multiply, exchange through barter tends to become more difficult and complicated. The
difficulties of a barter system can be discussed as follows.

1. Lack of Double Coincidence of Wants

The functioning of the barter system requires a double coincidence of wants on the part of those
who want to exchange goods or services. Double coincidence of wants refers to the act of
demanding to exchange a product owned to another person who has a good and want to
exchange it with what you own.

For example, you have a cow and want to exchange that with a horse. Therefore, you should look
for some one who has a horse and who want to exchange his horse with your cow.

To be successful, the barter system involves a multilateral transactions which are not possible
practically. For instance, assume that there are four different items in a community ready to be
exchanged. Here, in order to have a successful exchange the number of exchanges may reach to
6 times C = N(N – 1)/2 ( the formula for the number of process in a barter economy i.e.
Cow  horse, sheep and goat
Horse  sheep and goat
Sheep  goat
2. Lack of a Common Measure of Value
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. For example, the owner of a cow may want to exchange his cow with four
sheeps. However, the owner of a sheep may want to exchange his three sheep with a cow. Now
the exchange rate the two persons set differs. Who do you think will be the winner in this
transaction? It depends on the intensity of demand. If the owner of the sheep has highly

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demanded the cow, he is obliged to offer what is quoted by the owner of the cow-four sheeps.
Whereas, if the owner of the cow has highly demanded the sheep. Whereas, if the owner of the
cow has highly demanded the sheep, he has to accept the offer given by the owner of the sheep
three sheeps.

Moreover, under a barter system value of each good is required to be stated in as many quantities
as there are types and qualities of other goods and services.

In money economy there is only one price for each good. In a barter economy the number of
prices increases rapidly as the number of goods increases.

Illustration
Number of commodities Number of prices number of prices
Money economy Barter economy
5 5 10
10 10 45
1,000 1,000 499,500
1,000,000 1,000,000 499,999,500,000

3. Indivisibility of Certain Goods

Certain goods are indivisible by nature like ‘animals’; therefore, it is difficult to fix exchange
rates for such goods which are indivisible. Such indivisible goods pose a real problem under
barter. For example, in the example stated above, if the two parties – the owner of a cow and
a sheep – do not agree to accept the offer of the other, there will be no exchange made
between them, as there is no some value in between three and four sheeps or as the value of
the cow can not be reduced.
4. Difficulty in storing value
Society, naturally want to postpone consumption of wealth by storing its value. However, the
lack of facility to store value or the lack of existence of a generalized purchasing power is a
major inconvenience of the barter system to postpone consumption. Under barter, people can
store value for future use by storing wealth, but the difficulty arises when wealth consists of
perishable goods.

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 Moreover, the store of value in terms of real wealth involves cost and further, the problem of
storing the goods arises. In addition, bulky goods cannot be easily exchanged for other goods
as and when required. A quick exchange sometimes involves a heavy loss, too. To test this
you try to sell your tape that you have bought at an expensive price.
5. Difficulty in making differed payments
Differed payments arise as credit sales are made. Credit is also an indicator of societal
development. In a barter economy, it is difficult to make payments in the future. It is not the
credit sale that causes a problem, but it is the repayment. As payments are made in goods and
services, debt contracts are not possible due to disagreements on the part of the two parties
on the following grounds.
i. It would often invite controversy as to the quality of the goods or services to be repaid.
ii. The two parties would often be unable to agree on the specific commodity to be used for
payment.
iii. Both parties would run the risk that the commodity to be repaid could increase or
decrease seriously in value over the duration of the contract.
6. Lack of Specialization
Specialization is the result of division of labor. Everyone produces what he or she is more
effective and efficient. This is possible when he/she can sell it easily and can get at ease in
the market what he/she needs. However, this is not easy in the barter system. As exchanging
ones goods with others is difficult everyone starts to produce everything he/she wants. This
leads people to be simply a jack-of all trades i.e. who can do every thing but master of none.
This reduces specialization and then productivity in an economy.

b) Money Economy
A money economy is a well-developed economy. It is an economy in which transaction and
exchange is made through the medium of money. This economy is a monetary economy and
production is more for sale than consumption. Money introduced in an economy so as to
eliminate the above stated difficulties of barter system. However, money passes through different
stages so as to reach the present state.

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1.2.1 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.
1. Animal Money
Animals were being used as a common medium of exchange in the primitive hunting stage.
2. Commodity Money
Various types of commodities have been used as money from the beginning of human
civilization. The particular commodity chosen to serve as money depended upon various factors
like; Location of the community, climatic environment of the region, cultural and economic
standard of society, etc.
For example: * People living at the sea shore  used shells and dried fish
* People of the cold region  used skins and furs of animals
* African people  used Ivory and tiger jaws.
However, the use of commodities as money had the following defects;
i. Lack of uniformity and standardization make pricing difficult
ii. Difficult to store and prevent loss of value in the case of perishable commodities
iii. Uncertainty of supplies of such commodities
iv. Lack of portability and hence were difficult to transfer from one place to another
v. Indivisibility
3. Metallic Money
With the spread of civilization and trade relations by land and sea, metallic money took the place
of commodity money. The metallic money which was the raw metal, was an inconvenient thing
to accept, weigh, divide and assess in quality. Hence, metal was made into coins of
predetermined weight, which was attributed to king Midas of Lydia – a Greek city-state in 700
Bc. The first type of metal used as money was gold.

But some ingenious persons started debasing (lowering value) the coins by clipping a thin slice
off the edge of coins. This led to the minting of coins with a rough edge – check your coins in
your pocket. As the price of gold began to rise, gold coins were melted in order to earn more by
selling them as metal. This increases costs of melting to the government. Hence, government mix

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copper or silver or alloy or some other metal with gold so that their intrinsic value (its value as a
commodity) might be less than their face value (their value as money).

Metallic money possesses the following defects:

i. It was not possible to change its supply according to the requirements of the nation both
for internal and external use.
ii. Being heavy, it was not possible to carry large sums of money in the form of coins from
one place to another.
iii. It was unsafe to carry and could be easily lost or stolen.
iv. It was very expensive, the use of coins led to their debasement and their melting and
exchange at the melt, cost a lot to the government.
4. Paper Money
As the name represents paper money refers to money made of paper materials. The development
of paper money started with goldsmiths who kept strong safes to store their gold. Because of the
difficulties of commodity money stated above, merchants were hesitant to use commodity as a
medium of exchange. Hence, they used to keep their metallic money with the goldsmith. The
goldsmith in return offers a written paper stating the amount of metallic money kept with him by
the merchant whose name is written on it. The merchant, then, use this written paper as a means
of payment for his purchase or can withdraw the commodity money any time he or she wants by
returning the paper.

At the early age this paper money was emerged as “token money” – which is a representative
paper money – convertible to gold. In the later stages this “token money” become “Fiat money”
i.e., inconvertible legal tender.

5. Credit Money
With the development of banking and credit creation activities, another form of convertible
money developed in the form of money or bank money. This is referred as cheque system.
Cheque is a credit instrument used to facilitate exchange but is not a real money. It is a form of
money in a modern society. The greater the utilization of cheque in the exchange process in a
given society, the modern\civilized that society is. Cheques are created with the creation of
demand deposit accounts.

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6. Near Money
Near money items are financial assets which are easily convertible into money. They are not
money in real terms. But, they are financial assets used to facilitate exchange. They are: bills of
exchange, treasury bills, bonds debentures, saving certificates, etc.

In short, anything and everything can serve and has served as money provided it is generally
recognized and accepted as means of payment. But all things cannot serve as a good money. A
good money should possess the attributes of general acceptability cognoscibility, portability,
divisibility, durability, uniformity, adequacy and stability of value. (see the characteristics of
good money).

The Origin of Money

As historians believe money was originated as religious objects of value. By the ancient
Babylonian, Greek and Roman civilizations, monetary systems include coins with effigy of their
Goddess or rulers.

After the fall of Rome, the medieval economics of Europe moved towards a barter system. The
feudal system, which was referred as the Dark Age, was built largely on barter. However, barter
was neither a permanent nor a worldwide phenomenon. With the decline of the feudal system,
the barter system declines and the monetary economy gradually re-emerged. By the eleventh
century, there was a revival of trade and a renewed growth of towns, and gold emerged as a
medium of exchange.

In 1066 – William the conqueror, the ruler of England allowed only royal coinage to be used in
his kingdom.

Axsumite Kingdom was implementing coins as a medium of exchange. They first introduced
gold coins but through time as gold become scarce, they started to melt silver and copper coins.
After the fall of the Axumite Kingdom, the Zagwe’s replace the administration and the monetary
system is changed in to barter system. During this time besides, the barter system, different
commodities were used as a medium of exchange i.e., as money. Coinage in Ethiopia was
restarted during the 19th Century with the Maria Theresa Dollar. Besides to the Maria Theresa

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Dollar, the Italians has tried to introduce their coin known as “Shelling” during the rule of
Menelik II.

1.2.2 Classification of Money

Money can be classified based on the following different criterion.

1. Monetary system criterion or the physical characteristics of the materials of which money is
made.
 According to this criterion money can be further classified as follows:
a) Metallic Money
Money made of any metal such as gold, silver, nickel, copper, etc is called metallic money.
It has a given size, shape, weight and fineness whose value is certified by the
state/government. Metallic money can be further classified as:
i) Standard Money/Coins
This is money whose value as a commodity for non-monetary purpose is as great as its
value as money. i.e., its intrinsic value is equal to its face value. In other words, its value
as a commodity is equal to its value as money. Hence, it is also referred as full-bodied
money.
ii) Token money/coins
As debasement of metallic money widespread, government start to include other inferior
metals with gold coins and hence the value of the metal as money will be less than the
value of the metal as a commodity. It is representative money whose intrinsic value of the
metal is less than its face value.
iii) Subsidiary money/coins
These are metallic coins introduced to support the use of other metallic coins (token
money or coins).
b) Paper Money
Paper money refers to notes of different denominations made of paper and issued by the
central bank and/or the government of the country (state treasury). This can be classified
into:

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 i) Representative paper money
It is in effect a circulating warehouse receipt for full-bodied coins or their equivalent in bullion.
It is fully convertible into gold coins or bullion i.e., you can take the gold coins or bullion
equivalent to the value of the paper money in exchange for it. For example, you have deposited
three quintals teff in a certain warehouse and the owner of the warehouse gave you a receipt in
exchange for your property until you do not want the teff you have kept at the warehouse, you
can keep the receipt with you. But if you want to get back your property, you have to return the
receipt to the warehouse keeper. That is why it is referred as fully convertible money. It is also
known as representative full-bodied money.

ii) Convertible paper money

This is paper money which can be converted in to gold coins or bullions. However, it does not
have a 100 percent (100%) backing in the form of standard coins or bullion. Hence this paper
money cannot be fully converted into gold coins or bullion i.e., the amount of gold kept at the
issuer’s possession (eg. National Bank in Ethiopia) is less than the value of paper money in the
hands of the society. For example, in our example under (i) the warehouse receipt shows three
quintals of teff and whenever he wants, he can get it back. But in this case, though, the receipt
stated to be equivalent to three quintals of teff, the actual volume of teff that exists in the
warehouse is less than three quintals. Therefore, if you want to return the receipt and get back
three quintals of teff, you cannot get, as the volume of teff in the warehouse is less than three
quintal.

iii) Inconvertible paper money

This is a paper money which does not have any backing of standard coins or bullion and is not
convertible into them. Notes issued by Central Banks of all countries represent it. This money is
also known as fiduciary money.

iv) Fiat Money

This is a paper money which circulates in a country on the authority of the government. It is
created and issued by the state of the given country. It is not convertible by law and is legal
tender money. Fiat money is representative or token money. Practically, there is no difference
between fiat money and inconvertible paper money. This form of money exists only when the
society accepts the government of the country. It will have value only when the government

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(National Bank) declares that paper has to be accepted as money. Otherwise, its value as
commodity is very less than its value as money. Now you check your birr in your pocket and
read what it says. It says “payable to the bearer on demand “or “LUߨ<
“LUߨ< ”Ç=ŸðM IÓ ÁeÑÉÇM”.
ÁeÑÉÇM”.
Therefore, it shows that it is accepted only by the enforcement of the law of the country.

v) Credit money
Credit money is created and transferred by commercial banks in the form of a cheque or draft.
But a cheque or draft is not a legal tender money. No one is legally forced to accept cheques or
drafts as a payment for goods sold or services rendered.

Paper money has certain advantages and disadvantages compared with the metallic money.

Advantages of Paper Money

a) Paper money is economical. It is cheaper than any metal. Therefore, we can issue more
paper money with least cost.
b) Paper money economies the use of precious and scarce metals by serving as representative
money.
c) It is portable. It is very convenient to carry paper money from place to place
d) It is easy to store. Paper money can be stored in small place.
e) It is easier to count paper notes than metallic coins.
f) Supply of paper money is easily adjustable as per the need of the economy.

Disadvantages of paper money

a) There is the danger of over issue of notes as they can be easily printed.
b) Paper money lacks general acceptability if the people lose confidence in the government
for one reason or the other.
c) Durability of paper money is much less than metallic money
d) Paper money can circulate within the domestic economy only.

2. Acceptability Criterion (The nature of the issuer)

On the basis of acceptability criterion, money is classified into two as legal tender money and
non-legal tender money.
i) Legal Tender Money

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 It is that which the state and the people accept as the means of payment and in discharge
of debts. It is accepted compulsorily by the people. It becomes money only when the state
declares it to be accepted as money. For example, all notes and coins issued by the
government and the Central Bank are legal tender money. Our birr notes and coins are
legal tenders of the country. Legal tender money can be further divided into

a) Limited legal Tender Money

It is that in which payments can be made legally up to a certain limit. If the limit is stated
by the government, no one will be forced to accept that money more than the limit for
payment of goods and services.

b) Unlimited Legal Tender Money

This money is accepted by the people with out limit in the quantity. Buyers have the right
to pay any quantity for the goods they bought or services they get and the seller has no
power/right to refuse to accept money on the basis of the quantity.

ii) Non-Legal Tender or Optional Money

It is money which does not possess any legal authority of the state or the Central Bank.
People are not bound to accept such money because there is no legal sanction behind
their issue. They are created by commercial banks. Examples of non-legal tender or
optional money is bank money in the form of cheques and drafts. Time deposits, bonds,
securities, debentures, bills of exchange, treasury bills postal certificates, insurance
policies, etc are also known as optional money.
3. Money of Account and money proper or the relationship between the value of money as
money and the value of money as commodity
a) Money of account
It refers to the value of money as money. It is that in which debts and prices and general
purchasing power are expressed. In other words money of account refers to the nominal
value of money.
b) Money Proper
It refers to the value of money as commodity. It is the actual money in which contracts or
debts are settled. In other words, money proper refers to the real value of money.
4. Legal money and customary money

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 Legal money is any thing recognized and accepted as a means of payment by the instruction
of the state /National Bank. Anything that government declares to be money is a legal
money. Legal tender money is legal money.
Customary money is anything recognized and accepted as a means of payment by custom.
Anything that the society accepts as a means of payment by custom is a customary money.

Money and Near money

There has been lot of controversy and confusion over the meaning and nature of money. For
example, money is defined by many scholars as follows and all of them try to define money in
different ways.
Scitousky  “money is a difficult concept to define, partly because it fulfills not one but three
functions, each of them providing a criterion of moneyness … those of a unit of
account, a medium of exchange, and a store of value.”
Caulborn  “Money is the means of valuation and of payment; as both the unit of account and
the generally acceptable medium of exchange.”
Sir. John thiks  “Money is defined by its functions; anything is money which is used as
money: ‘money is what money does.”
Some Economists: - Any thing which the state declares as money is money.

Accordingly, money is defined in different ways. There are different approaches used to define
money.
1. The traditional Definition of money /Conventional approach
According to the conventional approach money is defined as currency and demand deposits,
and its most important function is to act as a medium of exchange.
2. Friedman’s definition of money / The monetarist or Chicago view
According to this approach, money is the sum of currency plus all adjusted deposits in
commercial banks such as savings and time deposits. The main function of money, to this
view, is to serve as a temporary abode/store/ of purchasing power.
3. The Redclift Definition
According to this definition, money is “note plus bank deposits”. It includes as money only
those assets which are commonly used as a media of exchange.
4. The Gurely-show definition

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 This approach is similar to Chicago approach in its objective. However, it is different in the
fact that it includes in the list of close substitutes for the means of payment the deposits of
and the claims against all types of financial intermediaries. Such as bonds, securities,
debentures, bills of exchange, treasury bills, insurance policies, etc. This definition
recognizes that, the total money supply in a country can be determined by converting the
value of this financial intermediaries by multiplying them against their liquidity rate and
adding them up with the most liquid assets such as currency and demand deposits (cheques
and drafts).
Therefore, money consists of currency and bank deposits. It includes coins and currency notes
issued by the central bank of a country and cheques of commercial banks of a country. They are
the most liquid assets. It is a legal-tender and gives the possessor liquidity in hand.

Whereas, near money consists of assets that serve the store of value function of money
temporarily and are convertible in to a medium of exchange in a short time without loss in their
face value. However, they do not have any legal status. Near money items fetch a fixed rate of
interest. Bonds, securities and debentures, bills of exchange, treasury bills, insurance policies and
time deposits fall in this category. They possess moneyness or liquidity and they are money
substitutes.

Bonds and securities are issued by government, while debentures are issued by companies. They
carry a fixed rate of interest and they are the means to borrow funds. A bill of exchange is
another forms of money issued by business persons so as to facilitate exchange. Treasury bills is
a promise by the government to pay a stated sum in the near future usually 30, 60, 90 days (you
can turn on your TV on saterday’s evening and see them as issued from the central treasury.) A
bill of exchange and treasury bills can be converted into money at a discount within a short
period. Life insurance policy holder and holder of time deposit certificate can obtain cash in the
form of loan on his policy or deposit certificate at a short notice.

Conclusion
Near money items possess moneyness or liquidity but not ready liquidity like money. They are
almost perfect substitutes for money as a store of value. They are superior to money because they
yield income. They also economies in the use of money proper and tend to reduce the quantity of

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money used by the people as a medium of exchange, as a means of differed payments and as a
store of value.

1.2.3 Characteristics of Good Money

Money has the following characteristics or qualities

a) General Acceptability
For anything to be money, it should be acceptable by every body as a means of payment in
exchange of goods sold or services rendered. Gold and silver are considered as good money
materials because they have alternative uses and are generally accepted. Paper notes are
accepted as money when they are issued by the central bank and /or the government and are
legal tender. Cheques and bills of exchange are not generally accepted. Hence, they are the
least form of money in terms of general acceptability.
b) Durability
Any thing to be a good money, it should be storable and last long without losing its value
over a period of time. Gold, silver, alloy, etc are best forms of money. Paper money which
includes currency notes and credit money are next. However, animal and perishable
commodities are not good money materials in terms of durability.
c) Portability
The material used as money should be easily carried and transferred from one place to
another. It should contain large value in small bulk. In this regard gold and silver money
possess high quality but there is transporting risk. Paper is considered as a better material and
is used in the form of notes. Hence, bank money or credit money is the most portable money.
d) Cognosability
The material with which money is made should be easily recognized by sight or touch. It
should be distinguishable by sight or touch from other types of money. Coins and currency
notes of different denominations in different designs and sizes meet this quality of good
money.
e) Homogeneity
The material with which money is made should be of the same quality. All forms of money
should be same, material, Weight, size and colors. For instance all coins of one denomination
must be of the same metal, Wight, shape and size. Similarly all paper notes of one

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 denomination must have the same quality of paper, design and size. This is the reason why
the blind in your village can identify each coins and paper notes.

f) Divisibility
The money material should be capable of being divided in to smaller parts without losing
value. This will facilitate transaction and exchange to the smallest unit. Gold, silver and other
such materials possess this quality and paper when notes of small and large denominations
are issued. The larger denomination can be divided in to smaller units notes.
g) Stability of value
Money to serve as a store of value and as a common denominator of value, it should be stable
in its own value. If its value fluctuate its function as a store of value and measure of value
will be jeopardize. Gold and silver possess this quality because they are neither available in
abundance nor very scarce. Paper money is preferred to Gold and silver because it is cheap
and easily available. Its value is kept stable by keeping control over its issue. As the value of
paper money increases unnecessarily, government increases its supply and decreases its
supply as its value declines below it is expected to be.

1.2.4 Functions of Money

Money performs a number of primary, secondary, contingent and other functions which not only
remove the difficulties of barter but also oils the wheels of trade and industry in the present day
world.
1. Primary Functions
The primary functions of money can be classified into two: Medium of exchange and unit of
value. They will be discussed as follows
a) Money as a medium of exchange
Money serving as a medium of exchange removes the need for double coincidence of
wants and the inconveniences and difficulties associated with barter. Then, money
serving as a medium of exchange separate transactions of sale and purchase, in time and
place. You can sale what you have today and may buy what you need in a future time.
You may sale your product at some place and may buy from other place. Besides, it
affords the freedom of choice, you can buy any thing that maximizes your utility and

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 allocate what you have in proportion with the utility that you can get from the products.
By doing so, money facilitates exchange and trade.

Moreover, money removes the clumsiness, inconvenience and inefficiency of barter. And
because, exchange is simple every one start to produce the most that he can which leads
to the creation of division of labor and specialization. Division of labor also intensifies
market competition which leads to the efficient allocation of resources.
b) Money as a unit of account
Alternatively, this function is known as unit of account, standard of value, common
measure of value and common denominator of value. Since one would have to use a
standard to measure the length or height of any object, it is only sensible that one
particular standard should be accepted as the standard. Money is the standard for
measuring value just as the yard or meter is the standard for measuring length. Money
acts as a means of calculating the relative prices of goods and services.

The use of money as a standard of value eliminates the necessity of quoting the price of
apples in terms of different other goods like the barter system. Money as a unit of value
also facilitates accounting. “Assets, liabilities, income, and expenses of all kinds can be
stated in terms of common monetary units to be added or subtracted.”

Money as a unit of account helps in calculations of economic importance such as costs,

revenues, profitability and gross national product. It also helps to reward different factors
of production according to their contribution to the economic development.
2. Secondary Functions
Money performs three secondary functions: as a standard of differed payments, as a store of
value and as a transfer of value. They can be discussed as follows.
a) Money as a Standard of Differed Payments
Debt taking was easy even in the barter system, but not repayment. Specially when there are
perishable articles. However, money simplifies both taking and paying debts, through this
function, money links the present values with those of the future and it offers the following
benefits:
- credit transactions are simplified
- contracts of goods supply in future with an agreed payment of money become possible

17
 - borrowing is facilitated by consumers, business persons and firms
- the buying the selling of shares, debentures of securities become simple
There is, however, a danger of changes in the value of money overtime which harms or benefits
the creditors and debtors. For example, if the value of money increases through time i.e., price of
goods decreases, the creditor will receive money that can buy more goods and services than the
time of credit. However, the borrower losses as he pays money that buys many goods and
services at the time of repayment. Therefore, so as to prevent this problem a price index is
applied so as to measure the change in price and to make the necessary adjustment.
b) Money as a Store of Value
The good chosen as money is always something which can be kept for long periods without
deterioration or wastage. It is a form in which wealth can be kept intact from one year to the
next. Money is a bridge from the present to the future. It is, therefore, essential that the
money commodity should always be one which can be easily and safely stored. However,
this could be defined as the functions of assets. Assets can serve as a store of value.
Ordinarily they yield an income in the form of interest, profits, rent or usefulness. But they
have certain disadvantages as a store of value.
i) They sometimes involve storage costs
ii) They may depreciate in terms of money
iii) They are illiquid in varying degrees and hence
- They are not generally acceptable as money
- It may be possible to convert them into money quickly only by suffering a loss
of value.
Therefore, commodities are not the best tools as a store of value
c) Money as a Transfer of value
Since money is a generally acceptable means of payment and acts as a store of value, it keeps
on transferring values form person to person, place to place and generation to generation.
3. Contingent Functions
According to Professor David Kinley contingent or incidental functions are the following and
they are discussed as follows.

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 a) Money as a means of maintaining liquidity
Money is the most liquid of all liquid assets. Though, individuals and firms may hold
wealth in infinitely varied forms, all are liquid forms of wealth which can be converted
into money, and vice-versa.
b) Money as a basis of the credit system
Business transactions are either in cash or on credit. Credit economies the use of money.
But money is at the back of all credit. With the absence of money, credit is impossible. If
a country (commercial banks) have huge cash/money, they will create a huge credit and
vice versa.
c) Money as an equalizer of marginal utilities and productivities
Marginal utilities refers to a concept which deals with the additional utility earned per
unit of consumption. Hence, the main aim of a consumer is to maximize his satisfaction
by spending a given sum of money on various goods which he wants to purchase.
Marginal productivity also refers to a concept which deals with the additional
productivity achieved per unit of input. The main aim of the producer is to maximize his
profits by allocating his resources in to the most productive resources.
Marginal utility and marginal productivity can be defined in terms of money i.e.,
marginal utilities refers to price of goods and marginal productivity refers to cost of
goods, and prices and costs are expressed in money terms
d) As a Measure of National Income
National Income refers to an income generated by a given country at a given time period.
This is achieved when the various goods and services produced in a country are assessed
in money terms.
e) As a means of distribution of National Income
Rewards of factors of production in the form of wages, rent, interest and profit are
determined and paid in terms of money. It is possible and simple to measure the
contribution of each factor to the national development and rewarding it with money.
4. Other functions
Money in addition to the above stated primary, secondary and contingent functions, have other
functions, too. They are:

19
 a) Helpful in making decisions
Money is a means of store of value and the consumer meets his daily requirements on the
basis of money held by him. Any purchase or action decisions made by individuals, firms
and the state depends on the amount of money possessed by him/her.
b) Money as a basis of adjustment
Money is used to make adjustments between money market and capital market, in foreign
exchange and international payments of various types.

1.2.5 Significance or Role of Money

Money is of vital importance to an economy due to its roles: Static and dynamic roles. Its static
role emerges from its static or traditional functions and in its dynamic role, money plays an
important part in the life of every citizen and in the economic system as a whole.

1. Static Roles of Money

In its static role, the importance of money lies in removing the difficulties of barter in the
following ways:
a) By serving as a medium of exchange:
Money removes the need for double coincidence of wants, the inconveniencies and
difficulties associated with barter. Besides, it breaks up the single transactions of barter in
to separate transactions of sales and purchases in time and place.
b) By acting as a unit of account:
Money becomes a common measure of value. It eliminates the necessity of quoting the
price of one item with many other items. Money is the standard of measuring value and
value expressed in money is price.
c) By acting as a standard of deferred payments:
Money eliminates the difficulties associated with taking loans and making repayments
that exists during the barter system. Money has simplified both taking and repayment of
loans because money is the unit of account and its value is durable. The future value of
money given/loaned today can be determined at time of loan and hence repayment is
expected to be made accordingly. Money also overcomes the difficulty of indivisibility of
commodities.

20
 d) By acting as a store of value:
Money removes the problem of storing of commodities under barter. Because, it is made
from a material that can be stored/kept for long periods without deterioration or wastage.
e) As a portable material:
Money removes the problem of transferring purchasing power from place to place. It can
be transferred simply through draft, bill of exchange, cheques, etc.
2. Dynamic Role of Money
In its dynamic role, money plays an important part in the daily life of a person whether
he/she is a consumer, a producer, a businessperson, an academician, a politician or an
administrator. Besides, it influences the economy in a number of ways. This can be discussed
below.
a) To the consumer
The consumer/person receives his income in the form of money. With this money in his
hand, he can get any commodity and services he likes in whatever quantities he needs,
and at any time he requires. Money acts as an equalizer of marginal utilities for the
consumer. It helps in equalizing the marginal utilities of goods. Money enables a
consumer to make a rational distribution of his income on various commodities of his
choice.
b) To the producer
The producer keeps his account of the values of inputs and outputs in money. The raw
materials purchased, the wages paid to workers, the capital borrowed, the rent paid, the
expenses on advertisements, etc, is with money. Hence, money helps the producer to
equalize the marginal productivity of the different inputs. He/she can rationally allocate
his wealth to the different inputs according to their contribution to the attainment of
organizational objectives.
Sale of products in money terms are his sale proceeds. The difference between the two
gives him profit. Thus, money is used as a measure of performance of the producer.
c) To division of labor and specialization
Money helps the capitalist to pay wages to a large number of workers engaged in
specialized jobs on the basis of division of labour. Each worker is paid money wages in

21
 accordance with the nature of work done by him. And every worker can get everything
he/she wants and able to buy with this money.
Therefore, money helps in the growth of industries. All inputs are purchased and all
output is sold in exchange for money. Money facilitates division of labor and hence
specialization. Specialization also helps to increase productivity which in turn facilitates
growth of an industry. That is why professor Pigou said, “In the modern world industry is
closely infolded in a garment of money.”
d) As the basis of credit
The entire modern business in a modern society is based on credit and credit is based on
money. All monetary transactions consists of cheques, drafts, bills of exchange, etc. They
are credit instruments which are not in a true sense money. But easily convertible into
money. Banks issue such credit instruments and create credit.
e) As a means of capital formation
Consumers and producers earn their rewards in money form. They allocate this reward in
to different things. They may buy what ever they want in their life and as it is already
discussed above this allocation is rational. Hence, from their income they may put aside
some money in form of savings. This savings will be deposited in a bank and the bank
lend this money to business persons to invest in machineries, equipments and raw
materials. This makes capital mobile and leads to capital formation and economic growth.
f) As an index of economic growth
The various indicators of economic growth are: National Income, per capita income,
economic welfare, etc. These are calculated and measured in money terms. Changes in
the value of money or prices also reflect the status of an economy. Fall in the value of
money or rise in prices means that the economy is not progressing in real terms.
Continuous rise in the value of money or fall in prices reflects retardation of the
economy. Somewhat stable prices imply a growing economy.
g) In the distribution and calculation of income
The rewards to the various factors of production in a modern economy are paid in money.
Workers get wages, capitalists get interest, landlords get rent, entrepreneurs get profit, etc
in money forms.

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h) In National and international trade
The use of money as a medium of exchange, as a store of value and as a transfer of value
has made it possible to sell commodities not only within the country but also
internationally. There are banks, financial institutions, stock exchanges, produce
exchanges, international financial institutions, etc which operate on the basis of the
money economy and the help in both national and international trade.
Trade relations among different countries have led to international cooperation. As a
result developed countries help undeveloped countries by giving them loans and technical
assistance. This is possible because the value of aid in foreign currency and the
repayment are made /measured in money.
i) In solving the central problems of an economy
The central problem of an economy is to determine what to produce for whom to
produce, how to produce and in what quantities. These are solved by money because on
the basis of its functions money facilitates the flow of goods and services among
consumers, producers and the government. The amount of money possessed by the
different categories of the society helps to determine the above stated problems.
j) To the government
Government carries out many functions using money. Money facilitates buying of the
government, collection of taxes, fines, fees and prices of services rendered by the
government to the people. It simplifies the floating and management of public debt and
government expenditure on development and non-developmental activities. It also
simplifies the functions of the government.
Money helps in achieving these goals of economic policy through its various instruments.
It also helps government in improving the standard of living of the people by removing
poverty, inequalities, unemployment and achieving growth with stability.
k) To the society
The superstructure of credit is built in the society on the basis of money. It simplifies
consumption, production, exchange and distribution of goods and services. It promotes
national unity-when people use the same currency in every corner of the country. It acts
as a lubricant for the social life of the people, and oils the wheels of material progress.

23
 Money is at the back of social prestige and political power. Thus money is the pivot
round which the whole science of economics clusters.

1.2.6 Defects of Money

The Bible says; “The love of money is the root of all evil” Classical economists regard money as
a veil or garment or wrapper for goods and services. They stated that money is simply a tool of
convenience to facilitate the exchange of goods and services, but it is not a determinant of the
quantities produced.

But money which is a useful servant, often misbehaves when it tries to act like a master. This
leads to a number of economic and non-economic defects of money. These can be discussed as
follows.

1. Economic Defects
The economic defects of money are:
a) Instability of the value of money
As the value of money is unstable, money fails to function its roles, as a standard of unit
and as a store of value, properly. When the value of money falls, it means rise in the price
level or inflation. On the contrary, rise in the value of money means fall in the price level
or deflation. These changes are brought about by increase or decrease in the supply of
money.
b) Unequal distribution of wealth and income
Inflation or deflation which brings benefits to some and damages to other leads to
redistribution of wealth and income not only between social and industrial classes, but
between different persons in the same class. Such changes in the structure of the society
widen the differences between the rich and the poor and lead to class conflict.
c) Growth of Monopolies
Too much of money and the redistribution of income and wealth leads to the
concentration of capital in the hands of a few capitalists. This leads to growth of
monopolies which exploit both consumers and workers. At monopoly market, quality of a
product, price, quantity of production and distribution, time of production and

24
 distribution of these products will be determined by the monopolist which negatively
affects consumers and employees.
d) Wastage of Resources
It is already discussed as money serves as a basis of credit. When banks create too much
of credit, it may be used for both productive and unproductive purposes. If it is used for
production, it leads to over capitalization and over production which in turn leads to
wastage of resources. Here the volume of production will be more than the volume of
demand. If credits are given for unproductive uses, they lead to misutilization of
resources which is a wastage.
e) Black Money
It is created when people hoard or store money, evade taxes and hide their income. The
tendency to hoard money and become rich is the root cause of the evil of black money.
f) Cyclical fluctuations in the economy
The nature of the supply of money leads to the cyclical fluctuations in the economy.
When money supply increases, it leads to boom, and when money supply contracts, there
is a slump (sudden or great full) in prices or value or in the demand for goods. In boom
out put, employment and income increases which lead to overproduction. In depression
output, employment and income decline which lead to under consumption.
2. Non-Economic Defects
Money has the following non-economic defects.
a) Money brought down the moral, social and political fiber of the society
The institution of money leads to corruption, turpitude (wickedness), political bankruptcy
and artificiality in religion based on materiality. More over, money is the cause of theft,
murder, deception and betrayal. You can see friends, families and business associated
killed each other for money. For example, the bureaucrat receives money in a form of
corruption, the prostitute sale her body for money, a husband send his wife to work as a
prostitute, a husband send his wife with her children to beg at the road side.

25
 b) Political Instability
Over issue of money leading to hyperinflation which inturn leads to political instability
and downfall of government. As money issued and supplied is more than the depended,
price of goods and services increases, that creates conflict with the government. If supply
of money declines, there will be scarcity of money, which leads to deflation. As the
purchasing ability of the society declines profitability, employment rate, investment, etc,
declines. Thus, such conditions lead the society stand against government which may
finally end up an over through of the government. For example you can take what was
happening in Argentina – three presidents resign within three months.
c) Tendency to Exploit
“Money has enabled strong nations to destroy backward communities to win them on
their side with the help of financial aid” Davenport. Exploitation of human being begins
with the accumulation of wealth with the hand of few and deprivation of the others.
Those who accumulate wealth become rich and others poor. Hence, the rich exploits the
poor. This can be at a country level rich countries exploit poor countries and at an
individual level – rich individuals exploit poor ones. Or you can see what you do to your
servant.

Conclusion
All these defects are not due to money but are the result of the of man towards the use of money.
Money has an immense importance to the present day activity. But its uncontrolled use, instead
of solving, creates many complicated problems. Money acts as a bad master, though it offers
many benefits, if it is handled improperly. Desracli describe this in the following statement.
“Money has made more people mad than love”

1.3 THE DEMAND FOR AND SUPPLY OF MONEY

1.3.1 The Demand for money

This concept represents the amount of money demanded by a given community at a particular
period of time. There are two distinct approaches to the concept of demand for money: the
Classical approach and the Keynesian approach.

The Demand for money

26
 The Classical Approach The Keynesian Approach

Fisher Marshall/Pigou J.M. Keynes

1. The Classical Approach

According to this approach, money is demanded because it serves some purposes. Money has
two purposes or functions.
i. Money acts as a medium of exchange (which is very much stressed by classical
economists)
ii. Money serves as a store of value.

They argued that; people demand money for transaction purposes. That means money is not
required for its own stake but to pay for goods and services and to carry out the economic
transactions over a period of time. They thought that the demand for money was determined by
the total quantity of goods and services that had to be paid for during a given period and on the
velocity of circulation of money. There are two distinct views under the classical analysis:
A. The fisherian view/The transactions balance version
B. The Cambridge economists view/the cash balance version.

The Fisherian View/Approach

It is also referred as the Transactions-Balance version. The demand for money relates to the
amount of money people “have to hold” to undertake a given volume of transactions over a
period of time. Thus the demand for money is determined by three objective factors.
i. the volume of transactions
ii. the average price level per unit of transaction, and
iii. the average velocity of circulation of money
The promoter of this idea, professor Irving Fisher develop a formalistic expression to this
approach in his equation of exchange, also known as the cash-transactions question: MV = PT.
where: M = stock of money

27
 V = velocity of circulation
P = price level, and
T = volume of transactions
Velocity(V) refers to the rate at which money circulated. It is measured as the average number of
times a unit of money changes hands during a year.

In the equation MV = PT, MV represents the supply of money and PT represents the demand for
money in terms of goods and services ready for exchange. Demand for money will be
equilibrium with the supply of money when the economy is under monetary equilibrium.
PT 1
Md = V or MD = V PT where, MD = demand for money i.e. the amount of money
people have to hold.

From this equation we can conclude that the demand for money is inversely related with
velocity(V) and positively related with the supply of goods and services ready for exchange
(PT). That is to say: as velocity increases the amount of money demanded to undertake the same
volume of transaction will decrease. Volume of transaction must be constant, as rate of
circulation of money increases the money demanded for that volume of transaction decreases.
Besides, volume of transaction increases, and velocity remain constant, the money demanded for
transaction increases.
Example: V = 10
V=5
T = 50, 000 units of item or
T = 50, 000 units of items
P = 10. 00/unit
P = 10.00/unit
PT 10.0050 , 000
Md = V  Md = 10 = 50,000.00

or
PT 10.0050 , 000
Md = V = Md = 5 = 100,000.00
or
V = 10
40 , 00010.00
T = 40, 000 Md = 10 = 40, 000.00
P = 10.00

The equation of exchange stresses the role of money in spending not in saving. The demand for
money is defined objectively, in a mechanical sense only, and no attention is paid to the motives

28
behind the demand for money. It assumes that people demand money not for saving but every
thing they get will be spendable which is not true in real life. Fisher considered the demand for
money, from the point of view of the velocity of money (V) rather than the motives of holding
money.
This approach has at leas the following two problems
i. T includes all kinds of transactions
It includes transactions relating to current output as well as transactions relating to just
transfer of capital assets. These transactions just transferred into capital assets will be
recounted. They were counted as an output of a certain company and they will be counted
as an output to the next producer. For example, semi-process items, tools, raw materials,
etc.
ii. The measurement of P(the general price level)
There is no price index comprehensive to measure all transactions of goods and services and
capital assets. Prices may be of retail prices, whole sale price, or the manufacturer’s price.
Therefore, “P” used in the equation does not represent any particular price and there is no
price comprehensive to all and the problem in this equation is which price to take.

B. The Cambridge View/Approach

It is also referred as the cash-balances version. It is developed by Marshall and Pigou. This
version stresses on money as a store of value not as a medium of exchange like the Fisherian
approach.

The total demand for money in the community is, thus, measured by aggregating the individual’s
demand to hold cash balance. The Cambridge approach analyzed the demand for money
according to the choice determined behavior of the people and recognized many factors. Such as
i. Interest rates
ii. Wealth possessed by the individuals
iii. Purchasing power of money, that provides the services of conveniences as well as
security to its holders.
iv. Expectations about future changes in the prices and interest rates tend to affect
individual’s decisions.

29
The approach has an assumption that during short period, these factors remain constant or
proportional to changes in the level of income. Therefore, the total demand for money or cash-
balances is the proportion of the nominal national income. They develop the following formula
to express their assumption.
Md = Kpy
where MD = the demand for money
K = the proportionality factor: - It refers to the proportion of national income that the
people desire to keep in the form of nominal money balances (cash balances)
py = the nominal national income
Therefore, as the nominal national income remains constant the change in the proportionality
factor will change the demand for money. i.e., as the proportionality factor increases the demand
for money also increases and vice versa.

Assume that the nominal national income is Br. 1, 000, 000.00 and the proportionality factor is
10%. Then, the demand for money will be calculated as follows.
Md = Kpy
10
Md = 100 x 1,000,000.00
Md = 100,000.00
As the proportionality factor increases to 20%, while the nominal national income remains
constant, the demand for money will be:
20
Md = 100 x 1,000,000.00
Md = 200,000.00
and the reverse will be true if the proportionality factor decreases to 5%
5
Md = 100 x 1,000,000.00
Md = 50, 000.00
2. The Keynesian Approach
It is also referred as the cash balance or liquidity preference approach. It is developed by John
Maynard Keynes and those who follow his approach are referred as Keynesians.

This concept is associated with the Keynesian analysis of the demand for money. It is an
extension of the Cambridge economists-view-the cash-balances approach and stresses the asset

30
role (i.e., the store of value function) of money. To Keynes-demand for money does not mean the
actual money balances held by the people, but what amount of money balances they want to
hold.

Money is not just meant for spending but to hold. Money can be held as a form of wealth or
asset, as the most liquid asset which is readily used for payment in the exchange process. Hence,
money being the most liquid asset, can serve as an efficient store of value; so it is demanded for
its own sake. In this sense, the demand for money is the inverse of the velocity of circulation.
Velocity of circulation refers to the rate of changing hands through spending but the liquidity
preference is a store of value.

Therefore, the demand for money, in the Keynesian sense, is a demand for liquidity or “liquidity
preference”. Hence, the modern approach is designated as the cash balance or liquidity
preference approach.

Keynes distinguished three motives which induce people to hold money. They are: the
transaction motive, the precautionary motive and the speculative motive. Corresponding to these
motives, Keynes separated the demand for money into three parts as: the transaction demand, the
precautionary demand and the speculative demand for money. The total demand for money,
hence, implies total cash balances. Total cash balances can be classified in to two parts as the
active cash balance and idle cash balance.

Active cash balances

It is related with the demand for money held under transactions motives demand precautionary
motive/demand for money.

i. Transactions demand for money

This is related with the primary functions of money – as a medium of exchange. Individuals
do not receive money income as frequently as they make payments. Thus, when income is
received at a discrete intervals of time, but is paid out more or less continuously against the
exchange of goods and services, it is inevitable that people should need a certain stock of
money all the time in order to carry out their transactions.

31
Keynes defines the transaction demand for money as “the need of cash for the current
transactions of personal and business expenditure”. Personal expenditure referred as income
motive and the business expenditure as business motive.

The Income Motive

Consumers hold money balances to facilitate their day-to-day purchases of consumption

goods. By keeping cash-balances they tend to bridge the gap of time interval between
receipts of incomes and its disbursement. The consumer’s / individual’s demand for money,
depends upon the following factors.
a) The level of income: -The
-The rich man tends to hold more money balances for transactions
purposes than the poor does.
b) The Price level: -During
-During inflation or as price rises, the consumer’s transactions demand
for money tends to rise, corresponding to the rising price level. The higher the price, the
lower the purchasing power of money will be. Hence, to fulfill the daily transaction
requirements more money is required by the consumer.
c) The spending habits: -A
-A spend thrift need more transactions demand for money than a
saver does.
d) The time-interval: -The
-The time-gap involved between the receipts of successive income
flows and the corresponding expenditure. As the time gap increases, more money is
demanded to spend throughout that time period than when the time gap is short. You can
take yourself as an example. You are receiving your salary every month. You need a
certain sum of money to spend it throughout that period. But, instead assume that your
payment is made every two months not every month. Now you need more money to
spend throughout the two months time than you were demanding to spend in a month
time.

The Business Motive

This refers to the transactions motive to the entrepreneur class or business community.
Business persons require money balances in order to meet business expenses. Money
balances held under this motive will depend on the turnover of the firm. The larger the
turnover, the larger will be the demand for money. Thus, the amount of money balances held

32
 under the transactions motive will depend on the time and size of the firm’s incomes, and the
turnover of business.

For example, money demanded for the transactions motive will rise as income of the firm
increases, during business prosperous, festive seasons, vacation periods busy seasons and
after harvest. Money demanded for the transactions motive declines in the slack season.
The trends of a community’s aggregate demand for money, under the transactions motive,
depicts a high degree of correlation of proportionality to the size of money of national
income which can be represented as Lt = f(y)
where L – the transactions demand for money, and
y = the level of national income.
Hence, as national income increases, the transactions demand for money will increases and vice
versa.

ii. Precautionary Demand for money

People generally desire to hold some additional money balances against unforeseen
contingencies. They keep some liquid reserves or cash balances to provie for unexpected
contingencies such as illness, accidents unemployment some ceremonial occasions, etc. The
amount of money demanded here will be devoted to fulfill the functions of a store of value.
The precautionary demand for money depends largely on the uncertainty of future receipts
and expenditures. It is sensitive to the anticipation of the level of income and hence it is
income-determined and is relatively stable. As income increases the cash balance set aside
for precautionary purpose also increases. It can be depicted with a formula as follows
Lp = f(y) where : - Lp = precautionary demand for money
y = national income
Finally, the demand for active cash balances (transaction demand for money and
precautionary demand for money) is a function of income. It will rise as income level
increases and decrease as income decline.

LA = Lt + Lp  LA = f(y)
where LA = Active cash balance

33
 Lt = Transaction demand for money
Lp = precautionary demand for money
y = national income
y
LA
Demand for money

(Lt + Lp)

B
A

x
0
y1 y2

Income

When income level is 0y1; the demand for money will be 0A, and when income level
becomes 0y2, the demand for money will be 0B. This shows that the transactions and
precautionary demand for money are income determined, more or less interest in elastic and
relatively a stable phenomenon.

iii. Idle cash balances / the speculative demand for money

The speculative demand for money represents the demand for cash for being invested rapidly
as and when attractive opportunities for monetary investments appear.
The speculative money, in fact, confines itself to the store of value property of money.
Money held under the speculative motive constitutes a store of value, a liquid asset, which
the holder intends to use for gambling or to make a speculative gain, example, investment in
securities at an opportune moment.

One has to pay an opportunity cost for preserving liquidity in terms of the yield forgone. The
yield-forgone in keeping cash balances is usually measured in terms of prevailing market rate
of interest. The rate of interest is the cost of being liquid.
In holding the active cash balances, the main consideration was convenience, and
prudence/showing carefulness and foresight, avoiding rashness. But list consideration for the
rate of interest. Whereas, in the holding of idle cash balances, much attention is paid to the

34
 rate of interest because these balances are held for income earning purposes of speculative
activity. The amount of money held under speculative motive depends upon the rate of
interest. When people expect interest rate rises and the prices of fixed income-yielding assets,
like bonds, to fall, more balances will be held in cash. Then the idle cash balance will be
invested in the future in such instruments that attract higher income than investing on such
instruments with lower prevailing interest rate. If people expect the rate of interest to fall and
prices of bonds to rise, there will be an increased tendency to hold bonds, and other near-
money assets than cash. In this assumption, the rate of interest at present is greater than the
future expected rate of interest, hence, its income at present is higher than its income in the
future. Thus, the speculative demand for money will be less. In other words, at the time rates
of interest is low, people prefer to hoard their money rather than use it to buy securities and
vice versa. Thus, the bond or securities price and interest rates always move in opposite
directions.

When interest rates rise, bond or security prices fall and when interest rates fall, bond or
securities prices rise. The reason for this inverse relationship lies in the fact that securities
prices (and also of all capital values) actually are the present (capitalized) value of the future
flow of income, discounted at the market rate of interest for the type of investment involved.
y
This can be depicted with the formula “V = i ” where ‘V’ denotes the present value of the
future income generated from security, ‘y’ stands for the future income per annum and “i” is
the market rate of interest.

Illustration
1st 2nd
Invested amount in bonds = Br. 1, 000.00 = Br. 1,000.00
Yielding annual interest rate = 6% = 6%
6
Yearly earning of the bond = 60.00 (1,000 x 100 ) = 60.00
Market rate of interest = 6% = 10%
Yearly earning of the market = 60.00 = 100.00
The present value of the future income
generated (V) =
y
i V=
y
i
 60.00
0.01 = 600.00
Br. 600.00 will be the price of
the bond as the market interest
rate rises from 6% to 10%. 35
Hence no one is gaing to buy the
bond for Br. 1,000.00
 60.00
= 6%

100
= 60.00 x 6

= 1000.00 the price of the bond

When the market interest rate is high, speculative cash balances are minimal and when the rate of
interest is low, the demand for speculative balances may become insatiable (unable to be
satisfied).
The idle cash balances or speculative demand for money is interest elastic, income determining
and very sensitive and fluctuating.

Total Demand for Money

The community’s total demand for money depends on the transaction and precautionary motives
and the speculative motive. In other words, it is equivalent to the active cash balances (L 1) plus
the idle cash balances (L2).
L = L1 + L2
where: L = stands for an overall demand for money (Active + Idle balance)
L1 = f(x)
L2 = f(I)
L = f(x, I)
This means that the community’s overall demand for money depends upon the level of national
income and the rate of interest.

1.3.2 The Supply of Money

Money supply refers to the amount of money which is in circulation in an economy at any given
time. In a broader sense, money supply refers to the total stock of domestic means of payment
which is held by the public. The public refers to individuals, business firms, state and local
government bodies, etc. Other than state treasury, central bank and commercial banks which are
referred as being money creating agencies. It is also known as money stock or stock of money or
quantity of money.

Money supply has two different concepts: stock and flow concepts. In its stock concept, money
supply is viewed at a point of time and it refers to the total of currency notes, coins and demand

36
deposits. Whereas, in its flow concept, money supply is viewed over a period of time. It is
money spendable as well as re-spendable. It is associated with the velocity of circulation of
money. The Fisher’s MV represents the flow of money supply over a period of time.
There are three alternative views regarding the definition or measures of money supply. They
are:
1. The Traditional Approach (M1)
This definition of money supply includes any asset (cash, traveler’s checks, and checkable
deposits of depository institutions) that is a generally acceptable medium of exchange. This
definition is a narrower definition and stresses the medium of exchange function of money.
The money supply is composed of:
a) Currency money and legal tenders i.e., coins and currency notes in the hand of the public.
This is referred as a high-powered money.
b) Demand deposits and other checking accounts that allow unlimited transfer of funds from
one financial institution to another. Such as checkable deposits at commercial banks,
checkable deposits at credit unions and thrift institutions, and traveler’s checks
outstanding. It is referred as secondary money.
2. Modern Definition (M2)
The M2 money supply emphasizes the role that money plays as a “store of value”. Thus it
includes both savings accounts in which customers may store idle cash to earn interest before
they spend it and the M1 money supply that can be spent immediately. In other words, M 2
includes M1 + non checkable savings accounts and small denomination time deposits (have
short period life) at depository institutions, money market deposit accounts, shares in money
market mutual funds, and retail repurchase agreements. It is a broader definition than M1.
3. The modern approach (M3)
This is associated with Gurely and show definition of money. This is also related with the
concept called “divisia money” which weights various types of financial assets according to
their degree of “moneyness” and sums them up to try to determine how much money people
will think they have when it comes time to spend it. For instance, savings deposits with early
withdrawal penalties may have less effect on consumer spending behavior than holdings of
money in checking accounts, so the savings deposits will be relatively less important and
thus, have less weight in “divisia money” calculations. For instance, cash and non interest –

37
 paying checking account deposits might have a 100 percent weight, while savings accounts
that require a passbook to make withdrawals might have a 10 percent weight and checkable
interest – paying savings accounts might have a 50 percent weight when determining the
magnitude of the “divisia” money supply that influences people’s current spending.

It includes M2 + large – denomination time deposits at depository institutions shares in

institution – only money market funds, and large – denomination repurchase agreements,
banker’s acceptances, commercial paper, short term treasury securities, bonds and equities,
etc.

Determinants of Money Supply

Chandler states that the major determinants of the quantity of money in an economy are:
1. The size of the monetary base
2. Community’s choice to hold currency and deposits
3. Extent of monetization
4. The cash reserve ratio
5. Government budgetary policy of monetary financing
These will be discussed one by one as follows.

1. The size of the monetary base

It refers to the group of assets which empowers the monetary authorities the central bank – to
issue high-powered money (the currency money) for the use in the economy from time to
time. Money supply varies directly in relation to the changes in this base. The monetary base
is composed of
a) Monetary gold stock
b) Reserve assets including government securities, bonds and bullion foreign exchange
reserve, etc.
c) Amount of central bank credit when central bank increases its loans and investments,
it makes payments to borrowers or sellers of securities, the volume of money in
circulation increases.

2. Communities choice to hold currency and deposits

38
 The relative amounts of cash and demand deposits which the community wishes to hold have
a great significance. If payment is made through demand deposits (cheques) rather than by
cash, then the total volume of money that will be maintained by a given monetary base will
be larger. This is because with a limited volume of cash/currency deposited in a bank, many
cheques and cheques with higher values can be issued. Thus, the money supply in a highly
monetized society will be higher than the money supply in a less monetized society.
3. Extent of Monetization
Monetization refers to the use of money in the system of exchange in an economy. A barter
economy is a non-monetized economy. A fully monetized economy needs more money
supply than a partially monetized economy of the same order.
4. Cash Reserve Ratio
This refers to the ratio of bank’s cash holdings to its total deposit liabilities. It is customarily
or statutory fixed by the central bank. It is also referred as required reserve ratio or reserve
deposit ratio. As cash reserve ratio increases the reserve amount increases and the excess
reserve decrease. The excess reserve is the basis for credit creation of a banker. Hence, as
excess reserve decreases the credit creation capacity of the bank and the money supply
decreases and vice versa. The excess reserves are important for the determination of the
money supply. The excess reserve is influenced through: open market operations and the
discount rate policy.
a) Open market operations
Open market operations refers to the buying and selling of securities in the money and
capital markets – (this will be discussed in the future in this same material).
When central bank sells securities in the open market the buyer of the security pays with
cheques drawn on a specific banker. Therefore, the level of the bank’s reserve will
contract. In other way, when central bank purchases securities in the open market, it
pay’s with cheques drawn on commercial banks. This expands the level of bank reserves.
b) The Discount rate policy
High discount rate means that commercial banks get less amount by selling to the central
bank. The commercial banks, in turn, raise their lending rates to the public thereby
making advances dearer for them. As the rate raise, customers will be reluctant to borrow

39
 at a higher rate. Thus there will be contraction of credit and the level of commercial bank
reserves. The opposite is the case when the bank rate is lowered.
Discount rate  cost of credit credit
credit in
in commercial bank reserves
Discount rate  cost of credit  credit  in commercial bank reserves
5. Government budgetary policy of monetary financing
The government can borrow from the banking and non-banking sources. When government
borrow’s directly from the non-banking sources (the public) it pumps out money from the
public and money supply with the public may shrink initially, but when spent by the
government money pumped into the public and the money supply will increase again. When
the government restores to the banking sector and borrows from the banking system to spend
it leads to a creation of demand deposits in favor of the government treasury in exchange for
government securities. The net central bank credit to the government is termed as deficit
financing. Profit (revenue) by government activities reduce money supply which reduces the
bank reserves there by contract credit creation and causes a decrease in money supply.

The effects of treasury’s fiscal operations on the money supply may be summarized as:
a) The collection of taxes or the sale of securities to the public directly reduces the money
supply with the public to the extent of the amount involved.
b) When the treasury spends money by drawing cheques upon its balances with the central
bank, the money supply with the public and the cash reserves of the commercial banks
will increase.
c) A favorable budgetary policy by the government will reduce the money supply and a
deficit budget will increase the money supply with the public.
d) Deficit financing always leads to an increase in the money supply, which usually has an
inflationary impact.

Creation of Money: Changes in money supply

Changes in money supply arises out of the action of the treasury, the central bank and the
commercial banks or in general the money creating agencies. Money supply, in reality, consists
of debts of the money creating agencies. The two important agencies in the structure of money
creation are:

40
1. Commercial Banks
They are the creators of the largest element of the money supply through the creation of
demand deposits. When a bank lends or advances credit to customers, it does not usually give
direct cash but opens an account in the customers name and issue cheques in his name (the
borrower’s name). The borrower can effect payments through cheques without using
cash/currency.
2. The Central Bank and State Treasury
The Central Bank can influence the reserve funds of the commercial banks and their credit
creating capacity through the bank interest rate or discount rate, open market operation and
required reserve ratio. When bank rate is lowered, open market purchase polity is pursued
and reserve ratio is decreased, the reserve funds of the commercial banks swell, and their
lending capacity increases and credit expands. The reverse will be true when bank rate rises,
open market sale policy is pursued and reserve ratio is increased.

Check Your Progress Exercises

1. What are the main functions of money?

………………………………………………………………………………………………
………………………………………………………………………………………………
2. What is the difference between barter economy and monetary economy?
………………………………………………………………………………………………
………………………………………………………………………………………………
3. What are the role of money and its defects?
………………………………………………………………………………………………
………………………………………………………………………………………………
4. Discuss about the types of money.
………………………………………………………………………………………………
………………………………………………………………………………………………
5. Discuss the different theories under the demand for money?
………………………………………………………………………………………………
………………………………………………………………………………………………

41
 6. What is /are the determinant factor(s) of price under the Cambridge version?
………………………………………………………………………………………………
………………………………………………………………………………………………
7. What is/are the determinant factor(s) of price under the Friedman’s version?
………………………………………………………………………………………………
………………………………………………………………………………………………
8. Discuss the different factors that determine the supply of money.
………………………………………………………………………………………………
………………………………………………………………………………………………
9. What is transaction demand for money? Discuss
………………………………………………………………………………………………
………………………………………………………………………………………………
10. What are the main determining factors of price and value of money as to Keynes’s Income
and expenditure?
………………………………………………………………………………………………
………………………………………………………………………………………………

1.4 SUMMARY

Money functions as a generally acceptable medium of exchange, a store of value and a unit of
account. There are various types of money, ‘including full-bodied money, representative money,
fiat money, convertible paper money, inconvertible paper money and credit money (which
includes checking deposits at financial institutions and drafts).

Money is important because it simplifies the exchange of goods and services and because
changes in the money supply can affect the level of economic activity and the rate of inflation.
The money supply is regulated by the monetary authorities. The quality of money demanded by
the society depends on different factors such as the transaction motive, the precautionary motive,
the speculative motive. The money supply is also depends on such factors as: the monetary base,
the community’s choice, cash reserve ratio, level of monetization, governments budgetary
policy.

42
1.5 ANSWERS TO CHECK YOUR PROGRESS

1. Refer section 1.2.4 5. Refer section 1.3.1

2. 1.2 6. 1.3.1
3. 1.25 7. 1.3.1
4. 1.2.2 8. 1.3.2

1.7 KEY TERMS

Barter economy Transaction motive

Monetary economy Precautionary motive
General acceptability Speculative motive
Medium of exchange Active cash balance
Store of Value Idle cash balance
Unit of account M1
Full-bodied money M2
Representative money M3
Convertible paper money Near money
Inconvertible paper money
Fiat money
Credit money
Legal tender

43
UNIT 2: THEORY OF MONEY AND PRICES

Content
2.0 Aims and Objectives
2.1 Introduction
2.2 Theory of Money and Polices
2.2.1 Quantity Theory of Money
2.2.2 Comparison between the Transactions and Cash Balance Approach
2.2.3 Keynes’ Income and Expenditure Theory
2.3 Summary
2.4 Answers to Check Your Progress
2.5 Key Terms

2.0 AIMS AND OBJECTIVES

At the end of this chapter, you are expected to:

 define the relationship between money and price
 identify the determinants of price and approaches used to define money and price
 understand the different factors that determine the value of money.

2.1 INTRODUCTION

This unit focuses on the relationship between the quantity of money and price. It discusses the
determinant factors of money supply and change in price and value of money. Supply of money
and price are positively related whereas supply of money and value of money are inversely
related. This will be discussed throughout this unit.

2.2 THEORY OF MONEY AND PRICES

The theory of money and prices is discussed through two different theories or approaches which
are going to be discussed as follows.

44
2.2.1 Quantity Theory of Money

The Quantity Theory of money is the oldest and has been the most influential theory to explain
the determination of the value of money at any one time and variations of this value over periods
of time. The originator of the idea was Davenzath – the Italian writer. David Hume’s was the one
who was make it accepted in the classical thinking. He mentioned that “prices are proportional to
the plenty of money supply.” The price level varies in direct proportion to the supply of money
and the value of money varies in an inverse proportion to the supply of money. As money supply
increases, price of goods and services rises and value of money declines and as quantity of
money declines, prices of goods and services decline but the value of money rises.

The value of money is meant the purchasing power of money over goods and services in a
country. This value of money may be an internal value i.e., over domestic goods and services or
an external value i.e., over foreign products.

There are two approaches to the traditional quantity theory of money. They are:
a) The cash transaction approach
b) The cash-balance approach

a) The Cash-Transaction Approach

It is also known as Fisher’s quantity theory of money. In this theory Fisher argues that “Other
things remaining unchanged, as the quantity of money in circulation increases, the price level
also increases in direct proportion and the value of money decreases and vice versa”. To explain
his concept, Fisher develops an equation known as “the equation of exchange”.
MV = PT  represents only currency money
MV + M1V1 = PT  includes bank money with currency money
where: P = Price level or 1/p = the value of money
M = the total quantity of legal tender money
V = the velocity of circulation of M
M1 = the total quantity of credit/bank money
V1 = the velocity of circulation of M1
T = the total amount of goods and services charged for money or transactions performed
by money.

45
 This equation equates the demand for money (PT) to supply of money (MV + M1 V1).
MV + M1 V1 = PT
MV  M V 
P=
T
Price level (P) varies directly as the quantity of money (M + M 1) provided the volume of trade
(T) and velocity of circulation (V&V1) remain constant. Price level (P) varies inversely as the
volume of trade(T) increases provided that the quantity of money (M + M 1) and the velocity of
circulation (V & V1) remain constant.

This relationship between quantity of money supply and price level and value of money can be
graphically depicted as follows:

P = f(m) P = Price
P1 1 1
P /p = value of money
Value of money
Price level

P2 1
P2

P4 1
p4 1
P = f(m)
M M2 M4 M M2 M4 M5
Quantity of money Quantity of money

1. Assumptions of the Theory

In this theory Fisher assumes the following points
i) P is a passive variable in the equation of exchange which is affected by the other factors
ii) The proportion of M1 to M remains constant because M1 depends on the commercial bank’s
credit creation activity which in effect is a function of the currency money (M).
iii) V and V1 are assumed to be constant and are independent of changes in M and M 1. Because
V depends upon outside factors such as payment habits of individuals and commercial
customs, density of population and development of transportation.
iv) T also remain constant and is independent of other factors such as M, M 1, V and V1. ‘T’
depends upon natural resources, technological development, population, etc which are
outside the equation.
v) It is assumed that the demand for money is proportional to the value of transactions

46
 vi) The supply of money is assumed as an exogenously determined constant
vii) The theory is applicable in the short period analysis
viii) It is based on the assumption of the existence of full employment in the economy.

2. Criticisms of the Theory

This theory is highly criticized by other scholars and economists. The criticisms made are
presented as follows.
a) It is just a mathematical truism
It is a statement of an obvious fact, because it states that money given in exchange for a
good is equal to its price or value. It does not state anything about money or prices or does
not indicate which is the cause and which is the effect. Which comes first and which
follows? The answer/response is not given by this equation.
b) Other things are not constant or equal
His assumption is based on – “other things remain constant or unchanged”. But in real life
nothing is constant and they are not independent. Consequently, as money supply changes,
price changes and as price changes total volume of transaction (T) will increase.
c) The velocity of circulation of money (V) may not be a constant factor
Fisher regards V as independent and constant. However, in practice nothing is independent
and constant. Hence, V may vary with the volume of trade (T), price level (P), volume of
money (M), density of population, development of transportation and payment habits of
individuals and commercial customers. M being constant V may increase causing the price
level to rise.
d) There is Technical inconsistency
Multiplying M and V is not correct because they represent different concepts. That is M
relates to a point of time which is the static or stock concept and V relates to a period of
time which is a dynamic or flow concept. Therefore, it is technically inconsistent to
multiply two non-comparable factors.
e) The assumption of full employment is unrealistic
Full employment refers to a situation where all resources in an economy are fully utilized.
However, this is a rare possibility in a modern society. When there are unemployed
resources in the country, changes in M may not affect P as T also changes. Every increase
in the money supply would lead to an increase in real income or output.

47
f) The ultimate determinants of the value of money lie behind the equation of exchange and
not in it.
According to Chandler M, V and T are an immediate determinants of P but they are in no
sense its ultimate determinants rather they are themselves determined by other factors.

For instance M and M1 are determined by the size of the monetary base, the community
choice to use cash or cheques as a means of payment, cash reserve ratio, level of
monetization and government budgetary policy.

T is also determined by the factors endowments in the country (availability of natural

resources), the quantity and quality of population, the state of capital formation, the state of
technological advancement, the extent of employment in the economy, transportation and
communication network, mobilization of savings and investment in the economy,
development of trade and commerce, growth of money and capital markets and the extent of
monetization and existence of barter.

V also depends on price level, quantity of money, total transaction or value of goods,
development of transportation, density of population and payment habits.
g) The approach is mechanical and lacks human touch
In the equation, there is no scope for the decision of consumers and producers about saving
and investment. The human element is absent in the equation. If money supply increases,
there is no guarantee that expenditure will also increase. In fact, it is the expenditure that
determines the price level.
h) The theory neglects the role of interest rate
Mrs. Robinson has stated that “changes in the quantity of money are of utmost importance,
but their importance lies in their influence upon the rate of interest and a theory of money
which does not mention the rate of interest, is not a theory at all. “The relationship between
the quantity of money and the price level is indirect. As money supply increases, the interest
rate declines and investment, consumption, and employment increases. As money supply
decreases, the interest rate increases, investment, consumption, and employment declines.
Hence the role of interest rate is great in affecting the elements of the equation of exchange.
i) The theory is a weak theory
According to Crowther it is weak in money respects

48
 a) It cannot explain why there are fluctuations in the price level in the short run.
b) It gives undue importance to the price level as if changes in prices were the most critical
and important phenomenon of the economic system.
c) It places a misleading emphasis on the quantity of money as the principal cause of
changes in the price level during the trade cycle. As quantity of money increases, price
may not increase and fall in price is not due to decrease in quantity of money during
depression and as quantity of money increases, prices may not decrease and rise in price
is not due to increase in quantity of money during boom or prosperity.
j) The equation neglects the store of value function
The equation concentrates on the supply of money and assumes the demand for money to be
constant. It neglects the store-of-value function of money and considers only the medium-
of-exchange function of money and everything gained by an individual is spendable not for
storage.
k) Neglects real balance effect
The theory fail to make use of the real balance effect i.e., the real value (purchasing power)
of cash balances. As price falls; the real value of cash balances rise and spending
consumption, income, output and employment in the economy increases.
l) The theory is static
It has a static assumption saying that every thing remains constant. Therefore, it is incapable
to modern dynamic conditions.

b) The Cash-Balance Approach

This is developed by the Cambridge economists, Marshall, Pigou, Robertson and Keynes and is
referred as the Cambridge version.

The cash-balance approach states that the value of money depends up on the supply of and the
demand for money. The variations in its value through time arise out of the changes in either its
supply or its demand or both. The basic postulate of the cash-balances theory is that the
community’s demand for money or cash-balances, induced by the transactions and precautionary
motives, constitutes a certain proportion of its annual real national income which the community
desires to hold in the form of money.

49
People in a community fix the amount of purchasing power that they wish to hold in the form of
money. They there by determine the aggregate purchasing power of the money supply. Supply of
money remains constant, the value of money depends upon the changes in the demand for
holding money or cash balances. As the demand for money increases, the demand for goods and
services decreases and so does the price level but increase in the value of money. As demand for
money decreases, the demand for goods and services and the price level will increase but the
value of money fall. The concept of velocity is discarded in this approach because it obscures the
motives and decisions of people behind it. This approach considers the demand for money not as
a medium of exchange but as a store of value. Robertson expressed this distinction as money “on
the wings” and money “sitting”. Money on the wings represents the medium of exchange and
money sitting represent the store of value function of money.

The Marshallian Equation

Marshall in his equation M = KPY defines the relationship between money supply and other
factors.
M = KPY
where M = stands for the quantity of money (currency + demand deposits)
P = refers to the price level
Y = denotes aggregate real income
K = is the fraction of the real income which people desire to hold in money form, as
ready purchasing power.
As K increases while other factors remain constant M will increase and as K remain constant and
PY increases, M will increases and vice versa. Hence, the supply of money is directly and
positively related with both K and PY. The value of money is the inverse of P, and is defined as
1
/p. Thus the equation M = KPY can be processed as
M = KPY
1
M=K p y
MP = KY
1 1
M x MP = Ky x m

Ky
P= M  The value of money equation.

50
 Therefore, when Ky remain unchanged. If M increases, the value of money decreases and if M
decreases, the value of money increases. When M and y remain constant, if K increases, the
value of money will increase and if k decreases, the value of money will decreases. Thus, M and
P (value of money) are inversely related and Ky and P(value of money) are positively related.

Pigou’s Equation
KR
His equation states as follows: P =
M
where P = represents the purchasing power of money (i.e., the value of money. It is the inverse of
P in the sense of price level.)
R = represents the total real income expressed in terms of any particular commodity
enjoyed by the community at any given period of time.
K = represents the proportion of real income (R) held by the people in the form of legal
tender (i.e., cash balances) commanding some real resources.
M = denotes the number of units of legal tender (or total money stock i.e., cash)
Pigou’s main emphasis is on K rather than M for explaining changes in the value of money.
The above equation is extended further to include the bank money component in the demand for
money, thus;
KR
P= {c + h (1-c)}
M
where c = the proportion of cash which people keep as legal tender.
1-c = implies the proportion of bank balances held by the people.
h = is the proportion of legal tender to deposits held by the banks.

In the equation k, c, h are all positive constants, being less than one but more than zero. If c and
h to be constant p varies directly with k or R or both and inversely to M.

When the value of money is less in real terms, people have to hold more money to represent a
specific amount of real goods and services under the transactions and precautionary motives.
P(purchasing power)

Q1 Q Q2
D

51
 P1 c
M = F(KRP)
M
P a D= = KR = a2
P
P2 b
D

M1 M M2
Quantity of money

Pigou’s cash-balance theory

On the basis of this equation, the value of money varies because people have a varying use for it.

Robertson’s equations
D.H. Robertson has developed the following equation
M
P=
KT
where P = Price level of things included in T
M = the supply of money
T = total amount of goods and services to be purchased during a year (i.e. the annual
volume of transactions)
K = fractional part of T over which people wish to hold command in the cash form.
Price level(p) inversely varies with KT ad positively related /varies with money supply. As K or
T or both increases while M remain constant, price level (p) decreases and vice versa and when
(M) money supply increases as KT remain constant, price level (P) increases and vice versa.

MV
This equation is similar with the Fisher’s cash transactions equation P = where P, M, T are
T
more or less the same in both cases and V is a reciprocal of K i.e., V = 1/k. This indicates that the
opposite of spending (V) is storing (K). As your spending increases, your saving decreases and
vice versa.

52
The difference between the Robertson’s and Fisherian equations lies on the fact that, the cash
transactions equation considers the spending of money and the Robertson equation takes into
account the holding (not spending/of money.)

Keynes’ Real Balance Equation

His equation is called the real balance quantity equation which is depicted as follows
n
P=  n = pk
k
where n = is the quantity of money in circulation
p = is the price of a consumption unit
k = refers to the real balance (the number of consumption units in the form of cash)
The bank deposits component of money supply was also considered as follows
n n
P= + rk1  n = P(k + rk1)  p =
k (k  rk )

where r = cash reserve ratio

k1 = the real balance held in the form of bank money
If k, k1 and r are constant, P will change in exact proportion to the change in n. As n remain
constant, p will change in the indirect or inversely to the change in k, r and k1.

He concluded that, the cash-balances (k) is outside the control of the monetary authority hence p
can be regulated by controlling n and r. k1 is also possible to be regulated by appropriate changes
in the bank rates. So p can be controlled by making appropriate changes in n, r and k 1 so as to
offset changes in k.

1. Critisms of the Cash Balance Approach

The cash balance approach is criticized by other economists including Keynes in his study
income and expenditure theory. These criticisms are presented as follows.

a. Mathematically truism
Take any Cambridge equation, it establishes a proportionate relation between quantity of
money and price level.
Marshall’s equation  P = M/Kt
Pigou’s equation  P = M/KR

53
 Robertson’s equation  P = M/KT
Keynes’s equation  P = n/K.
b. Price level doesn’t measure the purchasing power
Measuring the price level in consumption units implies that cash deposits are used only for
expenditure on current consumption. But in fact they are held for “a vast multiplicity of
business and personal purposes.”
c. Neglects other factors
It does not tell about changes in the price level due to changes in the proportions in which
deposits are held for income, business and savings purposes. It tails to analize variations in
the price level due to savings. Investment inequality in the economy. It also fails to consider
the effect of the rate of interest which exerts a decisive and significant influence upon the
price level. Demand for money is not interest inelastic.
d. K and Y are not constant
Assuming k and y as constant is unrealistic, because it is not essential that the cash balances
(k) and the income of the people (y) should remain constant even during short period.
e. Fasils to explain dynamic behavior of prices
The theory argues that changes in quantity of money will influence the general price level
equiproportionally. The fact is quantity of money influence the price level in an “essentially
erratic and unpredictable way.” In addition, it fails to measure the extent of change in the
price level as a result of a given change in the quantity of money in the short period.
f. Neglects real balance effect
The real balance effect shows that a change in the absolute price level does influence the
demand and supply of goods. The absolute price level in the economy is determined by the
demand and supply of money and the relative price level is determined by the demand and
supply of goods.

2.2.2 Comparison between the Transactions and Cash Balances Approaches

There are certain similarities and dissimilarities between the two approaches:
1. Similarities
The two approaches have the following similarities

54
a. Same conclusion
Both approaches conclude that the quantity of money and the price level are directly and
proportionally related and an inversely proportionate relationship between the quantity of
money and the value of money.
b. Similar equations
MV M
Fisher’s equation p = and Robertson’s equation P = are similar. The difference
T KT
lies between k and V which are reciprocal to each other. i.e., k = 1/v or V = 1/k where V
represents the rate of spending and k represents the rate of holding (not spending). The
difference can be reconciled by substituting 1/V for k in the Robertson’s equation and 1/k for V
in the Fisher’s equation.
c. Money as the same phenomenon
The total quantity of money in all equations may be referred with different symbols but refer
the same phenomenon. Under Fisher’s equation total quantity of money is represented by
MV + M1V1, under Pigou’s and Robertson’s equation with M and under Keynes’ equation
with n.
2. Dissimilarities
The two approaches have the following dissimilarities
1. Functions of money
The two approaches emphasize on different functions of money. The transactions approaches
emphasize on the medium of exchange and the cash-balances approach emphasize on the
store of value function.
2. Flow and stock concepts of money supply
The two approaches have different concepts regarding supply of money. Hence, the
transaction approach has a flow concept. Which is related to a period of time and the cash-
balances approach as a stock concept which is related to a point of time.
3. Differences in approach and emphasis on V vs K
The meaning given to the two symbol V and k in the two versions is different. In Fisher’s
equation V refers to the rate of spending and emphasizes the transactions velocity of
circulation. Whereas in Robertson’s equation k refers to the cash balances which people wish
to hold and emphasizes the velocity of income.

55
 4. Nature of price level (P)
The meaning of p given under the two approaches is different. In Fisher’s equation p refers to
the average price level of all goods and services and in Cambridge equations p refers to the
prices of final or consumer goods.
5. The Nature of T
The nature of T under the two approaches is different. In Fisher’s equation, T refers to the
total amount of goods and services exchanged for money and in Cambridge versions, T refers
to the final or consumer goods exchanged for money.
6. Emphasis on supply and demand for money
The two approaches differ in emphasis on either supply or demand for money. Fisher’s
approach emphasize the supply of money and the Cambridge approach emphasizes both the
demand for money and the supply of money.
7. Different in Nature
The two approaches are different in nature. The Fisherian version is mechanistic because it
does not explain how changes in V bring about changes in p. The Cambridge version is
realistic because it studies the psychological factors which influence K.
Hence, the Cambridge cash balances approach to the quantity theory of money is superior to
Fisher’s transaction approach in many respects.

2.2.3 Keynes’ Income and Expenditure Theory

The income theory was developed by Tooke, Wicksell, Aflation and Keynes. The quantity theory
of money establishes a direct relationship between the money supply and the aggregate demand.
As money supply increases, the aggregate demand for goods and services and the price level will
increase and vice versa.

According to Keynes and his associates change in income not money supply will bring change in
the aggregate demand and price level.

As income increases, the aggregate demand for goods and services and price of goods and
services increases and as income decreases, the demand for goods and services and the price
level decreases/decline.

56
The level of income depends upon the volume of saving and investment in the economy.
Besides, the change in the price level or value of money are caused by the income and
expenditure of the community or by the volume of saving and investment.

Income-Expenditure Approach
The income theory of prices involves on the one hand an analysis of income and aggregate
demand and on the other on analysis of costs and aggregate supply. Prices are determined by
money income and real income

The total money income (y) is the value of goods and services produced in any period of time
and expressed in terms of money. It is the remuneration paid to factors of production in terms of
money. It is also referred as total expenditure (E) incurred on goods and services during a period.
The real income is the total value of real goods and services produced in any period. It is
determined by the total money value of goods and services expressed in terms of a general price
level of a particular year taken as the base. The money value of real income is the money income
which is determined by the prices of goods and services or output.
Total Income (y) = Total expenditure (E)
Total expenditure = consumptions expenditure (c) + Investment expenditure (I)
Y = E(C + I)
Y=C+I
The income theory states that the increase in the quantity of money depends upon increase in
money income and aggregate expenditure, and prices start rising when the full employment level
is being reached. Once the full employment level is reached, prices rise in the same proportion as
the increase in money income and aggregate expenditure. Up to the level of full employment, as
income increases, investment increases, employment increases and expenditure increases and
price remains relatively stable. But after full employment, as money income increases,
investment, employment, and expenditure remain relatively constant and hence price alone rises.
Money income depends upon relation between saving and investment.

Saving-Investment Approach
The income-expenditure approach (y = C + I) is the same as the saving-investment approach
(S = y – c)

57
where s = savings
y = Income
c = consumption
S and I are both the excess of income over expenditure (consumption y–c)
S=y–c y=c+I
I=y–c s=y–c
Therefore S = I I=y–c
If saving and investment are equal, there will be the equilibrium level of income and the price
level will be stable. If saving and investment are disturbed, the price level also changes via the
change in expenditure.

If saving is greater than investment, expenditure on goods and services of the people reduce,
people hoard more money and spend less, reduction in the income of producers of goods and
services, lead to a fall in the price level, leads to fall in investment due to fall in marginal
efficiency of capital and further fall in income, output, employment and prices. This will
continue till prices reach the bottom of the depression. If investment is greater than saving,
expenditure on goods and services of the people increases, people spend more and save less,
increase the velocity of circulation, increases the income of the producers of goods and services,
increases the price level and increases the profit expectations or marginal efficiency of capital,
investment will increase, employment, income, expenditure, output and price increases (raise)
still higher levels. The increase in investment which leads to increase in aggregate expenditure,
demand and income do not lead to a rise in the price level immediately. If change in the output of
goods and services is equal to the change in the demand for goods and services, there would not
be a general rise in the price level. However, if out put does not increase proportionately,
increase in investment will increase income and the price level and increase in out put is possible
only if there are unemployed resources in the economy. When the economy reaches the full
employment level, further increase in income will not raise output to the level of increase in
aggregate expenditure.

Finally, it is the inequality in saving and investment that brings about changes in the price level,
and changes in the price level are due to changes in income rather than in the quantity of money.

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Check Your Progress

1. How does price change according to Fisherian theory?

………………………………………………………………………………………………
………………………………………………………………………………………………
2. What does “v” represent as define in the equation of exchange by Fisher?
………………………………………………………………………………………………
………………………………………………………………………………………………
3. Pick the main idea of cash-balance approach by Pigou, Marshall, Robertson and Keynes.
………………………………………………………………………………………………
………………………………………………………………………………………………
4. Any similarity between the cash-transaction and cash balance approaches? Identify. Any
difference?
………………………………………………………………………………………………
………………………………………………………………………………………………
5. How does the Income-expenditure approach by Keynes deviate from the cash balance
approach?
………………………………………………………………………………………………
………………………………………………………………………………………………

2.3 SUMMARY

Quantity theorists and monetarists think that changes in the supply of money have a direct effect
on the economy and/or the price level.

Keynesian theorists believe that monetary policy has an indirect effect on the economy by
changing interest rates and peoples willingness and ability to borrow to finance their spending –
They also believe that value of money and prices of goods and services depends upon the
relationship between saving and investment.

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2.4 ANSWERS TO CHECK YOUR PROGRESS

1. Refer section 2.2.1 (a) 4. Refer section 2.2.2

2. Refer section 2.2.1 (a) 5. Refer section 2.2.3
3. Refer section 2.2.1 (b)

2.5 KEY TERMS

Cash balance approach

Cash transaction approach
Savings
Investment
Value of money
Price

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UNIT 3: INFLATION AND DEFLATION

Content
3.0 Aims and Objectives
3.1 Introduction
3.2 Meaning, Characteristics and Types of Inflation
3.2.1 The Main Characteristics of Inflation
3.2.2 Features of Inflationary Economy
3.2.3 Types of Inflation
3.3 Effects of Inflation
3.3.1 On Distribution of Income and Wealth
3.3.2 On Production
3.3.3 Other effects
3.4 Measurement of Changes in the Value of Money or in Prices
3.4.1 Price Index
3.4.2 Methods of Construction of Index Numbers
3.4.3 Difficulties in the Construction of Index numbers
3.4.4 Uses of Index Numbers
3.5 Measures to Control Inflation
3.6 Inflation in under Developed Economy
3.7 Inflation in a Mixed Economy
3.8 Inflation in a Socialist Economy
3.9 Inflation and Economic Development
3.10 Deflation – meanings
3.11 Effects of Deflation
3.12 Comparison between Inflation and Deflation
3.13 Control of Deflation
3.14 Summary
3.15 Answers to Check Your Progress
3.16 Key Terms

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3.0 AIMS AND OBJECTIVES

This unit is designed to introduce students with the relationship between money and price.
At the end of this unit, you are expected:
 to define inflation and deflation
 to identify the characteristics of inflation and inflationary economy
 to identify the types and causes of inflation
 to understand the effects of inflation and deflation
 to understand the tools used to control inflation and deflation.

3.1 INTRODUCTION

Money performs its function most effectively when prices are stable. If inflation occurs, prices of
goods and services rise and money loses purchasing power over time as a fixed quantity of
money can purchase fewer goods when prices are higher. Thus, inflation reduces the value of
money as a store of value. It also reduces the value of money as a unit of account because
inflation will make the same good cost more after time elapses. Thus, it is hard to compare the
value of goods used in production to the value of products sold, if a long time elapses between
the time that the raw materials are purchased and the final good is produced. In countries where
inflation is severe, people may use their domestic currency only as a medium of exchange and
immediately convert it to another currency between purchases. They also may keep their
accounts in another currency with a more stable value.

Inflation has an important influence on your well-being. Assume for instance that you have a rich
grandmother who has put Br. 90,000.00 into your account so you can buy a new car when you
graduate from college. However, you will not get the money until you graduate. If you graduate
in two years and inflation is nonexistent, you can buy a car that now costs Br. 90,000.00.
However, if you graduate in two years and all prices rise 9 percent per year for the next two
years, you could still buy a Br. 90,000.00 car, but how would that car compared to one that you
could buy now? That is, how much would you have to spend to buy an equivalent car now? (You
will be able to answer this at the end of the unit after you see how to calculate the effects of
inflation on the purchasing power of money)

62
In calculating the effects of inflation on the purchasing power of money, we use various price
indexes. Those price indexes show that the purchasing power of money changes over time as
price changes.

National economic policy makers try to restrain inflation in order to maintain the value of
domestic money /currency. Some policy makers take a “monetarist” approach – Monetarists
believe that the stock of money times its predicted “velocity” equals the market value of nominal
gross domestic product (national output) produced in a year.

This unit will show you how inflation and deflation occurs in an economy, how it is measured
and how it will be controlled by the policy makers.

3.2 MEANING OF INFLATION

This is a controversial term to define and had undergone modifications since it was first defined
by the neo-classical economists. The following definitions were given:
Friedman  Inflation is always and everywhere a monetary phenomenon---and can be produced
only by a more rapid increase in the quantity of money than out put. He also
defined it as process of a steady and sustained rise in prices.
Ackley  Inflation is a persistent and appreciable rise in the general level or average of prices
Johnson  Inflation as a sustained rise in prices.
Professor Growther  Inflation is a state in which the value of money is falling i.e., prices are
rising.
Pigou  Inflation exists when money income is expanding more than in proportion to income
earning activity.
Professor Paul Einzig  Inflation is a state of disiequlibrium in which an expansion of
purchasing power tends to cause, or is the effect of an increase of the price level.
Keynes  So long as there is unemployment, employment will change in the same proportion as
the quantity of money and when there is full employment, prices will change in the
same proportion as the quantity of money. He does not deny that prices may rise
even before full employment but such a phenomenon he called “semi inflation” or
“reflation” or “bottleneck inflation”. True inflation, according to him is, after full
employment is reached.

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All these definitions attach inflation with quantity supply of money. When there is an over-
expansion of money supply and too much money chasing too few goods, inflation occurs.
However, any rise in price level should not be taken to mean inflation. No doubt, price rise is an
important feature of inflation, but it does not mean and always reflect inflation, as prices in a
dynamic economy do rise on account of other factors also. Inflation may sometimes occur
without a rise in prices. For example, when productivity increases, cost of production may fall
while prices are kept stable.

3.3 THE MAIN CHARACTERISTICS OF INEFLATION

Some of the salient features of inflation are discussed as follows.

1. It is a long-term operating dynamic process.
2. It is a process of persistently rising price level
3. Inflationary price rise is persistent and is irreversible within a short time.
4. A cyclical movement is not inflation. It is a rising trend in the price level.
5. It is endogenous to the economic system. It is born within the economic system and is fed
by the action and interaction of economic forces.
6. It is fostered by the interaction of a multitude of economic factors
7. It is also a monetary phenomenon (by monetarists like Friedman)
It is characterized by an overflow of money and credit. The root cause of inflation is the
expansion of money supply beyond the normal absorbing capacity of the economy.
8. It in a real sense, is a post-full employment phenomenon (Keynesian). Pre-full
employment situation as money supply increases, investment, employment, income,
expenditure, productivity increases proportionately. But after/post-full employment, as
money supply increases, investment, employment, productivity remains constant and
income increases which push price of goods and services up wards i.e., large amount of
money chasing a limited quantity of goods and services. If this situation stays long, that
will be inflation.

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 Y
C

F B D F
Full-employment ceiling
Price (P), output (Q)
employment (M)

n A E n

Time 

AB = This part is prosperity stage of an economy and in order to boost up the economy
intentionally raises prices of goods and services. As employment does not reach to the
ceiling, as price increases investment is encouraged and hence employment, productivity,
income, demand for goods and services increases. If inflation occurs it is not a true
inflation rather it will be referred as reflation or semi inflation or bottleneck inflation.
inflation.
BC = At B full employment is attained. If money supply further increases, price of goods and
services increases but employment, and out put remains constant. This is the true
inflationary situation.
CD = As price rises beyond the capacity of buyers, buyers will refrain from buying goods and
services. Hence, producers intentionally deduct prices. This is referred as disinflation.
disinflation.
This time employment and output also remains constant.
DE = This time price further declines and hence out put, employment and income which further
aggravates a decline in price until the price level falls down to the lowest level. This
situation is referred as deflation.
deflation. There is an under-employment situation.
Below E = Here every thing declines: price, output, employment and income. This is also
referred as depression.
depression.

3.4 FEATURES OF INFLATIONARY ECONOMY

The strategic features of an economy as identified by economists can be presented as follows.

1. There is a continuously rising price trend. Price rise must be continuous and be a long-
term phenomenon. Short-term and reversible price rise does not represent inflation.

65
2. The money supply is in excess of the requisite production and exchange needs of the
economy. That means a huge amount of money is chasing after a few nember of goods
and services.
3. There is over-expansion of credit by the economy. As commercial bank grant more credit
than is expected or than the economic requirement, there will be huge investment that
increases expenditure and income of the society. Besides as credit increases the amount
of money in the hands of the public increases which may lead to an over expenditure over
the real income of the society.
4. A good part of the flow of credit is supplied to unproductive channels. Speculative
activities and sick and non-viable units of production.
5. There is lack of financial discipline on the part of the government. If that economy is
under inflation government resort itself to deficit financing i.e., its expenditure exceeds
its income and the difference is filled by borrowing from banking and money creating
agencies.
6. A large number of commodities are in short supply paving ways for the sectoral price
disequilibruim. As commodities in certain areas become scarce, the price of the other
sector using the results of this sector as input also increases. For example, as there exists
the shortage of petroleum, the prices of other consequential activities using fuel as a
resource rises.
7. Artificial scarcity is commonly caused by hoarding activities, and has become
conspicuous for traders, producers and consumers.
8. The rate of return of variable income earning assets is greater than fixed income earning
assets. For example, speculative hoarding of commodities, precious metals, like gold and
silver and investments in immovable properties like land, buildings, flats, etc are much
high and fascinating than the rate of returns on shares and bonds.
9. Interest rates in the unaccounted and unorganized sectors tend to be higher than the
organized sectors of the money market. For example, interest rates of the money lender is
greater than the bank.
10. Labor unrest, strikes, lock-outs, etc are common. As the price of goods and services
constantly increases and the purchasing capacity of employees decline, they demand for a
higher pay. If this is not positively taken by the employer that will lead to labor unrest

66
 and strikes. This condition and lack of demand for goods and services by the public due
to higher prices will lead to lock outs.
11. The government is trapped in an ever increasing public expenditure larger budgets,
higher taxes, larger public debts, huge deficit financing and large number of controls,
which in turn encourage black money and dual accounting system, black marketing,
smuggling and other antisocial activities on account of the deterioration of the
community’s moral in general.

3.5 TYPES OF INFLATION

Inflation is classified by economists into various types using different bases. It is discussed
below.
1. According to the Rate of Inflation
According to the rate of inflation, it can be classified into groups as moderate inflation,
running inflation, galloping inflation and hyperinflation.
i) Moderate Inflation
It includes creeping and walking inflations. It is a mild and tolerable form of inflation. It
occurs when prices are rising slowly and only up to or less than 10% annually.
The major characteristics of moderate inflation are:
i. There is a single digit inflation rate (less than 10%) annually
ii. It does not disrupt the economic balance
iii. It is regarded as stable inflation in which the relative prices do not get far out of line.
iv. People’s expectations remain more or less stable
v. The real interest rate is not too low or negative, so, money can serve its role as a store
of value without difficulty.
vi. There are modest inefficiencies associated with moderate inflations
ii) Running and Galloping Inflation
When prices rise by more than 10 percent but less than 20 percent a year, running
inflation occurs and when the price rises by more than 20 percent but less than 100
percent per a year, galloping inflation occurs. Galloping inflation is really a serious
problem. It causes economic distortion and disturbances. Their effect is progressively
between moderate and hyperinflations.

67
 iii) Hyperinflation
Here prices rise every movement, and there is no limit to the height to which prices might
rise. Therefore, it is difficult to measure its magnitude, as prices rise by fits and starts.
This occurs when prices rise over 100 percent in a year.
The main features of hyperinflation are
i. The price rise is severe
ii. It represents the most pathetic deterioration in people’s purchasing pauper
iii. It is apparently generated by a massive fiscal dislocation
iv. It is amplified by wage-price spiral
v. It is a monetary disease
vi. The velocity of circulation of money increases very fast
vii. The structure of the relative prices of goods become highly unstable
viii. The real wages tend to decline fast
ix. Inequalities increase
x. Overall economic distortions take place.
2. According to the Nature of Time Period of Occurrence
Based on this criteria the type of inflation can be grouped as war-time, post war and peace
time inflation.
i) War-Time Inflation
It is the outcome of certain contingencies of war. During wartime government
expenditure for war increased, production shift to the necessities of war and supply of
consumption goods decline. This pushes up the price of consumption goods.
ii) Post-War Inflation
It occurs just at the end of a war in a given country. During wartime government impose
on the public additional taxes or contributions and borrow from the public to fulfill the
war requirement. Thus, just at the end of the war, the additional taxation and war
contribution ceases. This increases the public’s ability to buy and thus demand for goods
and services increase. On the other hand, producers do not start production at full
capacity due to wartime damage, infrastructure is not repaired and government spend
more to rehabilitation the general situation. Such as compensating war damaged people.

68
 All these causes demand to increase without increase in supply that causes price rise and
then inflation.
iii) Peace-Time Inflation
It is the result of increased government outlays on capital projects having a long gestation
period. In such cases investment increases, employment, income and demand for goods
and services increases, but production is not yet started i.e., supply remain constant. This
leads to rise in price of goods and services that creates inflation.
3. According to the Government’s reaction
It is based on government’s reaction/intervention to the prevalence of inflationary in the
economy.
i) Open Inflation
According to Milton Friedman open inflation refers to “the inflationary process which
prices are allowed to rise without being suppressed by government price control or
similar techniques. “When the government does not attempt to prevent a price rise,
inflation is said to be open. Thus prices rise without interruption. The adjustment of price
is done through the function of free market mechanism of rationing the short supply of
goods and distribute them according to consumer’s ability to pay. Creeping, walking,
running, galloping and hyperinflations are the different forms of open inflation.
ii) Suppressed or Repressed Inflation
It refers to a situation in which the government intervenes directly to control the price
system through various measures because no government can allow the prices to rise
beyond limits. It refers to those conditions where prices increase are prevented through
the adoption of certain measures like licensing, price control and rationing by the
government.

If these measures are taken by the government there will be a diversion of demand from
controlled to uncontrolled commodities to raise the price of these commodities. The
results of controlling are huge savings in the form of cash, bank balances and other
encashable private wealth. Because they could not spend it, reduces incentive to work.
They do not get the commodities they want, that leads to black marketing, corruption,
hoarding and profiteering.

69
 Because of these and other reasons like, hierarchy of price controllers and rationing
officers, uneconomic diversion of productive resources from essential industries to non-
essential or less essential goods industries and since there is a free price movement in the
latter and hence are more profitable to investors, open inflation is proffered to suppressed
inflation (Friedman and Halm)
4. According to the Scope of Coverage of Inflation
Inflation coverage may be general or partial and it can be classified as comprehensive and
sporadic inflation.
i) Comprehensive Inflation
This is a situation where by prices of every commodity throughout the economy rise. It is
a normal inflationary phenomenon and refers to a rise in the general price level.
ii) Sporadic Inflation
This is a kind of sectional inflation. It is a situation in which direct price control, if
skillfully used, is most likely to be beneficial to the community at large.
5. Based on the Cause Inducing Inflation
On the basis of this criteria, inflation is sorted out as follows.
i) Credit Inflation/Money Inflation
This is caused by excessive expansion of bank credit or money supply. As credit
increases, money supply increases and causes a price raise or inflation.
ii) Deficit Inflation
It is caused by the deficit financing by government. Deficit financing means the budgeted
expense is greater than its income. As government expenditure increases more than its
income, government resorts to borrowing. Borrowing may be from the public or financial
institutions. As government borrows from the public it pumps out money from the public
and pumps in as it spends. Therefore, money supply remains constant and there will be
no price rise. But as government borrows form the banking institutions, and spends it, the
money supply increases and price rise. Such price rise is referred as deficit inflation.
iii) Scarcity Inflation
It is caused by scarcity of real goods and when money is used for non-productive and
speculative uses. It is also caused when artificial scarcity created by the hoarding
activities of unethical traders and speculator.

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iv) Profit Inflation
This is caused by price rise in profits and wages. As producers wish to get more profit,
they raise price of goods and services. This is referred as profit inflation.
v) Foreign-Trade Induced Inflation
This refers to price rise due to two distinct causes which can be set as follows.
i. Export-Boom Inflation
This occurs when the demand for domestic products in the foreign market increases
without increasing domestic production. This leads to an increase in export and
scarcity of products in the domestic market so as to raise the price which fiscally
leads to inflation.
ii. Import Price-Hike Inflation
This occurs when prices of import components rise due to inflation abroad. This
causes, the domestic costs and prices of goods using these imported parts to rise. You
can take a simple example of rise in the price of fuel that causes rise in the
transportation cost and other related activities.
vi) Tax Inflation
As government raises taxes imposed on commodities (excise duties and sales tax) leads
to a price rise of taxed goods. This leads to inflation referred as tax induced inflation.
vii) Cost Push Inflation
Is a type of inflation that emerges on account of a rise in cost factor. This is when cost
(wage in particular) expands more than real productivity of labor. Causes of cost-push
inflation are discussed as follows.
1. Rise in wages
The main causes of cost-push inflation is the rise in money wages more rapidly than
the productivity of labor. As wage increases, cost of production increases which in
turn rise the price of commodities.
2. Sectoral rise in prices
The output of certain economic sectors price rise due to wage rise. If these output
serve as an input to the other economic sectors, their cost of production will rise. This
leads to a price rise to the output. Thus, wage-push inflation in a few sectors of the
economy may soon lead to inflationary rise in prices in the entire economy.

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 3. Rise in Prices of Imported Raw Materials
As price rises in a foreign market, the price of those imported materials will be
higher. The company which produces using this raw material will have high cost, and
its selling price will be higher which leads to inflation.
4. Profit-Push Inflation
Oligopolist and monopolist firms raise the prices of their products to offset the rise in
labor and production costs so as to earn higher profits. It is also called administered
price theory of inflation or price push inflation or sellers inflation or market power
inflation.
viii) Demand-Pull Inflation
It is a situation described as “too much money chasing too few goods”. An excess of
aggregate demand over aggregate supply will generate inflationary rise in prices.” The
earliest quantity theory of money.

It may be defined as a situation where the total demand persistently exceeds total supply
of real goods and services at current prices. So that prices are pulled upwards by the
continuous up ward shift of the aggregate demand function.

The modern quantity theory of money as defined by Friedman “Inflation is always and
everywhere a monetary phenomenon.” The higher the growth rate of the nominal supply,
the higher the rate of inflation. As money supply increases, spending will increase and
price level also increases. To the Keynesian theory, so long as there are unemployed
resources in the economy, an increase in investment expenditure will lead to increase in
employment, income and output. Price remain relatively constant. Once full employment
is reached and bottlenecks appear, further increase in expenditure will lead to excess
demand because out put ceases to rise, thereby leading to inflation.
Moreover, demand-pull inflation can also occur without an increase in the money supply
when the marginal efficiency of capital increases and the marginal propensity to consume
rise.

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 Causes of Demand Pull Inflation

There can be many reasons for an excess demand over aggregate supply. They are:
1. Increase in Public Expenditure
This is when public expenditure of government spending for consumption or capital
expenditure is more than public revenue i.e., deficit financing through public borrowings
form banks which leads to higher money supply.
2. Increase in Investment
As investment increases the demand for materials increase, employment increases,
income and demand for goods and services rise, productivity increases up to full
employment. At full employment, as investment increases employment, income, demand
for products will increase but productivity remains constant. This will lead to price rise.
3. Increase in Marginal Propensity to Consume (MPC)
If the increase in consumption per unit of income is higher, we say the marginal
propensity to consume rise. For instance, when your monthly salary was Br. 200.00 you
were spending the first Br. 150.000 and save the remaining Br. 50.00. But as your
monthly salary rises to Br. 300.00, your consumption also increases to Br. 240.00 and
save the remaining Br. 60.00. Now both your consumption expenditure and your saving
increases. But the rate of consumption increases at an increasing rate than increase in
your saving.
4. Increasing Exports and Surplus Balance of Payments
As export increase, without increase in the domestic production, there will be scarcity of
products in the domestic market but the income level increase due to exporting. Thus
export causes both increase in income and demand for goods and services but a decrease
in supply in the domestic market. An increasing surplus in the balance of payments leads
to an excess demand. This leads to a price rise.
5. Diversification of Goods
A diversion of resources from the consumption goods sector either to the capital goods
sector or the military sector will lead to scarcity of consumption goods in the market.
This leads to an inflationary pressure.

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 i. Other causes of inflation
1. Increase in disposable income
2. Cheap monetary policy
3. Increase in consumer spending
4. Expansion of the private sector
5. Black money
6. Repayment of public debt by the government

Mixed Inflation

Many economists have come to believe that the actual process of inflation is neither due to
demand-pull alone, nor due to cost push alone, but due to the combination of both the elements
of demand pull and cost-push called mixed inflation.
inflation. The major difference between demand-
pull and cost-push proponents lies on the responsiveness of both the money wages and prices to
change in demand.

Those who believes that there is wage and price flexibility in the economy argue in favor of
demand-pull inflation and those who believe that wages and prices are not flexible emphasize the
cost-push theory of inflation. Neither approach taken by itself should be considered a completely
satisfactory explanation of the cause and nature of inflation – both the approaches are
supplementary rather than competitive or alternative as explanations of the cause of inflation.
Pure demand-pull or a pure cost-push inflation is rarely found.

An inflationary process may begin with generalized excess demand and may be expected to
persist as long as excess demand is present, even though no cost-push forces whatsoever are at
work. Excess demand leads to a rise in prices and wages, but the rise in wage rates in this case is
not the result of cost-push.

An inflationary process may begin on the supply side but it will not long persist unless there is an
increase in demand. If wage rates rise, prices will also raise in the absence of any increase in
demand. For a cost-push inflation so initiated to be sustained, however, one wage increase must
be piled on top of another; but in the absence of an increase in demand this would mean ever-
smaller production and ever-greater unemployment.

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Stagflation

This is a new term added in the economic literature in the 1970’s. It is the combination of “stag
“stag””
from stagnation and “flation
“flation”” from inflation. Stagflation is a situation where recessing is
accombined by a high rate of inflation. It is also known as inflationary recession. Its causes are
excessive demand in commodity markets thereby causing price to rise and deficient demand in
commodity markets thereby causing price to rise and deficient demand for labor thereby creating
unemployment in the economy.

Samuelson defined the situation as “stagflation includes inflationary rises in prices and wages at
the same time so that people are unable to find jobs and firms are unable to find customers for
what their plants can produce.”

Factors Affecting Supply

So far we were discussing about demand and factors affecting demand. Now let’s see the
different factors that affect supply of goods and services.
1. Full Employment
Up to full employment as money supply increase, investment increases and so does
productivity. Productivity also increases supply of goods and services. However, at post-full
employment, though investment increases, employment and productivity will not increase
and hence supply of goods and services remains the same.
2. Shortages of Factors of Production
The scarcity of these factors of production such as land, labor, capital equipment and raw
materials, will lead to lower productivity and low supply of goods and services.
3. Operating of the Law of Diminishing Returns in Variable Factors
The law of diminishing returns states that as you use more of an item, the increase on
productivity of this item is on a decreasing rate. As the productivity of these items decrease
the supply of goods and services will also decrease.
4. Export Induced Scarcity
As the demand for domestic goods in the foreign market increases, without increasing in
productivity, the supply of goods and services in the domestic market will also decline.

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5. Wage-Price Spiral
As price increases, employees demand for higher pay. As wage increases cost of production
increase and so does price. As this situation occurs continuously there will be no one who is
willing to pay higher prices or they will be only few. Thus, the producer reduces the
production level so as to provide only few products only for few buyers who are willing and
able to pay higher prices. As the situation aggravates, productivity (output) decreases,
employment, income, and price will also decrease.

3.3 EFFECTS OF INFLATION

If money is to serve its good purpose its value must remain stable. Changes in value of money
lead to harmful consequences in the economy at large.

Inflation may be compared to a robber. Both deprive the victim some possession. But they have
differences.
Robber Inflation
* Robber is visible * Inflation is invisible
* The robbers victim may be one or * The victim of inflation is the whole nation
a few at a time
* The robber may be dragged to a court of law * Inflation is legal
*Inflation disrupt the economy and pave the
way for social and economic upheavals.
* Inflation is highly demoralizing

Inflation affects different people differently. Broadly speaking, there are two economic groups in
every society, the fixed income group and the flexible income group. People with fixed income
group will lose and people with flexible income group will gain.

When there is inflation, most prices are rising, but the rates of increase of individual prices differ
much. Prices of some goods and services rise fastly, of others slowly and of still others remain
unchanged. The effects of inflation on different sectors can be discussed as follows.

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1. On Distribution of Income and Wealth
Inflation tends to increase inequalities in the distribution of income and wealth. The poor and
middle classes suffer because their wages and salaries are more or less fixed but prices of
commodities continue to rise. They become more impoverished and lie in abject misery and
poverty. Business persons, industrialists, traders, real estate holders, speculators and others
with variable income gain during rising prices. They become rich at the cost of the first and
middle classes. They roll in wealth and indulge in conspicuous consumption.

The effects of inflation on different groups of society can be discussed as follows:

i) Debtors and Creditors

During periods of rising prices, debtors gain creditors lose because the real value of
borrowed money diminishes. For instance, the debtor borrowed last year Br. 100.00 to
repay it after one year. But the price of goods and services double at the time he repays.
As price rises, purchasing power of money declines and hence as price doubles, the value
of money declines by 50% i.e., 100 Birr can buy only half of what Br. 100.00 was able to
buy last year.
At periods of falling prices, debtors lose and creditors gain because the real value of
borrowed money rises.
ii) Salaried Persons and Middle Class
Both of them lose when there is inflation because their salaries are slow to adjust when
prices are rising.
iii) Wage Earners
They generally suffer during inflation because there is always gap between a rise in price
level and rise in wages. If they have strong unions, the gap may be narrowed and their
wage raise in proportion to the price level increase.
iv) Fixed Income Group
Pensioners, recipients of interest and renters belong to this group. They are losers during
inflation.

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 v) Equity Holders or Investors
Persons who hold flexible earning assets like share or stocks of companies gain during
inflation. Those who invest in debentures, securities, bonds, etc which carry a fixed
interest rate lose during inflation.
vi) Business persons
They gain during periods of rising prices. Prices raise at a faster rate than the cost of
production, besides there is a time lag between the rise in prices and cost of production.
Producers, traders and real estate holders are included in this category.
vii) Agriculturalists
They are of three groups: landlords, peasant proprietors and landless agricultural workers.
Landlords lose during rising prices because they get fixed rats. Peasant proprietors who
own and cultivate their farms gain. The landless agricultural workers are hit hard by
rising prices. Their wages are not raised by the farm owners.

In general, inflation redistribute income from wage earners and fixed income group to profit
recipients and from creditors to debtors. The very poor and the very rich are losers than the
middle income groups, because the very poor are low earners and the very rich may tend to give
credit but the middle income group are self sufficient, they do not borrow or lend. This situation
further leads to the following results.
i. It adversely affects the confidence in money
Price fluctuations implies that the value of money is unstable and as its value fluctuates the
community know that they will be losers, if price rises. Hence, people tend to refuse
accepting money as a means of payment and prefer other items than money itself. As such
money may become a source of peril and confusion. Besides, prices of all goods do not
change in the same order and the relative price structure is distorted.
ii. Price Variations in product and Factor markets are not Uniform
This situation leads to the cost-functions and revenues in different categories of production to
differ, profitability of firms and industry tend to differ, and marginal productivity of different
factors also differs.

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iii. When value of money changes incoherently in different types of real and financial assets,
assets portfolio management becomes a difficult task.
It distorts the pattern of wealth distribution and position in the wealth holders. When share
prices fall, the shareholder becomes a loser, but real estate prices rises and the owner
becomes a gainer.
iv. Effect of rising prices in
If adversely affects the course of economic planning and programming both at macro and
micro levels.
v. Savings and investment may be adversely affected
vi. It disturb business expectations and business planning
vii. Business risks would be high when value of money is not stable

2. Effects on Production
When prices start rising production is encouraged. As prices raise investment, employment,
production and profit will also rise up to full employment.
After full employment further investment leads to severe inflationary pressures within the
economy. Because prices rise more than production as the resources are fully employed.
Therefore, inflation adversely affects production after the level of full employment. The
adverse effects of inflation on production are discussed as follows:
i) Misallocation of Resources
As price rises, producers start to produce products that attracts more profits than that
satisfies customers and these products may be non-essential goods. When producers
divert resources from the production of essential to non-essential goods form which they
expect higher profits, the scarce resources will be misallocated.
ii) Changes in the system of transactions
Under normal economy businesspersons tend to facilitate the rate of transactions.
However, during inflation producers devote more time and attention on converting
money into inventories or other financial and real assets. Therefore, they hold a smaller
stock of real money holdings against unexpected contingencies than before.
iii) Reduction in Production
When price rises, the demand for goods and services decline. Thus, producers reduce
production.

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 iv) Fall in Quality
Continuous rise in prices creates a seller’s market. Hence, producers produce and sell
sub-standard commodities and adulterate commodities in order to get higher profits.
v) Hoarding and Black marketing
Producers hoard stocks of their commodities expecting still higher prices. Consequently,
an artificial scarcity of commodities is created in the market, then black markets are
created.
vi) Reduction in Saving
When prices rise rapidly, the propensity to save and investment decline because more
money is needed to buy goods and services than before. This further leads to reduction in
capital formation, investment, production, employment, income and demand for goods
and services.
vii) Hinders Foreign Capital
The rising of costs of materials and other inputs makes foreign investments less
profitable. Hence, foreigners become hesitant to invest.
viii) Encourage Speculation
When prices rise continuously, interest rate decline and their income from investment in
income earning assets decline. People hoard assets in expectation of issuance of financial
assets that yield higher interest rates.
3. Other Effects
Inflation leads to a number of other effects such as:
a) Government
As prices rise in the country, the income of the producers increases which in turn
increases the governments income through collection of higher tax from the producers.
But the government’s expenses also increase with rising production costs of public
projects and enterprises and increase in administrative expenses as prices and wages rise.
In aggregate, however, the government gains under inflation.
b) Balance of Payments
When prices rise more rapidly in the home country than in foreign countries, domestic
products become costly compared to foreign products. This tends to increase imports and
reduce exports which leads to a deficit balance of payment.

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 c) Exchange Rate
When prices rise more rapidly in the home country than in foreign countries, it lowers the
exchange rate in relation to foreign currency. The value of domestic currency declines in
relation to the value of foreign currencies and the demand for foreign currencies raises
more than the demand for domestic currency. This leads to a lower exchange rate to
domestic currencies.
d) Collapse of the Monetary system
If hyperinflation persists and the value of money continues to fall many times in a day, it
ultimately leads to the collapse of the monetary system.
e) Social /Public Moral
Inflation is socially harmful. It widens the gap between the rich and the poor. When
prices rise, cost of living will rise, this leads to workers strike, people resort to hoarding,
lowered profit, black marketing, adulteration, manufacture of substandard commodities,
speculative corruption etc.
f) Political Instability
When prices rise the living standard of the people declines. This leads to political
instability. The public rose against government.

3.4 MEASUREMENT OF CHANGES IN THE VALUE OF MONEY OR IN PRICES

Economists and the public are concerned about whether prices are rising or falling and by how
much. Changes in prices tell something about the cost of living and what is happening to the
purchasing power of money. Changes in the general level of prices are the easiest to measure by
converting individual price changes into a price index.
index.

3.4.1 Price Index

A price index is “a figure showing the height of average prices at one time relative to their height
at some other time that is taken as the base period” professor Chandler. To understand the term
index number, note the following three points.
1. An average figure relates to a single /representative group of commodities.
2. It measures the net increase or decrease of the average prices for the group under study.

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 3. It measures the extent of changes in the value of money /or price level/ over period of
time, given a base period.

For each time period, the index is constructed by dividing the cost of the market basket at the
present time by its cost in a period selected as the base period, prices in the base period are
typically established at 100 percent. The resulting price index shows relative price changes from
period to period. If prices rise, the price index will be greater than 100; if they fall, prices will be
less than 100; if prices stay the same, the index will remain at 100. Percentage changes in price
levels relative to the base year can be computed easily. For example, if price index rises from
100 to 120, we know that the average price of the commodities composing the index has
increased 20 percent (120-100)/100. If the index increases in the next period from 120 to 140, the
increase is only 16.7 percent (140-120)/100 because the starting period for our calculation was
120. The change of the entire two periods is 40 percent (140-100)/100. Note that changes from
the base period are automatically shown as percentages, whereas changes between other time
periods must be calculated. Percentage change calculations are computed as:
 Pt  Pt  1  100
p =
Pt  1
where p = Percentage change in prices between periods
Pt = price in period t
Pt-1 = price in the past period, period t-1

Illustration

Simple price index

Price in the Base Base period Prices in 1994 Price
No Commodities period (1970) p2 Index (p1) Relatives (R)
1 Wheat Br. 90/Qt 100 Br. 150/Qt 166
2 Teff Br. 130/Qt 100 Br. 300/Qt 230
3 Cloth Br. 10/Mt 100 Br. 30/mt 300
4 Edible oil Br. 6/Kg 100 Br. 12/kg 200
5 Milk Br. 0.70/Lit 100 Br. 1.25/lit 178
6 House Rent Br. 50/month 100 Br. 200/month 400
R = 1474

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 Price in 1994 P
* Price Relative (R) =  100 or 1  100
Price in 1970 P2

Price Index in 1994 =  R  1447 = 245.67

N 6
This indicates that price in 1994 increases by 145.67 percent than the base year (1970)
Pt  Pt  1
or p =  100
Pt  1
245.67  100
p =  100
100
p = 145.67
Weighted Price Index

Weight Price in the Base Base period Price WXR

No Commodities W period 1970 index Price in 1994 relative
1 Wheat 4 Br. 90/Qt 100 Br. 150/Qt 166 664
2 Teff 8 Br. 130/Qt 100 Br. 300/Qt 230 1840
3 Cloth 6 Br. 10/ Mt 100 Br. 30/mt 300 1800
4 Edible oil 5 Br. 6/kg 100 Br. 12/kg 200 1000
5 Milk 3 Br. 0.70/Lt 100 Br. 1.25/lt 178 534
6 House Rent 7 Br. 50/month 100 Br. 200/month 400 2800
W = 33 WR = 8636

Using arithmetic mean, the weight price index in 1994 =

 WR
W
8638
=
33
= 264.78
The weighted price index shows an increase of 164.78 percent in the price level in 1994 over
1970 as against the increase of 145.67 percent according to the simple price index.

3.4.2 Methods of construction of index numbers

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In constructing an index number, the following steps should be noted.
1. Purpose of the Index number
Before constructing an index number, it should be decided the purpose for which it is needed.
An index number constructed for one category or purpose cannot be used for others because
the variables included might be different.
2. Selection of the base period
It is the most important step in the construction of an index number. It is a period against
which comparisons are made. It should be normal and free from an unusual events such as
war, famine, earthquake, drought, boon, etc. It should not be very recent or remote.
3. Selection of number and kinds of commodities
The number and kinds of commodities to be selected depend up on the purpose or objective
of the index number to be constructed.

If the purpose of the index number is to measure the changes in the general purchasing power
of money then, we should select samples which are representative of the inverse they intend
to describe.

If we want to study the industrial workers cost of living, we must select only those goods and
services which dominate industrial workers’ consumption budget, namely wage goods. In
this regard, different individuals has recommended the right size and commodities to be
included in the index.

Iruing Fisher
The number items in the index numbers should be more than 20, 50 is a much better
number. After 50 the improvement is gradual and beyond 200 is doubtful to get the gain
after covering the extra trouble and expense.
Wesley Clair Mitchell
To know about the broad movement of prices the number of commodities chosen does
not matter; the number of commodity groups should be large enough to present a
comprehensive picture of the economy.

John Maynard Keynes

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 When our purpose of constructing index number is to measure the purchasing power of
money we should reckon the prices of consumer goods because the purchasing power of
money is the “power of money to buy the goods and services, on the purchase of which,
for purposes of consumption a given community of individuals expends its money
income.”
4. Listing of Prices of Commodities
After the base year and number of commodities having been decided, the next step is to list
prices of all the commodities in question in the base period year.

We have to determine which to use: the wholesale or retail prices. For a consumer price
index, wholesale prices are required. For cost of living index, retail prices are needed.

* Different prices should not be mixed up

Prices should be obtained form reliable sources for the purpose, otherwise, it will be a
misleading conclusion. It can be gathered from representative persons, places or journals or
other sources.
5. Averaging
The two principal methods that are most frequently used for the purpose are the
a) Arithmetic mean  The simple way is to add up the items and divide by the number of
items
b) Geometric mean  multiplying the numbers and finding the root of the product
Ex. Three numbers  multiply the three number and take the cube root
Four numbers  multiply them together and take the fourth root
6. Selection of an Average
Due weightage of importance should be given to the various commodities. More important
goods should be given more weightage. It can be measured in terms of money spent by
consumers. Weight may be given in terms of value or quantity.

3.4.3 Difficulties in the Construction of Index Numbers

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There are many difficulties in the construction of index numbers. They are
1. Difficulties in the selection of the base period
The base year should be normal. But it is difficult to determine a truly normal year.
Moreover, what may be the normal year today may become an abnormal year after some
period.
2. Difficulties in the selection of commodities
On account of changes in tastes and habits of the people during the base year and this year, it
is difficult to select commodities as a reference of study. In addition, at the same time
different classes of the society consumes different types of commodities and their possession
is quite different.

Moreover, many new commodities non-existence in the base year may appear on the scene in
this year and may dominate the consumption list of the workers. Or commodities which were
highly consumed during the base year may no more be in use in this year. Therefore, both
commodities must be excluded in the study.
3. Difficulties arising from changes overtime
Due to technological change, changes in the nature of commodities are taking place
continuously overtime. Hence, new commodities are introduced and people start consuming
them in place of the old ones. These commodities must be excluded form the index.
4. Difficulties in the collection of prices
It is often not possible to get adequate and accurate prices from the same source or place.
Further, the problem of choice between wholesale and retail prices arises. The wholesale
prices are better than the retail prices because the retail prices are very variable.
5. Arbitrary assigning of weights
The problem is to give different weights to commodities. The selection of higher weights for
one commodity and a lower weight for another is simply arbitrary.

Moreover, the same commodity may have different importance to different consumers. The
importance of commodities also changes with the change in the tastes and incomes of
consumers and also with the passage of time.

6. Difficulty of selecting the method of Average

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 There are a number of methods which can be used for this purpose. But all methods give
different results from one another.
7. No All purpose index number
There are no all-purpose index numbers. An index number constructed for a particular
purpose cannot be used for some other purpose. Therefore we are forced to prepare different
index numbers for different purposes.
8. International comparisons are not possible
The commodities consumed and included in the construction of an index number differ from
country to country. Similarly, weights assigned to commodities at different countries are also
different. Because of that we cannot compare the domestic price with the international price
level.
9. Comparisons of different places are not possible
Even if different places within a country are taken, it is not possible to apply the same index
number to them. This is because of differences in the consumption habits of people. People
living at different regions consume different commodities.
10. Not applicable at an individual
If an index number shows a rise in the price level, an individual may not be affected by it.
This is because an index number reflects averages. Therefore, an index number is not
applicable to an individual belonging to a group of which it is constructed.
11. Double-counting
Especially, if we study the prices of investment goods, there will be a possibility of double
counting of outputs.

Conclusion

The limitations and difficulties of index numbers is attributed from the approximations used to
measure changes in the value of money. To alleviate these limitations the time interval used to
construct the index number shall be short. Because, habits, tests, techniques of production and
qualities of commodities entering into a price index number do not change during the short
period.

3.4.4 Uses of index numbers

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Some uses of index numbers are:
1. In measuring changes in the value of money
They are used to measure changes in the value of money. A study of the rise or fall in the
value of money is essential for determining the direction of production and employment to
facilitate future payments and to know changes in the real income of different groups of
people at different places and times.
2. In cost of living
Cost of living index shows the rise or fall in the real income of workers. On the basis of cost
of living index money wages are determined, dearness and other allowances are granted to
workers. So wage negotiations and wage contracts are made.
3. In analyzing markets for goods and services
4. In measuring changes in industrial production
Index numbers of industrial production measure increase or decrease in industrial production
in a given year as compared to the base year. It measures changes in the quantity of
production.
5. In measuring internal trade
The study of indices of the wholesale prices of consumer and industrial goods and of
industrial production help commerce and industry in expanding or contracting internal trade.
6. In measuring external trade
The foreign trade position of a country can be assessed on the basis of its export and import
indices.
7. In developing economic policies
Index numbers measure change in such magnitude as prices, incomes, wages, production,
employment, products, exports, imports, etc. By comparing the index numbers of these
magnitudes for different periods, the government can know the present trend of economic
activity and accordingly adopt price policy, foreign trade policy and general economic
policies.
8. In determining the foreign exchange rate
Index numbers of wholesale price of two countries are used to determine their rate of foreign
exchange.

Conclusion

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The index numbers are used to measure all types of quantitative changes in the agricultural,
industrial and commercial fields, as also in such economic magnitudes as income, employment,
exports, imports, prices, etc. A close study of such changes helps the government to adopt
appropriate monetary and fiscal measures in order to achieve growth with stability.

3.5 MEASURES TO CONTROL INFLATION

Inflation can be controlled by increasing the supplies and reducing money incomes in order to
control aggregate demand; The various methods are discussed as follows.

3.5.1 Monetary Measures

Monetary measures aim at reducing money incomes and reducing the demand for goods and
services. It uses the following tools to achieve its objectives.

a) Credit control /Monetary policy

The central bank or the monetary authority in a given country adopts a number of methods to
control the quality and quantity of credit. For this purpose, it raises the bank rates, sells
securities in the open market, raises the reserve ratio, raise marginal requirements and
regulating consumer credit. Through these tools a monetary policy can control inflation
caused due to demand-pull but control inflation caused due to cost-push factors.
b) Demonetizations of currency
When there is abundant of black money (money acquired illegally) in the country demonetize
currency of a higher denomination. As you know, money in your pocket serve as a means of
payment, having such a big value than its value as a commodity, only because the national
bank (government) states it so. And if national bank (government denounces the
monetizaiton of these currencies, especially with big denominations, their value as a means
of payment will be very negligent and none accepted.
c) Issuance of new currency
Government /National bank may issue a new currency and order the community to exchange
many old currencies with very few new currencies by then reducing the quantity of money
supply. This is the most extreme monetary measure. The value of bank deposits is also fixed

89
 accordingly. This is an effective measure when there is an excessive issue of notes and there
is hyperinflation in the country. However, it hurts most of the small depositors.

3.5.2 Fiscal Measures

Fiscal measures aim at reducing expenditure. These are highly effective for controlling
government expenditure. Personal consumption expenditure and private and public investment.
There principal fiscal measures are:
a) Reduction in unnecessary expenditure
The government should reduce unnecessary expenditure on non-development activities in
order to curb inflation. This will lead to a cut to a private expenditure by reducing the income
of the society.
b) Increase in taxes
To cut personal consumption expenditure, the rates of taxes should be raised and new taxes
should be levied. But they should not be so high to discourage saving, investment and
production rather it should give incentives. Further to bring more revenue to the tax-net, the
government should penalize the tax evaders by imposing heavy fines. The government
should reduce import duties and increase export duties to increase the supply.
c) Increase in savings
This will tend to reduce disposable income with the people and hence personal consumption
expenditure. But when living cost increases people are not willing to save more. Therefore,
according to Keynes compulsory savings or “differed payments” must be adopted,
furthermore, in order to increase saving and discourage present consumption expenditure
different techniques can be used like forced provident fund, pension scheme, saving schemes
with prize money or lottery for long periods.
d) Surplus budgets
It is the opposite to deficit budget where more revenue is collected while spending less.
Government can issue anti-inflationary budgetary policy.
e) Stop or postpone payment of public debt
Government should stop repayment of public debt and postpone it to some future date till
inflationary pressures are controlled within the economy. Instead, the government should
borrow more to reduce money supply with the public.

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3.5.3 Other Measures

There are other measures aiming at increasing aggregate supply (production) and reducing
aggregate demand directly.
a) Increasing Production
The following measures should be adopted to increase production
i. Increase the production of essential consumer goods
ii. If there is need, raw materials for production of essential consumer goods can be
imported on preferential basis.
iii. Efforts should be made to increase productivity and industrial peace should be
maintained
iv. The policy of rationalization of industries should be adopted as a long term measure
v. All possible help should be given to increase production in the form of latest technology,
raw materials, financial help and subsidies.
b) Rational Wage Policy
Such a policy must be adapted to link increase in wages to increase in productivity. This will
have a dual effect: control wage and increase productivity at the same time. Increase in
wages must be related with the level of labor productivity. Under hyperinflation, there is a
wage price spiral. To control this, the government should freeze wages, incomes, profits,
dividends, bonus, etc.
c) Price Control
It means fixing an upper limit for the prices of essential consumer goods. They are the
maximum prices fixed by law and any body charging more than these prices is punished by
law.
d) Rationing
It aims at distributing consumption of scarce goods so as to make them available to a large
number of consumers. It is meant to stabilize the prices of necessaries and assure distributive
justice. But it is very inconvenient for consumers because it leads to queues, artificial
shortages, corruption and black marketing.

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Conclusion

If government need to achieve its goals; it should adopt all measures simultaneously for effective
control of inflation.

3.6 INFLATION IN UNDER DEVELOPMENT ECONOMY

According to Keynes there are two types of inflation: bottleneck inflation and true inflation.
Bottleneck inflation started before full employment and true inflation start from full
employment.

In underdeveloped economies the nature of inflation is essentially “bottleneck

“bottleneck inflation”
inflation” which
sets in much earlier than the level of full employment is reached. The bottleneck inflation is
caused when there is limited supply of factors of production and all increases in money income
result in price increases. The nature of inflation in underdeveloped economies may be in the
nature of bottleneck inflation, or scarcity inflation or cost-push inflation or price spiral all
combined in to one.

Inflation in backward economies started much earlier than in the advanced economies. Hence,
underdeveloped economies are highly inflation sensitive. The reasons are:
1. Market imperfection
The market in underdeveloped market is not a perfect one. There are certain rigidities that
prevents an optimum allocation of resources and the actual expansion of actual production
frontier to the optimum possible.

There is lack of responsiveness in the supply side to an increase demand and swelling up
money incomes, rather than real incomes. These market imperfections include: imperfect
knowledge, mobility and divisibility of factors and ignorance of market conditions, rigid
social status and institutional structures and lack of specialization. All result in imperfectly of
supply.
2. Capital Bottleneck
There is a very low rate of capital formation and consequent capital deficiency. As the
income of the public, in underdeveloped economies, is low, its propensity to save will be low
and so does the capital formation, if capital formation is low, investment, production,

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 employment, income and saving will be low. In general, the financial planning is found to be
deficit financing.
3. Entrepreneurial Bottleneck
People in underdeveloped economics lack skill, spirit of boldness and adventure. They are
not highly risk takers and do not want to try something new which retards innovation,
change, improvement and development. They prefer trading or safer traditional investments
rather than attempt risky innovations.
4. Food Bottlenecks
They gave high priority to the production of capital goods results in the deficiency of
consumer goods. There will be shortage of food due to slow growth of agriculture, over
pressure of growing population on land, primitive method of cultivation, defective land
tenure system and lack of adequate irrigation facilities. All these lead to shortage of
agricultural products specially food products.
5. Infrastructural Bottleneck
There are shortages of infrastructural facilities like power, transportation facilities,
communication measures, etc. This restricts the free mobility of resources from one place to
the other and creates regional imbalances.
6. Foreign exchange Bottleneck
Underdeveloped economics mostly depend on imports than exports. Thus, the creation of
foreign currencies will be weaker than its demand due to balance of payment disequilibuium.
The need to boast exports to meet the deficit balance of payment aggravates the price rise in
the domestic market.
7. Resources gap
When both public and private activities expand there will be shortage of resources like:
capital, skilled labor, raw materials, power, etc

3.7 INFLATION IN A MIXED ECONOMY

Ownership under this economy as dual: government and private. To avoid inflation thus, it is
necessary that the state and private enterprises should pull together in sharing the savings
available and should not compete in a manner that the easy solution of forced saving becomes
necessary to meet the investment demands of the state.

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3.8 INFLATION IN A SOCIALIST ECONOMY

A socialist economy determines economic activity by prior state plans into which all must fit and
only a small sector is left free to private initiative. A socialist economy can mobilize the savings
needed by holding down consumption, increasing hours of work, decreasing leisure, freezing
jobs, etc. Thus a socialist economy may escape the evil effects of inflation or cure inflation by
means which are not available or practiced in a democratic set up.

3.9 INFLATION AND ECONOMIC DEVELOPMENT

There are conflicting ideas regarding the contribution of inflation for economic development.
1st group like Keynes support inflation as a means of development. He said that redistribution of
wealth from the poor to the rich increases savings for capital formation to increase investment
and production. Government, in order to fulfill its budget, it issues more currency and distribute
to regional areas. As money income increases saving will increase and capital formation and
investment will increase.
2nd group contradict the contribution of inflation as a means of development like Friedman.
Freedman said that redistribution of wealth may be intentionally malfuncitonal by consumers
whenever an inflationary rise information released they save more. Issuing new notes rather lead
to more spending which in turn will lead to price rise.

3.10 DEFLATION

Deflation is the opposite of inflation. It is associated with the value of money rising i.e., prices
are falling, falling activity and employment. It is caused when prices are falling more than
proportionately to the output of goods and services in the economy as a result of decreasing in
the money supply.

Deflation is different from disinflation. Deflation is a situation where prices fall along with
reduction in output and employment. Whereas, disinflation is a situation where prices are
reduced deliberately but output and employment remain unaffected.

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Effects of Deflation

The effects of deflation are the reverses of the defects of inflation. It affects different groups
differently.
a) On the distribution of income and wealth
Theoretically, persons with fixed incomes gain because the value of money rises with falling
prices. Hence the lower and middle classes with low incomes like workers, white collar
salarial workers, pensioners, the retire class, gain. Persons with variable incomes like
producers, industrialists, traders, and equity holders, losses with falling prices. However, this
does not mean that there is improvement in income distribution and the low income or fixed
income groups gain and the higher income or variable income group losses. Rather,
practically, the low-income group suffers more because of the fall in employment and
income.

As prices of goods and services decline, profit of the producer fall and hence, the producer
deduct employment. These make many of salaried people and wage earners loss their jobs
and their means of survival.
b) On Production
When prices fall, profit, income, employment, aggregate demand and production decline.
This leads to the accumulation of commodities, small firms closed down and unemployment
spread. As employment decline, income of the community will decline, the demand for
goods and services will also decline, this further push down production level and
employment. This vicious circle leads to depression.
c) Government
Government also suffer during deflation. As revenue of the public decline, the income of the
government from the public in a form of income tax will decline. On the other hand, as the
living condition of the public become worse, government spends more to subsidize the
public. This leads government to lower in income and higher in expenditure which is a deficit
budgeting.

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3.12 COMPARISON BETWEEN INFLATION AND DEFLATION

Both inflation and deflation are equally bad and evil in their effects on the society. But inflation
is the lesser evil and deflation is worse.

Inflation
- Increases national output, employment and income
- It occurred at the state of full employment
- It redistribute income, and wealth in favor of the rich
- It is easy to control inflation through monetary, fiscal and direct control measures
- The inequalities between the poor and the rich can be reduced by larger expenditure on
social services by the government.
- It helps the economy to grow, however, it becomes dangerous when there is
hyperinflation
These conditions make inflation unjust and leads to the following situations.
a) It widens the gulf between the rich and the poor. The rich becomes richer at the cost of
the poor and the poor becomes poorer
b) Government resorts to deficit financing to meet its rising expenditure
c) Persons who save are losers in the long run
d) It is socially harmful. People are lured to amess wealth by unscrupulous means.
Therefore, they restore to hoarding, black marketing, adulteration, manufacturing of sub-
standard commodities, speculation and corruption.

Deflation
- Reduces national income and brings the economy backwards to a state of depression.
- It increases unemployment, leads to mass unemployment
- It redistributes income in favor of the low-income groups, yet it fails to benefit them
- The government is at worst position as its income declines and its expenditure increases.

Hence deflation is inexpedient (not suitable for a particular purpose).

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3.13 CONTROL OF DEFLATION

Deflation can be controlled by adopting the monetary and fiscal measures in just the opposite
manner to control inflation. The following methods can be applied
a) Monetary policy
Monetary policy during deflation aims at increasing the money income of the public. The
Central /National bank can increase the reserves of commercial banks through a cheap
monetary policy. This can be done through
- buying securities in the open market operation
- lowering the required cash reserve ratio
- lowering the interest rate
- lowing the marginal requirement
- circulating/Pumping in high money
- loose consumer credit expansion
b) Fiscal Policy
Fiscal policy aims at increasing expenditure. It increases public expenditure and reduces
taxes. It tends to raise national income, employment, output, and prices.

Government encourage public expenditure, reduce taxes, discourage savings, tend to deficit
budgeting and pay public debt. In general, government tend to increase expenditure.

Check Your Progress Exercises

1. What is the value of money? How can it be measured? What is the relationship between
prices and the value of money?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
2. How is money considered as an important economic variable? Explain why too much money
in the economy leads to inflation and why too little leads to recession.
…………………………………………………………………………………………………
…………………………………………………………………………………………………

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3. What are the fundamental cause(s) of inflation? Economists tell us that we all have instable
wants for goods and services, does this mean that consumers are really the cause of inflation?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
4. What is the fundamental cause of deflation?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
5. How is Keynes differ in his definition to inflation from the monetarists like Friedman?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
6. What are the consequences of inflation and deflation? Discusses separately?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
7. How does government /the monetary authority/ Control inflation and deflation?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
8. What are the main characteristics of inflationary or deflationary economy?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
9. Which country is easily affected by inflation – the developed or underdeveloped economic
country? Why?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
10. Discuss the different types of inflation
…………………………………………………………………………………………………
…………………………………………………………………………………………………

3.14 SUMMARY

Inflation results when the demand for goods exceeds the supply of goods so that goods’ prices
rise on a continuing basis. Inflation reduces the value of money because one monetary unit can

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buy less when prices are higher. Deflation occurs when the demand for goods and services
decline as a result of the lower income of the public.

Both inflation and deflation are the two evils of an economy. Both causes difference in the status
of the society. Both results in decline in employment, production, income and social moral status
of the society. But deflation is the worst of the two.

Price indexes are used to measure the amount that the prices of goods and services have
increased or decreased on average over a period of time. Price indexes can also be used to see if
real incomes (incomes in terms of purchasing power) are higher or lower in one place or at one
time than in another place or time. Nominal incomes do not provide a good basis for comparison
because they ignore the fact that the purchasing power (“value”) of a currency may vary over
time or be higher in one place than another. Inflation and deflation can be controlled through
different methods such as monetary measures, fiscal measures and others.

3.15 ANSWERS TO CHECK YOUR PROGRESS

1. Refer section 3.4 6. Refer section 3.3 and 3.11 respectively

2. Refer section 3.2 7. Refer section 3.5
3. Refer section 3.2.3 (viii) 8. Refer section 3.2.1
4. Refer section 3.10 9. Refer section 3.2.1
5. Refer section 3.2 and 3.3 10. Refer section 3.2.3

3.16 KEY TERMS

Inflation Real income

Deflation Nominal income
Reflation Price index
Disinflation Monetary policy
Stagflation

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UNIT 4: BANKING

Contents
4.0 Aims and Objectives
4.1 Introduction
4.2 Historical Background of Banking
4.3 Commercial Banks
4.3.1 Functions of Commercial Banks
4.3.2 Mechanism of Credit Creation
4.3.3 Limitation of Credit Creation
4.3.4 The Role of Commercial Banks in Economic Development
4.4 Central Banking/National Banking
4.4.1 Nature and Function of Central Bank/National Bank
4.4.2 Differences between Central Bank and Commercial Bank
4.4.3 Functions of a Central Bank/National Bank
4.4.4 Role of Central Bank in A Developing Economy
4.5 Summary
4.6 Answers to Check Your Progress

4.0 AIMS AND OBJECTIVES

At the end of this unit, you are expected to:

 understand the origin and development of banking
 understand the meaning of a commercial bank
 identify the credit creation mechanism by commercial banks
 discuss the difference between commercial and central bank
 identify the key functions of a national bank

4.1 INTRODUCTION

In ancient time, trade was using heavy materials as a medium of exchange. This retards the
development of trade and payment facility. Hence, traders start to deposit their metal money with

100
the known merchants and receive a written guarantee about the deposit. Traders, then, use the
written paper as a means of payment in their transaction.

Through, this process banks come into existence. These banks perform a number of function that
facilitate trade and transaction. They accept deposits, advance loans, agency services and create
credit. In the process they become cause to an increase or decrease in the money supply in a
given country. Hence, so as to facilitate and control whenever necessary a central bank is
established. Central banks (National bank in our country) perform many functions in this regard.

These and other activities will be discussed throughout the unit.

4.2 HISTORICAL BACKGROUND OF BANKING

The origin of banking can be traced back to around 2000 BC by Babylonians who was
performing the safe keeping and saving functions in its oldest form. In ancient Greece and Rome,
the practice of safe keeping of gold’s and coin at temples and granting loans for public and
private purpose on interest was prevalent. Traces of credit by compensations and by transfer
orders were found in Assyria, Phoenicia and Egypt before the system attained full development
in Greece and Rome.

In England, banking had its origin with the London goldsmiths who in the 17 th century began to
accept deposits from merchants and others for safe keeping of money and other valuables. Bank
of England was established in 1964 after the goldsmiths as safe keepers were ruined in the
1640’s by the then ruler Charles II.

The bank of Venice, established in 1157, is supposed to be the first bank founded as a public
enterprise. It was simply an office for the transfer of the public debt and originally it was not a
bank in the modern sense. There were other banks emerged in the Italian cities perhaps a little
before AD 1200. Some of these bankers were carrying out business on their own account. The
activity was almost similar to the modern bankers. People used to settle their accounts with their
creditors by giving a check or draft on the bank or through transfer order if the creditor has an
account in the same bank. These bankers were also received deposits and lent money.

As early as 1349 the drapers of Barcelona carried on the business of banking. They were
required to give sufficient security before they commence this business i.e., they were under

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regulation. During 1401 a public bank was established in Barcelona. It was used to exchange
money, receive deposits, and discount bills of exchange for both the citizens and for the
foreigners.

During 1407 the bank of Genoa (in Italy) was established. In 1609 the bank of Amsterdam was
established to meet the needs of the merchants of the city. It accepts all kinds of specie on
deposits. Deposits could be withdrawn on demand or transferred from the account of one person
to another. The bank also adopted a plan by which a depositor received a kind of certificate
entitling him to withdraw his deposit within six months. These written orders, course of time,
came to be used modern check. This time onwards many countries of the word institutionalized
banking activities in their respective countries. Many types of banks were established to meet the
needs of the community.

4.3 COMMERCIAL BANKS

Commercial banks are one form of banks that any country can have. They perform all kinds of
banking business. They generally finance trade and commerce. They usually accept short-term
deposits and advance short-term loans to the businessperson and traders and avoid medium term
and long term loans.

4.3.1 Functions of Commercial Banks

A modern bank performs a variety of functions. Hence it is difficult to discuss all functions here.
However, some basic functions performed by the banks are discussed as follows:

A. Accepting deposits
The bank accepts deposits from those who can save but cannot profitably utilize this saving
themselves. People consider it more rational to deposit their savings in a bank because by doing
so they, on the one hand, earn interest and on the other, avoid the danger of theft. Banks provide
alternative deposit accounts, that permits depositors to chose based on their respective objectives.
Some of these accounts are: Time deposits, savings deposit accounts, and chaking accounts.

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B. Advancing loans
The purpose of accepting deposit is to mobilize funds to be used for advancement of loans. The
bank, after keeping certain cash reserves, lend their deposits to the needy borrowers. Before
advancing loans, the bank must satisfy themselves about the credit worthiness of the borrowers.
The bank can grant different types of loans such as: call loans, cash credit, term loans, overdraft
facilities and discounting loans.

C. Agency services
In addition to the main functions of the bank stated above, banks perform many agency and
general utility functions. The bank offers the following agency services.
ix) Collection and payment of credit instruments
ii) Execution of standing customer orders
iii) Purchasing and sale of securities on behalf of customers
iv) Collection of dividends on shares on behalf of his customer
v) Income tax consultancy
vi) Acting as trustee and executor
vii) Acting as representative and correspondent
viii) Remittance of funds
The bank can also provides the following general service functions to customers
i) Traveler’s cheques
ii) Safe custody of valuables and securities
iii) Letters of credit facilities

D. Creation of Credit
A bank multiply its deposits (primary) into secondary or derivative deposits. As customers
initially deposit their money in the bank, an account is opened in their names. This is referred as
a primary deposit. However, the bank accepts this deposit to make loans to customers and as loan
is granted to customers, money/cash is not given to the customer rather an account is opened in
the borrower’s name to be withdrawable with cheques. Hence the account opened in the name of
the customer is referred as secondary or derivative deposits. Thus, the multiple expansion of
deposits is called credit creation.

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Credit means getting the purchasing power (i.e., money) now by a promise to pay at some time
in future. In a sense; the words credit, debt and loan are synonymous; credit or loan is the
liability of the debtor and the asset of the bank.

Creation refers to the ability of the bank to expand deposits as a multiple of its reserves.
Therefore, “credit creation refers to the process of making loans through investment in
securities”, Newlyn. “The creation of derivative deposits is identical with what is commonly
called the creation of credit”. Hence commercial banks have been aptly called the factories of
credit or manufacturers of money.

4.3.2 Mechanism of Credit Creation

There was a time when it was thought that a bank could not create credit. They believed as a
banker is just like a cloakroom attendant and cannot lend more than what it has received as
deposits. Suppose, the bank receives a deposit of Br. 10.00, it can lend only up to Br. 10.00, if no
cash reserve ratio is applied and no more-these people argue.

However, these days it is believed that commercial banks are credit creators. In order to create
credit, it must be accepted that the amount lent may come back to the same bank or some other
bank as fresh deposits. The bank whose deposits have increased will lend the same. This will
create more deposits with the same bank or some other bank. Thus, there will be creation of
credit by the banks. The mechanism of credit creation has been discussed in the following
manner.

Suppose, Ato Abebaw deposits Br. 10, 000.00 with Dashen Bank S.C and there are a number of
banks in the country which follow the cash reserve ratio of 10%. In this case Cash balance of
Dashen Bank will increase by Br. 10.000.00 because it is a case of primary deposit. The effect of
this deposit can be shown in the following balance sheet.

Balance sheet Dashen Bank

Liabilities Assets
Deposits 10,000.00 Cash 10,000.00

Credit creation takes place only when a bank grants a loan. If the cash reserve ratio is 10% the
bank can lend up to Br. 9,000.00 out of the primary deposits of Br.10,000.00, as the bank has to

104
keep only Br. 1,000.00 in cash. Suppose, Ato Hagos approaches Dashen Bank for a loan of Br. 9,
000.00 and the bank grants him the loan, then this transaction will appear in the balance sheet of
Dashen bank as follows.

Balance Sheet-Dashen Bank

Liabilities Assets
Deposits 10, 000.00 Cash 1,000.00
________ Loans to Ato Hagos 9,000.00
Br. 10,000.00 Br. 10,000.00
Suppose the borrower purchases goods from Ato Gemechu and makes him the payment of Br.
9,000.00, who deposits the amount with Abyssinia bank. The deposits of Abyssinia Bank
increases by Br. 9,000.00 and cash serves also by Br. 900.00. Abyssinia bank can lend the
amount retaining 10% of it. If the bank advances loans to Ato Bedru, then the position of the
bank will be follows.
Balance Sheet-Abyssinia Bank
Liabilities Assets
Deposits 9, 000.00 Cash 900.00
________ Loans to Ato Bedru 8,100.00
Br. 9,000.00 Br. 9,000.00
Ato Bedru can make payment to some other person, Ato Goitom in some settlement, who may
deposit the amount with United Bank. United Bank will also keep 10% of the deposits and lend
the balance to another customer, Ato Mustofa amounting to Br. 7, 290. If this happens, the effect
of this transaction will appear in the balance sheet of United Bank as follows:

Balance Sheet-United Bank

Liabilities Assets
Deposits 8, 100.00 Cash 810.00
________ Loans to Ato Mustofa 7,290.00
7,290.00
Br. 8,100.00 Br. 8,100.00
This process will continue till the credit is created by 10 times (the credit multiplier) the original
deposits of cash. But if banks have different cash reserve ratio, the outcome will be different.

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The above discussion was made on the assumption that there are many banks in the country
following similar bank lending policy. Now let us see if there is only one bank in the country.
The discussion will be presented as follows:
Assets Liabilities
Reserves Required Excess Loans & investment or Total demand
Total Reserve Reserve (ER) derivative demand deposits (TD)
(RR) 10% 90% deposits (DD)
10,000.00 1000.00 9,000.00 - 10,000.00
1 10,000.00 900.00 8,100.00 9,000.00 19,000.00
2 10,000.00 810.00 7,290.00 17,100.00 27,100.00
3 10,000.00 729.00 6561.00 24,390.00 34,390.00
4 10,000.00 656.10 5904.90 30,951.00 40,951.00
5 10,000.00 590.49 5314.41 36,855.90 46,855.90
6 10,000.00 531.44 4782.97 42,170.31 52,170.31
7 10,000.00 478.30 4304.67 46,953.28 56,953.28
. . . . .
. . . . .
. . . . .
Final stage 10,000.00 0 90,000.00 100,000.00

Assumption
1. The cash reserve ratio remains constant through all the stages of credit creation process
2. The banks adjust their assets in such a manner as to maintain a fixed relationship between
their deposit liabilities and cash reserves.
3. There is no leakage in the credit creation process
b) The excess reserves are turned in to derivatives through granting loans.
c) The derivative deposits, in turn, become primary deposits with the banks.
4. There is a well-developed banking system in the country and the people have banking habits.
5. The central bank does not adopt any credit control policy
6. There exist normal business conditions in the country.

If all the assumptions mentioned above are fulfilled, the amount of credit created will depend
upon the percentage of cash reserved to be maintained by the banks. This percentage will
determine the credit multiplier. The credit multiplier can be calculated by the following formula;

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1
, where C is the percentage of cash reserve. Hence, in our example above the cash reserve
C

100
ration is only 10% then the multiplier will be 1  110  = 10 times. If the cash
10% 100 10

1
reserve ratio is 25 percent, the credit multiplier will be  1 25  100 = 4 times. Thus,
25% 100 25
the higher the rate of cash reserves, the lower is the credit creation and vice versa.
Credit creation depends upon the ratio of cash reserves to deposits. The credit or the deposit
multiplier is k = 1/r = when k = the credit multiplier
r = the cash reserve ratio
Thus, credit multiplier is the reciprocal of cash reserve ratio. In order to determine the additional
aggregate deposits (AD), we can use the following formula.
R
 D = k R =
r

when D = Derivative deposits

R = Initial excess reserves (which are measured as initial primary deposits minus reserve
requirements)
r = cash reserve ratio
k = credit multiplier
In our example above, the initial excess reserve is Br. 9,000.00 and the cash reserve ratio is 10%.
Thus the additional aggregate deposit will be:
R
 D = k R or =
r
9,000
= 10 x 9,000.00 = 1
10

= 90,000.00 = 9,000.00 x 10
= 90,000.00

Therefore, the total deposit will be: the initial deposit (i.e., 10,000.00) plus the derivative deposit
(i.e., 90,000.00) = Br. 100,000.00. See the preceding table.

4.3.3 Limitations of Credit Creation

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Banks may not be able to create credit to the extent of maximum potential as dictated by the
deposit multiplier because of the following limitations.
A. Amount of Deposits: The power to create credit depends on the cash deposits received by the
bank. If the depositors have no faith in the banking system or are reluctant to deposit money
with the banks, the banks will have loss cash with them and thus their power to create will be
curtailed.
B. Cash Reserve Ratio: All the banks are required by law to keep a certain percentage of
deposits in cash as reserves. The higher the ratio of cash reserve, the lower will be the
amount of credit creation and vice versa. Some banks try to work safely by keeping larger
cash reserves than required by law. In such cases, they will be able to create less credit.
C. Leakages: There are at least two leakages in the credit creation process.
a) Excess reserves – The banks may not be willing to utilize their surplus funds for granting
loans and may decide to maintain excess reserves.
b) Currency drains – The system assumes that the amounts of loans granted by the banks
return to them by way of new deposits. But the people may use the currency without
making a deposit.
D. Security for Loans: The bank grants loans on the basis of certain security. If a customer is
not able to provide the bank with sufficient security, the bank will not lend money and hence,
there will be no credit expansion.
E. Liquidity Preference: The amount of credit creation is also limited if the people give
preference to the liquidity. Suppose, a bank gives loans to a customer who in turn makes
payment to his creditor. If the creditor keeps the amount in pocket, there will he no further
expansion of credit.
F. Business Condition: The nature of economic condition in the country also restricts the
ability of the banks to create credit. If there is depression in the country, traders will be
incurring losses. They will not willing to take loans and invest, and hence there will be no
credit creation. But during boom periods, the traders will approach the banks for loans and
the volume of credit will increase.
G. Monetary Policy: The monetary policy of the central bank also influences the extent of
creation of credit. The central bank is the controller of credit in the country. If it is of the
opinion that credit creation should be discouraged, it may increase the cash reserve ratio.

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 This will check the ability of the commercial banks to create credit. The Central/National
bank can also use other weapons of credit control either to expand or contract bank money in
the country.
H. Availability of Borrowers: Banks create credit by means of loans and advances. Loans and
advances will be given only when there are people who demand a loan. Demand for loan, is
not enough to create loans, the borrower must fulfill at least the minimum requirements
expected of him like security, credit worthiness, character, etc.
I. Credit Policy of Other Banks: If the said total deposits to be attained in the credit creation
process, all banks should apply and follow similar credit policy.
J. Banking Habits: Development of banking system and the banking habits of the people
influences the extent of credit creation. If the depositors have no faith in the banking system
or are reluctant to deposit money with the banks, the banks will have less cash with them and
thus their power to create will be curtailed. Moreover, if the society prefers cheques than
cash for transaction, credit creation will be increased.

Basic concepts for discussion

The following points/concepts shall be discussed in order to understand the credit creation
process of banks.
a) Bank as a Business Institution:
Institution: It aims at maximizing profits through loans and advances
from the deposits. A bank is organized on a joint stock company bases so as to maximize
rewards to the stockholders in a form of dividend.
b) Bank deposits:
deposits: They form the basis for credit creation. According to professor Halm they
can be classified into two types.
i) Primary deposits: When a bank accepts cash from the customer and opens a deposit
account in his name, these deposits simply convert currency money into deposit money.
However, they form the basis for the creation of credit or money. The bank remains
passive as regards this account. It is created only by the willingness of depositors.
ii) Secondary or Derivative Deposits: When a bank grants loans and advances, it, instead of
giving cash to the borrower; opens a deposit account in his name. This is secondary or
derivative deposit. Every loans are converted into deposits. The bank plays active role in

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 creating derivative deposits, they are also called active deposits as creation of derivative
deposits means creation of credit or money.
c) Cash-Reserve Ratio:
Ratio: The percentage of total deposits which the banks are required to hold in
cash reserves for meeting the depositors demand for cash is called cash-reserve ratio.
d) Excess Reserves:
Reserves: The reserve that the bank holds above the required cash reserves are called
excess reserves. They are equal to total reserves (total deposits) minus required reserves.
e) Credit Multiplier:
Multiplier: The ratio between the total amount of derivative deposits and the initial
excess reserves is known as the credit multiplier. It is the reciprocal of cash reserve ratio.
Total Derivative Deposits
K = 1/r or K=
Initial Excess Reserve
where k = credit multiplier
r = cash reserve ratio

4.3.4 The Role of Commercial Banks in Economic Development

Commercial banks play important roles in bringing economic development in a give country.
Some of the roles of commercial banks shall be discussed as follows:
a) Mobilizing savings for capital formation
Commercial banks provide facilities to customers to save their surplus income (Income-
consumption expenditure). Those who save their money in a bank gets interest income, or
can easily effect payment with convinency. This situation helps capital formation in the
country. Capital formation also helps to encourage investment, employment, production, etc
b) Financing Industry
Commercial banks finance industries by providing loans to buy raw materials machineries,
etc., through different loan mechanisms.
c) Financing Trade
d) Financing Agriculture
e) Financing consumers to acquire durable goods
f) Financing service rendering enterprises
g) Co-operate with the central bank to implement monetary policy.

4.4 MEANING AND DEVELOPMENT OF CENTRAL BANKING

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Central banking is the apex of banking system. It plays an active role in implementing
government’s economic policy in the country.

According to Will Rogers, Central Bank is one of the three great inventions in the human
development, with fire and wheel. It may not be accepted by others even if the importance is
known for certainty by all.

Today, central bank is the central arch of the monetary and fiscal framework in every country of
the world and its activities are essential for the proper functioning of the economy and
indispensable for the fiscal operations for the government.

Central banking is mostly a recent development being essentially a product of the nineteenth
century.
century. The following cases can be considered here:
- Riksbank of Sweden – established in 1668
- Bank of England – established in 1694 – serve as a central bank in 1844
- Bank of France – established in 1800
- Reichs bank of Germany – established in 1876
- Bank of Netherlands – established in 1814 – on the ruins of old bank of Amsterdam
- National bank of Austria – established in 1817 – reorganized as the bank of Austria-
Hungary in 1877
- The bank of Norway – established in 1817
- The national bank of Denmark - established in 1818
- The national bank of Belgium - established in 1850
- The bank of Spain - established in 1856
- The bank of Russia - established in 1860
- The bank of Japan - established in 1882
- The bank of Italy - established in 1893
- The Swiss national bank - established in 1907
- National bank of Ethiopia - established in 1942 – National & Commercial Bank
proclamation, August 1942
- The Federal Reserve system in America - established in 1913
- The bank of Canada - established in 1934

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In the nineteenth century Central Banks of many other countries were established. They were
empowered to issue notes with special principles and powers. They became bankers and advisers
of their respective governments

In 1920, The International Financial Conference held at Brussels resolved that “All those
countries which had not yet established a central bank should proceed to do so as soon as
possible, not only with a view to facilitating the restoration and maintenance of stability in their
monetary and banking systems but also in the interest of world cooperation.”

Hence, a number of Central Banks were added to the list of central banks in the world and there
is no independent country with out a central bank.

The central banks of these countries establish an effective relationship with IMF matters relating
to foreign exchange.

4.4.1 Nature and Function of Central Bank

A Central Bank may be defined as that central monetary institution which is charged with
performing the duties of bankers’ bank, fiscal agent for the government and managing the
monetary system of the country.

Economists have defined central bank differently, emphasizing its one function or the other.
 Vera Smith – The primary definition of central banking is a banking system in which a single
bank has either complete or a residuary monopoly of note issue.
 Show – The Central Bank is a bank which controls credit.
 Haultrey – Central Bank is a bank which controls credit.
 Statutes of the bank for international settlements – A Central Bank is the bank in any country
to which has been entrusted the duty of regulating the volume of currency and
credit in the country.
 Kisch and Elkin – A Central Bank is a bank whose essential duty is to maintain stability of
the monetary standard.

4.2.2 Difference between Central Bank and Commercial Bank

A central bank is basically different from a commercial bank in the following ways:

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 1. The Central Bank is the apex institution of the monetary and banking structure of the
country. The commercial bank is one of the organs of the money market.
2. The Central Bank is a non-profit institution which implements the economic policies of
the government. But the commercial bank is a profit-making institution.
3. The Central Bank is owned by the government, whereas the commercial bank is owned
by shareholders.
4. The Central Bank is a banker to the government and does not engage itself in ordinary
banking activities. The commercial bank is a banker to the general public.
5. The Central Bank has the monopoly of note issue, while the commercial bank can issue
only cheques. The notes are legal tender. But the cheques have the nature of near-money.
6. The Central Bank is the banker’s bank. As such, it grants accommodation to commercial
banks in the form of rediscount facilities, keeps their cash reserves, and clears their
balances
7. The Central Bank controls credit in accordance with the needs of business and economy.
The Commercial Bank creates credit to meet the requirements of business.
8. Every country has only one Central Bank with its offices at important centers of the
country. On the other hand, there are many Commercial Banks with hundreds of branches
within and outside the country.
9. The Central Bank is the custodian of the foreign currency reserves of the country while
the Commercial Bank is the dealer of foreign currencies.
10. The chief executive of the central bank is designated as “Governor” whereas the chief
executive of a Commercial Bank is called “chairman” or “president” or “managing
director”.
11. The Central Bank helps the expansion of Commercial Banks whereas Commercial Bank
facilitates the expansion of industries by underwriting shares and debentures and by
meeting financial requirements.

4.4.3 Functions of a Central Bank

According to De Kock, and as accepted by the majority of economists the functions of a Central
Bank are:
A. Bank of Issue/Regulator of Currency

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 The central bank is the monopoly of bank note issue. Notes issued by it circulate as legal
tender money. The reasons for granting the exclusive monopoly of note issue to the central
bank are:
a) for credit control purpose
b) to impart the notes a distinctive prestige i.e., it brings stability in the monetary system and
creates confidence among the public.
c) to ensure uniformity in the notes issued which helps in facilitating exchange and trade
within the country.
d) to make it easy for the state to supervise and control the irregularities and malpractices
committed by the central bank in issuing notes.
e) to restrict or expand the supply of cash according to the requirements of the economy.
f) to control the banking system by being the ultimate source of cash.

B. Government Banker, Fiscal Agent and Advisor

a) As banker to the government the Central Bank keeps deposits of the Federal and regional
governments makes payments on behalf of governments, but it does not pay interest on
government deposit’s. It buys and sells foreign currencies on behalf of the government
and keeps the stock of gold of the government. Thus it is the custodian of government
money and wealth.
b) As a fiscal agent, the central bank makes short-term loans to the government for a period
not exceeding 90 days, floats loans, pays interest on them, and finally repays them on
behalf of the government.
c) As advisor, the central bank advises the government on such economic and money
matters as controlling inflation or deflation, devaluation or revaluation of the currency,
deficit financing and balance of payments, etc

C. Custodian of commercial banks cash reserves

Commercial banks are required by law to keep a certain percentage of the time and demand
deposits as a reserve at the Central Bank. The purpose of keeping reserves at the central
banks are:
a) For transfer of funds between commercial banks through the clearinghouse.

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 b) As a source of great strength to the banking system of the country.
c) As the basis of a large and more elastic credit structure than if the same amount were
scattered among the individual banks.
d) Centralized cash reserves can be utilized fully and most effectively during periods of
seasonal strains and in financial crises or emergencies.
e) By varying these cash reserves the central bank can control the credit creation by
commercial banks.
f) The central bank can provide additional funds on a temporary and short term basis to
commercial banks to overcome their financial difficulties.

D. Custody and Management of Foreign Exchange Reserves

This function derived from its functions as the bank of issue and the custodian of member
banks’ cash reserves.
It is an official reservoir of gold and foreign currencies. It buys and sells foreign currencies at
international prices. It sells gold to the monetary authorities of other countries. It fixes the
exchange rates of the domestic currency in terms of foreign currencies and tries to bring
stability in foreign exchange rates. It manages exchange control operations by supplying
foreign currencies to importers and persons visiting foreign countries on business, studies,
etc. In keeping with the rules laid down by the government.
E. Lender of the Last Resort
In its capacity of lender of the last resort, the central bank meets directly or indirectly all
reasonable demands for financial accommodation from the commercial banks, discount
houses, and other credit institutions subject to certain terms and conditions which constitute
its discount rate policy. Today this function is regarded as the sine qua non of central banking
F. Bank of Central Clearance, Settlement and Transfer
As a bankers’ bank, the central bank acts as a clearing house for transfer and settlement of
mutual claims of commercial banks. Since commercial banks keep their surplus cash reserves
in deposits with the central bank it is far easier to clear and settle claims between them by
making transfer entries in their accounts maintained with the central bank.

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 This function of the central bank is sometimes granted by law where as some other times by
customary functions of banks. It saves time and creates convinency plus test at any time the
degree of liquidity of banks.
G. Controller of Credit
The most important function of the central bank is to control the credit creation power of
commercial banks in order to control inflationary and deflationary pressures within the
economy.

For this purpose, it adopts quantitative and qualitative methods. Quantitative methods aim at
controlling the cost and quantity of credit by adopting bank rate policy, open market
operations and variations in reserve ratio of commercial bank.

Qualitative methods control the use and direction of credit. It involves selective credit controls
and direct action. By adopting such methods, the central bank tries to influence and control credit
creation by commercial banks in order to stabilize economic activity in the country.

Besides to these, the central bank in a number of developing countries has been entrusted with
the responsibility of developing a strong banking system to meet the expanding requirements of
agriculture, industry, trade and commerce.

Accordingly, the central bank possess some additional powers listed as follows.
- supervision and control over the commercial banks
- issuing licenses to newly established financial institutions
- the regulation of branch expansion by commercial banks
- see that every bank maintains the minimum paid up capital and reserves as provided by
law
- inspecting or auditing the accounts of banks
- approve the appointment of chairmen and directors of such banks in accordance with the
rules and qualifications
- to control and recommend merger of weak banks in order to avoid their failure and
protect the interest of depositors
- to recommend nationalization of certain banks to the government in public interest

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 - to publish periodical reports relating to different aspects of monetary and economic
policies for the benefit of banks and the public, and
- to engage in research and train banking personnel, etc

i. Objective of Credit Control

The central bank controls credit to achieve the following objectives
a) To stabilize the internal price level
Inflationary or deflationary trends need to be prevented. This can be achieved by
adopting a judicious policy of credit control. As price rise the central bank decreases
money in circulation and as price decline it increases the money supply.
b) To stabilize the rate of foreign exchange
With the change in the internal prices level, exports and imports of the country are
affected. When price decline exports increase and imports decline which leads to increase
in the demand for domestic currency in the foreign markets and exchange rate also
increased. When price rise in the domestic market export decline and imports increase.
This leads to an increase in the demand for foreign currency and decline in demand for
domestic currency which in turn leads to a decline in exchange rate.
c) To protect the outflow of gold
The central bank holds the gold reserves of the country in its vaults. Increase in bank
credit leads to increase in prices and decline in exports and rise in imports. This create an
unfavorable balance of payments. This necessitates the export of gold to other countries
in order to have an equilibrium balance of payments.
d) To control business cycles
Business cycles are characterized by alternating periods of prosperity and depression.
During prosperity – Large expansion in the volume of credit; production, employment
and prices rise
During depression – Credit contracts: production, employment and price fall. The central
bank can counteract such cyclical fluctuations through contraction of bank credit during
boom periods, and expansion of bank credit during depression.

e) To meet business needs

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 Credit is needed to meet the requirements of trade and industry. As business expands,
larger quantity of credit is needed and when business contracts, less credit is needed.
Therefore, it is the central bank which can meet the requirements of business by
controlling credit.
f) To have growth with stability
The principal objective of credit control is to have growth with stability; price stability
foreign exchange rate stability, to help in achieving full employment, and accelerate
growth with stability in the economy without inflationary pressures and balance of
payments defects.

ii. Methods of Credit Control

The central bank adopts two methods of credit control. They are:
1. The quantitative methods
Which aims at controlling the cost and quantity of credit by adopting such techniques as
variations in the bank rate, open market operations and variations in the reserve ratios of
commercial banks.
a. Bank rate or discount rate policy
These rates are determined by the central bank. The central bank rediscounts first
class bills of exchange and government securities held by the commercial banks.
The central bank controls credit by making variations in the bank rate.
 If the need of the economy is to expand credit; central bank lowers the bank rate
thus borrowing from the central bank will be cheaper and easy, commercial banks
will borrow more. They will intern advance loans to customers at a lower rate. The
market ate of interest will be reduced which encourages the business activity and the
expansion of credit. This results in a rise in prices of goods and services.
 If the need of the economy is to contract credit: Central bank raises the bank rate,
making borrowing costly for commercial banks. The banks borrow less and raise their
lending rates to customers. The market rate of interest also raise which discourages
fresh loans and puts pressure on borrowers to pay their past debts and discourage
business activity.

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Lowering the bank rate offsets deflationary tendencies and raising the bank rate controls
inflation

 The significance of central bank’s bank rate policy

1. The bank rate indicates the rate at which the public should be able to obtain financial
accommodation against the approved securities from the commercial banks.
2. The bank rate indicates the rate of interest at which the commercial banks can borrow
funds from the central bank against the security of government and other approved
securities.
3. The bank rate acts as a barometer of the economic situation in the country. A rise bank
rate is a danger signal while a fall shows clear path.
 The bank rate policy proves more ineffective during depression than during the boom

Limitations of bank rate policy

Its credit controlling efficiency is limited by the following factors
1. Market rates do not change with bank rate: The theory of bank rate policy pre-supposes
that other rates of interest prevailing in the money market change in the direction of the
change in the bank rate.
1. Wages, costs and prices are not elastic: The success of the bank rate policy requires
elasticity not only in interest rates but also in wages, costs and prices i.e., when bank rate
rise wages, costs and prices should automatically be lower.
2. Banks do not approach central bank: It is only if the commercial banks approach the
central bank for rediscounting facilities that this policy can be a success. But the banks
keep with them large amounts of liquid assets and do not find it necessary to approach the
central bank for financial help.
3. Bills of exchange is not used: The bills of exchange as an instrument of financing
commercial and trade has fallen into disuse. Business men and banks prefer cash credit
and overdrafts.
4. Pessimism or optimism of business men: If they are pessimism, even if bank rate fall,
they do not need the bank loan. Whereas if they are optimism, even if bank rate rises they
will take /need the bank loan.

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 5. Power to control deflation is limited: Its power to force a reduction in the market rates of
interest is limited whereas, it may control inflationary tendencies by forcing an increase
in the market rates of interest
6. Level of bank rate in relation to market rate: If in a boom the bank rate is not raised to
such an extent as to make borrowing costly from the central bank, and it is not lowered
during a recession so as to make borrowing cheaper form it, it would have a destabilizing
effect on economic activity.
7. Non-discriminating: It does not distinguish between productive and unproductive
activities in the country. It affects all sectors uniformly.
8. Not successful in controlling BOP (Balance of Payment) disequilibrium: Because it
requires the removal of restrictions on foreign exchange and movements of international
capital.

B. Open Market Operations

This method refers to the sale and purchase of securities, bills and bonds of government and
private financial institutions by the central bank in the financial market.
There are two principal motives of open market operations
1. To influence the reserves of commercial banks in order to control their power of credit
creation, and
2. To affect the market rates of interest so as to control the commercial bank credit.

The method of operation is used as follows

To control inflationary pressures: Central bank sells securities, bills and bonds in the open
market. The buyer (the commercial bank or the public) pay the value of these documents with
cheques drawn on the commercial bank. This reduces the reserve of commercial banks at the
central bank and curtails their lending abilities as the reserve determines the credit creation
capacity of commercial banks.

To control depression of the economy (recessionary period) expansionary policy is used: central
bank purchases securities from commercial banks and other government and private institutions.
The central bank pays the sellers its cheques drawn against itself which are deposited into their

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accounts with the commercial banks. This increases the reserve of the commercial bank which
rises its ability to create credit.
 When the supply of money changes as a result of open market operations, the market rates of
interest also changes. A decrease in the money supply leads to rise in rates of interest and
increase in the money supply leads to a decline in the rate of interest.

Limitations of open market operations

The success of the system depends upon the existence of a number of conditions
a) Availability of securities market. This is a very essential condition to buy and sell
securities by the central bank. In addition the central bank must have enough saleable
securities with it.
b) Stability of cash reserve ratio by the commercial banks. Commercial banks should have
stable cash reserve ratio and should be able to sensitive to the central bank policy.
However, in actuality, commercial banks usually have excess reserves and become non-
responsive to the central bank policies.
c) Penal bank rate. Penal bank rate should be available to control the credit creation of
commercial banks whenever there is higher credit interest from the public.
This rate is a higher rate by the central bank over the market rates of interest i.e., if the
central bank applies a higher rate of interest, whenever commercial banks borrow from it,
it is going to be expensive for commercial banks which makes in turn, borrowing from
commercial banks dearer to the borrowers.
d) The act of others should be similar with the central bank. The people should act the way
the central bank expects them. But in actuality this may not be possible. When the central
bank sells securities people start to demand more credit and when the central bank buys
securities, people start to hoard money.
e) Pessimistic or optimistic attitude of borrowers
During depression, even if the central bank purchases securities and increase the supply
of bank money, businessmen may not be willing to take loans – pessimistic situation.
situation.
During boom, even if the central bank sells securities and decrease the supply of bank
money, and rise the market rate of interest, businessmen may not be discouraged to take
loans – optimistic situation.
situation.

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 f) Non constant velocity of credit money. The success of the method needs/depends upon a
constant velocity of circulation of bank money. But the velocity of credit money is not
constant. It increases during periods of risk business activity and decreases in periods of
falling prices.

C. Variable reserve ratio

Alternatively, known as required reserve ratio, or legal minimum requirements
It was first suggested by Keynes in 1930 and was adopted by the federal reserve system of the
USA in 1935. Every commercial bank is required by law to maintain a minimum percentage of
its deposits with the central bank. This amount may be a percentage of its time and demand
deposits together or separately.

The excess amount of money over the required reserve that remain in the commercial bank is
known as the excess reserves. The excess reserve is the basis of credit creation. The larger the
excess reserves, the greater is the power of a bank to create credit, and vice versa. The larger the
required reserve ratio the lower the excess reserve the lower the power of a bank to create credit,
and vice versa.
If the commercial bank has birr 100.00
The required reserve ratio = 10%
10
x 100 = 10 birr should be deposited with the central bank
100
The excess reserves will be Birr 90.00
Therefore, the maximum amount of credit the bank can create is Br. 900.00
ER 90 90
i.e., =   x 100 = 900.00
RRr 0.10 10
or
1 100
C.M = 1 RRR   = 10
10 10
Credit creation = credit multiplier  initial excess reserve
= 10  90
= 900.00

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* Limitations of variable reserve ratio
a) Excess reserves by commercial bank. Commercial banks possess higher/large excess reserves
and they are not responsive to the reserve ratio requirements of the central bank.
b) Clumsy method. The method does not clearly define the area, place and time when it is
applied.
c) Discriminatory. It affects only banks with lower excess reserve but not banks with large
excess reserves. In addition, non-banking financial intermediaries are not affected by this
policy like
- co-operative societies - building societies
- insurance companies - development banks, etc.
d) Inflexibility. This policy is applicable at a time to all banks in a country.

Variable reserve ratio Vs open market operations

The Variable reserve ratio

- Affects the power of the commercial banks more directly, immediately and
simultaneously than open market
- It is not time consuming – simply declaring the change of RRr
- It is meant for making major and long run adjustments in the liquidity position of the
commercial banks. Therefore, they are not suitable for short-term adjustments.
- It is used in underdeveloped or developed countries.
The open market operations
- It affects non-banking financial intermediaries. They are outside the legal control of the
central bank. Therefore, they are not required to deposit a reserve with the central bank.
But they buy and sell government or private organizational securities.
- Its success depends upon the existence of broad and well-organized market for securities.
Therefore, it is successful only in developed countries
- It has a loss in buying and selling securities on a day-to-day and week-to-week basis.

2. Selective/Qualitative Credit Controls

The aim of selective credit controls is to channelise the flow of bank credit from speculative and
other undesirable purposes to socially desirable and economically useful activities. They also

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restrict the demand for money by laying down certain conditions for borrowers. The main types
of selective credit controls used by the central banks in different countries are discussed as
follows.
a) Regulation of Margin Requirements
Its purpose is to prevent excessive use of credit to purchase or carry securities by speculators.
The central bank fixes minimum margin requirements on loans for purchasing or carrying
securities.
Advantages
1. It is non-discriminatory – applied equally to borrowers and lenders to commercial banks
and non-banking financial intermediaries. It affects all financial institutions uniformly.
2. It increases the supply of credit for more productive uses.
3. It controls the expansion of credit in those sectors of the economy which breed inflation
4. It is simple and easy to administer.
Disadvantages
1. A borrower may not show his intention clearly
2. A borrower may purchase stocks with his own source and borrow to finance other
activities.
3. Non-banking financial intermediaries may increase their security loans when others are
being controlled by high margin requirements.

b) Regulation of Consumer Credit

It aims at the regulation of consumer installment credit or hire purchase finance. Its main
objective is to regulate the demand for durable consumer goods in the interest of economic
stability. It employees two devices: Minimum down payment and Maximum periods of
repayment
It is technically defective and difficult to administer because it has a narrow base. It affects
only a particular class of borrowers whose demand for credit forms an insignificant part of
the total credit requirements.

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c) Rationing of Credit
There are two types of credit rationing methods
1. Variable portfolio ceiling. The central bank fixes a ceiling on the aggregate portfolios of
the commercial banks and they cannot advance loans beyond this ceiling.
2. Variable capital assets ratio. This is the ratio which the central bank fixes in relation to the
capital of a commercial bank to its total assets.
d) Direct Action
The central bank resort to direct the action of commercial banks by issuing “directives” from
time to time so that all or some of the commercial banks to follow. For example,
The central bank may refuse rediscounting facilities to certain banks which may be granting
too much credit for speculative purposes, or in excess of their capital and reserves, or
restrains them from granting advances against the collateral of certain commodities, etc.
 The central bank may also charge a penal rate of interest form those banks which want to
borrow from it beyond the prescribed limit.
 The central bank may even threaten commercial bank to be taken over by it in case it fails
to follow its policies and instruction.
e) Moral Suasion (Strong recommendation not an order)
It is the method of persuasion, of request, of informal suggestion and advice to the
commercial bank usually adopted by the central bank.
Limitations
It is a method “without any teeth” and hence its effectiveness is limited to
1. The extent to which commercial banks accept central bank as a leader and need
accommodation from it
2. The excess reserve maintained by the commercial banks. If the commercial banks possess
excessive reserves, they may not follow its advice.
3. The economic condition. It may not be successful during booms and depression when
there is a wave of pessimistic and optimistic situations
4. It is not a controlling device at all, as it involves cooperatives by the commercial banks.

f) Publicity
It publishes weekly or monthly statements of the assets and liabilities of the commercial bank
for the information to the public.

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 It also publishes statistical data relating to money supply, prices, production and
employment, capital and money market, etc at making the public aware to the policies being
adopted by the commercial bank vis-à-vis the central bank in the light of the prevailing
economic condition in the country. It needs well educated public that can understand and act
according to the requirement.

Limitations of selective credit controls

1. Limited coverage. They are only applicable to the commercial banks but not to non-banking
financial institutions.
2. No guarantee for use of specific purpose. There is no guarantee that the bank loans would be
used for the specific purpose for which they are sanctioned.
3. Difficult to distinguish between essential and non-essential factors.
4. Require large staff by the central bank to check the credits given by the commercial banks
5. Discriminatory. It unnecessarily restrict the freedom of borrowers and lenders. Small
borrowers and small banks are hit harder by this method than big borrowers and large banks.
6. Malallocation of resources. When they are applied to selected sectors, areas and industries
while leaving others to operate freely, leads to malallocaiton of resources.

Conclusion
Indeed the coordination of selective and general controls appears to have been more effective
than the use of any one of them singly and by itself. Selective credit controls are adjoin to the
general controls and are only “second-line instruments”

4.4.4 Role of Central Bank in a Developing Economy

The central bank in a developing economy performs both traditional and non-traditional
functions. The traditional functions are the monopoly of note issue, banker to the
government, banker’s bank, lender of the last resort, controller of credit and maintaining
stable exchange rate.

It aims at the promotion and maintenance of a rising level of production, employment, and real
income in the country. It is given a wider power to promote the growth of economies in
underdeveloped countries. They, therefore, perform the following functions towards this end.

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 1. Creation and expansion of financial institutions
2. Proper adjustment between demand for and supply of money
3. Creating a suitable interest rate policy
4. Debt management
5. Credit control
6. Open market operations
7. Solving the balance of payments problem

Check Your Progress Exercise

1. Who contributes for the establishment of a bank? How?

………………………………………………………………………………………………
………………………………………………………………………………………………
2. What are the functions of commercial banks? And which are the primary and secondary
functions?
………………………………………………………………………………………………
………………………………………………………………………………………………
3. How do commercial banks contribute to the economic development of a country?
………………………………………………………………………………………………
………………………………………………………………………………………………
4. What is a central bank? What are its main functions?
………………………………………………………………………………………………
………………………………………………………………………………………………
5. How does the central bank control credit?
………………………………………………………………………………………………
………………………………………………………………………………………………
6. What is open market operation? How does it function?
………………………………………………………………………………………………
………………………………………………………………………………………………

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 7. What is cash reserve ratio? How it affects the credit creation capacity of a commercial
bank?
………………………………………………………………………………………………
………………………………………………………………………………………………
8. What is a discount rate? How it affects the credit expansion?
………………………………………………………………………………………………
………………………………………………………………………………………………

4.5 SUMMARY

Commercial banks are organized with the objective of making profit and so as to make profit
banks perform different functions such as accepting deposits, advancing loans, agency services,
generally utility services and credit creation.

Central banks /national banks in our country/ are the 19 th century phenomenon. Many countries
of the world established their independent central banks so as to facilitate the monetary activities
of the country and the trade relationship worldwide. Central banks perform many functions in the
process like: regulate currency, government banker, Fiscal agent and advisor, custodian of
commercial banks cash reserves, custody and management of foreign exchange reserves, lender
of the last resort, bank of central clearance, settlement and transfer, and control credit – through
quantitative and qualitative methods.

4.6 ANSWERS TO CHECK YOUR PROGRESS

1. Refer section 4.2

2. Refer section 4.3.1
3. Refer section 4.3.4
4. Refer section 4.4 and 4.4.3
5. Refer section 4.4.3 – G-ii
6. Refer section 4.4.3, G-ii-B
7. Refer section 4.4.3, G-ii-C
8. Refer section 4.4.3, G-ii-A

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UNIT 5: FINANCIAL SYSTEMS

Contents
5.0 Aims and Objectives
5.1 Introduction
5.2 Financial Systems – An Overview
5.3 Transferring Funds in the Market
5.4 Financial Institution /Intermediaries
5.4.1 Benefits of Financial Institutions
5.4.2 Types of Financial Institutions
5.5 Financial Instruments
5.6 Financial Markets
5.7 Money Markets and Capital Markets
5.7.1 Money Markets
5.7.2 Capital Markets
5.8 Distinction between Money and Capital Markets
5.9 Interrelations between Money and Capital Markets
5.10 Summary
5.11 Answers to Check Your Progress
5.12 Key Terms

5.0 AIMS AND OBJECTIVES

At the end of this unit, you are expected to:

 understand a financial system
 identify the elements of a financial system
 identify the role of the different financial institutions
 understand the meaning of financial instruments
 identify and understand the financial markets

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5.1 INTRODUCTION

Financial systems of countries function to gather and allocate funds in the economy. The larger
the flow of funds and the more efficiently the funds are allocated, the greater the accommodation
of individual preferences and the greater the output and welfare of the economy.

The financial system consists of financial markets and institutions. Financial markets are
designed so that financial institutions transact financial instruments. The different types of
financial markets, financial institutions and financial instruments are the key points of this unit.

5.2 FINANCIAL SYSTEM – AN OVER VIEW

The financial system consists of financial markets and institutions. Financial institutions, as part
of the financial system, facilitate the flow of funds from savers to borrowers in the most efficient
manner. Savers are known as surplus spending units (SSUs) and borrowers are deficit spending
units (DSUs). For a given budget period, any unit within a group can have one of three possible
budget position:
1. a balanced budget position, where income and planned expenditures are equal
2. a surplus position, where income for the period exceeds planned expenditures
3. a deficit position, where expenditures for the period exceed receipts
The financial system is concerned with funneling purchasing power from surplus spending units
(SSUs) to deficit spending units (DSUs). DSUs include some households, some state and local
governments, the federal government and a large number of businesses. Taken as groups,
business firms and governments are typically DSUs and somewhat surprisingly, households are
SSUs.

The problem is how to transfer the SSUs’ excess purchasing power to the DSUs that wish to
borrow to finance current expenditures. The transfer can be accomplished by an SSU lending
money to and accepting an IOU from a DSU. An IOU is a written promise to pay a specific sum
of money (the principal) plus a fee (an interest rate) for the privilege of borrowing the money
over a period of time (maturity of the loan). IOUs are called financial claims. They are claims
against someone else’s money at a future date.

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To a DSU, a financial claim is a liability, and the interest payments are the penalty for
consuming before income is earned. To the SSU, the financial claim is an asset, and the interest
earned is the reward for postponing consumption. The SSU can hold the financial claim until the
expiry date of the instrument or he can sell it to someone before it maturities. The DSU continues
to have use of the funds even though the lender is now a different party. The ease with which a
financial claim can be resold is called its marketability. Financial claims differ according to
maturity, risk of default, marketability and tax treatment. At any time, these factors interact to
determine the interest rate of a financial claim. This will be discussed under unit 6.

5.3 TRANSFERRING FUNDS FROM SSUs

SSUs TO DSUs
DSUs

The purpose of the financial system is to transfer funds from SSUs to DSUs in the most efficient
manner possible, either for investment in real assets or for consumption. The job of bringing
DSUs and SSUs together can be done by
1. Direct financing
2. Indirect financing or intermediation financing
Regardless of the financing method, the goal is to bring the parties together at the least possible
cost and with the least inconvenience.
1. Direct Financing
In direct financing, DSUs and SSUs exchange money and financial claims directly – DSUs issue
financial claims on themselves and sell them for money to SSUs. The SSUs hold the financial
claims in their portfolios as interest bearing assets. The financial claims are bought and sold in
financial markets.

The claims issued by the DSU are called direct claims and are typically sold in direct credit
markets, such as the money or capital markets: Direct financing gives SSUs an outlet for their
savings, which provides an expected return, and DSUs no longer need to postpone current
consumption to forgo promising investment opportunities for lack of funds. Thus, direct credit
markets increase the efficiency of the financial system.

Some of the institutional arrangements that facilitate the transfer of funds in the direct credit
markets can be discussed as follows.

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a) Private placement: This is the simplest method of transferring funds between SSUs and
DSUs. Here, a DSUs, such as a corporation, sells an entire security issue to a single
institutional investor or small group of such investors. The advantages of a private placement
over a public offering are the speed with which funds can be committed, the low transaction
cost of bringing the securities to market, and the fact that the issue need not be registered
with the securities and exchange commissions.
b) Brokers and Dealers: To aid in the search process of bringing buyers and sellers together, a
number of market specialists exist. Brokers do not actually buy or sell securities; they only
execute their clients’ transaction at the best possible price. They act merely as matchmakers,
bringing SSUs and DSUs together. Their profits are derived by bringing a commission fee
for their services.
A dealer’s primary function is to “make a market” for a security. Dealers do this by carrying
an inventory of securities from which they stand ready either to buy or sell particular
securities at stated prices. For example, a dealer making a market in a stock might offer to
buy shares from investors at Br. 100.00 and sell shares to other investors at Br. 103.50. The
bid price is (Br. 100.00) the highest price offered by the dealer to purchase a given security;
the ask price (103.50) is the lowest price at which the dealer is willing to sell the security.
The dealer’s gross profit is the Br. 3.50 differences between the bid and the ask price, which
is called the bid-ask spread.
c) Investment Bankers: Another direct market participant is the investment banker. Investment
bankers help DSUs market newly created financial claims to market. An important economic
function of the investment banker is risk bearing, or underwriting – In many transactions, the
investment banker purchases an entire issue of stocks or bonds from the DSU at a guaranteed
price and then sells the securities individually to investors. The investment bankers’ gross
project (called the underwriting spread) is the difference between the fixed price paid for the
securities and the price at which they are resold. Investment bankers provide other services,
such as helping prepare the prospective, selecting the sale date and providing general
financial advice to the issuer.

2. Indirect Financing or Financial intermediation

Flows can be indirect if financial intermediaries are involved. Financial intermediaries
transformation financial claims in ways that make them more attractive to the ultimate investor.

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5.4 FINANCIAL INSTITUTIONS /INTERMEDIARIES

Financial intermediaries include commercial banks, mutual savings banks, credit unions, life
insurance companies, and pension funds. These and other financial intermediaries emerged
because of inefficiencies found in direct financing. Financial intermediaries intervene between
the borrower (DSU) and the ultimate lender (SSU). They purchase direct claims with one set of
characteristics (eg. term to maturity, denomination) from DSUs and transform them into indirect
claims with a different set of characteristics, which they sell to the SSU. This transformation
process is called intermediation. Firms that specialize in intermediation are called financial
intermediaries or financial institutions.

5.4.1 The Benefits of Financial Intermediation/Financial Institutions

Financial intermediaries are firms that produce specialized financial products such as business
loans, consumer installment loans, now accounts, life insurance policies, financial claims in such
a way as to make them more attractive to both DSUs and SSUs. Financial intermediaries enjoy
three sources of comparative advantage over others who may try to produce similar services.
They are:
1. Financial intermediaries can achieve economies of scale because of their specialization.
Because they handle large numbers of transactions, they are able to spread out their fixed
costs. Also, specialized equipment allows them to further lower operating costs.
2. Financial intermediaries can reduce the transaction costs involved in searching for credit
information. A consumer who wishes to lend directly can also search for information, but
usually at a higher cost.
3. Financial intermediaries may be able to obtain important but sensitive information about a
borrower’s financial condition because they have a history of exercising discretion with this
type of information.
For these reasons, financial intermediaries are often able to produce financial commodities at a
lower cost than individual consumers. In producing financial commodities, intermediaries
perform four basic services:
1. Denomination divisibility: Financial intermediaries are able to produce a wide range of
denominations – from Br. 1 to many millions. They can do this by pooling the funds of

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 many individuals and investing them in direct securities of varying sizes. Of particular
importance is their acceptance of the deposits of small savers who do not have an adequate
amount of money to engage in the large denomination transactions fund in direct financial
markets.
2. Maturity flexibility: Financial intermediaries are able to create securities with a wide range
of maturities – from one day to more than 30 years. Thus they are able to buy direct claims
issued by DSUs and issue indirect securities with precisely the maturities (usually shorter)
desired by SSUs.
3. Liquidity: Many of the financial commodities produced by intermediaries are highly liquid.
4. Credit risk diversification: By purchasing a wide variety of securities, financial
intermediaries are able to spread risk.

5.4.2 Types of Financial Intermediaries/ Institutions

Many types of financial intermediaries exist in an economy. Though different, financial

intermediaries/institutions all have one function in common. They purchase financial claims with
one set of characteristics from DSUs and sell financial claims with different characteristics to
SSUs.

Financial intermediaries/institutions are classified as:

1. Deposit-type /depository/ institutions
2. Contractual saving intermediaries
Non-depository institutions
3. Other types of intermediaries

1. Deposit-Type Institutions
They are the most commonly recognized intermediaries because most people use their services
on a daily basis. Depository institutions issue a variety of checking or savings accounts and time
deposits and they use the funds to make consumer, business and mortgage loans. In other words,
they accept deposits from individuals and firms and use these funds to participate in the debt
market, making loans or purchasing other debt instruments.

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The major types of depository institutions are:
 Commercial banks  referred as banking institutions
 Savings and loans associations
 Mutual savings banks, and referred as near banking institutions
or
 Credit unions thrift institutions

a) Commercial Banks: They are the largest, most important and most diversified
intermediates on the basis of range of assets held and liabilities issued. They are referred to
as the “department stores of finance”. Their main sources of fund (liabilities) are in the form
of checking accounts, saving accounts and various time deposits. Most bank deposits are
insured. The main purpose of these funds is to create a wide variety of loans in all
denominations to consumers, businesses and state and local governments. These are the
asset part of the commercial banks.

Because of their vital role in the nation’s monetary system and the effect they have on the
economic well-being of the communities in which they are located, commercial banks are
among the most highly regulated of all financial institutions.
b) Savings and Loan Associations: They are specialized financial institutions obtaining most
of their funds by issuing now accounts, savings accounts, and a variety of consumer time
deposit accounts, then using the funds to purchase long term mortgage. They were designed
specifically for operating in the mortgage markets. Hence they are the largest provider of
residential mortgage loans to consumer. In addition, they are now allowed to make a limited
amount of consumer and commercial loans. In effect, they specialize in maturity and
denomination intermediation, because they borrow small amounts of money short term with
checking and savings accounts and lend long-term on real estate collateral. Besides all this,
they were originally designed as mutual association (i.e., owned by depositors) to convert
funds from savings accounts into mortgage loans.
c) Mutual Savings Banks: They are similar to savings and loans association. To the customers
the difference is simply technical. They issue consumer checking and timesavings accounts
to collect funds from households, and they invest primarily in residential mortgages. They
are owned cooperatively by members with common interest such as company employees,

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 union members or congregation members. They were designed to encourage thrift among
the working class.
d) Credit Unions: They are small, non-profit, cooperative, consumer organized institutions
owned entirely by their member-customers. The primary liabilities of credit unions are
checking accounts (called share drafts) and savings accounts (called share accounts); their
investments (assets) are almost entirely short-term installment consumer loans. They are
organized by consumers having a common bond, such as employees of a given firm or
union. To use any service of a credit union an individual must be a member.

2. Contractual Savings Institutions

Contractual savings institutions obtain funds under long-term contractual arrangements and
invest the funds in the capital markets. Firms in this category are insurance companies and
pension funds. These institutions are characterized by a relatively steady inflow of funds from
contractual commitments with their insurance policy holders and pension fund participants.
a) Life Insurance Companies: They obtain funds by selling insurance policies that protect
against loss of income from premature death or retirement. In the event of death, the
policyholder’s beneficiaries receive the insurance benefits and with retirement the
policyholder receives the benefits. In addition to risk protection, many life insurance policies
provide some savings. Because life insurance companies have a predictable inflow of funds
and their outflows are actuarially predictable, they are able to invest primarily in higher
yielding, long-term assets, such as corporate bonds and stocks.
b) Casualty Insurance Companies: They sell protection against loss of property from fire,
theft, accident, negligence, and other causes that can be actuarially predicted. The major
source of funds for these firms is premiums charged on insurance policies – casualty
insurance policies are pure risk-protection policies; as a result, they have no cash surrender
value and thus provide no liquidity to the policyholders. As might be expected, the cash
outflows from claims on policies are not as predictable as those of life insurance companies.
Consequently, a greater proportion of these company’s assets are in short-term, highly
marketable securities. To offset the lower return typically generated by these investments,
casualty companies have substantial holdings of equity securities. Casualty insurance
companies also hold many municipal bonds to reduce their taxes.

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 The assets insurance companies hold are purchased with insurance premiums rather than
deposits. Thus it is not possible to write a check against an insurance policy.
c) Pension Funds: They obtain their funds from employer and employee contributions during
the employees’ working years and provide monthly payments upon retirement. Pension funds
invest these monies in corporate bonds and equity obligations. The purpose of pension funds
is to help workers plan for their retirement years in an orderly and systematic manner.
Because the inflow into pension funds is long-term and the outflow is highly predictable,
pension funds are able to invest in higher yielding long-term securities. To increase earnings
and reduce the amounts of monthly payments needed to support a retirement income, pension
funds have in recent years invested heavily in equity securities.

Funds are collected by regular contributions from employees, usually via payroll deduction.
It is not possible to write a check against your balance in a pension fund.

3. Other Types of Financial Intermediaries

There are several other types of financial intermediaries that purchase direct securities from
DSUs and sell indirect claims to SSUs. These include: Finance companies, mutual funds, money
market mutual funds and investment companies.
a) Finance Companies: They make loans to consumers and small businesses. Unlike
commercial banks, they do not accept savings deposits from consumers. They obtain the
majority of their funds by selling short-term IOUs, called commercial paper, to investors.
The balance of their funds comes from the sale of equity capital and long-term debt
obligations like promissory notes and debentures. There are four basic types of finance
companies: Business and commercial finance companies, mortgage finance companies,
consumer finance companies and sales finance companies.
i. Business and commercial Finance companies: They specialize in loans to business on
accounts of accounts receivable. The title of the commodity is in the name of the buyer.
The buyer is expected to pay the amount at maturity. If the buyer fails to pay at maturity
this finance company will cover. This is a risky business.
ii. Mortgage finance companies: They specialize in financing and securing mortgages that
are sold to other institutions. They originate mortgages either from funds borrowed from
commercial banks and their own issues of papers.

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 iii. Personal/Consumer finance companies: They specialize in installment loans or small
consumer loans.
iv. Sales finance companies: They specialize in consumer durable lending like automobiles.
Repayment will be on installment plan. However, they do not directly lend to the public
but to large retail stores. Hence consumers are financed indirectly through the retail
stores.
b) Mutual funds: They sell equity shares to investors and use these funds to purchase stocks or
bonds. The advantage of a mutual funds over direct investment is that it provides small
investors access to reduced investment risk that results from diversification, economics of
scale in transaction costs, and professional financial managers. The value of a share of a
mutual fund is not fixed; it fluctuates as the prices of the stocks its investment portfolio
comprises change. Most mutual funds specialize within particular sectors of the market. For
example, some invest only in equities or debt, others in a particular industry, others in growth
or income stocks, and still others in foreign investments.

Owners of shares receive pro rata shares of the earnings from these assets, minus safe assets
such as treasury bills and certificates of deposits.
c) Money market mutual funds (MMF): A MMF is a mutual fund that invests in short-term
securities with low default risk.
d) Investment companies: They raise money by selling stock and earn income for the
stockholders by investing the proceeds in a diversified portfolio of assets. They can be
classified broadly according to the way in which the shares in the company are sold. They
are:
i. Closed-end investment companies: They do not sell shares directly to the public. Fixed
amount of shares are sold through the investment banks and thereafter the shares are
traded on stock exchanges. Shares are not redeemable to the company.
ii. Open-end Investment companies: They sell shares directly to the public in a continuous
basis and stand ready to redeem shares held by the public. They are also called mutual
funds. The fund is in being invested in a variety of fixed income securities like short term
government securities, short-term corporate securities, commercial bank certificate of
deposit, and other-term debt instruments.

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5.5 FINANCIAL INSTRUMENTS

Financial instruments which are alternatively known as credit instruments or debt instruments or
financial assets. They are defined as “written evidences of the extension of credit.” Through
credit instruments, it is possible to transfer debt form one borrower to another or from one lender
to another lender. Credit instruments have the following common features or components: The
identity of the debtor, the amount of the debt, the arrangements as to maturity and repayment
arrangements.

Classifications of credit instruments

Credit instruments can be broadly classified as: Negotiable credit instruments and non-negotiable
credit instruments. They are similar in terms of marketability. Therefore, they can be used to
transfer debt from one person to another. However, they are different in certain aspects like the
rights of those who are a party to the transactions when the debt is made and when it is
transferred. Negotiable credit instruments give better title or right on the instrument to the
transferee than the transferor. But the transferee in the non negotiable credit instruments will
have only a right similar with the transferor. The transferor and transferee will stand on the same
position.

Non-Negotiable Credit Instruments

They are covered under a contract law. Payment in non-negotiable instruments is conditional i.e.,
the buyer (debtor) can refuse payment at maturity on his own ground. Examples are money
orders and postal orders, deposit receipts, share certificates, bills of lading, dock warrants, etc.
They can be transferred by delivery and endorsement but they are notable to give better title to
the bona fide transferee for value than what the transferor has.

Negotiable Credit Instruments

It is defined as any writing that is signed by the maker or drawer, an unconditional promise or
order to pay a certain sum of money, payable on demand or at a fixed or determinable future
date, and payable to order or to bearer. They can be transferred by delivery (if made payable to
the bearer) and by endorsement and delivery (if made payable to the order). They give a better
title to a bona fide transferee for value than what the transfer or has. They are either promises to

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pay or an order to pay. The following are some of the negotiable instruments used in the business
practices. They will be discussed as follows.
1. A promissory note: is unconditional statement in writing made by one person to another and
signed by the maker, promising to pay on demand, or at a fixed or determinable future date, a
sum certain in money to order or to bearer.
2. Commercial paper: is a promise to pay back a higher specified amount at a designated time
in the immediate future – say, 30 days. It is a form of direct short-term finance by large,
credit-worthy companies.
3. Negotiable bank certificates of deposit: It is a debt instruments sold by banks and other
depository institutions. A CD pays the depositor a specified amount of interest during the
term of the certificate, plus the purchase price of the CD at maturity. They can be sold in the
secondary market.
4. Treasury Bills: They are short-term debt instruments used by the federal government to
obtain funds. They are issued in 3-, 6-, and 12 month maturities. They do not pay regular
interest but instead are sold at a discount. They are different from treasury notes and treasury
bonds on two basis: maturity period and interest payment.
 Maturity period
Treasury bills – in less than one year
Treasury notes – in one to ten years
Treasury bonds – in more than ten years
 Interest payment
Treasury bills do not pay explicit interest. Instead, interest is earned implicitly i.e., based
on the difference between the purchase price and the face value. They are called zero
coupon instruments. They are payable to the bearer.
5. Repurchase Agreement: It is an agreement by two parties in which the borrower sells and
agrees to buy back a financial instrument such as a government bond, note or T-bills.
Repurchase agreement is a short-term loan in which the treasury bills serve as collateral.
6. Eurodollars: They are U.S. dollars deposited in banks located in other countries like Europe.
7. Banker’s Acceptances: It is a letter of credit (a bank’s promise to pay on a specific date) that
has been stamped as “accepted” (guaranteed) by another bank. It might be analogous to a
post-dated “check” or bank draft. If the party issuing the cheque has insufficient funds in the

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 account to cover the draft when it is payable, the bank that stamped the draft is obligated to
pay the amount of the “check” to the party who holds it.
8. Federal Funds: are simply short-term (usually overnight) loans between banks. The funds
are loaned at an interest rate known as the federal funds rate.
9. Corporate stock: is an equity instrument that represents ownership of a share of the assets
and earnings of a corporation. They are long-term instruments and are used by the capital
markets. The profits earned by a corporation and paid to shareholders are known as
dividends.
10. Corporate Bonds: are debt instruments issued by a corporation that states the firm will make
specified interest payments and a principal amount of “face value” at maturity. They
(bondholders) are entitled only to the interest payments and the fact value due on maturity,
but they do not share the profits.
11. Mortgages: are debt instruments used to finance the purchase of a home or other form of real
estate when the underlying real estate serves as collateral for the loan. If the borrower
defaults, the lender receives title to the real estate as payment of debt. There are two major
types of mortgage instruments
a) Fixed-rate mortgages: Interest rate is fixed
b) Adjustable-rate mortgages: the ceiling and floor or the maximum and minimum
interest rate that will be charged during the life of the mortgage are determined.
Each type of mortgage specifies a term (the length of the mortgage), a down payment (expressed
as the fraction of the house value that must be paid up front as prepaid interest), and points (the
fraction of the loan value that must be paid up front as prepaid interest)
12. Government Securities: Are debt instruments issued by state treasury and include such
instruments as treasury bonds. The funds obtained from the sale of these bonds are used to
refinance the current federal debt as well as current federal deficits.
13. Consumer and commercial loans: Consumer loans are loans obtained by individuals for
intermediate-term purchases such as car purchases as well as merchandises. Commercial
loans are essentially credit lines issued to businesses. They are the least liquid of all capital
market instruments. Because there is a less active secondary market for these instruments.
14. Municipal Bonds: are issued to obtain long-term funds for such things as highways and
schools. The interest received from these bonds is exempted from income tax.

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15. Call and notice money: call money is a type of funds borrowed and lent for one day and
notice money is a fund borrowed and lent for 14 days without any collateral security.
16. Bill of exchange or commercial bill: It is similar with the promissory note but it is drawn by
the creditor while the letter is drawn by the debtor.
Principal Financial Assets and Liabilities owned by Financial Intermediaries
This table presents a summary of the most important assets held and liabilities issued by the
financial institutions discussed above
Types of Intermediary Assets Liabilities
Direct securities purchased Indirect securities sold
1. Deposit-type institutions
*commercial banks Business loans Checkable deposits
Consumer loans Savings deposits
Mortgages Time deposits

* Savings and Loan Associations Mortgages Savings deposits and

Time deposits
* Mutual savings banks Mortgages Saving deposits
Credit unions Saving deposits

2. Contractual savings Institutions

Life Insurance companies Corporate bonds Life insurance policies
Mortgages
Casualty Insurance companies Municipal bonds Casualty insurance policies
Corporate stock Pension funds’ reserves
Government securities
Private pension funds Corporate stock Pension funds reserves
Corporate bonds
State & local government Corporate bonds
pension funds Corporate stock
Government securities
3. Other financial institutions
finance companies Consumer loans Commercial paper
Business loans Bonds
Mutual funds Corporate stock Shares in Fund
Government securities
Municipal bonds
Corporate bonds
Money market funds Money market securities Shares in fund
Investment companies Consumer loans Shares in fund
Commercial loans Borrowings from commercial
Mortgage loans banks

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5.6 FINANCIAL MARKETS

Financial system of any country consists of two components: Financial markets and financial
institutions.
Financial market is an institution or arrangement that facilitates the exchange of financial assets,
including deposits and loans, corporate stocks and bonds, government bonds, etc. Financial
markets can be classified into different categories based on different factors as follows:
a) According to the nature of the instruments traded
On the basis of this factor a financial market can be reclassified as primary and secondary
markets. They will be discussed here under.
i. Primary markets: They are financial claims sold by deficit spending units in a primary
financial markets. Surplus spending units are wiling to buy financial claims with their
surplus savings because they want to earn future returns. Initial buyers of financial claims
are attracted because they believe that the future pay off from owning the claim will be
large relative to the risk of loss.
ii. Secondary financial markets: are markets where by existing financial assets are bought
and sold. They let people exchange “used” or previously issued financial claims for cash
at will.
b) According to the purpose of the instruments traded
Financial markets can be classified as: Debt, equity and financial service markets.
i. Debt markets: Lenders provide funds to borrowers for some specified period of time. In
return for the funds, the borrower agrees to pay the lender the original amount of the loan
(principal) plus some specified amount of interest. They use to buy new cars and houses,
to working capital and new equipments and to finance various public expenditures. New
funds occur in the primary debt market. Assets in the debt market are further classified
as: short-term (if the underlying obligation when issued is one year or less, intermediate
(between one and ten years and long term (more than 10 years)
ii. Equity markets: In these markets ownership of tangible assets (such as houses or shares
of stock are bought and sold. New houses and new issues of stock are sold in primary
markets. Existing houses and shares of stock are traded in the secondary markets.

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 iii. Financial service Markets: Individuals and firms use financial service markets to
purchase services that enhance the workings of debt and equity markets. For instance:
commercial banks (provide depositors many services), brokerage services (they are
intermediaries who compete for the right to help people buy or sell something of value),
insurance services (give some means of insuring against various forms of loss), etc. There
is no secondary markets for financial service markets.
c) Organized exchanges and over-the-counter markets
Organized security exchanges provide a physical meeting place and communication
facilities for members to conduct their transactions under a specified set of rules and
regulations. Only members of the exchange may use the facilities and only securities listed
on the exchange may be traded.

Financial claims also can be traded “over the counter” by visiting or phoning an “over-the-
counter” dealer or by using a computer system that links over-the-counter” dealer or by using
a computer system that links over-the-counter dealers. Over-the-counter markets have no
central location. Usually, however, they have strict rules that must be followed by dealers in
the market.

Over-the-counter securities dealers “make a market” in a security by quoting a “bid” price at

which they are willing to buy the security and an “ask” price at which they are willing to sell
the security. They can make money by selling at a higher price than the price they paid to
buy the security. Thus, they profit from their bid-ask spreads.
spreads.
d) Spot, Futures and Forward Markets
The spot market involves the exchange of securities or other financial claims for immediate
payment. The term “immediate” can mean a day or a week depending on the terms of
settlement procedures in the particular market. The spot market is also called the “cash”
market.

A Future market is a market in which people trade contracts for future delivery of securities
(such as government bonds), cash goods (such as a kilo of gold) or the value of securities
sold in the cash market. The future contract “delivery” date is the future time when the
contract is scheduled to be settled by the exchange of cash for the contracted “goods”.

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 If a contract for the future delivery of cash in exchange for a foreign currency or a security is
negotiated and sold over the counter; rather than through an exchange, it is referred to as a
forward contract and the market in which it is negotiated is known as the forward market.
market.
e) Option Markets
Options markets trade options contracts that call for conditional future delivery of a security
or good or futures contracts. Options contracts call for one party (the option writer) to
perform a specific act if called upon by the option buyer or owner. Typically, an options
contract gives the buyer the right to either buy or sell a security, depending upon whether the
option is a “call” or “put” option. Call options give the buyer the right to buy a
predetermined amount of a security at the predetermined exercise or strike price on, or
possibly before, the expiration date of the option. Put options give the buyer the right to sell
a predetermined amount of a security at the pre agreed price prior to the option’s expiration
date.
f) Foreign exchange market
The foreign exchange market is the market on which foreign currencies are bought and sold.
Foreign currencies such as the British pound, Japanese yen, German mark, or French franc
are traded against other foreign currencies.
g) International and domestic markets
Financial markets can be classified as either domestic or international markets depending
upon where they are located.

5.7 MONEY MARKETS AND CAPITAL MARKETS

5.7.1 Money Markets

The money market is a market for short-term instruments that are close substitutes for money.
The short-term instruments are highly liquid, easily marketable, with little chance of loss or low
default risk and low cost of executing transactions. It provides for the quick and dependable
transfer of short-term debt instruments maturing in one year or less, which are used to finance
the needs of consumers, business agriculture and the government.

Money markets are markets in which commercial banks and other businesses adjust their
liquidity position by borrowing, lending or investing for short periods of time. In the money

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market, businesses, governments, and, sometimes, individuals borrow or lend funds for short
periods of time – usually 1 to 120 days commercial paper, repurchase agreements, federal funds,
promissory notes, treasury bills, certificates of deposits, bill of exchange call and notice money
and banker’s acceptances also are important money market instruments.

The money markets are also distinct from other financial market in that they are wholesale
markets because of the large transactions involved. Money market transactions are called open
market transactions because of their impersonal and competitive nature. There are no established
customer relationships.

A. Economic Role of the money market

The most important economic function of the money market is to provide an efficient means for
economic units to adjust their liquidity positions. Money markets help governments, businesses,
and individuals to manage their liquidity by temporarily bridging the gap between cash receipts
and cash expenditures. If a firm is temporarily short of cash, it can borrow in the money market;
or if it has temporary excess cash, it can invest in short-term money market instruments. In doing
so a money market performs a number of functions in an economy.
 It provides funds
 It helps to use surplus funds
 It eliminates the need to borrow from banks
 It helps government to borrow money at a lower interest rate
 It helps the implementation of the monetary policies of the central bank
 It facilitates the financial mobility from one sector to the other
 It promotes liquidity and safety of financial institutions
 It brings equilibrium between demand and supply of funds
 It economizes the use of cash.
B. Institutions of the Money Market
The various financial institutions which deal in short-term loans in the money market are:
1. The Central Bank: It does not itself enter into direct transactions. But control the money
market through variations in the bank rate and open market operation. It acts as a guardian of
the money market.

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2. Commercial Banks: They deal in short-term loans which they lend to business and trade.
They discount bills of exchange and treasury bills. They lend against promissory notes and
through advances and overdrafts.
3. Non-bank Financial Intermediaries: This includes savings and loans associations, mutual
funds and credit unions. They deal in short term lending and advances.
4. Discount Houses and Bill Brokers: Discount houses’ primary function is to discount bills on
behalf of others. Bull brokers or dealers act as an intermediary between borrowers and
lenders by discounting bills of exchange at a nominal commission. Dealers buy securities for
their one position and sell from their security inventories, when a trade takes place. Dealers
and brokers specialize in one or more money market instruments and they remain to be the
main part of the money market.
5. Acceptance Houses: They act as agents between exporters and importers and lender and
borrower traders. They accept bills drawn on merchants whose financial standing is not
known in order to make the bills negotiable.
C. Sub Markets of the Money Market
The money market is a network of markets that are grouped together because they deal in
financial instruments that have a similar function in the economy and are to some degree
substitutes from the point of view of holders. However, these markets use different credit
instruments. As the money market consists of varied types of institutions dealing in different
types of instruments, it operates through a number of sub-markets.
1. The call loan market: It is a market for marginal funds, for temporarily unemployed or
unemployable funds. For instance, commercial banks advance loans to bill brokers and
dealers in stock exchange so as to use the fund to discount or purchase bills or stocks for a
short period of time, one night, a week or not more than 14 days. The same thing is true that
central banks advance loans to commercial banks for a short period. The central bank applies
a rate called “call rate”, which is usually less than the normal rate but sometimes it may be
even greater than the normal rate.
2. The bill market: It is the short period loan market. In this market Commercial banks,
discount houses and brokers lend to businesspersons. The commercial banks discount bills of
exchange, lend against promissory notes, or through advances or overdrafts to the
businessperson and lend government through treasury bills.

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 The discount houses and bill brokers lend to businesspersons by discounting their bills of
exchange before they mature.
3. The collateral loan market: the commercial banks lend the discount houses and bill brokers
against collateral bonds, stocks; securities, etc. The commercial banks borrow from big/large/
banks and the central bank on the basis of collateral securities.
4. The acceptance market: The merchant bankers accept bills drawn on domestic and foreign
traders whose financial standing is not known commercial banks have started the acceptance
business.

D. Characteristics of the Money Market

Money markets may be developed and undeveloped markets. Their characteristics can be
presented as follows.
i. Characteristics of an Undeveloped Money Market

The main characteristics of such a market are:

1. There is Personal Touch: The lender and borrower are known each other and decision made
in this market are not rational and objective.
2. There is flexibility in loans: The amount of the loan depends upon the nature of security or
the borrowers good will with the moneylender.
3. Multiplicity of Lending Activities: Money lending activity is combined with other economic
activities i.e., money lending is not the only activity of the moneylender.
4. Varied Interest Rates are Applied: The rate depends on the need of the borrower, the amount
of the loan, the time for which it is required and the nature of security.
5. Defective Accounting System: The accounts of the moneylenders are not liable to checking
by any higher authority.
6. Absence of link with the developed Market: There is no established channel to create a link
between the developed and undeveloped markets. The undeveloped money market consists
of the moneylenders, the indigenous bankers, traders, merchants, landlords, brokers, etc.

ii. Characteristics of a Developed Money Market

The main characteristics of such a market are:
1. It is a well-developed market and consists of the central bank, the commercial bank, bill
brokers, discount houses, acceptance houses, etc.

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 2. The central bank controls, regulates and guides the entire money market
3. It consists of a number of specialized sub markets dealing in various types of credit
instruments such as the call loan market, the bill market, the treasury bill market, the
collateral loan market, the acceptance market and the foreign exchange market.
4. It has a large number of near money assets of various types such as: bills of exchange,
promissory notes, treasury bills, securities, bonds, etc.
5. It has an integrated interest rate structure. The change in the bank rate leads to proportional
changes in the interest rate prevailing in the sub-markets.
6. It has an adequate financial resources form both within and outside the country.
7. It provides easy and cheep remittance facilities for transferring funds from one market to
the other.
8. It is highly influenced by such factors as restrictions on international transactions, crisis,
boom, depression, war, political instability, etc.

5.7.2 The Capital Market

The capital market is a market which deals in long-term loans. It functions through the stock
exchange market. A stock exchange market is a market which facilitates buying and selling of
shares, stocks, bonds, securities and debentures for both new and old ones.

It supplies industry with fixed and working capital and finances medium-term and long-term
borrowings of the central, state and local governments. It deals in ordinary stocks, shares and
debentures of corporations and bonds and securities of governments. The funds which flow in to
the capital market come from individuals who have savings to invest, the merchant banks, the
commercial banks, and non bank financial intermediaries, such as insurance companies, finance
houses, unit trusts, investment trusts, venture capital, leasing finance, mutual funds, building
societies, and underwriting companies.

Importance or Functions of Capital Market

The capital market helps in capital formation and economic growth of the county. The
functions/importance are discussed as follows:

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1. It acts as an important link between savers and investors
The savers are called the “surplus units” and they are lenders of funds. Whereas the investors
are called the “deficit units” and they are borrowers of funds. Hence, the capital market is the
transmission mechanism between surplus units and deficit units. It is a conduct through
which surplus units lend their surplus funds to the deficit units. Surplus units buy securities
with their surplus funds and deficit units sell securities to raise funds they need. This fund
flow may be directly or indirectly.
2. It gives incentives to savers and investors
Savers or surplus spending units will be rewarded in a form of interest, if they deposit their
money in a bank and buy interest bearing financial assets or in a form of dividend, if they
buy shares and stocks, for their postponement of present consumption. This leads to capital
formation which is used by investors or deficit spending units. Investors of DSUs will be also
rewarded in a form of profit from their investment activity. By doing so, it diverts resources
from wasteful and unproductive channels to productive investments.
3. It brings stability in the value of stocks and securities
It does so by providing capital to the needy at reasonable interest rates and helps in
minimizing speculative activities.
4. It encourages economic growth
The various institutions which operates in the capital market give quantitative and qualitative
direction to the flow of funds and bring rational allocation of resources. They do so by
converting financial assets in to productive physical assets. Business firms invest in the
projects offering the highest rates of return and that households invest in direct or indirect
financial claims offering the highest yields for given levels of risk.

5.8 DISTINCTION BETWEEN MONEY AND CAPITAL MARKETS

The money market differs from the capital market on several grounds.
1. The money market deals in short-term funds, whereas, the capital market deals in long-term
funds.
2. The money market uses short-term instruments, such as promissory notes, bills of exchange,
treasury bills, certificates of deposits, commercial papers, etc. whereas; the capital market

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 uses long-term securities such as shares, debentures, bonds of industrial concerns and bonds
and securities of the government.
3. Institutions operating in the two markets differ. In the money market: the central bank,
commercial banks, non-bank financial intermediaries and bill brokers operate. In the capital
market, stock exchange, mutual funds, insurance companies, leasing companies, investment
banks, investment trust, etc, operate.

5.9 INTERRELATION BETWEEN MONEY AND CAPITAL MARKETS

These markets are closely interrelated because most corporations and financial institutions are
active in both. Their interrelation is discussed as follows:
1. Lenders may choose to direct their funds to either or both markets depending on the
availability of funds, the rates of return and their investment policies.
2. Borrowers may obtain their funds from either or both markets according to their
requirements.
3. Some corporations and financial institutions serve both markets by buying and selling short-
term and long-term securities.
4. All long-term securities become short-term instruments at the time of maturity. So some
capital markets instruments also become money market instruments.
5. Funds flow back and forth between the two markets whenever the treasury finances maturing
bills with treasury securities or whenever a bank lends the proceeds of a maturing loan to a
firm on a short-term basis.
6. Yields in the money market are related to those of the capital market. As the long-term
interest rates fall, the short-term interest rate will fall. However, money market interest rates
are more sensitive than are long-term interest rates in the capital market.

Check Your Progress

1. Who would typically purchase a financial claim, a DSU or an SSU?

…………………………………………………………………………………………………
………………………………………………………………………………………………..

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 2. How can a financial claim be both an asset and a liability at the same time?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
3. What are some problems with direct financing that make indirect financing a more
attractive alternative?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
4. Explain how you believe economic activity would be affected if we did not have financial
markets and institutions.
…………………………………………………………………………………………………
…………………………………………………………………………………………………
5. How do financial intermediaries generate profit?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
6. Does it make sense that the typical household is a surplus spending unit (SSU) while the
typical business firm is a deficit spending unit (DSU)? Explain.
…………………………………………………………………………………………………
…………………………………………………………………………………………………
7. What are the primary functions of capital markets and the money markets, respectively?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
8. What are the major types of debt instruments traded in the money markets and capital
markets; respectively?
…………………………………………………………………………………………………
…………………………………………………………………………………………………

5.10 SUMMARY

SSUs are economic units whose total receipts exceed expenditures for a given period. DSUs are
economic units whose total expenditures exceed receipts. The role of the financial system is to
facilitate the efficient transfer of funds from SSUs to DSUs. Transfers of funds from SSUs to
DSUs can take place through (1) direct financing and (2) indirect (intermediation) financing.

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Brokers, dealers, and investment bankers are institutions that facilitate direct financial
transactions. Commercial banks are the largest and most important financial intermediaries in the
economy.

Commercial banks, along with savings and loan associations, mutual savings banks and credit
unions are classified as deposit type institutions. Deposit type institutions typically receive their
funds from short-term deposits and use the funds to make longer-term consumer, commercial,
and mortgage loans. Given the short-term nature of the liabilities, liquidity is a major
management problem. Life and causality insurance companies and pension funds are classified
as contractual savings institutions. Contractual institutions usually obtain funds under long-term
contractual arrangements and invest the funds in capital market. They can invest in long-term
securities because of the relatively stable inflow of funds and the actuarial predictability of their
outflows. Credit instruments which are written evidences for an extension of credit are classified
as negotiable and non-negotiable instruments. Negotiable credit instruments give a better title to
a bona fide transferee than the transferor. Non-negotiable credit instruments does not give a
better title to a bona fid transferee. Both the transferee and transferor will have the same right in
the instrument.

Financial markets exist so people can exchange financial claims for cash or vice versa. Primary
markets are markets in which financial claims are first sold to the public to raise cash for the
selling DSU. Underwriters assist in such sales. Secondary financial markets provide a place
where existing financial claims can be resold.

Capital markets trade financial claims with maturities greater than one year, such as mortgages,
other long-term debts, and stockholders equity claims. Money markets allow people to adjust
their liquidity as needed. They trade large quantities of highly marketable, relatively riskless,
liquid assets with maturities under one year.

Spot markets or cash markets trade securities for immediate purchase and settlement within a
few days at most. Forward markets trade foreign currencies and interest rate contracts for
exchange at a future time. Forward contracts between two counter parties can be customized as
to amounts, delivery date, and delivery terms. Future markets trade contracts for future delivery
and settlement. Futures contracts are traded on futures exchanges that set future delivery dates,

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terms, amounts, and conditions for each standardized contract. Options markets trade puts and
calls that give people the right but not the obligation to sell or buy specific assets at the contract’s
exercise price until the contract expires. Organized markets provide a place and set of rules to
facilitate trading. Over-the-counter markets link dealers in may locations through phone lines or
computers.

5.11 ANSWERS TO CHECK YOUR PROGRESS

1. Refer section 5.3 5. Refer section 5.4.2

2. Refer section 5.3 6. Refer section 5.3
3. Refer section 5.3 & 5.4 7. Refer section 5.7
4. Refer section 5.4 8. Refer section 5.5

5.12 KEY TERMS

Surplus spending units (SSUs) Private placement financial intermediaries

Deficit spending units (DSUs) Broker capital markets
Financial system Dealer Money markets
Financial claim Bid price Stock exchange
Direct financing Ask price Spot market
Financial intermediation Bid-ask spread Cash market
Futures market Options market
Forward market

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UNIT 6: VALUATION OF FINANCIAL ASSETS

Content
6.0 Aims and Objectives
6.1 Introduction
6.2 Interest Rates
6.2.1 Interest Rate and Inflation Rates
6.2.2 Interest Rate and Taxes
6.3 Time Value of Money
6.3.1 Future Value Analysis
6.3.2 Present Value Analysis
6.4 The Valuation of Debt Instruments
6.5 Variables that Shift the Demand and /or Supply of Loanable Funds
6.5.1 Determinants of Demand for Loanable Funds
6.5.2 Determinants of the Supply of Loanable Funds
6.6 Coupon Bonds and Other Interest Bearing Debt Instruments
6.7 Valuing Stocks and Other Assets
6.8 Summary
6.9 Answers to Check Your Progress
6.10 Key Terms

6.0 AIMS AND OBJECTIVES

After the end of this unit, you are expected to:

 define interest rate and identify types of interest rates
 understand the relationship between interest rate inflation rate and taxes
 understand how the time value of money is calculated
 able to calculate the values of debt instruments

6.1 INTRODUCTION

This unit focuses on valuation of financial assets. Financial assets are instruments used by
financial institutions in the financial market – as discussed under unit five of this material. For a

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number of reasons, the value of money changes from time to time and so does the value of
financial assets. Hence, before committing ones money to these assets the investor needs to know
their future and present value, the effects of inflation and taxes on the value of these financial
assets. Such points will be discussed in this unit.

6.2 INTEREST RATES

What is interest?
When a bank or other financial institutions lends you money, it requires you to repay the funds
lent (the principal), plus an additional payment called interest.

The interest rate on a loan is the ratio of the interest payments on the loan to the principal amount
(the amount borrowed). In other words, it is the cost of borrowing funds as a percentage of the
amount borrowed. Interest rates are stated as interest rate per year – annual rate of interest. The
interest rate is the amount over and above the principal amount that is paid in a given year,
expressed as a percentage of the principal amount. Interest is the price of borrowing money. The
interest rate expresses this price as the percentage of the principal amount that the borrower pays
to use someone else’s money.

A brief description of how interest payments are structured on some common types of loan
contracts is discussed as follows.
a) A Simple Loan
A simple loan allows the borrower the use of a given amount of funds (the principal) for a
specified period of time. In exchange the borrower repay the loan amount (principal) plus the
interest at a future specified date.
b) A Fixed-Payment Loan
With a fixed-payment loan, a borrower obtains funds in return for a series of fixed payments
(usually monthly) that include both principal and interest. The interest rate is usually fixed
for the length of the loan, and the regular payments are of equal amounts.
c) A Coupon Bond
A coupon bond specifies (1). a face value, (2). a term, and (3). the coupon rate, which is the
percentage of the face value that will be paid annually as interest when the holder redeems
coupons attached to the bond at specified points in time

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d) A Zero Coupon Bond
The bond is sold at a discount from its face or redemption value. Therefore, the owner of a
zero coupon bond receives no regular interest payments. The change in the value from its
price at issue to its redemption value is implicit interest that the purchaser receives on the
bond.

6.2.1 Interest rate and Inflation Rate

The Real Interest Rate

A prudent investor should consider the real interest rate when making a loan. The normal interest
rate is the interest rate stated in the loan contract. The real interest rate is the nominal interest rate
minus the expected rate of inflation.
r = i - e
where = R = Real interest rate
i = nominal interest rate
e = expected inflation rate

Illustration
A watch costed Br. 100 last year is cost Br. 110.00 this time you wanted to buy this watch last
year. But you postponed your purchase for one year and loan out your Br. 100.00 to a friend with
an interest rate of 8%. Do you gain or lose? Can you buy the watch today with your existing
money?
Answer
Price increases from last year to this year by Br. 10.00 Therefore, inflation rate is 10% Your
income by lending your money is 100 x 8/100 x 1 = Br. 8.00. Now you have Br. 108.00 but the
watch costs Br. 110.00 Hence you cannot buy the watch with what you have now therefore, you
are a loser.

The real interest is = Nominal Interest – Inflation rate

= 8% - 10%
= -2%
The fact that the real interest rate is negative means that by loaning out money at 8% when prices
are expected to rise by 10%, you will actually lose 2% of your purchasing power.

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Lenders will charge an inflation premium – an amount over and above the real interest rate to
compensate for the decline in purchasing power due to inflation. This inflation premium will
equal the expected inflation rate during the period of the loan.
i = r + e
When i = nominal interest rate
r = real interest rate
e = Inflation rate
Illustration
Suppose a lender expects inflation to be 4% and want to earn a 3% real rate of interest; i.e.,
she/he wants the amount paid back to have 3% more purchasing power than the money loaned
out. In this case, the interest rate the lender must charge on the loan is 3% + 4% = 7%
The real interest rate may be considered as an ex ante real interest rate or an ex post real interest
rate. The ex ante real interest rate is the real interest rate i.e., the nominal interest rate minus
the expected inflation rate.
ex ante signifies that “before the fact”  meaning it is calculated from expected inflation
rates and hence is itself an expectation of the real return from a given nominal interest rate.
The ex post real interest rate is the nominal interest rate minus the actual inflation rate.
ex post means “after the fact” and the ex post real interest rate is calculated using actual
inflation rates. Inflation may be either anticipated or unanticipated.

Anticipated inflation: -
Is inflation that participants in financial markets expect and thus take into account when
making their plans.

Unanticipated Inflation: -
Is inflation over and above what participants in financial markets expected at the time funds
were issued.

6.2.2 Interest Rate and Taxes

Interest income is subject to personal income tax. This means lenders must pay a fraction of
interest earning to the government in the form of income taxes.

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Suppose the marginal tax rate is ‘T’ and the pretax interest rate is ‘i’. Then the after tax interest
rate the lender earns is
i = (1 – T) x i

Illustration
What will you earn if you make a Br. 100.00 one-year loan at an interest rate of 10% and
marginal tax rate is 30% you will receive Br. 110.00 from the borrower of this amount: Br.
100.00 is principal Br. 10.00 is interest income which is subject to the income tax.

You pay the government 30% of Br. 10.00 which is 3.00 and keep the remaining Br. 7.00

After taxes, you end up with Br. 7.00 in interest on the $100.00 loan. In other words, your after
tax rate of interest is 7 percent. Which is (1 – 0.3) x 10%.
i = (1 – T) x i or (1 – T) x i
10
= (1 - 0.3) 100 or (1 – 0.3) x 0.10
10
= 0.7 x 100 or 0.7 x 0.10
= 70% or 0.07
= i.e. 7%

6.3 THE TIME VALUE OF MONEY

6.3.1 Future Value Analysis

It provides a way to determine how much you will have in the future time.

Eg. Principal Br. 1,000.00. Interest rate 5% Time – 1 year

FV = PV x (1 + i)r or = 0.05 x 1000 + 1000.00
= 1,000 x (1 + 0.05)1 = 50 + 1000.00
= 1,000 x (1.05) = 1050.00
= 1,050.00
What is the future value of Br. 1,000.00 in two years at 5% I.R?
Future value
End of 1st year = (1 + 0.05) x 1,000 = Br. 1,050
End of 2nd year = (1 + 0.05) x 1,050 = Br. 1,102.50

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 FV = PV x (1+i)T
= 1000 x (1+0.05)2 where =
= 1000 x 1.1025 PV = Present value
= 1000 x 1.1025 i = interest rate
= 1,102.50 T = Time period

6.3.2 Present Value Analysis

The present value is the value today of funds available at some future date. The PV of an amount
received in the future is the amount you would have to invest today, at the prevailing interest
rate, to end up with the future amount.
FV = PV x (1+i)T
FV
PV =
(1  i ) T

Your family promised to pay you Br. 2,000.00 two years from today. What is the present value
of this sum at 5% interest rate?
2000.00
PV =
(1  i) T

2000.00
=
(1  0.05) 2

2000.00
=
1.1025
= 1.814.06
Note: - 1. So long as the interest rate is positive, $1 in the future is worth less than $1 today
2. The present value of a given sum received in the future is inversely related to the
interest rate i.e. As the interest rate rises, the present value falls; conversely, the lower
the interest rate, the greater the present value of a given future amount
The present value of a future sum of money depends on
1) The interest rate
2) The length of time until you will receive the future amount, and
3) The size of the future amount

1&2 above are inversely related with PV. As they increase the PV will decrease and vice versa.

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3rd above is directly related with PV. As the size increase the PV will also increases and vice
versa.
FV1 FV2 FV3 FVT
PV =   
(1  i ) 1
((1  i ) 2
(1  i ) 3
(1  i ) T

6.4 THE VALUATION OF DEBT INSTRUMENTS

A debt instrument is simply a written promise by a borrower to pay the owner of the instrument a
specified amount (or amounts) in the future.
a) Treasury Bills and other debt instruments sold on a discount basis
Treasury bills, banker’s acceptances, discount bonds, etc. do not pay interest directly, instead
they are sold on a discount basis, that is, at a price lower than their face value. At maturity, the
owner presents these bonds to the borrower, who pays the face value. Thus, here, the return to
the owner is the difference between the face value collected at maturity and the purchase price.

There are two methods of measuring the yield of debt instruments said on a discount basis: the
discount yield method and the yields to maturity.

Fv  PTB 360
The discount yield is defined as: 
Fv Days to maturity

Where Fv = the future value of the treasury bill

PTB = the price paid for the treasury bill
For instance a Br. 10,000.00 treasury bill that matures in 365 days and was purchased for Br.
9.500 would have a discount yields of
10,000  9,500 360
Discount yield =  = 0.0498 = 4.9%
10,000 365

The yield to maturity is the interest rate at which the amount used to purchase the Treasury bill
would have to be invested to grow to the face value paid at maturity.
FV
Yield to maturity =
1 i
Consider the one-year, br. 10,000.00 Treasury bill purchased for br. 9,800.00. At what interest
rate would one have to invest Br. 9,500.00 today to end up with Br. 10,000.00 at the end of one
year?

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 10.000
Br. 9,500.00 =
1 i
10
1+i =
9.5
i = 1.053 – 1
i = 0.053 which is 5.3% This is greater than the discount yield because under
the discount yield case
- The no of days is 360
- The denominator is the Fv then the PTB

Valuing debt instruments sold on a discount basis

How much will a bank or other investor pay for a debt instrument that is sold on a discount
basis? The answer depends on the market interest rate i.e., when the interest rate is low, the
investor is willing to pay a relatively high price and earn a relatively low yield, since alternative
investments also give a low return and vice versa. The market interest rate is determined by the
interaction of demand and supply.

Interest S1
Rate (%) S2
A
7 B
6
D1
Loanable funds (m)
At this demand and supply curve interaction at the equilibrium point A the market interest rate is
7% and when the supply of money increases from S1 to S2 as (wealth) increases the equilibrium
point will be B where the market interest rate is 6%.

Calculate the present value of Br. 10,000.00 promised to be paid one year from now:
FV
Pv =
1 i
10,000
=
1.07
= br. 9,345.79

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The maximum price the seller of the Treasury bill could obtain at 7% market interest rate.
When wealth of lenders increase supply of loanable fund curve shifts to the right and the market
interest rate fall to 6%.
What will be the price of the Treasury bill with a face value of Br. 100,000 after one year?
Fv 10,000
Pv =  = Br. 9,433.96
1 i 1.06
: - The price of this Treasury bill increases from Br. 9.345.79 to Br. 9,433.96 as interest rate
decreases (falls) from 7% to 6%.

6.5 VARIABLES THAT SHIFT THE DEMAND AND/OR SUPPLY OF LOANABLE FUNDS

6.5.1 Determinants of Demand for Loanable Funds

Effects on the demand for
An increase in Loanable Funds
1. Interest rate on alternative sources of funds +
2. Inflationary expectations +
3. Tax deductibility of household interest payments +
4. Taste for borrowing +
5. Profitability of business projects +
6. Size of government budget deficits +

6.5.2 Determinants of the Supply of Loanable Funds

Effects on the supply of

An increase in Loanable Funds
1. Interest rate on alternative use of funds -
2. Inflationary expectations -
3. Tax rate on interest income -
4. Wealth +
5. Riskiness of Loan -
6. Liquidity of Loan +

6.6 COUPON BONDS AND OTHER INTEREST-BEARING DEBT INSTRUMENTS

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Unlike discount bonds, some debt instruments – such as Treasury bonds, and corporate bonds,
provide regular interest payments in addition to paying their face value at maturity.

A coupon bond specifies a coupon rate of interest. This coupon rate determines the percentage of
the face value that will be paid each year as interest.
Consider a coupon bond with
- a face value of Br. 1,000.00
- a coupon rate of 5 percent
- maturity in 20 years
The owner of the bond will receive 20 coupon payments of 0.05 x 1000. = Br. 50 each (annual
payment) i.e., interest payment to the owner.

Note: - The coupon rate of interest is applied the face value of the bond rather than to its
purchase price.

Because the coupon rate applies to the face value of the bond, it generally does not reflect the
actual yield the owner will receive over the bond’s life. This is because the owner may pay more
or less for the bond than its face value, depending on the relationship between the coupon rate
and the market interest rate.

The coupon rate will exceed the yield on a bond when the price paid exceeds the bond’s face
value; the coupon rate will be less than the yield on a bond when the price paid is less than the
face value. To measure the yield on a coupon bond we use the following methods.
1) The current yield: - It is simply the ratio of the annual coupon payment to the price paid for
the bond.
Annual coupon paynment
Current yield =
PCB

Where PCB is the price paid for the coupon bond.

Illustration = Face value of a coupon bond = Br. 1,000.00
Price paid on a coupon bond = Br. 950.00
Coupon rate of interest = 6%
Annual coupon payment = 0.06 x 1000 = Br. 60.00

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 Br.60
Current yield = = 0.063 or 6.3 percent
Br.950
: - The current yield is greater than the coupon rate because you paid less than the bond’s face
value
2) The yield to maturity - is the interest rate at which the price paid for the bond would have to
be invested to return the stream of payments generated by the bond

Annual coupon paynment  Face Value

Yield to maturity =
1 i

$60.00  $1000.00
$950.00 =
1 i
1060
1+i =
950

1+i = 1.1158
i = 0.1158 which is 11.58%
The yield to maturity is higher than both the coupon rate (6%) and the current yield (6.3 percent)
because:
- The yield to maturity takes into account the money received from both the coupon
payments and the face value payments.
- The face value of the bond exceeds the price paid for the bond.

Valuing Coupon Bonds

The price of a coupon bond reflects the present value of all future payments the bondholder
receives. If the market interest rate is i, the price of a coupon bond (PCB) will be.

PMT PMT PMT PMT  F

PCB =   
(1  i )1 (1  i ) 2 (1  i ) 3 (1  i ) T

Suppose a coupon bond pays $100 each year for two years, plus the face value of $1,000.00 at
the end of the second year. The market interest rate is 8%. What is the maximum price you
would be willing to pay for the bond?

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