Section 5 Slides

Section 5
The Financial Sector
SKG
SKG Section 5The Financial Sector 1 / 71
Objectives
Students should be able to:

Explain the concept of the Financial Sector.
Discuss the role of the Financial Sector.
Discuss the concept of money.
Explain the concepts “demand for money” and “money supply”.
Describe the role of the Central Bank.
Describe the role of financial institutions and arrangements other than the
Central Bank.
Explain the differences among the types of financial instruments. SKG Section
5The Financial Sector 2 / 71
The Financial Sector
The financial sector is a section of the economy made up of firms and

institutions that provide financial services to commercial and retail
customers. This sector comprises a broad range of industries including
banks, investment companies, insurance companies, and real estate
firms.
The financial sector plays an important role in the functioning of the

economy through intermediation. Simply put, the financial sector sits
between savers and borrowers: it takes funds from savers (for
example, through deposits) and lends them to those who wish to
borrow such as households, businesses and governments.
Functions of the Financial Sector
Encourages savings.
Lends savings to borrowers (investors) and make a profit from
it. Provides support for businesses so that they succeed.
Provides short-term loans to firms so that they can cover

their expenses.
Money
Money is defined by its functions. It is a medium of exchange, unit of

account, store of value and standard of deferred payment, generally
accepted as a means of settling debts.
Money is also a legal tender. A legal tender is anything recognized by

law as a means to settle a public or private debt or meet a financial
obligation.
Functions of Money
1. Medium of Exchange: Money is widely accepted in exchange

for goods and services. The Central Bank declares money as
a legal tender, that is, it is acceptable in the settlement of
debts.
2. Unit of Account: Money is a common measure of the relative value of

goods and services. Without money, it is difficult to set prices for
goods and services.
3. Store of Value: Money has the ability to hold value overtime. It can
be put away without spoilage.
4. Standard of Deferred Payment: Money facilitates transactions to be

carried out on a credit basis - payments for goods and services can
be made in the future.
Characteristics of Money
1. Homogeneity: Money should be uniform. Each unit should be of the

same size, shape and value.
2. Durability: Money must be able to last a very long time. It should

not wear out easily.
3. Divisibility: It should be easy for money to be broken down into

smaller units.
4. Scarce/Limited in supply: In order to maintain its value, money must

have a limited supply. It should not be plentiful like sand.
5. Portability: Money should be very lightweight so it can be easily

carried around.
6. Acceptability: Money must be easily recognizable and

generally accepted by a population.
The Development of Money

Money has been part of human history for at least the last 3,000
years. Before that time, people relied on the barter system.
Barter is the direct exchange or trade of goods and services. For

example, a farmer may exchange a bushel of wheat for a pair of shoes
from a shoemaker. The process of meeting ones needs is slow,
cumbersome, time consuming and very impractical. There must be what
is called double coincidence of wants, whereby two people have to have
the appropriate goods or services which each other wants. Therefore,
money makes the whole process of exchange and trade so much easier
and simpler.
Slowly, a type of currency, involving easily traded items, like animal

skins, salt and shells, developed over the centuries. These traded goods
served as the medium of exchange (even though the value of each of
these items was still negotiable in many cases). This system of trading
spread across the world, and it still survives today in some parts of the
globe.
Around 770 B.C., China used tools and weapons as a medium of
exchange. However, these were eventually simplified into objects in
the shape of a circle. So, China was the first country to use an object
that modern people might recognize as coins. Also, around this time,
the Chinese moved from coins to paper money.
Parts of Europe were still using metal coins as their sole form of
currency all the way up to the 16th century. However, banks eventually
started using paper banknotes for depositors and borrowers to carry
around in place of metal coins. These notes could be taken to the bank
at any time and exchanged for their face value in metal, usually silver or
gold, coins. This paper money could be used to buy goods and services.
In this way, it operated much like currency does today in the modern
world. However, it was issued by banks and private institutions, not the
government, which is now responsible for issuing currency in most
countries.
In the 21st century, people also use credit and debit cards,
electronic money such as PayPal, and virtual currencies such as
Bitcoin.
Problems with Barter
Double coincidence of wants: A person had to find someone who

wanted what they had and who is also offering what they
themselves want. For example, if Paul had a cow and want some
chickens, he would have to find someone who wants a cow and
can offer him chickens at the same time. This is extremely difficult
at times.
Divisibility of goods: Some rates of exchange made it difficult for
exchange to take place because the goods cannot be divided into
smaller parts. For example, if a live cow is worth 20 chickens and
Paul came across a person who only has 10 chickens, it would not
be
possible for trade to take place because a half cow cannot be
kept alive.
Storage of wealth: It was impossible for certain goods to be kept for

a long period of time as they would spoil.
It is because of these disadvantages that the development of money

took place.
The Demand for Money
The demand for money refers to the desire to hold money in the form of
cash or in current accounts.
There are three motives for holding money:

1. Transaction Demand for Money
2. Precautionary Demand for Money
3. Speculative Demand for Money
Transaction Demand for Money
The transaction demand for money refers to the stock of money people
hold for everyday expenses (predictable expenses).
The transaction demand for money is determined by the level of

income. The larger a person’s income, the more money he/she will
demand for transaction purposes.
The transaction demand for money is also determined by the price level.
If prices are increasing, more money will be held for the transaction
motive.
This demand for money is interest inelastic (not affected by changes in

the interest rate).
SKG Section 5The
Financial Sector 17 / 71
SKG Section 5The Financial
Sector 18 / 71
Precautionary Demand for Money

The precautionary demand for money refers to money held as a means
of insurance against unforeseen circumstances.
This demand for money increases as income increases and is also

interest inelastic.

SKG Section 5The Financial
Sector 20 / 71
SKG Section 5The
Money held for the transaction and precautionary motives are

sometimes referred to as active balances, as they are likely to be spent
in the near future.
Speculative Demand for Money
The speculative demand for money is when people wish to hold money
rather than buy bonds or risky investment.
This motive is interest elastic and money held for this motive is
sometimes called idle balances.
SKG Section 5The
Money Supply
The money supply is the total stock of assets that are generally
acceptable as media of exchange within an economy at a particular
time.
Measurement of the Money Supply

There are three main measures of the money supply:
1. M0
2. M1
3. M2
M0
This is currency in the hands of the public plus reserves held on behalf
of commercial banks.
M1
This is notes and coins outside of the banking system plus current
account balances.
M2
This is M1 plus short-term time savings deposit, foreign currency

transferable deposits, certificates of deposit and repurchase
agreements.
NB: M2 is sometimes referred to as broad money, while M0 and M1 are

sometimes referred to as narrow money.
Central Bank
A Central Bank is responsible for overseeing the monetary system for a

nation (or group of nations), along with a wide range of other
responsibilities, from overseeing monetary policy to implementing
specific goals such as currency stability, low inflation, and full
employment.
Central Banks also supervise other financial institutions,

especially commercial banks.
Example: Bank of Jamaica
Roles of a Central Bank
Issue money: The Central Bank will have responsibility for

issuing notes and coins and ensure people have faith in notes
which are printed, e.g. protect against forgery. Printing money is
also an important responsibility because printing too much can
cause inflation.
Lender of last resort to commercial banks: If banks get into liquidity

shortages then the Central Bank is able to lend the commercial bank
sufficient funds to avoid the bank running short. This is a very
important function as it helps maintain confidence in the banking
system. If a bank ran out of money, people would lose confidence
and want to withdraw their money from the bank. Having a lender of
last resort means that we do not expect a liquidity crisis with our
banks, therefore people have high confidence in keeping their
savings in banks.
Target low inflation: Many governments give the Central Bank a

target for inflation, e.g. the Bank of Jamaica has an inflation target
of 4% to 6%.
Target growth and unemployment: As well as low inflation, a

Central Bank will consider other macroeconomic objectives such as
economic growth and unemployment. For example, in a period of
temporary cost-push inflation, the Central Bank may accept a
higher rate of inflation because it does not want to push the
economy into a recession.
Operate monetary policy/interest rates: The Central Bank set

interest rates to target low inflation and maintain economic growth.
The Central Bank uses interest rates to control the money supply
in the economy, which then affects the level of inflation.
Instruments of Monetary Control
There are various ways in which the Central Bank can control the
money supply:
Interest rate
Reserve requirement
Open market operation
Moral suasion
Interest Rate
This instrument of monetary policy aims to influence the amount of bank

lending by acting on the demand for loans. This is based on the view
that the demand for bank loans depend on the price. The price, in this
case, is the interest rate. Central Banks will, therefore, target the interest
rate in order to influence the money supply.
When interest rate decreases, people demand more loans, money

supply increases (more money in the hands of the public).
When interest rate increases, people demand less loans, money

supply decreases (less money in the hands of the public).
Reserve Requirement
Commercial banks practice fractional reserves banking, that is, a portion

of what they accept as deposit is kept at the Central Bank as reserves
and the other portion is used to make loans. The amount that is kept as
reserves is determined by the reserves ratio. This is the percentage of
deposits that commercial banks will hold as reserves.
For example, if the reserves ratio is 10% and the total deposits are
$1000, then $100 will be kept as reserves and $900 will be used to
make loans.
If the Central Bank wants to increase the money supply, it could

decrease the reserves ratio, so banks would have more money to lend. If
it wants to decrease the money supply, it could increase the reserves
ratio.
Open Market Operation
This describes the purchase and sale of financial instruments by the

Central Bank to increase or decrease the money supply. These financial
instruments are certificates issued by the Central Bank. Trading is done
in the open market through regular dealers and securities.
To decrease the money supply, the Central Bank will sell treasury bills
- taking money out of the hands of the public. The public will be
issued with certificates of deposits which carry a special rate of
interest.
To increase the money supply, the Central Bank will purchase treasury
bills or certificates of deposits, putting money into the hands of the public.
Moral Suasion
This is persuasion that takes place in the form of letters and verbal
statements that the Central Bank uses to try to encourage commercial
banks to take actions necessary to control or encourage spending.
Governments sometimes appeal to the public to control spending or
reduce imports.
Commercial Bank
A commercial bank a financial institution that accepts deposits, offers

checking account services, makes various loans, and offers basic
financial products like certificates of deposit (CDs) and savings
accounts to individuals and small businesses.
Example: National Commercial Bank (NCB)

Roles of a Commercial Bank
Accepting deposits: Commercial banks accept money from the

public in current accounts, savings account or fixed deposits.
Granting loans/Credit creation: A percentage of deposits is used

to make loans to the general public.
Promoting entrepreneurship: Loans by commercial banks induces

new entrepreneurs to start their own businesses.
Financing foreign trade: A commercial bank helps in foreign trade

by financing his customers and by accepting foreign bills of
exchange. Also, it transacts foreign exchange business and buys
and sells foreign currency.

Financing the government: Banks provide long-term credit to
governments by investing their funds in government securities
and short-term finance by purchasing treasury bills.
Governments also borrow from commercial banks to finance
budget deficits.
Stock Exchange
A stock exchange is a market where securities such as stocks, shares
and bonds are bought and sold.
Example: Jamaica Stock Exchange
Roles of a Stock Exchange
Creating investment opportunities for small investors: Stock

markets allow investors to put their money to good use in a
business without dealing with all the hassles of actually owning and
running a company. If investors choose wisely, they make money
through their investments. In return, the companies they invested in
get to use the influx of money to develop their businesses.
Individual investors get a chance to participate in and benefit from
the growth of various businesses, while limiting their risk to no more
than what they invested.
Raising capital for businesses: For businesses that lack the

resources necessary for growth, selling shares on the stock market
can provide an infusion of capital, which a company can then use
to develop and
strengthen the organization. For example, suppose a company has
an idea for a new product but can’t afford to produce and market it.
The company can sell shares of itself on a stock exchange, trading
partial ownership for the chance to increase the company’s value.
Government capital-raising for development projects: Governments

may decide to borrow money in order to finance infrastructure
projects such as sewage and water treatment works or housing
estates by selling bonds. These bonds can be raised through the
stock exchange, where members of the public buy them, thus
loaning money to the government. The issuance of such bonds may
result in a reduction in taxes as the government may not see a need
to tax citizens in order to finance development.
Credit Union
A credit union is a cooperative that makes small loans to its members at
low interest rates and offers other banking services (such as savings
and checking accounts).
Like banks, credit unions accept deposits, make loans and provide a
wide array of other financial services. However, as member-owned and
cooperative institutions, credit unions provide a safe place to save and
borrow at reasonable rates.
Example: EduCom Co-operative Credit Union
Development Bank
A development bank is a bank which have been set up mainly to provide
infrastructure facilities for the industrial growth of a country.
Example: Development Bank of Jamaica
Roles of a Development Bank
Development of the housing sector: Development banks promote

and finance housing.
Agricultural and rural development: Development banks help in the

development of agriculture by providing credit to the agriculture
sector and also for rural development activities. It coordinates the
working of all financial institutions that provide credit to agriculture
and rural development. It also provides training to agricultural
banks and helps to conduct agricultural research.
Enhance foreign trade: Development banks help to promote foreign

trade by providing medium and long-term loans to exporters and
importers. They also encourage abroad banks to provide finance to
the buyers in their country to buy capital goods from local countries.
Regional development: Development banks facilitate rural and

regional development. They provide finance for starting companies
in backward areas. They also help the companies in project
management in such less-developed areas.
Insurance Company
An insurance company is a financial institution that provides a range of

insurance policies to protect individuals and businesses against the risk
of financial losses in return for regular payments of premiums.
Example: Advantage General Insurance Company

Roles of an Insurance Company
Pay a beneficiary in the event of a claim: When a client purchases

an insurance policy, he pays a premium every month as part of the
contractual understanding that he will receive a certain amount of
money in the event of a specific loss.
Act without discrimination: While an insurance company may

reserve the right to refuse service, it cannot refuse service to an
individual or cancel a policy based on a client’s marital status, race,
disability, religion or sexual orientation. Additionally, an insurance
company cannot restrict the terms or benefits listed in an insurance
policy because of a client’s marital status, race, disabilities, religion
or sexual orientation.

Mutual Fund
A mutual fund is a company that pools money from many investors and
invests the money in securities such as stocks, bonds, and short-term
debt.
Example: Jamaica National Mutual Funds

Roles of a Mutual Fund
Make investment decisions for potential investors: Some persons

prefer to let mutual funds make their investment decisions for
them.
Sell unprofitable investments: After making an investment

decision, mutual funds can always sell any securities that are not
expected to perform well.
Building Society
A building society is a bank that holds and invests the money saved by
its members and that provides loans and mortgages.
Example: Victoria Mutual Building Society (VMBS)

Roles of a Building Society
Attract savings from its members: The savings of the members

provide most of the funds that the borrowers use to buy their
properties. The borrowers pay interest on their loans and this is
used to pay investors interest on their deposits.
Make loans for house purchases to borrowers

Investment Trust Company
An investment trust company is a company which exist to invest in the

shares of other companies.
Example: PanJam Investment Limited

Roles of an Investment Trust Company
They provide funds to business by acting as intermediaries: They

channel funds from financial institutions and households to
businesses through the stock market and these funds can help
businesses grow and expand.
They provide their investors with investments tailored to investors’

individual requirements, for example, the degree of risk an investor
is willing to take and the rate of return he/she expects.

Informal Credit Institutions
Informal credit institutions are financing activities that are mostly legal but
their activities are often unrecorded, unregistered and unregulated by
government. They are also referred to as Informal financial institutions.
Example: Partner, also known as Sou-Sou, Box, Meeting Turns SKG Section 5The
Roles of Informal Credit Institutions
They minimise transaction costs that are generally not available

to most formal financial institutions.
They act like a “bank” in rural areas and for people who do not trust
formal financial institutions.

Financial Instruments
A financial instrument is a contract between two parties that holds a

monetary value.
Some examples of financial instruments are:

Treasury bills
Treasury notes
Treasury bonds
Corporate bonds
Municipal bonds
Equity securities
Share and stock certificates
Certificates of deposit (CDs)

Treasury Bills, Notes & Bonds
Treasury bills are government bonds or debt securities with maturity of

less than a year.
Treasury notes are government bonds or debt securities with maturity of

2 to 10 years.
Treasury bonds are government bonds or debt securities with maturity of

more than 10 years.

Corporate Bonds
Corporate bonds are bonds issued by companies that are seeking to

raise funds to invest in their businesses.

Municipal Bonds
Municipal bonds are debt securities issued by state and local

governments. These can be thought of as loans that investors make
to local governments, and are used to fund public works such as
parks, libraries, bridges & roads, and other infrastructure.

Equity Securities
Equity securities are investments in stock issued by another company. SKG
Section 5The Financial Sector 66 / 71

Share & Stock Certificates
Share and stock certificates are legal documents that certifies ownership
of a specific number of shares or stock in a corporation.

Certificate of Deposit (CD)
A certificate of deposit (CD) is a savings account that holds a fixed

amount of money for a fixed period of time, such as six months, one
year, or five years, and in exchange, the issuing bank pays interest.

Past Paper Questions
Paper 2 June 2013 #4

(a) Define EACH of the following terms:
(i) Barter
(ii) Legal tender [4 marks]
(b) State the main disadvantage of barter. [1 mark]
(c) Explain THREE functions of a Central Bank. [6 marks] SKG Section 5The Financial
Sector 69 / 71
(d) To which function of money does each of the following

scenarios apply?
(i) Mark compares the price of a Lacoste polo shirt to the price of a pair
of Ralph Lauren shorts.
(ii) Margaret joins a meeting turn (sou-sou or box hand or partner or
sindicato).
(iii) Odette takes a loan to pursue a Masters degree.
(iv) Peter buys a Mercedes Benz car for US $120,000. [4 marks] Total 15
marks
Paper 2 June 2009 #3

(a) List TWO functions of money. [2 marks]
(b) Identify THREE roles of the financial sector in an economy. [3 marks]
(c) Explain how the Central Bank can restrict the money supply in a
named Caribbean country. Include TWO ways in your response. [4
marks]
(d) Outline THREE functions of a Central Bank other than restricting the
money supply. [6 marks]
Total 15 marks

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Section 5

The Financial Sector

SKG Section 5The Financial Sector 1 / 71

Students should be able to:

5The Financial Sector 2 / 71

The Financial Sector

The financial sector is a section of the economy made up of firms and

The financial sector plays an important role in the functioning of the

SKG Section 5The Financial Sector 3 / 71

Functions of the Financial Sector

it. Provides support for businesses so that they succeed.

Provides short-term loans to firms so that they can cover

SKG Section 5The Financial Sector 4 / 71

Money is defined by its functions. It is a medium of exchange, unit of

Money is also a legal tender. A legal tender is anything recognized by

SKG Section 5The Financial Sector 5 / 71

1. Medium of Exchange: Money is widely accepted in exchange

2. Unit of Account: Money is a common measure of the relative value of

4. Standard of Deferred Payment: Money facilitates transactions to be

SKG Section 5The Financial Sector 6 / 71

1. Homogeneity: Money should be uniform. Each unit should be of the

2. Durability: Money must be able to last a very long time. It should

3. Divisibility: It should be easy for money to be broken down into

4. Scarce/Limited in supply: In order to maintain its value, money must

SKG Section 5The Financial Sector 7 / 71

5. Portability: Money should be very lightweight so it can be easily

6. Acceptability: Money must be easily recognizable and

The Development of Money

SKG Section 5The Financial Sector 9 / 71

Barter is the direct exchange or trade of goods and services. For

SKG Section 5The Financial Sector 10 / 71

Slowly, a type of currency, involving easily traded items, like animal

SKG Section 5The Financial Sector 11 / 71

SKG Section 5The Financial Sector 12 / 71

Problems with Barter

Double coincidence of wants: A person had to find someone who

SKG Section 5The Financial Sector 13 / 71

Storage of wealth: It was impossible for certain goods to be kept for

It is because of these disadvantages that the development of money

The Demand for Money

There are three motives for holding money:

Transaction Demand for Money

The transaction demand for money is determined by the level of

This demand for money is interest inelastic (not affected by changes in

SKG Section 5The

Precautionary Demand for Money

This demand for money increases as income increases and is also

SKG Section 5The Financial Sector 19 / 71

Money held for the transaction and precautionary motives are

Speculative Demand for Money

SKG Section 5The

SKG Section 5The Financial Sector 25 / 71

Measurement of the Money Supply

SKG Section 5The Financial Sector 26 / 71

SKG Section 5The Financial Sector 27 / 71

SKG Section 5The Financial Sector 28 / 71

This is M1 plus short-term time savings deposit, foreign currency

NB: M2 is sometimes referred to as broad money, while M0 and M1 are

SKG Section 5The Financial Sector 29 / 71

A Central Bank is responsible for overseeing the monetary system for a

Central Banks also supervise other financial institutions,

Example: Bank of Jamaica

SKG Section 5The Financial Sector 30 / 71