Master of Business Administration

Department: Finance and Banking

Course: money and banking

Course Code: MBA2125

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 MONEY AND BANKING

INTRODUCTION
Money and banking is a significant course to you in your academic pursuit as it will
assist you to gain an in-depth understanding on how the banks and other financial
institutions operate. More importantly, this course critically examined the relevant
issues regarding money, credit and financial issue. It made some assumptions to
serve as a guide to you for you to know the crucial role of the course in enhancing
the stability of money in our economy.
Furthermore, this course will broaden your knowledge on how the economy is
stabilized using the government monetary and fiscal policies. Subsequently, the
course will inform you on what money and banking is and how money can be created
in the banking industry.
Aside that, the course will also expose you to knowledge about different kinds of
exchange rate in the exchange rate market. This course guide will provide you some
guidance on your Tutor-Marked Assignment (TMA) as contained herein.

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 Money Evolution and functions of money
The barter system before the evolution of money, exchange was done on the basis
of direct exchange of goods and services. This is known as barter. Barter involves
the direct exchange of one good for some quantity of another good. Example, a
horse may be exchanged for a cow, or 3 sheep or 4 goats. For a transaction to take
place, there must be a double coincident of wants. Thus a barter economy is a
moneyless economy, it is also simple economy where people produce goods either
for self-consumption or fro exchange with other goods which they want, barter was
found in primitive societies, but it is still practiced at place where the use of money
has not spread much. Such non monetized areas are to be found in many rural areas
of underdeveloped countries.

Difficulties of barter
The barter system is the most inconvenient method of exchange. It involves loss of
much time and effort on the part of people in trying to exchange goods and
services. As a method of exchange the barter system has the following difficulties
and disadvantages.

Difficulties and disadvantages

1. Lack of double coincidence of wants: The functioning of the barter system

requires a double coincidence of wants on the parts of those who want to

exchange goods or services. It is necessary for a person who wishes to trade his
good or service to find some other person who is not only willing to buy his
good or service but also possesses that good which the former wants
2. Lack of a common measure of value : Another difficulty under the barter
system relates to the lack of a common unit in which the value of goods and
services should be measured
.even if the two persons who want each other’s goods meet by coincidence ,the
problem arises as to the proportion in which the two goods should be
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exchanged there being no common measure of value the rate of exchange
will be arbitrarily fixed according to the Intensity of demand for each other’s
goods consequently ,one party is at a disadvantage in the terms of trade
between the two goods.

3. Indivisibility of certain goods: The barter system is based on the exchange

of goods with other goods. It is difficult to fix exchange rates for certain goods
which are indivisible. Such indivisible goods pose a real problem under barter.
A person may desire a horse and the other a sheep and both may be willing to
trade the former may demand more than four sheep for a horse but the other is
not prepared to give five sheep and thus there is no exchange. If a sheep had
been divisible a payment of four and a half sheep for a horse might have been
mutually satisfactory. Similarly, if the man with the horse wants only two
sheep then how will he exchange his horse for two sheep? As it is not possible
to divide his horse no trade will be possible between the two people. Thus
individuality of certain goods makes the barter system inoperative

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 .
3. Difficulty in storing value: Under the barter system it is difficult to store
value. Anyone wanting to save real capital over a long period would be faced
with the difficulty that during the intervening period the stored commodity
may become obsolete or deteriorate in value. As people trade in cattle grains
and other such perishable commodities it is very expensive and often the long
period.
4. Difficulty in making deferred payments: In a barter economy it is difficult to

make payments in the future. As payments are made in goods and services debt
contracts are not possible due to disagreements on the part of two parties on the
following grounds:
a. It often invites disagreement as to quality of the goods or service to be repaid.

b. The two parties would often be unable to agree on the specific commodity to

be used for repayment.

c. Both parties would run the risk that the commodity to be repaid would

increase or decrease seriously in value over the duration of the contract.

5. Lack of specialization. Another difficulty of the barter system is that it is

associated with a production system where each person is a jack –of-all trades.
In other words, a high degree of specialization is difficult to achieve under the
barter system. Specialization and interdependence in production is only
possible in an expanded market system based on the money economy. Thus no
economic progress is possible in a barter economy due to lack of
Specialization. The above mentioned difficulties of barter have led to the
evolution of money.

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The evolution of money
The word money is derived from the Latin word Moneta which was the
surname of the roman goddess of Juno in whose temple at Rome money was
coined the origin of money is lost in antiquity. Even the primitive man had
some sort of money. The type of money in every age depended on the nature of
its livelihood. In a hunting society the skins of wild animals were used as
money. The pastoral society used livestock whereas the agricultural society
used grains and foodstuffs as money. The Greeks used coins as money.
Stages in the evolution of money

The evolution of money has passed through the following five different times
and places.

1. Commodity money: Various types of commodities have been used as

money from the beginning of human civilization. Stones, spears, skins,
bows, and arrows

The use of commodities as money had the following defects

a. All commodities were not uniform in quality, such as cattle, grains, etc. thus
lack of standardization made pricing difficult.

b. Difficult to store and prevent loss of value in the case of perishable

commodities.
c. Supplies of such commodities were uncertain
d. They lacked in portability and hence were difficult to transfer from one place
to another.

e. There was the problem of indivisibility in the case of such commodities as

cattle.
2. Metallic money: With the spread of civilization and trade relations by land
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and sea, metallic money took the place of commodity money. Many nations
started using silver, gold, copper, tin, etc as money. But metal was an
inconvenient thing to accept, weigh, divide, and assess in quality. Accordingly,
metal was made into coins of predetermined weight. This innovation is
contributed to king Mides of Lydia in the eighteen century. But gold coins’
Ware used in india many centuries early then Lydia. Thus coins came to be
accepted as convenient method of exchange.

As the price of gold began to raise, gold coins’ ware meted in order to earn
more by selling them as a Metal led government to mix copper or silver in gold
coins so that their intrinsic value might more than their face value. Metal
money had the following defects.

a. It was not possible to change its supply according to the requirements of the

nation both internal and external use

b. Being heavy, it was not possible to carry large sum of money in the form of

coins from one place to another by merchants

c. It was unsafe and inconvenient to carry precious metals for trade purpose

over long distances

d. Metallic money was very expensive

3. Paper money: The development of paper money started with goldsmiths

who kept strong safes to store their gold, as goldsmiths were thought to
be honest merchants, people started keeping their gold with them for safe
custody. In return, the goldsmith gives the depositors a receipt promising
to return the gold on demand. These receipts of the goldsmiths were
given to the seller of commodities by the buyers. Thus receipts of
goldsmiths were a substitute for money. This ultimately led to the

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 development of bank notes. The bank notes are issued by the central
bank of the country.

4. Credit money. Another stage in the evolution of money in the modern

world is the use of the cheque as money. The cheque is like a bank note
in that it performs the same function. It is a means of transferring money
or obligations from one person to another, but a cheque is different from
a bank note. A cheque is made for a specific sum, and it expires with a
single transaction, but a cheque is not money. It is simply a written order
to transfer money. However large transactions are made through cheques
these days and bank note are used only for small transactions.
5. Near money. The final stage in the evolution of money has been the use
of bill of exchange, Treasury bill bonds, debentures, savings certificates,
etc they are known as near money they are close substitutes for money
and are liquid assets. Thus in final stage of its evolution money has
become intangible. Its ownership is now transferable simply by book
entry Thus the origin of money has been through barious stages: from
commodity money to metallic money and to paper money and from
credit money to near money.

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Classification of Money
Money can be classified on the following different bases.
1. The physical characteristics of the materials of which money is made: or the

monetary system standard and

2. the nature of the issuer such as a government, central bank commercial bank or

other or the acceptability standard and

3. The relationship between the value of money as money and the value of money

as commodity or what Keynes called money of account and proper.

We shall follow this classification while explaining the various kinds of money.
1. Monetary system standard: the monetary system standard classified money
into.

a. Metallic money

b. Paper Money

c. Credit money

2. Acceptability standard: on the bias of acceptability standard money is

classified into legal tender money and non –legal tender money Legal tender
money is that which the state and the people accepted as the means of
payment and in discharge of debts.
It has the authority of the government; such money is accepted compulsory
by the people. All notes and coins are issued by the government and the
central bank of a country is compulsory legal tender in that country. Non
legal tender or optional money, money which does not possess any legal
authority of the state or central bank in non-legal tender money People are
not bound to accept such money because there is no legal authorize behind
their issue.
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 3. Money of account and money proper: Keynes distinguished between

money of account and money proper. According to him “money of account

is that in which debts and prices and general purchasing power are
expressed. “on the other hand money proper is the actual money in which
contracts or debts are settled such as the Indian rupee the British pound the
American dollar the French franc the German mark the Japanese yen the
Italian liar etc.
Characteristics of money
Economists have pointed towards the following characteristics or qualities for a
thing to be money

1. General acceptability. For anything to be money, it should be acceptable by

everybody. People accept thing as money which is used by everybody as a

medium of exchange. Gold and silver are considered 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
accepted generally, hence they are not money.
2. Durability. For a think to be money, it must possess durability. It should be

storable and last long without losing its value over a period of time. Animals
and perishable commodities are not good money materials because they do
not possess durability. In this sense, gold, silver, etc. are the best material
which are used as money, paper money are less durable than these metals.
But they are money because they are legal tender.
3. Portability. The material used as money should be easily carried and

transferred one place to another. It should contain large value in small bulk.
Gold and silver possess this quality; hence they are good money materials.
But they involved risk in carrying or transferring them from one place to
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 another.
4. Homogeneity: The material with which money is made should be of the

same quality. All coins of one denomination must be of same metal, weight,
shape and size, similarity, paper notes of one denomination must have the
same quality of paper, design and size.
5. Divisibility: The money material should be capable of being divided into

smaller parts without losing value. Gold, silver, and other such materials
possess this quality; gold has the same value in whatever number of parts it
may be divided. The sum is the case with paper when notes of small and
large denominations are issued which facilitate the operation of small and
large transactions.
6. Stability: Money should be stable in the value because it has to serve as a

measure of value. Gold and silver possess this quality because they are not
available in abundance. They are neither very scarce because being durable,
they can be easily stocked. Their supplies can thus increase or decreased
when required, so they act as a store of value because their value is stable.
But governments prefer paper money to gold and silver because it is cheap
and easily available. Its value is kept stable by keeping control over its issue.
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. The functions are
discussed below:

3.3.1 Primary Functions of Money

The primary functions are subdivided into two they are medium of exchange
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and money as a unit of value
i. Money as a Medium of Exchange-- Money as a medium of exchange,
acts as an intermediary i.e. it facilitates exchange. The introduction of
money as a medium of exchange decomposes the single transaction of
barter into separate transactions of sale and purchase, thereby
eliminating the double coincidence of want. Also money as a medium of
exchange helps production indirectly through specialization and division
of labour which in turn increase efficiency and output.
ii. Money as Unit of Value: Money as a unit of value means that money is
the standard for measuring value just as the yard or metre is the standard
for measuring length. The use of money as a standard of value
eliminates the necessity of quoting the price of apples in terms of
oranges, the price of oranges in terms of nut etc. Thus, money as a unit
of value facilitates accounting and also helps in calculation of economic
importance such as the estimation of the costs and revenues of business
firms, the relative costs and profitability of various public enterprises
and projects under a planned economy.
3.3.2 Secondary Function of Money
The secondary functions money is subdivided into three, they are;
i. Money as a standard of deferred payment---- Money as a standard
of deferred payment means that purchase can be made now and payment
will take effect in the future. Thus, by acting as a standard of deferred
payment, money helps in capital formation both by the government and
businesses Enterprise. The important thing about these functions is that
it develops the financial and capital markets and also helps in the growth
of the economy.

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ii. Money as a store of value---- Money as a store of value is meant to
meet unforeseen emergencies and to pay debt. In other words, one can
store value for the future by holding short-term promissory notes, bonds,
preferred stocks, e.t.c The disadvantages of these function is that they
sometimes involve storage cost, depreciate in terms of money and are
illiquid in varying degrees.
iii. 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 from person to person and place to place. A person who holds
money in cash or assets can transfer that to any other person.
3.3.3 Contingent Functions of Money
Money performs certain contingent or incidental functions, such as;
i. Money as the most liquid of all liquid assets: This means that money
is the most liquid of all liquid assets in which wealth is held. Individuals
or firms may hold wealth in various forms. They may decide to hold
their wealth in currency, demand deposit, time deposit, treasure bills,
short term government securities etc. All these are liquid forms of
wealth which can be converted into money.
ii. Basis of the credit system: Money is the basis of credit system,
meaning that a commercial bank cannot create credit without having
sufficient money in reserve.
iii. Equalizer of Marginal utilities and productivities: Money acts as an
equalizer of marginal utilities for the consumer. The main aim of a
consumer in this regard is to maximize his satisfaction by spending a
given sum of money on various goods which he wants to purchase.
iv. Distribution of National Income: Money also helps in the distribution
of national income. Thus, the rewards of factors of production in the
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 form of wages, rent, interest and profit are determined and paid in terms
of money
3.3.4 Other Functions of Money
Money performs other functions apart from the aforementioned ones such as;
i. Money is helpful in making decisions--- This means that money is a
means of store of value and the consumer can meet her daily
requirement on the basis of money held by him. If the consumer has a
scooter and in the near future he needs a car, he can buy a car by selling
his scooter and money accumulated by him. In this way, money helps in
taking decisions.

ii. Money as a basis of adjustment--- To carry on trade in a proper

manner, the adjustment between money market and capital market is
done through money. Similarly, adjustment in foreign exchange rate and
international payments are made through money.
ROLE OF MONEY IN THE ECONOMY
Money is of vital importance to an economy due to its static and dynamic roles. Its
static role emerges from its static or traditional functions. In its dynamic role, money
plays an important part in the life of every citizen and in the economic system as a
whole (M.L.Jhingan, 2010).

3.4.1 Static Role of Money

In its static role, the importance of money lies in removing the difficulties of barter in
the following ways:

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i. By serving as a medium of exchange, money removes the need for double
coincidence of wants and the inconveniences and difficulties associated with barter.
The introduction of money as a medium of exchange breaks up the single
transactions of barter into separate transactions of sales and purchases, thereby
eliminating the double coincidence of wants

ii. By acting as a unit of account, money becomes a common measure of value. The
use of money as a standard of value eliminates the necessity of quoting prices.
iii. By acting as a store of value, money removes the problem of storing of
commodities under barter. Money being the most liquid asset can be kept for long
periods without deterioration or hostage.

iv. Money removes the difficulty of barter by facilitating the transfer of value from
one place to another.

V. Money as a standard of deferred payment, simplified both taking and repayment

of loans because the unit of account is durable. It also overcomes the difficulty of
indivisibility of commodities.
3.4.2 Dynamic Role of Money
Money in its dynamic role plays an important part in the daily life of a person
whether he is a consumer, producer, business man, politician etc. The Dynamic role
of money influences the economy in number of ways:
i. Money possesses much significance for the consumer: That is, consumer
receives his income in the form of money rather than in goods and services. With
money in his hand, he can get any commodity and services he likes, in whatever
equalizer of marginal utilities for the consumer.

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ii. Money is of equal importance to the producer. He keeps his account of the values
of input and outputs in money.

iii. Money plays an important role in large scale specialization and division of labour
in modern production i.e. it helps the capitalist to pay wages to a large number of
workers engaged in specialized jobs on the basis of division of labour.

iv. By transforming savings into investment, money acts as a means to capital

formation. Money in its form is a liquid asset which can be stored and storing of
money implies savings and savings are kept in bank deposit to earn interest on them.

v. Money is also an index of economic growth. The various indicators of growths are
national income, per capita income and economic welfare. These are calculated and
measured in money terms. For instance, changes in the value of money or prices also
reflect the growth of an economy.

vi. Money facilitates both national and international trade. The use of money as a
medium of exchange, store of value and as a transfer of value has made it possible to
sell commodities not only within a country but also internationally.
vii. Money helps in solving the central problems of an economy; what to produce, for
whom to produce, how to produce and in what quantities. This is because on the
basis of its functions, money facilitates the flow of goods and services among
consumers, producers and the government

viii. Money facilitates the buying and collection of taxes, fines fees, and prices of
service rendered by the government to the people. It also simplifies the floating and
management of public debt and government expenditure on development and non
developmental activities.
The Concept of Monetary Policy
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What Is Monetary Policy?
Simply put, monetary policy is a government policy about money. It is a deliberate
manipulation of cost and availability of money and credit by the government as a
means of achieving the desired level prices, employment output and other economic
objectives. The government of each country of the world embarks upon policies that
increase or reduce the supply of money because of the knowledge that money supply
and the cost of money affect every aspect of economy. By affecting the aggregate
demand, money supply affects the level of prices and employment. It also affects
investment levels, consumption, and the rate of economic growth. An increase or
reduction in the cost of money (interest rate) affects all these variables.
Monetary policy can be defined “the combination of measures designed to regulate
the value, supply and cost of money in an economy, in consonance with the expected
level of economic activity.”
One idea is central in this and other definitions given above - that monetary policy
focuses on money supply as a means of achieving economic objectives. If the
government thinks that economic activity is very low, it can stimulate activities again
by increasing the money supply. But when the economy is becoming so much that
the rate of inflation is high, it will reduce the supply of money. This will reduce
aggregate demand in and the general price level. However, it can also lead to
unemployment and stunted economic growth. As you will see later, there is often a
conflict between the objectives of monetary policy. It is difficult to achieve all the
objectives simultaneously.

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Mpolicy is a major economic stabilization weapon which involves measures
designed to regulate and control the volume, cost of availability and direction of
money and credit in an economy to achieve some specified macroeconomic policy
objectives.
That is, it is a deliberate effort by the monetary authorities (the Central Bank) to
control the money supply and credit conditions for the purpose of achieving certain
broad economic objectives (Wrightsonan, 1976).
Monetary policy is administered by the Central Bank, in some cases with degree of
political/ Government Interference. the Central Bank has the duty of ensuring that
policies are set in motion to ensure that the monetary system is directed towards
achieving national objectives.

Monetary policy is the control of the supply of money and liquidity by the Central
Bank through “open market” operations and changes in the “minimum lending rate”
to achieve the government’s objectives of general economic policy.
The control of the money supply allows the Central Bank to choose between “a tight
money” and “easy money” policy and thus in the short to medium-run to affect the
fluctuation in output in the economy.
Monetary policy could, therefore, generally be defined as follows:
(a) As an attempt to influence the economy by operating on such monetary variables
as the quantity of money and the rate of interest; OR
(b) As a policy which deals with the discretionary control of money supply by the
monetary authorities in order to achieve stated or desires economic goals; OR
(c) As steps taken by the banking system to accomplish, through the monetary
mechanism a specific purpose believed to be in the general public interest; OR
(d) The use of devices to control the supply of money and credit in the economy. It
has to do with the controls that are used by the banking system.
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 Objectives of Monetary Policy
Objectives of Monetary Policy
Generally, the objectives of monetary policy in various countries are the same as the
economic objectives of the government. the objectives of monetary policy as
explained by the government of Central Bank are as follows
(i)Promotion of price stability
(ii) Stimulation of economic growth
(iii) Creation of employment
(iv) Reduction of pressures on the external sectors, and
(v) Stabilisation of the Naira exchange rate (ogwuma 1997:3). These are discussed
briefly in turns:
(i) Promotion of Price Stability
This involves avoiding wide fluctuation of prices which are highly upsetting to the
economy. Not only do such wide prices gyrations produce windfall profits and
losses, but they also introduce uncertainties into the market that make it difficult for
business to plan ahead. They therefore, reduced the total level of economic activity.
This objective of avoiding inflation is desirable since rising and falling prices are
both bad, bringing unnecessary losses to some and necessary undue advantages to
others. Prices stability is also necessary to maintain international competitiveness.
(ii) Slowly rising prices, slowly falling prices and constant prices (though the last
option is rather unrealistic in the world).
(ii) Stimulation of economic Growth i.e. - Achievement of a High, Rapid and
Sustainable Economic Growth: This mean maximum sustainable high level of
output, that is, the most possible output with all resources employed to the greatest
possible extent, given the general society and organizational structure of the society
at any given time. This highly desirable economic growth implies raising people’s

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standard of living. The growth of the economy is the wish of every government and
monetary authorities. Therefore, when growth is achieved, it should be sustained.
(iii) Creation of Employment: Attainment of High rate or Full Employment: This
does not mean Zero unemployment since there is always a certain amount of
frictional voluntary or seasonal unemployment (Acklay, 1978). Thus, what most
policy makers aim is actually minimum unemployment and the percentage that varies
among countries.
The monetary policy should always aim at reducing the level of unemployment in the
economy. Unemployment is a social ill which should not be allowed to exist in the
economy. The effects of unemployment to individuals as well as the society as a
whole is so enormous that if left unchecked it will spell doom for both individuals
and society.
(iv) Reduction of pressures on the external sectors - i.e. Maintenance of balances
of payments Equilibrium This involves keeping international payments of receipts in
equilibrium, that is, avoiding fundamental or persistent disequilibrium in the balance
of payments positions. Usually, however, nations worry about persistent balance of
payments deficits. The pursuit of this objective, arises from the realization that deficit
in the balance of payments will retard the attainment of the other objective of other
objectives, especially the objective of rapid economic growth. Deficit balance of
payment is not healthy and therefore the monetary authorities should try to achieve
healthy balance of payment.
Instability in the economy creates an atmosphere of uncertainty for the investors and
discourages them from investing while stability encourages investment. Monetary
policy will, therefore, endeavour to achieve economic stability so as to encourage
both local and foreign investors to invest in the economy.
The above discussed objectives of monetary policy are achieved through the
manipulation of the monetary policy tools by the Central Bank
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 Stance of Monetary Policy
Stance of Monetary Policy
The stance of monetary policy refers to the position taken by (CB) - the monetary
authorities about whether to increase or reduce the supply of money in the economy
during a policy period, usually one year. This gives rise to two types of monetary
policies, namely expansionary or a monetary ease policy, and contractionary or
stringent or tight monetary policy.

Monetary policy is said to be an expansionary or a monetary ease policy when the

monetary authorities decides to increase the supply of money or reduce the cost of
money in the economy so as to stimulate an increase in economic activities. This can
be accomplished through the buying of securities in the open market, a reduction in
interest and discount rates, a reduction in reserve requirements, and relaxing of credit
controls, among others. The overall effect of expansionary monetary policy is to have
more money in the hands of the public. This will lead to an increase in aggregate
demand, investment, savings, employment, output and economic growth, while at the
same time increasing the rate of inflation.

A contractionary stringent or tight monetary policy does the opposite of an

expansionary policy. Monetary policy is said to be contractionary, stringent, or tight
when the monetary authorities embark on policies that will reduce the supply of
money or increase the cost of money in economy, in other to generate a contraction
in economic activities. The effect of contractionary policies is to reduce the general
price level and curb inflation. However, it will equally lead to a reduction in the level
of investment, employment, output and economic growth.
The government switches from contractionary to expansionary policies as the need
arises depending on the economic objectives, which she is giving priority
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 Monetary Policy Instruments/Weapons/Tools
Monetary Policy Instruments/Weapons/Tools
Instruments of monetary policy are many and varied. Their respective effects on the
economy also vary in terms of where they start and transmission route. Sometimes,
some tools are not compatible with others i.e. in which case, the adoption of one set
instruments will negate or be at cross purposes with the effects of others. That is why
monetary authorities usually consider the operational efficiency, the technical
features, the lags and other effects of any given instruments before it can be used.
Apart from minor variations based on level of economic development of each
country, the tools used to attain the monetary objectives of various countries of the
world are virtually the same. In discharging its obligations, the Central Bank has to
have at its disposal a number of control mechanism usually referred to also as tools
of monetary policy.
Instruments or tools of monetary policy can be classified into two:-
(a) Quantitative Instruments (Traditional and Non-Traditional).
(b) Qualitative Instruments (Ranlett, 1977).

A. Qualitative Instruments
These are “impartial or impersonal” tools which operate primarily by influencing the
cost, volume, and availability of bank reserves. They lead to the regulation of the
supply of credit and cannot be used effectively to regulate the use of credit in
particular areas or sectors of the credit market.
Quantitative tools are further classified into traditional or market weapons and
nontraditional tools or credit direct control of bank liquidity.
. Traditional or market weapons.
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This are called market weapon because they rely on market forces to transmit their
effects to the economy. Specifically, these tools include Open Market Operations
(OMO), Discount Rate Policy and Reserve Requirements.
(i) Open Market Operations
This is the buying and selling of securities by the monetary authorities in the open
market. Securities are sold to reduce money supply and bought to increase money
supply.
(ii) Discount Rate Policy or the Rediscount Rate Policy or Bank Rate
Discount rates are interest rates paid in advance based on the amount of credit
extended by increasing the rediscount rates that Central banks charges from
borrowing for the Central Bank and makes banks to increase their own discount rates
and interest rates. This discourages banks lending and reduces money supply. A
reduction in rediscount rates increases the supply of money. Interest rates is the cost
of borrowed money. An increase in interest rates discourages people from borrowing
from banks. This reduces money supply. A reduction in interest rate does the
opposite.
(iii) Reserve Requirements/ Required Reserve Ratios
The monetary authorities set a minimum level of reserves that will be maintained by
banks. Banks maintain two types of reserve - Cash Ratio, and Liquidity Ratio. An
increase in bank reserves reduces money supply by reducing bank loanable funds,
while a decrease in reserves increases the supply of money.
(a) Non-traditional Instruments or Direct Control of Bank Liquidity: These tools
are non- market tools that strike directly at bank’s Liquidity. They include
supplementary reserve requirements and variable Liquidity ratios.
(b) Supplementary reserve requirements or special deposits: The Central Bank
here requires banks to hold over and above the legal minimum cash reserves, a
specified percentage of their deposits in government securities such as stabilisation
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securities issued by the Central Bank, hence it is also called special deposits policy.
The main objective is to influence banks’ lending by freezing a certain percentage of
their assets. Stabilization securities which the Central Bank is authorized by law to
issue and sell to banks compulsorily at any rate they may fix and redeem them at any
time they may fix. It is used to mop up excess liquidity to reduce money supply.
It is important to understand how this works. Assuming that the Central Bank wants
to reduce the money supply in the economy, it may impose a special deposit of say
5% on banks and this will force the banks to deposit 5% of their total deposits
liquidity with the Central Bank on a special account. The special deposit is mainly
used when other instrument fail to achieve their objectives or targets. This is,
therefore, regarded as instrument of the last resort
(2) Variable Liquid Assets Ratio
Here, Banks are required to diversify their portfolio of liquid assets holding.
These means that banks are required to redefine the composition of their Liquid
assets portfolios at different times to reduce or increase their credit base.
B . Qualitative or Selective Controls or Instruments
These confer on the monetary authorities the power to regulate the terms on which
credit is granted in specific sectors. These powers or control seek typically to
regulate the demand for credit for specific uses by determining minimum down
payments and regulating the period of time over which the loan is to be repaid. In
other words, they involve official interference with the volume and direction of credit
into those sectors of the economy which planners believe are a crucial importance to
economic development. These tools include moral suasion and selective credit
controls or guidelines.
(1) Moral Suasion
Moral suasion is an appeal of persuasion from the Central Bank to other banks to
take certain actions in line with government economic objectives. Unlike directives,
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no penalty is attached to non-compliance to moral suasion. Banks have the freedom
not to comply, but they often comply so as to have a good relationship with the
Central Bank.
This involves the employment of persuasions or friendly persuasive statements,
public pronouncements or outright appeal on the part of monetary authorities to the
banks requesting them to operate in a particular direction for the realisation of
specified government objectives. For example, the Central Bank or the government
may appeal to the banks to exercise restraint in credit expansion by explaining to
them how excess expansion of credit might involve serious consequences for both
the banking system and the economy as a whole. Moral suasion is supposed to work,
through appeal and voluntary action rather than the regulation and authority.
(2) Selective Credit Controls and Guideline
These are specific instructions given by the Central Bank to other banks which they
must comply with. Such directives come in the form of credit ceilings, special
deposits and sectoral allocations of credits, among others. This can be used to
increase or reduce money supply.
Selective credit controls or guidelines involve administrative orders whereby the
Central Bank, using guidelines, instructs banks on the cost and volume of credit to
specified sectors depending on the degree of priority of each sectors. Thus, selective
credit controls are examples of the use of monetary policy to influence directly the
allocation of resources indicating a lack of faith in the working of the free market
.Apart from the quantitative control which regulates the amount of money in
circulation, the Central Bank can monitor the economy by giving directives to banks
in all areas of operation. The selective control or directives can be in form of:
(a) Credit Ceiling: Every year the Central Bank dictates the rate of credit expansion
in the economy.

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(b) Sectorial Allocation of Credit: The Central Bank divided economic activities in
the country into sectoral allocations. The divisions are agriculture, forestry, fishing,
mining, quarrying, manufacturing and real estate.
(c) Interest Rate Ceiling: The interest rate may be controlled to favour particular
sectors.
(d) Loans to Rural Borrower: This is aimed at improving investment in the rural
areas.
(e) Grace Period on Loans: Longer period may be granted to some important sector
like agriculture.
(f) Refinancing Facilities
(g) Indigenization of Credit

Conflicts in Achievements of Monetary Policies Objectives

A look at the objectives of monetary policy shows that these multiple objectives are
not compatible at all. In some cases, they are not achieved simultaneously but rather
the achievement of one objective may take the economy further away from the other
objective. This actually means that the attainment of one objective may preclude the
attainment of another or even in other word there is existence of trade-offs in the
attainment of objectives. Authorities have identified two types of conflicts in the
attainment of monetary objectives. These are necessary conflict and policy conflict.
The relevant questions here are:
(1) Are the multiple objectives of monetary policy compatible?
(2) Can they be achieved simultaneously?
(3) Or thus the pursuit of one objective lead us further away from another? Two
types of conflicts in the attainment of policy objectives exist.
(i) Necessary Conflict

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The necessary conflicts exist whenever the attainment of one objective precludes the
attainment of the other.
In other words, this is a situation where the said objectives are inherently
incompatible with each other. In fact, a good example will make the understanding of
this clearer. Let us look at the twin objectives of attaining full employment and price
stability. The full employment in this context means unemployment rate of between
3% and 5% or employment rate of between 95% and 97%.
Experience has shown that the pursuance of the objectives of full employment
normally works against price stability. Full employment situation means that almost
anybody who wants to work is able to find job at the existing wage rate. The fact that
almost everybody is working makes individuals to have high purchasing power and
the economic activities will be high indeed. This situation will induce inflation which
will eliminate price stability in the economy

THEORY OF MONEY

1.0 INTRODUCTION
Having discussed extensively on the relevance and meaning of money in the
previous unit, this current unit will further explain the theory of money, by
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focusing on the theory of demand for money only. Having said that, one can
define the demand for money as the amount of wealth everyone in the society
wishes to hold in the form of money balances. In other words, it is the desire
of people to hold money balances either in cash or in demand deposit form. It
is important to note that the demand for money is directly related to the level
of income i.e. the higher the income level; the greater will be the demand for
money. Consequently, in this unit, we will discuss in detail the classical
approach to demand for money, the Keynesian and the post Keynesian demand
for money.

3.1 The Classical Approach to Demand for Money

The Classical economists did not explicitly formulate demand for money
theory but their views are inherent in the quantity theory of money. The
Classical economist which has Irving Fisher and the Cambridge School has
slightly different views on the demand for money theory. These two will be
explained subsequently in detail.

3.1.1 Irving Fisher View to Demand for Money

Irving Fisher was the first classical economist to develop a theory on quantity
theory of money, although he did not explicitly formulate demand for money.
In his theory postulated in 1928, established the link between quantities of
money and total amount of money spent on goods and services in the
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economy. In his equation of exchange he said that MV = PT Where

M is Money stock

V is Velocity,

P is Price Level and

T is Average Transaction of goods in the economy.

According to his theory, holding velocity and average transaction constant,

anything that happens to money stock will also happen to price, that is, if
money stock doubles in the economy, price will also double. Consequently,
the Fisher‟s equation of exchange shows that the right hand side of the
equation i.e. PT represent the demand for money, which depends upon the
value of the transactions to be undertaken in the economy and is equal to
constant fraction of those transaction while MV represents the supply of
money. Furthermore, the demand for money in Fisher‟s approach is a constant
proportion of the level of transaction which in turn bears a constant
relationship to the level of national income. The theory of demand for money
by fisher‟s has faced several criticisms. It is said that the theory failed to
incorporate or consider interest as a factor and also that there is no way
velocity in economy can be held constant, just to mention a few. Lastly,

One of the problems Fisher theory has among other problems is that he did not
explain fully why people hold money and also he did not clarify whether to
include money in such items as time deposit or saving deposit that are not
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immediately available to pay debts without first being converted into currency.

3.1.2 The Cambridge or Cash Balance Approach

The Cambridge economists are set of classical economists who are interested
to know why people want to hold their assets in the form of money. Unlike
Irving Fisher who dwelt so much on the transaction motive for demand for
money and who also see money as a medium of exchange, the Cambridge
economist view the demand for money from the precaution aspect and also see
money not as a medium of exchange but as a stock of value. Also, just like
Fisher, the Cambridge expresses the demand for money function as Md = KPY
where

Md is the demand for money

K is the Constant of proportionality or the fraction of the real money income

which people wish to hold in cash

P is the price level and

Y is the aggregate real income.

The Cambridge approach to demand for money includes time and saving
deposits and other convertible funds in the demand for money. They also
stressed the importance of factors that make money more or less useful, such
as the cost of holding it, uncertainty about the future etc. Just the way Fisher‟s
theory was criticized, the Cambridge theory was also criticized.
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In a nutshell, the classical economist was subjected to criticism. One of the
major criticisms of the classical approach to demand for moneys is that they
emphasized only on medium of exchange and store of value function of money
without considering other factors that affects demand for money such as
interest rate.

Second, it failed to analyze variation in the price level due to saving-

investment inequality in the economy.

Third, the theory is weak in that it ignores other influence such as the rate of
interest which exerts a decisive and significant influence upon the price level.

Fourth, the theory neglected speculative demand for money. The neglect of the
speculative demand for cash balance makes the demand for exclusively
dependent on money income thereby neglecting the role of the rate interest and
the store of value function of money.

Fifth, the cash balance approach does not tell about changes in the price level
due to changes in the proportions in which deposits are held for income,
business and saving purposes..

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3.2 THE KEYNESIAN APPROACH TO DEMAND FOR MONEY:

LIQUIDITY PREFERENCE

The Keynesians are the set of British economists who believe in the efficiency
of fiscal policies as opposed to the use of monetary policies to control
economic activities. They hold the view that demand for money falls within
the realm of liquidity preference. Lord Keynes in his theory of demand for
money suggested three motives to demand for money. These motives are:

A. Transaction Demand for Money This simply refers to the need to

hold some money for daily business transaction. The transaction
demand for money arises from the medium of exchange function of
money in making regular payment for goods and services. Keynes in his
theory of demand for money divided the transaction demand for money
into two i.e. Income Motive which means to bridge the interval between
the receipt of income and its disbursement and secondly Business
Motive which means to bridge the interval between the time of incurring
business cost and that of the receipt of the sale proceeds (see
M.L.Jhingan, 2011:186). Consequently, Keynes in his theory further
argued that the transactions demand for money is a stable function of the
level of income and that the transaction demand

for money has a direct proportional relationship with the level of income
i.e. LT = f (KY), while LT of transaction demand for money while KY
represent linear and proportional relationship between transaction
demand for money and the level of income. Keynes in his transaction
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 demand for money did not stress the role of interest rate.

B. Precautionary Demand for Money This is a situation where money

is held for unforeseen circumstance and eventualities. Both individuals
and businessmen keep money or cash to meet unexpected needs. The
precautionary demand for money depends upon the level of income, and

Business activity, opportunities for unexpected profitable deals,

availability of cash, the cost of holding liquid assets in bank reserve etc.

Keynes in his analysis held that the precautionary demand for money
like transaction demand is a function of the level of income. But the
Post-Keynesian economists believe that like transaction demand, it is
inversely related to high interest rate. Note both the transaction and
precautionary demand for money will be unstable, particularly if the
economy is not at full employment level and transactions are therefore,
less than the maximum and are liable to fluctuate up and down.

According to Keynesian, the precautionary demand for money is

expressed as LT = f (Y, r).

C. The Speculative Demand for Money The speculative or asset or

liquidity preference of demand for money is for securing profit from
knowing better than the market what the future will bring forth. Also, it
is a situation where people hold money not for transactions or
precautionary purpose, but for the purpose of making more profit in the
future or taking advantage of investment in the future. Thus, money held
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for speculative purposes is a liquidity store of value which can be
invested at an opportune moment in interest bearing bonds or securities.

According to Keynesian, in his liquidity preference theory, bond prices

and the rate of interest are inversely related to each other. This is to say
that low bond prices are indicative of high interest rate and high bond
price reflect low interest rates. Note importantly that wealth holders go
for capital gain so as to avoid capital loss. For instance, if the rate of
interest is higher than normal and so is being expected to fall, wealth
holders demand less money, that is, they hold more bonds in
anticipation of capital gain i.e. they will buy bonds to sell them in future
when their prices rise in order to gain. Conversely, if the rate of interest
is low than normal and so being expected to rise, the demand for money
will be high, this giving the wealth holders the opportunity to sell bonds
in the present so as to avoid capital. Thus, it is important to note that the
speculative demand for money is a decreasing function of the rate of
interest. The higher the rate of interest, the lower the speculative
demand for money and vice versa.

Speculative demand for money according to Keynesian is expressed as

LS = f (r). Also, he further explain liquidity trap as a situation where the
real interest rate cannot be reduced by any action of the monetary
authorities. This is likely to happen when the market interest rate is very
low so that the yields on bonds, equities and other securities will also be
low.

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3.2.1 Criticisms of the Keynesian Theory of Demand for Money

The Keynesian theory of demand for money was undoubtedly a radical

improvement over the classical and neoclassical theories of money. His theory
has however been criticized on the following ground by post-Keynesian
theorist;

Firstly, Keynes division of demand for money between precautionary and

speculative motive is unrealistic, because people do not maintain a separate
purse for each motive. They have one purse for all purposes. Besides,
empirical evidence shows that, contrary to Keynes postulate, even the
transaction demand for money is interest elastic.

Secondly, critics reflect the Keynesian postulate that there exists a normal rate
of interest and the current rate of interest may not necessarily be the same as
the normal rate: there may always be a difference between the two. According
to Keynes, the speculative demand for money is governed by the difference
between the normal and the current rate of interest, but the critics argues that if
the current rate of interest remains stable over a long period of time, people
tend to take it to be normal rate. Consequently, the difference between the
current rate and the normal rate disappears.

Thirdly, Keynes assumed unrealistically that the people hold their financial
assets in the form of either idle cash balance or bond. In fact, people hold their
assets in a combination of both assets.

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3.3 THE POST-KEYNESIAN APPROACH TO DEMAND FOR MONEY

The Post-Keynesian has their approaches to demand for money. According to

Keynes in his approach to demand for money brought out three motives to
demand for money. These motives have been extensively analyzed in the
Keynes demand for money. Consequently, Keynes in his demand for money
believed that the transactions demand was primarily interest inelastic. He
analyzed speculative demand for money in relation to uncertainty in the
market.

Basically, outside Keynes and the Keynesian approach to demand for money,
we have others who have dealt immensely on the demand for money in recent
time. These scholars are Baumol Williams (1952), who analyzed the interest
elasticity of the transactions demand for money on the basis of his inventory
theoretical approach, the second scholar is James Tobin (1956) who in his
analysis explain liquidity preference as behavior toward risk and the third
scholar is Friedman Milton (1959), who formulated that the demand for money
is not merely a function of income and the rate of interest, but also of the total
wealth. These three Post-Keynesian approaches to demand for money will be
explained subsequently.

3.3.1 Williams Baumol Inventory Theoretic Approach

Baumol made an important addition on the Keynesian transaction demand for

money. As Keynes regarded transaction demand for money as a function of
level of income and that the relationship between transaction demand and
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income is linear and proportional. Baumol in his analysis show that the
relation between transaction demand and income is neither linear nor
proportional, rather changes in income lead to less than proportionate change
in the transaction demand for money. Furthermore, as Keynes considers
transaction demand as primarily interest inelastic, Baumol analyses the interest
elasticity of transactions demand for money. Baumol‟s analysis on transaction
demand for money is based on the holding of an optimum inventory of money
for transaction purposes by a firm or an individual.

i. Thus, he further writes that a firm‟s cash balance can usually be

interpreted as an inventory of money which its holder stands ready to
exchange against purchases of labour, raw materials etc. In a
nutshell, Baumol is saying that firms should try to keep minimum
transaction balances in order to earn maximum interest from its asset
i.e. the higher the interest rate on bonds, the lesser the transaction
balance which a firm holds. Thus, the holding of cash balance
consists of interest cost and non-interest cost. Interest cost are
opportunity cost because when a firm holds cash balance for
transaction purpose it forgoes interest income, while non-interest cost
include such items as brokerage fee, mailing expense etc. Lastly,
Baumol‟s inventory theoretic approach to the transaction demand for
money is an improvement over the classical and Keynesian in that
The theory has the merit of demonstrating the interest elasticity of
the transaction demand for money as against Keynes view of interest
inelastic.

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 ii. The theory also analyses the transaction demand for real balances
thereby emphasizing the absence of money illusion.

The theory also integrate the transaction demand for money with the capital by
taking assets, interest and non- theory approach interest cost into account.
3.3.2 James Tobin’s Portfolio Selection Mode: The Risk Aversion
theory of liquidity preference

James formulated the risk aversion theory of liquidity preference which is

based on portfolio selection. His theory removed the two major defects of the
Keynesian theory of liquidity preference. Firstly, that Keynes‟s liquidity
preference function depends on the inelasticity of expectations of future
interest rate and secondly, that individuals hold either money or bonds in
wealth has been remove. Furthermore, Tobin‟s theory does not depend on the
elasticity of expectation of future interest rate but he proceeds on the
assumption that the expected value of capital gain or loss from holding interest
bearing assets is always zero. James Tobin further in his portfolio selection
model described the three categories of investors.

James Tobin starts his portfolio selection model liquidity preference with the
presumption that an individual assets holder has portfolio of money and bonds.
In other words, money neither brings any return nor imposes any risk on him,
but bond tends to yield interest and also bring income. He further said that
income from bonds is uncertain because it involves a risk of capital losses or
gains i.e. the greater the investment in bonds, the greater is the risk of capital
loss from them. For instance, if g is the expected capital gain or loss, it is
assumed that the investor bases his actions on his estimate of its probability
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 distribution. He further assumed

that this probability distribution has an expected value of zero and is

independent of the level of the current rate of interest on bonds. It is important
to note that Tobin‟s portfolio selection consist of a proportion M of money and
B of bond where both M and B add up 1 and has a return on portfolio R i.e. R
= B (r + g). Tobin‟s further described the three categories of investors.

i. The risk lover who enjoy putting all their wealth into bonds to
maximize risk. They accept risk of loss in exchange for the income
they expect from bonds.

ii. The risk plungers, they are investors who will either put all their
wealth into bonds or will keep it in cash.

iii. The third category is the risk averters or diversifiers. These kind of
investor prefer to avoid the risk of loss which is associated with holding bonds
rather than money. In other words, they are prepare to bear some additional risk
only if they expect to receive some additional return on bond.

3.3.3 Friedman Milton Theory of Demand for Money

Friedman Milton theory of demand for money is a capital or wealth theory
because he regards money as an asset or capital good. He developed a model
for money demand based on the general theory of asset demand. In his theory,
he said that money demand like the demand for any other asset should be a
function of wealth and the returns of other assets relative to money. According
to his theory, wealth can be held in five different forms such as:
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 i. Wealth can be held in the form of money, meaning that money is
taken in the broadcast sense to include currency, demand deposit and
time deposit which yield interest on deposits.

ii. Wealth can be held in the form of Bonds, meaning that the yield on
bonds, Rb includes coupon interest rate or the expectation of capital
profit or loss due to fall or rise in the expected market rate of interest.

iii. Wealth can be held in the form of equities, that is, the yield on
equalities Re includes return on dividend rate, expected profit or loss
due to changes in interest rate.

iv. Wealth can be held in the form of physical goods or non-human

goods. Physical goods or non-human goods are inventories of producer and
consumer durables. The returns are affected by expected rate of changes in price.
v. Wealth can be held in the form of Human Capital i.e. W = Y/r where W is the
current value of total wealth, Y is the total flow of expected income and r is the
interest rate.
3.3.4 Criticisms of the Friedman Milton Theory of Demand for Money
i. Frised Milton theory does not tell about timing and speed of adjustment or
the length of time to which his theory applies
ii. The theory ignores the effect of prices, output or interest rates on the money
supply, but there is considerable empirical evidence that the money supply can be
expressed as function of the variables earlier given.
iii Friedman`s demand for money function, wealth variables are preferable to
income and the operation of wealth and income variable simultaneously does
not seem to be justified.
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iv Friedman takes the supply of money to be unstable, thus, the supply of
money is varied by the monetary authorities in an exogenous manner.

4.0 CONCLUSION
The unit extensively explains the various approaches to demand for money,
ranging from the classical approach to demand for money down to the Post-
Keynesian demand for money. Also, series criticisms were made. Although the
classical approach to demand for money focuses on the transaction and
precautionary demand for money, but they tend to neglect or consider interest
rate as a factor. Keynes elaborated on what the classical approach did and
more so incorporate interest rate by introducing speculative motive or Keynes
liquidity preference which considered interest rate. Although Keynes theory
was criticized by the Post-Keynesian monetary theorist because the theory has
some faults.

5.0 SUMMARY
In this unit, we have succeeded in explaining the theories of demand for
money, starting from the classical approach to demand for money, the
Keynesian demand for money and the Post-Keynesian demand for money.
Also, the unit immensively discussed the various criticisms and fault each of
the approaches has apart from that of the Post-Keynesian approach to demand
for money.
6.0 TUTOR-MARKED ASSIGNMENT
i. Distinguish between the Fishers equation of exchange and the
Cambridge approach to demand for money.
ii. Explain James Tobins Risk Aversion theory of liquidity preference.
iii. When should a wealth holder make capital gain.
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iv. Explain the three criticisms in the Keynesian demand for money theory.
v. Describe the five different forms of wealth in Friedman Milton theory of
demand for money.
Explain the Fisher‟s equation of exchange as regards the demand for money

Banking
Meaning of Banking
Chambers twentieth century dictionary a bank as an intuition for the keeping
lending and exchanging etc. of money economists have also defined a bank
highlights thing its various function according to crow her (the bankers
business is to take the debts of other been given by Kent who defines a bank
as ?an organization whose principal operation are concerned with the
accumulation of the temporarily idle money of the general public for more
detailed definition of a bank thus: ?ordinary banking business consists of
changing cash for bank deposits and bank deposits for cash transferring bank
deposits from one person or corporation (one depositor) to another; giving
bank deposits in exchange for bills of exchange government bonds. The
secured or unsecured promises of businessmen turn advances loans by
creating credit. It is different from other financial institutions in that they
cannot create credit though they may be accepting deposits and making
advances

Types of banks
Banks are of various types which are explained as under:
1. Commercial banks: Commercial banks are those banks which perform
all kinds of banking function such as accepting deposits advancing loans credit
creation and agency function. They are also called joint stock banks because

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 they are organized in the same manner as joint stock companies. They usually
advance short-term loans to customers of late they have started giving
medium term and long-term loans also. In India 20major commercial banks
have been nationalized, whereas in developed countries they are run like joint
stock companies in the private sector.

2. Exchange banks: Exchange banks are those banks which deal in foreign
Exchange and specialize in financing foreign trade. They are also called foreign
exchange banks. Industrial banks. Industrial banks are those banks which
provide medium term and long-term finance to industries for the purchase of
land, machinery etc. They underwrites the debentures and shares of industries
and also subscribe to them. In India there are a number of financial institutions
which perform the functions of industrial banks such as industrial development
bank of India, industrial finance corporation of India, industrial credit and
Investment Corporation of India etc.

4. Agricultural banks: Agricultural banks are those banks which provide

credit to farmers for short-term, medium-term, and long-term needs. In India,

commercial ban regional rural banks and Agricultural cooperative banks
provide short-term loans farmers. Land development banks give medium-
term and long-term loans to farmer’s other mortgage of their land.

5. Cooperative banks: Cooperative banks are those financial institutions

which are organized on the principle of cooperation. They provide short-term
and medium-terms loans to their members. In rural areas, there are
agricultural cooperative banks which accept deposits and give loans to
agriculturists, rural artisans, etc., in urban areas, there are also cooperative
banks which perform the functions of ordinary commercial banks but give
loans to their members only. There is a state cooperative bank in every state
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of India with its branches at the district level known as the central cooperative
bank. The central cooperative bank, in turn, has its branches both in urban
and rural areas

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6. Saving banks: Saving banks help promote small savings and mobilize

them. They have been very successful in Japan and Germany. In India, post
offices act savings bank.

7. Central bank: The central bank is the apex bank in country which
controls its monetary and banking structure. Commercial Banking
Commercial banks are those institutions which conduct the business purely
on profit motive. Commercial banks receive surplus money from the people
who are not using it and lend to those who need it for productive purpose .

A commercial bank is a dealer in short and medium-term credit. It borrows

money from a group of people at a lower rate of interest and lends to the other
group of people at some higher rate of interest. The difference between the
two rates of interest is the profit of the bank.

Commercial banks are those institutions which conduct the business purely
on profit motive. Commercial banks receive surplus money from the people
who are not using it and lend to those who need it for productive purpose
A commercial bank is a dealer in short and medium-term credit. It borrows
money from a group of people at a lower rate of interest and lends to the
other group of people at some higher rate of interest. The difference between
the two rates of interest is the profit of the bank

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 .
Definition of a Commercial Bank
According G. Crowther. "A bank is a firm which collects money from those
who have it spare. It lends to those who require it." According Parking. "A
bank is a firm that takes deposits from households and firms and makes
loans to other household and firms.

Functions of Commercial Bank

Modern time, the functions of a modem commercial bank are
manifold. The functions Of a bank may broadly be divided into two
parts.
a. Basic or primary functions.

b. Secondary functions

a. Primary Functions of Commercial Banks

Primary Functions of Commercial Banks Accepting Deposits is the primary
functions of commercial banks and is the basis of its existence. Without
accepting deposits, a bank cannot execute any other functions and as such
it is very important to understand the primary functions of commercial
banks.

Accepting Deposits: Accepting deposits is the main function of a commercial

bank it Attracts deposits for the purpose of making loans and investments.
People deposit their money in banks for the sake of safety and for earning
interest. A commercial bank receives deposits from individuals, firms and
other institutions. Banks offer different type of deposit accounts to suit the
needs of various depositors. Public deposits constitute the main resources of
a bank. Banks receive the following types of deposits.

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 a) Fixed Deposits: A lump sum is deposited for a fixed time period. These

deposits are repayable on the expiry of the stated period. Generally, the
time period varies from three months to five years. The rate of interest
on these deposits is higher the payable on other deposits. The actual
rate depends on the period for which the deposit is made.
b) Savings Deposits: This account is opened for the purpose of depositing

small savings. In these deposits money can be withdrawn for a specified

number of times in a Week. But deposits can be made any number of
times. Rate of interest allowed on such deposits is higher than that on
current deposits but lower than that allowed on fixed Deposits. The
depositor has to open an account with the bank and is given a pass
book. The main objective of savings deposits is to promote the habit of
savings among people.
c. Current Deposits: Such deposits are made by business firms in current

accounts.
Money can be deposited and withdrawn as often as the depositor wants.
Generally, no Interest is allowed on these deposits. A small fee, known as 'bank
charge' or 'incidental charge' is often charged for maintaining current
deposits. Overdraft facility is available on current accounts.

d. Recurring Deposits: In these deposits, the deposit holder is required to make

a deposit of fixed amount every month for a specified period. The amount goes
on accumulating along with interest. At the end of the prescribed period, the
depositor can withdraw the deposit or renew the same for another term.

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 Types of loans granted and advance by commercial banks

1. Secured loan

Secured loan is a loan in which the borrower pledges some asset (e.g. a car or
property) as collateral for the loan, which then becomes a secured debt owed
to the that the borrower defaults, the creditor takes possession of the asset
used as collateral and may sell it to regain some or all of the amount originally
lent to the borrower, For example, foreclosure of a home. From the creditor's
perspective this is a category of debt In which a lender has been granted a
portion of the bundle of rights to specified property.
If the sale of the collateral does not raise enough money to pay off the debt,
the creditor can often obtain a deficiency judgment against the borrower for
the remaining amount. The opposite of secured debt/loan is unsecured debt,
which is not connected to any specific piece of property and instead the
creditor may only satisfy the debt against the borrower rather than the
borrower's collateral and the borrower

2. Mortgage loan
A mortgage loan is a very common type of debt instrument, used to purchase
re estate. Under this arrangement, the money is used to purchase the
property. Commerzbank’s, however, are given security - a lien on the title to
the house - until the mortgage is paid off in full. If the borrower defaults on the
loan, the bank would have the legal right repossess the house and sell it, to
recover sums owing to it.in the past, commercial banks have not been greatly
interested in real estate loans and have placed only a relatively small
percentage of assets in mortgages. As their name implies, such financial
institutions secured their earning primarily from commercial and consumer

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loans and left the major task of home financing to others. However, due to
changes in banking laws and policies, commercial banks are increasingly
active in home financing changes in banking laws now allow commercial
banks to make home mortgage loans on a more liberal basis than ever before.
In acquiring mortgages on real estate, these institutions follow two main
practices. First, some of the banks maintain active and well- organized
departments whose primary function is to compete actively for real estate
loans. In areas lacking specialized real estate financial institutions, these
banks become the source for residential and farm mortgage loans. Second, the
banks acquire mortgages by simply purchasing them from mortgage bankers
or dealers.

In addition, dealer service companies, which were originally used to obtain

car loans for permanent lenders such as commercial banks, wanted to
broaden their activity beyond their local area. In recent years, however, such
companies have concentrated on acquiring mobile home loans in volume for
both commercial banks and savings and associations. Service companies
obtain these loans from retail dealers, usually on a nonrecourse basis.
Almost all bank/service company agreements contain a credit insurance
policy that protects the lender if the consumer defaults.

1. Grant of loans and advances:

The second important function of a commercial bank is to grant loans and

advances. Such loans and advances are given to members of the public and
to the business community at a higher rate of interests than allowed by
banks on loans and advances varies depending upon the purpose, period and
the mode of repayment. The difference between the rate of interest allowed
on deposits and the rate charged on the loans is the main source of a banks
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income.

i) loans
Generally commercial banks grant long-term loans but term loans that is loan
for more than a year may also be granted. Interest is charged on the full
amount of loan. Loans are generally granted against the security of certain
assets. A loan may be repaid either in lump sum or in installments.

i) Advances
An advance is a credit facility provided by the bank to its customers. It differs
from loan in the sense that loans may be granted for a short period but
advances are normally granting advances is to meet the day to day
requirements of business. The rate of interest charged on advances varies
from bank to bank. Interest is charged only on the amount withdrawn and not
on the sanctioned amount

Modes of short-term financial assistance

Banka grant short-term financial assistance by way of cash credit,

overdraft and bill discounting

a. Cash credit: Cash credit is an arrangement whereby the bank allows

the borrower to draw amounts up to a specified limit.
The amount is credited to the account of the customer can withdraw
this amount and when he requires. Interest is charged on the amount
actually withdrawn. Cash credit is granted as per agreed terms and
conditions with the customers.

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 b. Overdraft: Overdraft is also a credit facility granted by bank. A
customer who has a current account with the bank is allowed to
withdraw more than the amount of credit balance in this account. It is
temporary arrangement. Overdraft facility with a specified limit is
allowed either on the security of assets or on personal security or both.

c. Discounting of bills: Banks provides short-term finance by

discounting bills that is, making payment of the amount before the due date
of the bills after deducting a certain rate of discount. The party gets the
funds without waiting for the date of maturity of the bills.
Secondary Functions
Sides the primary functions of accepting deposits and lending money, banks
perform a number of other functions which are called secondary functions.
These are as follows.

a. Issue letters of credit, travelers cheques, circular notes, etc.

b. Undertaking safe custody of valuables, important documents, and
securities by providing safe deposit vaults or lockers.

c. Provide customers with facilities of foreign exchange.

d. Transferring money from one place to another and from one branch to
another branch of the bank.

e. Standing guarantee on behalf of its customers for making payments for

purchase of goods machinery vehicles etc.

f. Collecting and supplying business information

g. Issuing demand drafts and pay orders and
h. Providing reports on the credit worthiness of customers

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Difference between primary and secondary functions of commercial
banks

Primary function secondary function

1. These are the main 1. these are the secondary

Activities of the bank Activities of the bank

2. These are the main sources 2. These are not the

main Of income of the bank of income of the
bank
. 3: These are obligatory on the 3. These are not
obligatory Part of bank to perform. Part of bank to
perform But generally all commercial bank
Perform these activities
Role of commercial banks in a developing country
1. Mobilizing savings for capital formation. The commercial banks help in
mobilizing saving through a network of branch banking.
2. Financing industry. Sector in a number of ways. They provide short-
term, medium- term and long-term loans to industry.

3. Financing trade. The commercial banks help in financing both internal

and external trade. The banks provide loans to retailers and
wholesalers to stock goods in which they deal. also help in the
movement of goods from one place to another by providing all types of
facilities such as discounting and accepting bills of exchange.

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4. Financing agriculture. The commercial banks help the large
agricultural sector in developing countries in a number of ways. They
provide loans to traders in agricultural commodities.
5. Financing consumer activities. People in underdeveloped countries
being poor and having low income do not possess sufficient financial
resources to buy durable consumer goods.
6. Financing employment generating activities. The commercial banks
finance Employment generating activities in developing countries.
7. Help in monetary policy. The commercial banks help the economic
development of country by faithfully following the monetary policy of
the central bank.

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