MONEY AND

BANKING
SYSTEM
MONEY AND BANKING

LEARNING OBJECTIVES:
(a) Money: Barter system. Evolution of money. Qualities of good money.
Advantages of using money. Functions of money, Kinds of money, and Value
of money
(b) Demand and Supply of money
(c) Quantity Theory of Money
(d) Financial Institution: Traditional financial institution, Modern financial
institution, Money market, Capital market, Central bank. Commercial banks
and other Liquidity financial institution
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(e) Interest: Definition and Determinants of Interest Rate.
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 quantities of another good.

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Difficulties of Barter System

The barter system is the most inconvenient method of

exchange. It involves loss of much time and effort on the
part of people in trying to exchange goods and services. As
a method of exchange, the barter system has the following
difficulties and disadvantages:
a. Lack of Double Coincidence of Wants:The functioning of the
barter system requires double coincidence of
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Difficulties of Barter System (cont.)
wants on the part of those who want to exchange goods or
services. It is necessary for a person who wishes to trade his
good or service for another, find some other person who is not
only willing to buy his good or service, but also possesses that
good which the former wants.

The existence of such a double coincidence of wants is a remote probability. For it is a very
laborious and time-consuming process to find out a person who wants the other's goods.

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Difficulties of Barter System (cont.)

b. 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.
c. Indivisibility of Certain Good: The bailer is based on the
exchange of goods with other goods. It is difficult to fix
exchange rates for certain goods which are indivisible

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Indivisibility of Certain Good:

The bailer is based on the exchange of goods with other goods. It is difficult to
fix exchange rates for certain goods which are indivisible. Such indivisible goods
pose a real problem, under barter. A person may desire a horse and the other a
sheep and both may be willing to trade. The former may demand more than four
sheep for a horse but the other is not prepared to give five sheep and thus there
is no exchange. If a sheep had been divisible, a payment of four and a half
sheep for a horse might have been mutually satisfactory

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Difficulties of Barter System (cont.)

d. Difficulty in Store Value: Under the barter system, it is

difficult to store value. Anyone wanting to save real capital over a
long period would be faced with the difficulty that during the
intervening period the stored, commodity may become obsolete
or deteriorate in value

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Difficulties of Barter System (cont.)

Difficulty in Making Deferred Payments: In a barter

economy, it is difficult to make payments in future. As payments
are made in goods and services, debt contracts are not possible
due to disagreements on the part of the two parties on following
grounds. It would often invite controversy as to the quality of the
goods or services to be repaid.
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Difficulties of Barter System (cont.)

Lack of Specialization: Another difficulty of the baiter system

is that it is associated with a production system where each
person is a jack-of-all-trades. In other words, a high degree
of specialization is difficult to achieve under the barter
system.
The above mentioned difficulties of barter have led to the

10 evolution of money.
 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 Roman Goddess Juno in whose temple at Rome,
money was coined.
 The origin of money is lost in antiquity.
 The type of money in every age depended on the nature of its
livelihood.

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 The Evolution of Money (cont)

 In a hunting society, the skins of wild animal were used as

money.
 The pastoral society used livestock, whereas the agricultural
society used grains and food stuffs as money.
 The Greeks used coins as money.
 The development of money was to overcome the various
difficulties of trade by barter.
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 The Evolution of Money (cont)

 Money is anything that is generally acceptable as a means

of exchange.
 This general acceptability is the most important
requirement of money. No matter how precious a material
is, if it is not generally acceptable by the people as a means
of exchange, it will not qualify as money.

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 Stages in the Evolution of Money

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Stages in the Evolution of Money;

The evolution of money has passed through the following five stages
depending upon the progress of human civilization at different times and
places:
I. Commodity Money: Various types of commodities have been used as
money from the beginning of human civilization. Stones, spears, skins,
bows and arrows and axes were used as money in the hunting society. The
pastoral society use cattle as money.

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Stages in the Evolution of Money; (cont)

Commodity Money : (cont) . The Mongolians used squirrel skins as

money.Precious stones, tobacco, tea, shells, fishhooks, and many other
commodities served as money depending upon time, place and
economic standard of society.

The use of commodity as money had the following defects:

(a) All commodities were not uniform in quality, such as cattle, grains,
etc.
17 Thus lack of standardization made pricing difficult.
Stages in the Evolution of Money; (cont)

(b) Difficult to store and prevent loss of value in case of perishable

commodities.
(c) Supplies of such commodities were uncertain,
(d) They lacked in portability and hence were difficult to transfer from
one place to another,
(e) There was the problem of indivisibilities in the case of such
commodities as cattle.

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Stages in the Evolution of Money; (cont)

II. Metallic 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.
III. Paper Money: The development of paper money started with goldsmiths
who kept strong safes to store their gold. As goldsmiths were thought to be
honest merchants, people started keeping their gold with them for safe
custody. In return, the goldsmiths gave the depositors a receipt promising to
return the gold on demand
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Stages in the Evolution of Money; (cont)

III. Paper Money: (cont)

 These receipts of the goldsmiths were given to the sellers of commodities by the
buyers.
 Thus the receipts of the goldsmiths were a substitute for money. Such paper money
was backed by gold and was convertible on demand into gold.
 This ultimately led to the development of bank notes.
 The bank notes are issued by the central bank of the country. As the demand for gold
and silver increased with the rise in their prices, the convertibility of bank notes into
gold and silver was gradually given up during the beginning and after the First World
20War in all the countries of the world.
Stages in the Evolution of Money; (cont)

IV. Credit Money :

 Another stage in the evolution of money in the modem world is the use of the
cheque as money
 The cheque is like a bank note in that it performs the same function. It is a means
of transferring money or obligations from one person to another. But a cheque is
different from a bank note.
 A cheque is made for a specific sum, and it expires with a single transaction. But a
cheque is not money.
 Large transactions are made through cheques these days and bank notes are used
only for small transactions.
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Stages in the Evolution of Money; (cont)

V.Near Money: The final stage in the evolution of money has been
the use of bills of exchange, treasury bills, bonds, debentures,
savings certificates, etc. They are known as "near money". They are
close substitutes for money and are liquid assets. The final stage of its
evolution money has become intangible. Its ownership is now
transferable simply by book entry.

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 Qualities of Good Money

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Qualities of Good Money

It is important to know that in the past, many things had been used as money

in West Africa. The most important one that comes to mind is the Cowry,

which dominated West African trade as a common medium of exchange in the

nineteenth century. Cowries and other things that were used suffered a

number of problems, such as being too heavy to carry and being subjected to

intense depreciation. However, since they were then generally acceptable as a

medium of exchange, they qualified as money.

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 For anything to serve satisfactorily as money, that thing must fulfill
the following requirements;
(i).Divisibility: Money must be easily divisible into smaller units to
facilitate both big and small transaction.
(ii).Portability: Money must be easy to carry around to long and
short distances.
(iii).Acceptability: Money must be legal tender. Money is legal
lender when it has the backing of law, in which case it cannot be refused
in payment or settlement of debt within a defined territory. Such money
is said to be generally acceptable.
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 (i). Scarcity: Money must be relatively scarce, but not too
scarce. Gold and diamond are too scarce; hence they do not meet
this requirement.
(ii). Standardized Unit: The various unit of money must be
homogeneous. There must be no disagreement about value and
identity.
Stability: The value must be relatively stable over time. Money
whose value is very unstable may cease to be generally
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acceptable
 Advantages of Using Money

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Advantages of Using Money

The use of money provides the following advantages;

1.Access to a variety of Goods and Services: Money
enables the owner to obtain a variety of goods and
services that could give him maximum satisfaction.
2. Division of Labour: Exchange is an important condition
for division of labour. Without the use of money, division
of labour would have been unreasonable. It is only when
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money is used that it makes sense for people to specialize
Advantages of Using Money (cont)
3. Easy Facility for Loans: The use of money facilitates the making of
loans. When you loan someone a hundred naira, you collect back a
hundred naira later. Without the use of money, it would have been
difficult to operate this system as disagreements might occur over
the identity of objects after a few years interval.
4. Deferred Spending: The use of money makes it possible to save
now and spend later. Without money, saving would have been
difficult. Living things might die and objects might depreciate or rot.

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Functions of Money
Money performs four main functions:
1. A Medium of Exchange: Money facilitates the exchange of goods
and services. This was probably the earliest function of money.
Without money, we will probably have trade by barter with all the
disadvantages which we mentioned earlier.
2.A Unit of Account and a Measure of Value: Money serves as a
common unit which is used to measure the relative value of goods
and services.we use money to express the value of one commodity
in terms of other commodities, say rice in terms of shoes, house,
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chairs, books, etc.
Functions of Money (cont)

3. A Store of Value: Money makes it possible to save now for

later use. Goods and services are difficult to store. Farmers
cannot store if their goods are perishable. Many producers
cannot even store their products at all.
4. A Standard of Deferred Payment: Deferred payment
means settlement of debts at a later date. Money makes it
possible for payment to be deferred -from now till a later
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date.
The Value of Money

People want money not for its sake but to enable them buy
goods and services. The value of money is the quantity
of goods and services that money can buy. This is what is
called the "purchasing power" of money. If prices are
high, a given quantity of money will buy less than when
prices are low.
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Effects of Changes in the Value of Money

Changes in the value of money have different effects on production and

distribution of income. These effects include:
Effect on Level of Production: When prices are rising, business
activities will be stimulated. High prices would encourage expansion of
business. Since all costs do not generally increase immediately as
prices begin to rise, profit would be greater for businessmen.

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 DEMAND AND SUPPLY OF MONEY

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Effects of Changes in the Value of Money

Effect on Distribution of Income: Price changes bring about

changes in the value of money which will have different effects
on the incomes of different groups of people. Now, let us
examine three groups of people:
Those who derive their income from profit
Salary and wages earners
Those who receive fixed income (e.g. Pensioners)

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Definition of demand for money

Demand for money refers to the total amount of money balances that
people want to hold for certain purposes. Nominal money balances
(MD ) are measured in monetary units, while real
money balances (MD /P ) are measured in terms of the purchasing
power of the quantity of money demanded.

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Motives of Demand for Money
According to John Maynard Keynes there are 3 motives for
demanding money: the transaction, precautionary and
speculative motives.
a.The Transactions motive: Money is held tor the purchase of
goods and services because of the non-synchronization of the
periods of income receipts and their disbursements. This is
determined directly by the level of income.

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Motives of Demand for Money

b. Precautionary Motive: Money is also demanded to cater for

emergencies and contingencies or to provide for unexpected
expenditures. This is also directly dependent on the income
level.

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Motives of Demand for Money

c. Speculative Motive: This has to do with money held for the

purpose of avoiding capital losses in a declining securities
market. This arises out of uncertainty. Due to changing or
fluctuating interest rates, the individual may decide to hold
money in cash or in bond or in equities, etc. this varies
inversely with the rate of interest.

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 Figure below shows demand for money curve.

Interest rate

Md

Demand for Money

40Figure 3.1: Demand for money curve

Determinants of Money Demand
Apart from the factors identified by Keynes, other factors were
later identified by Professor Milton Friedman in his modern
quantity Theory of money. These include the price level, the
rate of change of prices or inflation, real permanent income
or wealth and return on bonds and equities.

Therefore, the determinants of money could be seen as:

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Determinants of Money Demand (cont)
a. Income: demand for money varies directly with the level of
income, that is, the higher the level of income the higher the
level of money demand.
b. Interest rate: demand for money varies inversely with
interest rate.
c. Price level: there is direct positive relationship between
money demand and the price level.

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Determinants of Money Demand (cont)

d.The rate of price changes: inflation rate varies

inversely with money demand. This is a weak determinant
of money.
e. Real permanent income: Real permanent income or
wealth varies directly with money demand
f. Return on bonds and equities: The higher the return
on bonds and equities the lower the demand for money.
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Money Supply

Money Supply and Its Component

The problem of defining money supply is still associated with a

considerable degree of controversy. Generally, however, money
supply is taken as the total amount of money in circulation in a
country at any given time.

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Money Supply (cont.)

Currency in circulation is made up of coins and notes, while

demand deposits or checking current account are those
obligations which are not associated with any interest
payments and accepted by the public as a means of
exchange drawn without notice by means of cheques.

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 Money Supply (cont.)

Money supply can be defined narrowly or broadly.

Narrow money can be defined as those assets which represent
immediate purchasing power in the economy, and hence
function as a medium of exchange.

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Money Supply (cont.)

Narrow money supply can be defined as those assets which

represent immediate purchasing power in the economy, and hence
function as a medium of exchange.The narrow money supply (M1)
is defined as currency outside banks plus demand deposit of
commercial banks plus domestic deposit with the Central Bank, less
Federal Government deposit at commercial banks. In simple terms,
M1 is defined as M1 = C + D.
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Money Supply (cont.)

Where
Ml = narrow money supply
C = currency outside banks
D = demand deposits

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Money Supply (cont.)

Broad money on the other hand includes narrow money assets

but in addition, includes those assets which have the quality of
liquidity. They can be quickly and readily converted to cash and
the conversion is achieved with little or no less in terms of either
interest penalty or capital loss through forced sale.

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 Money Supply (cont.)
broad money (M2) is defined as M1 plus quasi- money.
Quasi-money as used here is defined as the sum of savings and
time deposits with the commercial banks. Thus, M2 is
symbolically shown as:
M2 = C + D + T + S
Where:
M2 = broad money C = currency in circulation D = demand deposits
T = time deposits S = savings deposits

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Determinants of Money Supply (cont)
It is normally assumed that nominal money supply is exogenously
determined, i.e. it is supplied
monetary authority or the central bank. But the real money supply is
endogenously determined since the price level variation cannot be
fixed. In other words, it is determined by the following factors:
a. Total reserves supplied by the Central Bank:
If the total reserve supplied by the Central Bank is high, money
supply will be high.

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Determinants of Money Supply (cont)

b. Reserve requirement: If the reserve requirement (percentage of

commercial banks' deposits legally required to be kept with the
Central bank) is high, money supply will be low.
c.Demand for currency: If the non-bank public increases its
demand for currency, money .supply will increase.

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Determinants of Money Supply

d. Interest rates:
There is a positive relationship between money supply and interest
rate. That is the higher the interest rate the higher the money
supply.
e. The bank rate:
If the rate at which commercial banks borrow from the Central bank
or discount bill rises, money supply falls.

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The Elementary Quantity Theory of Money

In the seventeenth century, it was discovered that there was

connection between the quantity of money (M) and the general level
of prices (P).
This the connection led to the formulation of the Quantity Theory of
Money. In its simplest form, the quantity theory of money stated
that an increase in the quantity of money (M) would bring about a
proportionate rise in prices.

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The Elementary Quantity Theory of Money (cont)

Professor Irving Fisher introduced a new concept to describe the

relationship between M and P. This new concept is called the
"velocity of circulation of money" written as "V". Money circulates
from hand to hand.

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The Elementary Quantity Theory of Money (cont)

Ex. The farmer, spent P50 to buy ice cream, the ice cream
boy spent the same P50 to pay for the lunch in a nearby
restaurant, while the restaurant attendant spent the same
P50 to buy vegetables from farmer. The P50 was returned
to where it was before the first transaction took place. In
this case, the same currency has been used for four
separate transactions

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 The Elementary Quantity Theory of Money (cont)

If one unit of money is used to serve four transactions,

as in our example, this is equivalent to four units of money,
each being used in only one transaction. Velocity of
circulation of money can, therefore, be defined as the rate
at which the stock of money is turning over per year to
consummate income transactions.

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Financial Institution

Financial institution is defined as an organized way or system of

managing money.
Financial institutions can be classified into two broad headings:

(i)Traditional Financial Institutions, and

(ii)Modern Financial Institutions

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Traditional Financial Institutions

 The traditional financial institutions will include all

arrangements for the management of money before the
development of the banking system
 This was the system of borrowing and lending that existed
before the development of modern financial institutions.

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Modern Financial Institutions

 An institution for buying and selling things, either

commodities or labour, was called a market. Since
financial institutions deal with the lending and borrowing
of money, they are generally called financial markets.

 Banks are financial markets and, therefore, one of the

modern financial institutions.

 Also included under financial markets are development

banks, insurance companies, building societies and the
stock exchange.
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Types of financial Institutions in the Philippines.

The Bangko Sentral ng Pilipinas (BSP) is the monitory and regulatory

body of all the financial institutions inside the Philippines.

Broadly, there are 4 different types of financial institutions in the

country:

1. Universal and commercial banks: Resource wise, these

represent the largest group of financial institutions. These banks offer
a range of financial services.

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Types of financial Institutions in the Philippines (cont)

2. Rural and cooperative banks: These banks are well known and
popular among rural communities in the Philippines. These banks play
an active role in developing the rural economy by providing basic
financial services to the rural communities

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Types of financial Institutions in the Philippines (cont)

3. Thrift banking system: The system is composed of

savings and mortgage banks, private development banks,
stock savings and loan associations and microfinance thrift
banks. These banks are engaged in accumulating savings of
depositors and investing them.

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Types of financial Institutions in the Philippines (cont)

4. The market also consists of some non-banks with

quasi-banking functions. This group consists of institutions
engaged in the borrowing of funds from 20 or more
lenders for the borrower's own account through issuance,
endorsement or assignment with recourse or acceptance
of deposit substitutes for purposes of re-lending or
purchasing receivables and other obligations.
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 THANK YOU

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