BRIAN ROPI A LEVEL ECONOMICS NOTES MONEY AND THE PRICE LEVEL

MONEY AND THE PRICE LEVEL

TOPIC OBJECTIVES

Learners should be able to:

 explain characteristics of money

 examine the functions of money
 explain the functions and role of money market institutions in an economy
 calculate the money multiplier
 illustrate how banks create money
 discuss the impact of credit creation in an economy
 explain the determinants of money demand and supply
 examine the use of economic theories in explaining interest rate determination

INTRODUCTION
Money, as defined in economics, is anything that is readily and widely accepted as a medium
for the exchange for goods and services or in settlement of debts. Money plays a crucial role in
the economic system of any country. It is a means for promoting specialization and exchange
on which modern economic activity is based. Before the invention of modern money in the
forms of currency notes and coins as we know today, trade had been conducted by barter,
through the use of commodity monies such as gold, cow, iron bars, etc.

The barter system refers to a situation where goods are directly exchanged for goods. The
problems associated with the system are:

(i) Double coincidence of wants: It entails finding a person who has what you want
and requires what you have. For example, a person who has a cow and needs maize
must search for another person who has maize and needs a cow. This process is
cumbersome and leads to a waste of time.
(ii) No common unit of measure: It is difficult to arrive at a uniform or an easily
acceptable exchange rate between different commodities
(iii) The absence of a means of storing wealth or value: Under the barter system. It is
difficult to store wealth because most articles of trade, especially agricultural
products are easily perishable.

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(iv) Difficult in making deferred payment: As a result of exchange rate problem, it is

difficult to store wealth because most articles of trade, especially agricultural products are
easily perishable.

(iv) Problem of bulkiness and indivisibility of most goods: The goods are often too
bulky to be carried from one place to the other, and are not capable of being into
divided similar units to facilitate transaction. The introduction of money has
enabled man to overcome the problem associated with the barter system.
FUNCTIONS OF MONEY

A medium of exchange

 Money facilitates the exchange of goods and services because, people exchange the
goods and services they produce for money and then use the money to buy other goods
and services they want. This enabled man to overcome the problem of ‘double
coincidence of wants’ associated with trade by barter.
A store of wealth / store value

 People now store their wealth in the form of money because money is easy to keep
unlike physical goods.
 Money is easy to convert into goods and services, however this function of money is
the one most affected by the high rate of inflation.
 A high rate of inflation erodes the value of money; people will prefer assets to money,
which appreciates in an inflationary environment.

Unit of account

 All transactions private and public can be recorded and presented only if goods and
services are expressed in terms of money.
 Through prices we can account for goods and services.
 It is possible to add different goods and services together for example premises and
machinery.

A Measure of value

 As said before goods and services are expressed in terms of money, the value of each
can be determined and compared to that of other goods and services therefore money

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makes it possible to exchange goods for other goods e.g. to find out how many hens are
worth a good.

A standard of deferred payment

 The use of money makes it possible to enter credit and other long term obligations or
contracts.
 People get goods and services today and can pay for the later (postponed payments).
 Money makes it possible for people to enter into contracts, such as lending, borrowing,
and enjoyment of services for fixed amount of money payable at a future date. The
exchange rate problem makes this impossible under the barter system.

QUESTIONS

 Explain the functions of money (10)

 How are the functions of money affected by a high rate of inflation (15)

CHARACTERISTICS OF GOOD MONEY

For anything to perform the functions of money outlined above effectively, it must possess the
following attributes or qualities.

(i) General acceptability:- It must be acceptable by all economic agents in the country in
which it is used in payment for goods and services, and in settling debts and obligations.

(ii) Divisibility: It should be available in units of a standard size sufficiently divisible to

facilitate the purchase and sale of goods and services over a wide range of prices.

(iii) Durability: It should be able to last for a long time without losing its value. This is the
reason why high quality papers are used to print paper currency and precious metals are used
in minting coins.

(iv) Portability: Money should be convenient to carry about for easy transfer to other people
during transactions.

(v) Homogeneity: One unit of money must be the same in all respects (i.e. identical)
everywhere throughout the country. This will promote general acceptability.

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(vi) Relative Scarcity: It must be unique, not something that can be found easily anywhere.
And it must not be supplied in excess so as not to lose its value whereby will not be able to
serve effectively as a store of value and a standard of deferred payment.
GRESHAM’S LAW = BAD MONEY DRIVES OUT GOOD MONEY

 If there are two types of money and one is more valuable that the other, the inferior
money gets used or circulated and it drives the valuable or superior money out of
circulation.
 People will hoard the good money and spent it.

TYPES OF MONEY
The three main types of money are classified as:
a. Paper money and coins:

b. Bank deposits: These are money deposited with financial institutions, especially commercial
banks which are withdrawable or transferable without prior notice by writing a cheque. Such
deposits are held in current account of the customer, and a fee is charged for processing the
cheque.
Types of Bank Deposits
i. Demand deposits: It is deposit of funds (usually paper money and coins) with a bank
which are withdrawable or transferable without prior notice by writing a cheque. Such
deposits are held in current account of the customer, and a fee is charged for
processing the cheque.

ii. Saving deposit: It is a deposit of fund with a bank which can be withdrawn with or
without a notice of withdrawal. Savings deposits are held in savings account and they
yield interest for the depositor.

iii. Time Deposit: It is a deposit of fund that cannot legally be withdrawn from the bank
without at least 30 days notice of withdrawal. Time deposits are held in fixed deposit
accounts opened for depositors and they yield interests.

c. Near Money/Quasi Money

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These are financial assets held as close substitutes for money and largely performing the
same functions as those performed by money. Examples are demand and savings deposits.
People may prefer to these assets because of their following desired attributes:
i) Profitability
Generally all the categories of quasi money earn a return in the form of interest. When
inflation is generally high people may prefer to hold near money as a way of hedging against
the value-eroding effect of inflation on cash.
ii) Liquidity
Some financial assets such as demand deposits are almost as liquid as cash yet safer to hold
than cash. Wealth holders are not inconvenienced by holding such assets when they want to
carry out their transactions. For financial assets to be highly liquid and equally acceptable as
money, a stable and liquid financial sector needs to be in place.
iii) Less Risk
Money assets should be risk free for people to hold them in the sense that the holder should be
certain of the return on and the liquidity of the asset without fears of loosing of value. In a
highly liquid financial sector with good banking practices, the risk associated with holding
financial assets is reduced and people can safely hold them.

THE NATURE OF MONEY

The nature of money is usually discussed under three headings:
a. Legal tender: Money which by nature must be accepted in payment for goods and in
discharge of debt obligations. Currency notes and coins are legal tender in all modern
economies.

b. Fiat money: Money that is not a commodity and it is not redeemable in any commodity.
What gives such money value and acceptability is their being declared as legal tender by the
government. Money in the form of currency notes fit into this description.

c. Token money: This refers to money whose face value is greater than the actual value of the
material of which it is made. In most economies, coins are token money, whose value as metal
is less than their monetary value.

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MONEY AND SUPPLY MEASUREMENTS

 The money supply is the total amount of assets in circulation, which are acceptable in
exchange of goods.
 In modern economies people accept either notes and coins or an increase in their current
account as payments. Hence the money supply is made up of cash and bank deposits.
 Every government through its monetary authority has a role to measure money supply
in the economy.
Reasons
 The need to manage the level of economic activities through the use the monetary
police.
 The government needs to know state of financial markets to assess the developments.
 The government needs to know the composition of money supply in order to pursue an
effective monetary policy.
 However money supply measurement is an area of controversy because economists
define money supply differently.
 The items in money supply are different :-
o In different societies
o From time to time

Monetary Aggregates in Zimbabwe/Official definition of money in Zimbabwe

The aggregates of money supply in Zimbabwe are as defined below:

M1=Notes and Coins in Circulation + Demand Deposits (with the RBZ; Discount Houses;
Commercial Banks; & Merchant Banks).

M2=M1 + Savings Deposits with Commercial Banks + Under 30-Day Fixed Deposits with
Commercial and Merchant Banks.

M3=M2 + Over 30-Day Fixed Deposits with Commercial Banks; the RBZ; Merchant Banks
+ Fixed Foreign Currency Accounts.

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M4=M3 + Savings and Fixed Deposits with other Banking Institutions-the POSB; Finance
Houses; Building Societies + Private Sector Foreign Currency Holdings.

Of these aggregates, M1 is the narrow definition of money while M2 to M4 are broader

definition. The broadly defined categories are generally more active in terms of influencing the
interest rate, inflation and the level of economic activities. These are therefore commonly the
targets of monetary policy in Zimbabwe (especially M3).

THE DEMAND FOR MONEY

Demand for money otherwise referred to as liquidity preference means the desire of people to
hold their resources or wealth in the form of cash i.e. currency notes and coins, instead of
interest – yielding assets. The British economist John Maynard Keynes (1883 – 1946)
identified three reasons for demand for cash balances or why people hold money:

THEORIES OF INTEREST RATE DETERMINATION

Interest rates are the cost of borrowing money. Interest rates are normally expressed as a % of
the total borrowed, e.g. for a 30-year mortgage, a bank may charge 5% interest per year.

Interest rates also show the return received on saving money in the bank or from an asset like
a government bond.

LIQUIDITY PREFERENCE THEORY

The cash money is called liquidity and the liking of the people for cash money is called
liquidity preference.
According to Keynes people demand liquidity or prefer liquidity because they have three
different motives for holding cash rather than bonds etc.
1. Transaction Motive
2. Precaution Motive
3. Speculative Motive
The Transactions Motive:
This represents cash balances held in order to carry out ordinary, everyday transactions. For
example, individual persons need to hold money to buy fares, and so on. Similarly, business
organisations need money to pay wages and electricity bills, buy raw materials, vehicles and

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equipments, etc. The transactions demand for money is directly related to income. This demand
depends upon the following.
 Size of the income -If size of the income is high more will be the transactions and vice
versa.
 Time gap between the receipts of income -If a person gets his pay daily he will
demand less cash money. On the other hand if time gap is more a person will demand
more money to carry on his daily transactions.
 Spending habit -If a person is spendthrift he will do more transactions. Naturally he
will demand more money and vice versa.
The demand for money for this purpose is completely interest inelastic.
The Precautionary Motive:

This refers to holding cash balances as a precaution against unexpected expenses. For
instance, people hold money to provide them with some degree of security against sudden
illness, accidents, fire or flood disaster, etc., while firms hold money against unpredictable
occurrences such as sudden breakdown of vehicles, equipments and so on. The main factor
influencing this motive is the level of income. This demand depends upon many factors.

 Size of the income -If the size of the income of a person or a firm is large, he will
demand more money for safeguarding his future.

 Nature of the person-Some persons are optimistic while others are pessimistic .The
former think always about the bright side of future. So they anticipates less, if any risk
and danger in the future. Naturally such persons will demand less money for
precautionary motive. On the contrary, pessimistic persons or firms foresee many
dangers, calamities and emergencies in the future. In order to meet these, they want to
have more cash with them.

 Farsightedness -A farsighted person can see better about the future. He will make a
proper guess of the future. Thus if he expects more emergencies, he will keep more
money with him in cash and vice versa.

The demand for money for precautionary motive is also completely interest inelastic.

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The transactions balances and precautionary balances are sometimes jointly referred as
demand for active balances. Demand for active balances that is demand for transactions and
precautionary motive is perfectly interest inelastic.

The Speculative Motive:

This refers mostly to the desire to hold cash balances in order to make speculative dealing in
the bond or securities (interest – yielding assets) markets. The demand for money for
speculative purposes is interest – elastic. The higher the rate of interest, the lower the demand
for speculative cash balances. Thus, there is an inverse relationship between the price of bond
and interest rate. This motive for holding money, is a decreasing function of the rate of interest
and it is also influenced by incomes.

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Lord Keynes refers to the money held for transactions and precautionary motive as active
balances, and that which is held for speculative motive as idle balances. The total demand for
money is found by the summation of transactions, precautionary, and speculative demands.

THE LIQUIDITIY PREFERENCE CURVE

The transactions balances and precautionary balances are held with the intention of being used
to make purchases as and when required, they are sometimes jointly referred as demand for
active balances. The important point about the demand for active balances is that it is not
responsive to changes in the rate of interest i.e it is interest inelastic. The demand for
speculative balances, on the other hand is sometimes referred to as the demand for idle
balances.
We can have the community’s total demand for money or liquidity preference schedule by
adding the demand for active (La) and idle balances (Li ) together.

La Li LP (La + Li)

Qm Qm Qm

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SUPPLY OF MONEY
The supply of money is quite different from the demand for money. No private individual can
change it. Supply of money is controlled by the central bank or its government. Money supply
depends upon the currency issued by the government and the policies of the central bank
regarding with credit creation. In the short run at a particular period of time supply of money
remains constant. That’s why the supply curve money is perfectly inelastic.
Rate of Interest Ms

Supply of Money

Determination of market interest rates

The intersection of the demand for money curve (LP) and the supply of money curve determine
the market equilibrium rate of interest.

Rate of interest Ms

LP

Qm

In the above diagram LP is the demand for money and the Ms is the supply of money. This
gives an equilibrium rate of interest i . At any rate of interest above i , the supply of money
exceeds demand and this will pull down the rate of interest, while at any rate of interest below
i the demand for money exceed supply and this will bid up the rate of interest. Once the rate of
interest is established at i , it will remain at this level until there is a change in the demand for
money and or the supply of money.

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This implies that the authorities have two choices

(i) They can fix the supply of money and allow interest rates to be determined by the
demand for money; or
(ii) They can fix the rate of interest and adjust the supply of money to whatever level is
appropriate so as to maintain the rate of interest.

The liquidity trap

LP

Rate of interest Ms Ms1

Qm

Qm Qm1

It is the situation in which changes in money supply have no influence on the rate of interest,
monetary policy cannot be used to influence other variables such as consumption and
investment when the rate of interest is i.

Applicability in Zimbabwe:

The Kenesian transactions and speculative motives for money demand are generally applicable
and well explain the nature of money demand in Less Developed countries with thin money
and capital markets. The speculative motive tends to be more appropriate in advanced
economies were people are rich and more monetised. Such people would be expected to worry
more about financial investment opportunities for their monies than would the average money
holder do in Less Developed Countries. Most research studies have also proved this by failing
to find any systematic relationship between money demand and the interest.

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LOANABLE FUNDS THEORY

The loanable funds theory states that interest rates will be determined by the supply and demand
for funds.

The loanable funds theory is based on the following assumptions:

 The market for loanable funds is a fully integrated market, characterised by perfect
mobility of funds throughout the market.
 There is perfect competition in the market so that one and only one rate of interest
prevails in the market at any time.
 Flexibility of interest rate is assumed so that it freely moves according to the changes
in the demand and supply of loanable funds.
 The theory is stated in flow terms, considering flow of demand for and supply of
loanable funds per unit of time.
 The theory assumes full employment of resources which implies constant level of
income and output. In other words, an increase in investment, instead of increasing
output, becomes inflationary.
 Money is assumed to play an active role in the determination of the rate of interest and
the banks adopt a stabilizing policy with the objective to establish monetary
equilibrium.

Demand for Loanable Funds

According to this theory demand for loanable funds arises for the following three
purposes; Investment, hoarding and dissaving:

1. Investment (I):

The main source of demand for loanable funds is the demand for investment. Investment refers
to the expenditure for the purchase of making of new capital goods including inventories. The
price of obtaining such funds for the purpose of these investments depends on the rate of
interest. An entrepreneur while deciding upon the investment is to compare the expected return
from an investment with the rate of interest. If the rate of interest is low, the demand for
loanable funds for investment purposes will be high and vice- versa. This shows that there is
an inverse relationship between the demands for loanable funds for investment to the rate of
interest.

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2. Hoarding (H):

The demand for loanable funds is also made up by those people who want to hoard it as idle
cash balances to satisfy their desire for liquidity. The demand for loanable funds for hoarding
purpose is a decreasing function of the rate of interest. At low rate of interest demand for
loanable funds for hoarding will be more and vice-versa.

3. Dissaving (DS):

Dissaving’s is opposite to an act of savings. This demand comes from the people at that time
when they want to spend beyond their current income. Like hoarding it is also a decreasing
function of interest rate.

Supply of Loanable Funds:

The supply of loanable funds is derived from the basic four sources as savings, dishoarding,
disinvestment and bank credit.

They are explained as:

1. Savings (S):

Savings constitute the most important source of the supply of loanable funds. Savings is the
difference between the income and expenditure. Since, income is assumed to remain
unchanged, so the amount of savings varies with the rate of interest. Individuals as well as
business firms will save more at a higher rate of interest and vice-versa.

2. Dishoarding (DH):

Dishoarding is another important source of the supply of loanable funds. Generally, individuals
may dishoard money from the past hoardings at a higher rate of interest. Thus, at a higher
interest rate, idle cash balances of the past become the active balances at present and become
available for investment. If the rate of interest is low dishoarding would be negligible.

3. Disinvestment (DI):

Disinvestment occurs when the existing stock of capital is allowed to wear out without being
replaced by new capital equipment. Disinvestment will be high when the present interest rate

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provides better returns in comparison to present earnings. Thus, high rate of interest leads to
higher disinvestment and so on.

4. Bank Money (BM):

Banking system constitutes another source of the supply of loanable funds. The banks advance
loans to the businessmen through the process of credit creation. The money created by the
banks adds to the supply of loanable funds.

Determination of Rate of Interest:

According to loanable funds theory, equilibrium rate of interest is that which brings equality
between the demand for and supply of loanable funds. In other words, equilibrium interest rate
is determined at a point where the demand for loanable funds curve intersects the supply curve
of loanable funds.

The equilibrium interest rate is at R1 – when demand equals supply for loanable funds.

Criticism:

1. Full Employment:

Keynes opined that loanable funds theory is based on the unrealistic assumption of full
employment. As such, this theory also suffers from the defects as the classical theory does.

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2. Indeterminate:

Like classical theory, loanable funds theory is also indeterminate. This theory assumes that
savings and income both are independent. But savings depend on income. As the income
changes savings also change and so does the supply of loanable funds.

3. Impracticable:

This theory assumes savings, hoarding, investment etc. to be related to interest rate. But in
actual practice investment is not only affected by interest rate but also by the marginal
efficiency of capital whose affect has been ignored.

4. Unsatisfactory Integration of Real and Monetary Factors:

This theory makes an attempt to integrate the monetary as well as real factors as the
determinants of interest rate. But, the critics have maintained that these factors cannot be
integrated in the form of the schedule as is evident from the frame work of this theory.

5. Constancy of National Income:

Loanable funds theory rests on the assumption that the level of national income remains
unchanged. In reality, due to the change in investment, income level also changes accordingly.

CREDIT CREATION BY COMMERCIAL BANKS

The process of credit creation is said to be one of the most important of the functions that are
performed by a commercial bank.

The central bank of a country is responsible for ensuring money supply in the economy by
currency circulation. It also ensures that for fulfilling all the transactions, there should be
appropriate currency in the system.

This process cannot be implemented by the central bank alone, for this they require the help
of commercial banks and their reserves. The commercial banks perform the function of credit
creation in an economy.

Therefore, the money that is created by the commercial banks is known as credit money. This
is achieved by the commercial banks in the form of purchasing of securities and providing

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loans. Commercial banks facilitate the loans by utilising the deposits that are obtained from
the public.

There are restrictions on the amount of money that can be provided as credit from the total
deposits that a bank obtains from the public. As per the rule, commercial banks need to
maintain a certain portion of the public deposits as reserves with the central bank which will
be used for meeting the immediate cash requirements of the depositors.

Only after keeping aside the required amount of those reserves, the commercial banks are
permitted to lend to individuals or businesses.

Conditions essential for Credit Creation

The following conditions are essential for credit creation in an economy

1. Public depositing money into the commercial banks

2. The willingness of commercial banks to lend money to individuals or businesses in
the form of credit.
3. The willingness of individuals or businesses in seeking money from commercial
banks in the form of credit.

Simplifying assumptions

 Assume a multiple banking system that is, assume that there are numerous banks in the
economy.
 Assume a 10% cash reserve ratio, that is, 10% of total deposits need not be advanced
as loans but set aside as cash reserve requirement. This amount is set aside for client
withdrawal and will not be advanced as an overdraft.
 Bank transactions are only loans and payments are made and paid by way of cheques.
 There are no cash leakages and banks keep no excess reserves.

Formula for determining the Credit creation/Money supply

The following formulae can be used to determine the total credit creation/money supply

Total Credit Creation/total deposit = Original Deposit ✕ Credit Multiplier Coefficient

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Where,

Money/Credit multiplier coefficient= 1 / CRR

CRR = Cash reserve requirement also known as Cash Reserve Ratio

Credit/Money Multiplier It refers to the fraction by which commercial banks would be able
to multiply money from their initial level of deposits.

Let’s understand this with an example

If the money deposited in bank is $10 000 and the bank has a CRR of 10%, then Credit
multiplier coefficient will be

Credit multiplier coefficient = 1 / 10%

= 1/ 0.1

= 10

Total Credit Creation = 10000 ✕ 10 = 100000

ILLUSTRATION OF THE CREDIT CREATION PROCESS

Assuming that the credit reserve ratio is 10% and initial deposit is 10 000, the credit creation
process can be illustrated as follows

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ROUND BANK DEPOSIT CASH LOAN/OVERDRAFT

RESERVE
1 CBZ 10 000 1000 9000

2 ZB 9000 900 8100

3 CABS 8100 810 7290

4    

5    

TOTAL 100 000 10000 90 000

Similarly, if CRR = 20 %

Then

Credit multiplier coefficient = 1 / 20%

= 1/ 0.2

=5

Therefore, Total Credit Creation = 10000 ✕ 5 = 50000

From the above values we can understand that low CRR value results in high credit creation
and high CRR results in less credit creation. Therefore, with the help of credit creation,
money gets multiplied in the economy.

However, commercial banks face many challenges and limitations while performing the
credit creation in an economy which is discussed below.

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Limitations of Credit Creation

Following are some of the limitations that are experienced by the commercial banks during
the credit creation process

1. Cash amount present in bank

The higher the amount of deposits made by the public, the higher credit creation from
commercial banks can be seen, but there is a certain limit on the amount of cash that can be
held by the banks at a time.

This limit is determined by the central bank, as the central bank may contract or expand this
limit by selling or purchasing the securities.

2. Cash Reserve Ratio or CRR

It refers to the amount of money in form of reserve that needs to be kept with central banks
by the commercial banks. This amount is used for meeting the cash requirements of the users.
Any fall in the CRR will lead to more credit creation.

3. Excess Reserve

This takes place when a country faces recession, at that time banks find it conducive in
maintaining reserves in place of lending which leads to less credit creation.

4. Currency Drainage

It refers to the situation when the public is not depositing money in the banks, which results
in reduced credit creation in the economy.

5. Borrower Availability

Credit creation will flourish if there are borrowers, credit creation will not be done if there are
no borrowers of the money in an economy.

6. Prevalent business conditions

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If an economy is witnessing a depression then the businesses will not be seeking credit which
leads to contraction of credit creation. Whereas, if a nation is prospering then businesses will
seek new funds in the form of credit from the banks which leads to credit creation.

THE QUANTITY THEORY OF MONEY

The theory suggests the existence of a direct relationship between money supply and the
average price level in the macro economy. Specifically the quantity theory of money states that
the price level is strictly proportional to the money supply. The quantity of money which was
pioneered by the 18th century economists including Adam Smith and David Hume, was
modified and popularized in 1911 by the American Economist, Irvin Fisher (1867 – 1947) in
what is known equation of exchange:

MV = PQ/MV=PT

Where M = Total money supply

V = velocity of circulation of each unit of money

P = average price level

Q = real national output or real GNP/T=Number of transactions

The assumptions of the theory are that:

 The velocity of money circulation (V) is fixed.

 The real GNP denoted (Q) is fixed in the short – run.
 The money stock (M) is determined from time to time by the country`s monetary
authorities.
 The economy is at full employment level.

Given the above assumptions, the equilibrium price level (P) is determined by the money
stock (M) as expressed in equation

P = MV/Q

Equation above which presents the quantity theory of money is obtained by making P the
subject of the relation in equation MV=PQ. It follows, for example, that a 5 percent increase
in money stock will cause average price level in the economy to rise by 5 percent. Thus,

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inflation is conceived as a monetary phenomenon. The major policy implication of the

theory is that monetary policy of the restrictive type, is most relevant for effective control
of inflation. In other words to curb the problem of inflation effectively requires the
reduction of money stock through the use of monetary policy instruments such as open
market operations (OMO) reserve requirements, and bank rate.

A Critique of the Quantity Theory of Money

 The theory sees money exclusively as a medium of exchange in the sense that people
do not have other uses for money other using it to facilitate their transactions. This
assumption fails this theory in practice where people have got diverse uses for money
eg money can be used to store one‟s wealth; money can be used to speculative purposes.
 The assumption of a fixed velocity of circulation of money is unrealistic. The
development of the financial sector and the wide use of cheques and other plastic
technologies (ATMs; credit cards; debt cards) all affect money demand and the
velocity of circulation of money.
 The theory defines money supply in its narrow terms as the amount of currency in the
economy plus the value of demand deposits. In modern economies where broad
money is used for monetary policy and transactions purposes, the theory becomes
inapplicable.
 The postulation of money neutrality by the equation of exchange has failed in practice
as it has generally been observed that whenever the level of money supply is changed
its effect would fall on both real variables and the price level. This is because
economies are not always at full employment as assumed by the theory. Again, the
existence of market and information imperfections, unemployment, money illusion
and price rigidities make money non-neutral.

FINANCIAL INSTITUTIONS

Financial institutions are the main channel by which funds flow from the sectors of the
economy with surplus funds to other sectors with insufficient funds to ensure efficient
utilization of such resources in the promotion of economic growth and development. Financial
institutions may be broadly divided into two groups – banking and non-banking financial
institutions. The banking institutions include commercial and merchant banks, development
banks, and the Central Bank. On the other hand, the non-banking institutions include insurance

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companies, equipment – leasing companies, hire – purchase companies, building societies,

discount houses

COMMERCIAL AND MERCHANT BANKING

The commercial and merchant banks are profit – making enterprises, as well as the major
financial intermediaries through which the monetary authorities facilitate effective distribution
of money in the economy.

Functions of Commercial Banks

The commercial banks offer a range of services which include the following:

(i) Accepting deposits of money: Commercial banks, as savings institutions, provide facilities
for the mobilization of savings by accepting deposits form households, firms and government.
They use current account, saving account and fixed deposit account to accept demand deposits,
saving deposits and time deposits respectively.

(ii) Granting loans and advance: The most profitable function of commercial banks is
extending credits to worthy borrowers charging interest rate higher than the rate they pay on
deposits. Short – term credit facilities are extended to customers using special loan account or
in the form of overdraft using current account. It may also take the form of loan syndication
whereby two or more banks agree to finance a large project.

(iii) Acting as agents of payment: Commercial banks` customers keep current accounts from
which they can draw for settlement of debt and for payments for goods and services. They also
transfer funds on behalf of their customers through collection of standing orders and direct
debiting.

(iv) Creating demand – deposit money: By lending out the money – i.e. deposit that they
collected from some customers, commercial banks create additional purchasing power in the
economy.

(v) Providing international trade service: Commercial banks are involved in the financial
aspects of international trade, especially by discounting bills of exchange for their customers
who are exporter and opening letters of credit in favour of their customers who are importers.
A letter of credit is an undertaking by the bank accepting to redeem the liability of its customers
on an import contract.

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(vi) Providing brokerage services: Commercial banks undertake to buy and sell stocks and
shares on behalf of their customers.

(vii) Foreign exchange services: Commercial banks act as intermediaries between the Central
Bank or authorized foreign exchange declares and their corporate customer to process foreign
exchange allocation. They also provide traveler`s cheque to their customers who are traveling
out of the country.

(viii) Safekeeping of valuable items: The commercial banks undertake to keep, for their
customers, valuable items such as government stock, share certificates, academic certificates,
certificate of occupancy, jewelries, insurance policies, etc.

(ix) Equipment leasing: This is the activity of banks in financing purchases of fixed assets by
their customers (mostly business enterprises) and allowing repayment over an agreed period of
time. The bank is the lessor, while the beneficiary is the lessee.

Functions of Merchant Banks

The traditional functions of merchant banks include the following:

(i) Acting as issuing houses in the capital market: Merchant banks are engaged in issuing or
floating of new securities for private and public companies and for government (state and local)
seeking to raise long-term or permanent finance for their projects. For all services involved in
the performance of this function, merchant banks receive a commission called brokerage.

(ii) Accepting deposit: Merchant banks accept large deposits from their customers mostly
corporate bodies. Such deposits attract interest and can be withdrawn only with certificate of
deposits (CD) and not with cheques as in the commercial banks transactions.

(iii) Providing foreign exchange services: Merchant banks are authorized dealers in the
foreign exchange market and as a result they are engaged in the buying and selling of foreign
exchange (forex) for commercial and other purposes. They also provide services for both
imports and exports.

(iv) Grating loans and advances: The banks provide medium and long-term loans and
advances to manufacturers and big-time traders. They are also engaged in loan syndication.

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(v) Project Financing: The merchant banks are engaged in the financing of new industrial and
agricultural projects on the understanding that the repayment would be made from the revenue
stream generated by the project.

(vi) Providing advisory services: Merchant banks offer advice to their clients on project
financing, joint ventures, mergers and acquisitions debt financing, and on the rationalization of
the companies capital structure.

(vii) Equiment Leasing: The business of equipment leasing, as described under commercial
banking, is more popular with the merchant banks. Equipment leasing can be in the form of
finance lease where a bank provides funds to a firm to purchase the equipment, or operation
lease where a bank or lessor buys the equipment and rent it out to the firm – i.e (the leasee).

Building societies:

Definition:

- Are societies that aim at helping their customers acquire real estates

- They are registered by the building societies Act but controlled by the central bank.

- Account holders in these societies are considered as owners rather than customers.

Functions:

 They offer mortgages that assist individuals to buy or put up residential houses.
 They build housing estates which are sold to members of the public by selling housing
bonds.
 They are able to develop housing units and earn income to investors.
 They offer fixed deposits accounts and savings accounts to members of the public.

CENTRAL BANK

A Central Bank is the apex institution of the monetary and banking system of every country
for example the reserve bank of Zimbabwe (RBZ). It is owned by the government but the
responsibility of its management is usually rested in the Board of Directors whose members
are appointed by the government.

Traditional Functions of the Central Bank

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In both developed and developing economies, the following are perform by the Central Bank.

(i) Currency issue and distribution: The Central Bank is the only institution empowered by
law to issue currency notes and coins that are used as a medium of exchange in the country.
The monopoly power of issuing legal tender currency is important to control the supply of
money in order to prevent inflation.

(ii) The bankers’ bank: The Central Bank provides facilities for other banks especially
commercial banks to keep their cash reserve and clear their balance through the cleaning house.
It also grants loans to or discount the bills of commercial banks when they are short of fund;
hence the Central Bank is referred to as ‘lender of last resort’.

(iii) Banker to the government: The Central Bank keeps the accounts of the government and
of all its corporations and agencies. It receives all payments due to the government, as well as
undertake borrowing on behalf of the government through the issuance of short-term and long-
term securities e.g. treasury bills, treasury certificates and long term securities e.g. development
stocks. The Central bank is also responsible for the management of domestic and external debts
of the government.

(iv) Promotion of monetary stability: The Central Bank controls money supply in the economy
to promote price stability. This involves the use of instruments of monetary policy such as open
market operations (OMO), reserve requirements, discount rate, etc.

(v) Foreign exchange management: To ensure that foreign exchange disbursement and
allocation are consistent with economic priorities, the Central Bank acquires, allocates and
monitors the use of scarce foreign exchange resources as well as maintains the country`s
foreign exchange reserves.

(vi) Supervision of finance houses: In every modern economy, the Central Bank is backed by
law to monitor and supervise the activities and practices of financial houses in order to promote
effective execution of monetary policy.

Developmental Functions of the Central Bank

These are activities of the Central Bank to promote growth in various sectors of the economy.

(i) Promotion of the growth of financial markets: The Central Bank usually initiate
instruments of mobilizing short-and long-term funds in both the money and capital markets.

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(ii) Promotion of development of financial institutions: The Central Bank participates

actively (morally and financially) in the establishment of development banks.

(iii) Human capital development: The Central Bank participates directly and indirectly in the
training of manpower for the banking industry.

(iv) Establishment of special schemes and funds: The Central Bank promotes special
schemes and funds in the areas of agricultural finance, export development and small and
medium scale enterprises so as to enhance economic development.

(v) Sources of data for research: Through its regular publications, the Central Bank provides
information on financial indices and indicators for use in research and development (R&D)
efforts.

MONETARY POLICY

Monetary policy refers to the combination of measures designed to regulate the value, supply
and cost of money in the economy in consonance with the expected level of economic activity.
An expansionary monetary policy is that which is designed to increase money supply, while a
contractionary or restrictive monetary policy is that which is intended to reduce money supply.

Instruments of Monetary Policy has main instruments or tools of monetary policy vary
between economies an over time. However, the main instruments of monetary policy are:

i. Open market operations (OMO): This refers to purchases and sales of securities in the open
market by Central Bank in order to achieve the desired level of money stock in the economy.
To reduce money supply, the Central Bank will sell securities in the open market. Conversely,
to increase money supply it will require the purchase of government securities.

ii. Reserve requirements: This refers to the proportion of the total deposit liabilities of the
commercial and merchant banks which they are required by law to keep as reserve with the
Central Bank. The reserve requirements i.e cash reserve ratio and liquidity ratio will be
increased to reduce money supply or reduced to increase money supply.

iii. Discount rate: It is the minimum lending rate of the Central Bank at which it rediscounts
bills and government securities, or the rate charged by the Central Bank on its loans to the
commercial and merchant banks as a lender of last resort. It is used to regulate credit conditions
and availability in the economy because other rates depend on it.

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iv. Moral suasion: It is the use of persuasion rather than compulsion by the Central Bank to
get other financial institutions to adopt a pattern of behaviours that is favourable to effective
conduct of the monetary policy.

v. Special deposits: Sometimes, commercial and merchant banks are required by law to hold a
non-interest bearing special deposit with the Central Bank to complement other contractionary
monetary policy measures.

vi. Selective credit control: It involves issuance of credit guidelines to commercial and
merchant banks to direct their credit facilities to the so-called favoured or preferred sectors of
the economy.

vii. Credit ceiling: It is a directive by the Central Bank prescribing the growth rate of credit
expansion by the commercial and merchant banks. This is to ensure stability in both the
domestic and external sectors of the economy.

Monetary Policy Targets

The instruments of monetary policy can be manipulated in different ways by Central Bank to
achieve macroeconomic objectives of full employment, economic growth, price stability, and
balance of payment (BOP) equilibrium. Monetary policy and inflation: The problem of
inflation will call for contractionary monetary policy measures:

i. Sales of government securities (under OMO)

ii. Increase of reserve requirements

iii. Increase of discount rate

iv. Call for special deposit

All of these will reduce money supply and aggregate demand in the economy and thereby
operate to stem the inflationary pressure.

Monetary Policy and full employment:

To raise the level of employment and output in the economy will require adoption of
expansionary monetary policy measures i.e a reverse of the measures listed above for inflation.

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Limitations of monetary policy in Zimbabwe

The advantage of monetary policy is that it is flexible and can be applied fairly quickly unlike
fiscal policy that needs to have both cabinet and parliamentary approval before it can be
applied. However the effectiveness of monetary policy in Zimbabwe is affected by;

 Financial dualism that is the existence of a monetised and non-monetised sectors in the
economy. The monetised sector uses money for its transactions while the non-
monetised sectors engage in barter trade. There is a large non-monetized sector which
is little affected by monetary policy.
 There is a narrow size and inactive money and capital market.
 There is a limited array of financial stocks and assets.
 The notes constitute a major proportion of total money supply, which implies the
relative insignificance of bank money in the aggregate supply of money.
 Foreign owned commercial banks in Zimbabwe can easily neutralise the restrictive
effects of a strict monetary policy as they can replenish their reserves by selling foreign
assets and can draw on the international market.

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