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KWAME NKRUMAH UNIVERSITY OF SCIENCE AND TECHNOLOGY, KUMASI

INSTITUTE OF DISTANCE LEARNING


(BSc Business Administration, 3)

ACF 363: MONEY AND BANKING


[Credit: 3]

G. N. ASAMOAH & J. M. FRIMPONG

Publishers Information
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Course Writer
Course writer(s): Gordon Newlove Asamoah Joseph Magnus Frimpong

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Acknowledgement
The author wishes to thank the Institute of Distant Learning for the opportunity to write this course material. I wish to thank my wife Angela Asamoah, the Kids Chelsea Asamoah and Paris Asamoah for all the patience they had for me when I denied them the time they needed when I was putting this piece together. I also wish to express my sincere gratitude to Millicent Konadu Yeboah at Provost Office, CASS for her help in typing and putting this work together. Thanks also go to everyone who in diverse ways helped to bring this work to light. Gordon Newlove Asamoah.

Course Introduction
Welcome to ACF 363: Money and Banking. This is a 3-credit hour course designed for BSc Business Administration, year 3 Semester 1 COURSE OVERVIEW Money and the evolution of money and the functions and characteristics of money; the demand for money; classical theory. The supply of money, and a model of money supply. Money market equilibrium and money in growth and inflation; the business of banking in Ghana). What banks are; the system and services. The Central Bank of Ghana. Inflation, its causes and the tools/instruments the central bank uses to control inflation. COURSE OBJECTIVES 1. Define and describe money, and explain the evolution of money 2. Explain the functions and characteristics of money 3. State and explain the demand for money 4. State and explain classical theories 5. Illustrate the supply of moneyin Ghana using a model of money supply 6. Explain money market equilibrium 7. Define banks, and Explain The business of banking using the example of banking in Ghana 8. Describe the functions of the central bank of Ghana 9. Explain inflation and its causes 10. Identify the tools/instruments the central bank uses to control inflation COURSE OUTLINE Unit 1 Money: The evolution of money; Functions and characteristics of money Unit 2 The Demand For Money: Classical theory Unit 3 The Supply Of Money: A Model of Money Supply Unit 4 Money Market Equilibrium: Money in Growth and Inflation Unit 5 The Business of Banking (Banking in Ghana): What banks are; The Central Bank of Ghana (Bank of Ghana) Unit 6 Inflation: the Causes of Inflation; and the Tools/instruments the central bank uses to control inflation COURSE STUDY GUIDE This provides a monthly/weekly schedule of progress of your learning. Week # Unit/Session FFFS/Practical/Exam/Quiz 1 Units 1 , Unit 2 FFFS 2 Unit 3, Unit 4 FFFS 3 Unit 5, Unit 6 Exam/Quiz

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GRADING Continuous assessment: 30% End of semester examination: 70% RESOURCES

REFERENCES 1. Banking Act 2004 (Act 673) 2. Banking (Amendment) Act 2007(Act 738) 3. Donald, R. F, (1995) Commercial Banking: The management of Risk. West Publishing Company 4. Jacques, I, (2006) Mathematics for Economics and Business, Prentice Hall 5. Levy, H, and Post, T. (2005), Investments, Prentice Hall 6. Lipsey, R.G., and Chrystal, K.A. (1995), An Introduction to Positive Economics (8th Ed), Oxford University Press. 7. Mishkin, F. S., (2007), The Economics of Money, Banking, and Financial markets,(8 th Edition) 8. Mishkin, F.S and Eakins, S.G. (2009), Financial markets and Institutions (6 th Edition), Pearson International Education

READING LIST / RECOMMENDED TEXTBOOKS / WEBSITES / CD ROM 1. Mishkin, F. S., (2007), The Economics of Money, Banking, and Financial Markets, (8th Edition) 2. Mishkin, F.S and Eakins, S.G. (2009), Financial markets and Institutions (6th Edition), Pearson International Education 3. http://spruce.flint.umich.edu/~mjperry/notes.htm

Table Of Contents
Publishers Information..............................................................................................................ii Course Writer............................................................................................................................iv Acknowledgement......................................................................................................................v Course Introduction...................................................................................................................vi Table Of Contents....................................................................................................................vii Unit 1..........................................................................................................................................1 MONEY.....................................................................................................................................1 SESSION 1-1: THE EVOLUTION OF MONEY..................................................................1
1-1.1 Barter System........................................................................................ 1 1-1.2 Commodity Money................................................................................. 2

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SESSION 2-1: FUNCTIONS AND CHARACTERISTICS OF MONEY............................3


2-1.1 Functions................................................................................................ 3 2-1.2 Characteristics / qualities of good money..............................................4 2-1.3 Definition of money................................................................................5 2-1.4 Measuring Of Money...............................................................................6

Unit 2........................................................................................................................................10 The demand for money.............................................................................................................10 SESSION 1-2: CLASSICAL THEORY..............................................................................10
1-2.1 Keynesian Theory.................................................................................12 1-2.2 Monetarist Theory................................................................................13 1-2.3 Portfolio Balance Theory.......................................................................14

Unit 3........................................................................................................................................18 the supply of money.................................................................................................................18 SESSION 1-3: A MODEL OF MONEY SUPPLY.............................................................18
1-3.1 Money Supply in Ghana........................................................................20 1-3.2 Monetary Policy in Ghana.....................................................................21

Unit 4........................................................................................................................................24 money market equilibrium.......................................................................................................24 SESSION 1-4 DEMAND FOR MONEY............................................................................24
1-4.1 IS-LM Models........................................................................................ 24

SESSION 2-4: MONEY IN GROWTH AND INFLATION ..............................................29


2-4.1 The Role Of Money In Growth...............................................................29 2-4.2 The Role Of Money Inflation.................................................................29

Unit 5........................................................................................................................................32 The business of BANKING (banking in ghana)......................................................................32 SESSION 1-5: WHAT BANKS ARE .................................................................................32
1-5.1 Ghanas banking system......................................................................33

SESSION 2-5: THE CENTRAL BANK OF GHANA (BANK OF GHANA)....................34


2-5.1 Bank of Ghana Bill 2000, Part 1The Bank of Ghana, Its Objects And Capital........................................................................................................... 34 2-5.2 Objects and Functions of the Central Bank...........................................34 2-5.3 Commercial (Universal) Banking..........................................................36 2-5.4 General Functions Of Commercial (Universal) Banks...........................38 2-5.5 Importance of Commercial (Universal) Banks......................................39

Unit 6.......................................................................................................................................42 inflation....................................................................................................................................42 viii

SESSION 1-6: DEFINITION AND CAUSES OF INFLATION........................................43


1-6.1 Definition of Inflation............................................................................43 1-6.2 Cost Push Inflation................................................................................43 1-6.3 Demand Pull Inflation...........................................................................44 1-6.4 Inflation Measurement..........................................................................44 1-6.5 Hyperinflation....................................................................................... 45

SESSION 2-6: TOOLS/INSTRUMENTS THE CENTRAL BANK USES TO CONTROL INFLATION (MONEY SUPPLY)......................................................................................46
2-6.1 Open Market Operations (OMO)...........................................................46 2-6.2 The Rediscount Rate............................................................................47 2-6.3 Reserve Requirements.........................................................................47 2-6.4 Direct Credit Control............................................................................. 47 2-6.5 Moral Suasion....................................................................................... 47

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Unit
Introduction

MONEY
The importance of money lies in its usage as a medium of exchange. By acting as the intermediary in exchange transactions, money provides a lubricant for rapid economic growth through trade. Indeed the supply of and the demand for money determine to a large extent fluctuations in the level of economic activity through their effect on rates of interest and hence on consumption, investments, exports and imports. It is not out of the benevolence of the brewer, the baker or the butcher that we get our daily bread but they are perpetuated by their own selfish interest Adam Smith.

Learning Objectives
After reading this unit you should be able to: 1. Define and describe money. 2. Define and explain The Evolution of Money and how this relates to Barter System and Commodity Money. 3. Explain the Functions and Characteristics Of Money.

Unit content
SESSION 1-1: THE EVOLUTION OF MONEY 1-1.1: Barter System 1-1.2: Commodity Money SESSION 2-1: FUNCTIONS AND CHARACTERISTICS OF MONEY 2-1.1: Functions 2-1.2: Characteristics and qualities of good money 2-1.3: Definition of money 2-1.4: Measuring Of Money

SESSION 1-1: THE EVOLUTION OF MONEY


1-1.1 Barter System
In the primitive society, goods and services were exchanged directly for goods and services. This is known as the barter system. The barter system is a simple form of exchange in which individuals or trading partners swap goods and services. There is no intermediary. For 1

example, fish from the coast could be exchanged for yam from the farm. There were lots of difficulties associated with the barter system. They are:

(a) Coincidence of wants Exchange under the barter system could be accomplished only if the wants of the parties involved coincided. That is, if you have TV and you need LAPTOP, you would have to find a person who needs your TV and also has LAPTOP to offer in exchange. This implies that your want must coincide with his; otherwise there could be no transaction. (b) Indivisibility Many commodities cannot be divided into small units without losing their value. Consider a scenario where two laptops are equivalent to a TV set, but there is only one laptop. This means there can be no trade since it is not possible to give half of ones TV and still have a TV. (c) Universal Swap Rate Under the conditions of barter, there is no standard unit or common denominator for measuring the relative values of goods. For example, traders must have to find answers for such questions as How many bags of maize are worth one bag of cement? (d) Time Factor The system was time wasting, as traders had to locate their partners on their own effort. It was also cumbersome, as traders had to carry their goods around in search of partners or had to save in the form of stocks of goods like maize, cattle and peeper.

1-1.2 Commodity Money


The problem posed by these money commodities was that they were bulky and at the same time subject to physical deterioration. Money commodities, therefore, could not overcome the problems of barter and had to be replaced by such precious metals as gold and silver. These metals after a very long use had to give way to paper money and coins made from base metals. The modern paper money is known as fiat(fiat money has no value other than the fact that its accepted in exchange for goods and services) money because the political authority has given it blessing to be money, and to be accepted in the settlement of all debts arising from trade or exchange. Since everybody is obliged under the law to accept or use it in exchange transactions, it is referred to as legal tender. Paper money issued by the Bank of Ghana, for instance, has the following statement on it. THIS NOTE IS ISSUED ON STATUTORY AUTHORITY AND IS LEGAL TENDER FOR THE PAYMENT OF ANY AMOUNT.

Self Assessment 1-1 1. The barter economy was more efficient than our present day money economy. Do you agree with this statement? 2. The barter system although was pinned on confidence, had its own stomach ache. Critically analyze this statement.

Answer tips 1. The answer is No. Explain your reasons by bringing out the problems associated with barter systems. 2. Still discuss the problems of barter systems.

SESSION 2-1: FUNCTIONS AND CHARACTERISTICS OF MONEY


The basic economic functions of money and the characteristics that it must possess to serve these functions are:

2-1.1 Functions
(a) Medium of Exchange The primary function of money is to facilitate exchange. In the modern economy, money acts as the intermediary in the process of exchange: people with something to sell will always accept money in exchange for it, and people who want to buy will always offer money in exchange. As a medium of exchange, the commodity (notes, coins, etc.) that serves as money must be generally acceptable in the settlement of all bills, portable and easily divisible into smaller units. The law makes the currency legal tender. Portability implies that it must be easy to carry around and must have a high value for its weight. Heavy or bulky commodities cannot serve as money since they constitute a nuisance in carrying around. In the modern economy, paper currency and especially cheques and money cards act as good money because they have less weight and can be kept in pockets without being noticed. Divisibility of various values is to be carried out. This requirement provides the reason why currency often comes in various denominations like GH20, GH5, GH10, and coins 10p, 20p, 50p. (b) Unit of Account Money also serves as a unit of account, which is an agreed measure for stating the prices of goods and services. Money acts as a measuring rod or valuation of all other commodities. Cars, computers, etc. are valued in terms of money, as so many cedis, dollars, etc., per unit. Wages, interest, rent and profits which are expressed in terms of money. Money does not 3

need any special qualities to serve as a unit of account since the function is purely accounting in nature. (c) Store of Value It is an asset that allows people to transfer purchasing power from one period to another. Money can be held and exchanged later for some other good or service. In the modern economy there is no need to keep wealth in the form of goods since such goods are subject to physical deterioration. As a store of wealth, money acts as a temporary abode of purchasing power, whilst it gives its holder freedom of choice through time. To serve as an efficient store of value, money must be durable. That is, money must be easy to store for long periods without any physical deterioration. If it loses its face value through storage, very few people will hold their wealth in the form of money. To be a satisfactory store of wealth, money must have a stable value. The value of money, that is, its purchasing power, is inversely related to the rate of change in prices. The higher and the more unpredictable the rate of inflation, the less useful is money as a store of value since the value of money falls with time (d) Standard for Deferred Payment A standard of deferred payment is an agreed measure that enables contracts to be written for future receipt and payments. In the modern world, a great deal of business is carried on under credit terms in which money acts as the standard for deferred payment. A car mechanic may repair my car he knows that I will pay him at the end of the month. As a standard of deferred payment, money does not need any special qualities since the purpose is purely accounting in nature.

2-1.2 Characteristics / qualities of good money


1. General acceptability As a medium of exchange, the commodity (notes, coins, etc.) that serves as money must be generally acceptable in the settlement of all bills 2. Portability Portability implies that it must be easy to carry around and must have a high value for its weight. Heavy or bulky commodities cannot serve as money since they constitute a nuisance in carrying around. In the modern economy, paper currency and especially cheques and money cards act as good money because they have less weight and can be kept in pockets without being noticed.

3. Divisibility Divisibility of various values to be carried out. This requirement provides the reason why currency often comes in various denominations like GH20, GH5, GH10, and coins 10p, 20p, 50p. Durability 4. That is, money must be easy to store for long periods without any physical deterioration. If it loses its face value through storage, very few people will hold their wealth in the form of money. 5. Homogeneity Money must be the same in all parts of the community in which it is used. For example, the cedi should be the same in Accra or in Kumasi.

6. Scarcity If money is easy to come by it will soon lose its value. There must therefore be some restriction in its supply. 7. Non-counterfeitability To create confidence in the money, money must not be readily counterfeitable. That is, it must be difficult to be imitated. If the cedi could be printed easily, or duplicated, it would lose its value and people would be wary in accepting it in the settlement of debts. 8. Recognition It must be easily recognized by all in the community so that counterfeit copies can be detected.

2-1.3 Definition of money


Anything commonly accepted in exchange for goods/services Money is whatever is generally accepted in exchange for goods and services; - accepted not as an object to be consumed but as an object that represents a temporary abode of purchasing power to be used for buying still other goods and services. -Milton Friedman

MONEY, INCOME, & WEALTH Money: what is accepted as payment? Income: earnings during time period (year) Wealth: accumulated assets at point in time Money and wealth are stocks: amount at a point in time Income is a flow: amount during a time period 5

Examples: 1. I own GH2 million in diamonds. (Period). I am wealthy but I have no money 2. I have won GH5 million in lottery, I put it under my bed and I quit my job I am wealthy and I have a lot of money but my income is zero 3. Software engineer earnings GH100,000/year. He blows it all; he has high income but has no wealth Are debit and credit cards money? They are not money but payment mechanisms that access money. The use of a credit card is merely a convenient way to arrange for a loan. Credit card balances are a liability. Thus, credit card purchases are not money.

2-1.4 Measuring Of Money


Formal definitions of money take account of the composition of money. That is, the aggregates that constitutes money in the financial economy. The financial or money aggregates include: M0: currency in circulation (CC) i.e. Notes and Coins M1: CC+ Demand Deposits (DD) M2: CC+ DD + Savings deposits (SD) + Time deposit (TD) M3: M2 + Deposits with other financial non-bank institutions. We shall consider two bases for defining money: The functional (or theoretical) definition The empirical definition. Functional Definition of Money Money can be defined using its two basic functions as criteria: the medium of exchange and store of value functions. Under the medium of exchange function criterion, M 0 is money since it can be exchanged for any goods and services. M 1 is also money since demand deposits (DD) are used readily as a medium of exchange. In the modern economy, cheques are acceptable in the settlement of bills and debts. Payments for goods bought in bulk can be done with cheques to be drawn on current accounts in banks. M 2, which includes SD and TD, cannot be used readily as a medium of exchange. The low degree of liquidity of SD and TD does not make them money. Using the medium of exchange criterion, therefore, leads to a narrow definition of money. Under store of value function criterion M0, M1 and M2 are all money since money is held and exchanged later for some other goods and services, giving its holder freedom of choice through time. These do point to a broader definition of money. In Ghana, the Bank of Ghana has adopted M2 as money which is in consonance with the IMF.

Empirical Definition of Money The essence here is to determine similarities in behavior of the financial aggregates. Substitutability criterion of behavior will be used to define money. Substitutability points to the determination of whether the other money aggregates can be substituted for M0 (i.e. Currency) using the following criteria: liquidity-wise and rate of return. In terms of liquidity, DD is substitutable for CC. However, SD and TD are not close enough to M0 and so may not be regarded as money. CC has zero percent rate of return. That is, M0 as money is sterile. In general, DD also has zero rate of return. Indeed DD only attracts about 3%- 6% interests depending upon the balance for a particular period. DD is, thus, close to CC. SD and TD rather attracts interest (between 10%-30%). The longer the term deposit is, the higher the return. On the basis of rate of return SD and TD may not be defined as money.

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Self Assessment 2-1


The efficiency of any medium of exchange lies in the stability of its value. Discuss.

2. Money is what money does. It depends, however, on its attributes. Discuss.

Answer tips 1. Discuss the characteristic of money that has got to do with scarcity which will make the value of money more stable. 2. Discuss the attributes or characteristics of money

Learning Track Activities


Answer the self assessment questions and then check the answers with the notes if you are correct.

Unit Summary
Thanks for successfully completing this units. In this unit, we learnt that In the primitive society, goods and services were exchanged directly for goods and services. Exchange under the barter system could be accomplished only if the wants of the parties involved coincided The modern paper money is known as fiat(fiat money has no value other than the fact that its accepted in exchange for goods and services) money because the political authority has given it blessing to be money, and to be accepted in the settlement of all debts arising from trade or exchange Money performs certain functions of Medium of Exchange, Unit of Account, Store of Value and Standard for Deferred Payment Money must possess certain characteristics in order to perform its functions.

Key terms/ New Words in Unit


1. Barter system: The barter system is a simple form of exchange in which individuals or trading partners swap goods and services.

Discussion Question:
The best definition for money is the notes and coins that have the legal backing of the state for use as money.

Unit Assignments 1
1. What makes money perform its role in an economy? 2. The barter economy was more efficient than our present day money economy. Do you agree with this statement?

Unit

THE DEMAND FOR MONEY


Introduction This chapter discusses the various money demand theories. It begins with an analysis of the classical theory, then Keynesian theory, the monetarist theory and the portfolio balance theory of money demand. The amount of wealth that people want to hold in the form of money balances is termed as demand for money.

Learning Objectives
After reading this unit you should be able to: 1. Define and explain Keynesian Theory. 2. Define and describe Monetarist Theory. 3. Portfolio Balance Theory. 4. Explain how the Keynesian Theory, Monetarist Theory, and Portfolio Balance Theory apply to the demand for money.

Unit content SESSION 1-2: CLASSICAL THEORY 1-2.1: Keynesian Theory 1-2.2: Monetarist Theory 1-2.3: Portfolio Balance Theory

SESSION 1-2: CLASSICAL THEORY


Classical economists refer to all economists who had written on macroeconomic questions prior to 1936. the classical period is the period dominated by the works of Adam Smith (wealth of Nations, 1776), David Ricardo (Principles of Political Economy, 1 st ed., 1817), Alfred Marshall (Principles of Economics, 8th ed., 1920), Irving Fisher, (The purchasing Power of money, 1922) and so on. The classical economists stressed that money had no intrinsic value. Money was held only for the sake of the goods that could be purchased with it. Classical economists focused on the role of money as a means of exchange The starting point for the classical theory of money was the equation of exchange, which was an identity relating the volume of transactions at current prices to the stock of money times the turnover rate of each cedi. The most prominent quantity theorist, Irving Fisher, relates quantity of money to nominal income. He expressed this identity as 10

MV = PY Where M = quantity of money P = price level Y = real output = real income V = transaction velocity of money: that is number of times money used to Purchase output or number of times money changes hand (it is defined as national income divided by the quantity of money), that is V=PY/M. For example if the national income (GDP) in a year is Two hundred (200) million cedis and quantity of money supplied is Twenty (20) million, then the velocity of money is Ten (10), meaning that the average cedi is spent 10 times in purchasing final goods and services in the economy. Another variety of the quantity theory was the Cambridge or cash balance approach. Marshall and co assumed that the demand for money would be a proportion of income and wealth. The Cambridge equation was written as Md = kY or Md = kPy Where Md is money demand and k is a proportion of nominal income (Y = Py) in equilibrium the exogenous stock of money must equal the quantity of money demanded: M= Md = kY = kPy. With the proportion of income that would be optimal to hold in the form of money (k) assumed to be relatively stable in the short run, and real output (y) determined, the Cambridge equation reduces to a proportional relationship between the price level and money stock. That is, the quantity of money determines the price level. Important conclusions of the classical theory are: Money had a role in the economy only as a means of exchange Money demand (Md) was proportional to nominal income The velocity of money, equal to
1 , was assumed to be stable. k

Money matters, i.e. monetary policy is potent in influencing nominal income. Increasing money supply will automatically increase the price, hence inflation will go up.

The Difference between Fisher and Cambridge versions of the quantity theory of money In the Cambridge approach the principle determinant of peoples taste for money holding is the fact that it is a convenient asset to have, being universally acceptable in exchange for goods and services. The more transactions an individual has to undertake, the more cash he will want to hold and to this extent the approach is similar to Fisher. The emphasis, however, is on want to hold, rather than have to hold; and this is the basic difference between Cambridge monetary theory and the Fisher framework.

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1-2.1 Keynesian Theory


The Keynesian theory of money demand, also referred to as liquidity preference, considers three motives for holding money. Transactions motive Precautionary motive Speculative motive Transactions Demand Transactions demand for money is the amount of money people are prepared to hold in order to meet daily and unavoidable expenses on items like food, clothing and shelter. Money is the most liquid of all assets and since it gives its holder an instantaneous command over goods and services, one of the rational motives for holding cash is to facilitate transactions. The amount of money held for the transactions purpose would vary positively with the volume of transactions. Income was assumed to be a good measure of this volume of transactions, and thus the transactions demand for money was assumed to depend positively on the level of income. The higher ones income, the greater will the persons purchases, and the greater will be the amount of cash he will hold for transaction purposes, all other things being equal. That is, Mdt = f(Y) and the amount of money that would be held against transactions is also determined to a large extent by the payments habits and payments technology of the society. Factors such as the average length of the pay period, practice of using bankcards, E-zwich, prevalent of trade credit will all affect the cash held for transactions purposes. Precautionary Demand Precautionary demand for money is the desire to hold liquid cash as a hedge against unforeseen circumstances. Example, unexpected illness, unexpected travels etc. To meet such unforeseen contingencies it is necessary and rational for individuals to hold cash. Keynes believed that the amount held for precautionary purpose would depend positively on income. He viewed income as the primary variable determining the amount of money held due to the precautionary motive; higher values of income increasing the amount of money held for this purpose. That is, Mdp = f(Y). Speculative Demand To buy things in anticipation of rise or fall in prices or other reasons. Keynes believed that such an additional demand for money did exist only because of uncertainty about future interest rates and the relationship between changes in the interest rate and market price of bonds. If interest rates were expected to move in such a way as to cause capital losses on bonds, it was possible that these expected losses would outweigh the interest earnings on the bonds and cause investors to hold money instead. Such money will be held by those speculating on future changes in the interest rate. 12

Money held in anticipation of a fall in bond prices (i.e. a rise in interest rates) is Keyness speculative demand for money. Thus, Mds = f (, r) The total money demand function in the Keynesian system can then be written as Md =f(Y, r) Where Y is income and r is the interest rate. A rise in income increases money demand; a rise in interest rate leads to a fall in money demand.

1-2.2 Monetarist Theory


The first stage in the development of monetarism centered around redefining the quantity theory. The central monetarist figure in this analysis was Milton Friedman. He saw the need to restate the quantity theory in terms that took account of Keyness emphasis on the role of money as an asset; and income as one determinant of money demand. Friedmans money demand function can be written as follows: Md = f (P,y,rB, rE, ) Where P = price level; y= real income; rB = nominal interest rate on bonds; rE = nominal return on equities; = expected rate of inflation With this specification, money demand is assumed to depend on nominal income. An increase in nominal income would increase money demand. Friedmans income variable, which he calls permanent income, is expected average long-term income from both human and non-human wealth. The other arguments are the rates of return on the major alternatives to money as an asset. These are the opportunity cost variables, which include bonds, equities and durable goods such as consumer durables, land and houses. The return on durable goods would be the expected increase in the price of the good over the period for which it is held. Thus, the expected rate of inflation is also a determinant of money demand. An increase in the rate of return of any of these alternative assets causes the demand for money to decline. In Friedmans view, The money demand function is stable; Changes in the money stock do come mostly from the supply side as a result of central banks policies; Such changes in the quantity of money are important in determining nominal income; Monetary policy is potent

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1-2.3 Portfolio Balance Theory


The starting point of this portfolio theory of money demand is the work of James Tobin. Tobin analyzed the individuals allocation of his portfolio between money holdings (M) and bond holdings (B). The demand for money considered here is solely the demand for money as a store of wealth. M is a safe asset and is normally certain. The expected return on B is the interest rate (r). Since the interest rate will generally not remain fixed, the bonds are a risky asset and their actual return is uncertain. Tobin argues that an individual will hold some proportion of his wealth (Wh) in money because by so doing he lowers the overall riskiness of his portfolio below what it would be if he held all bonds. In fig. 2.1 R is the expected return, T is the total risk of the portfolio. The portfolio allocation at the origin (0) indicates that the individual holds all his Wh in money and none in bonds, such that the portfolio has zero expected return and zero risk. Schedules C and D represent positive relation between R and T, and between B and T respectively. As the investor moves along C more bonds and less money are being held. The demand for money as an asset is Md = Wh B. To find the optimum portfolio allocation, we need to consider the preferences of the investor. Assuming the investor is risk averse with the utility function. U3 R R E R* U2 H U1 C

0 B B* M* Wh

T*

Fig.2.1 U1, U2 and U3 are indifference curves for the investor. As we move from U1 to U2 to U3, we are moving to higher levels of utility (i.e. higher levels of R and lower levels of T). The 14

curves are drawn sloping upward to represent a risk averse investor who will take on more risk only if compensated by a higher return. The point of utility maximization occurs at E, where the C schedule is tangential to the indifference curve U2, with expected return R* and total risk on the portfolio of T*. The combination (T*, R*) is achieved by holding an amount of bonds equal to B* and by holding the remainder of wealth (M*) in the form of money. Tobins theory has the implication that the amount of money held as an asset will depend on the level of the interest rate. In Fig. 2.2, increase in the interest rate from r 0 to r1, then to r2 will increase the slope of the C schedule. Thus the point of portfolio optimization shifts from E to F and then to G. Consequently, the individual will increase the proportion of his wealth held in the interestbearing bonds (from B0 to B1 to B2), and will decrease his holding of money (from M0 to M1 to M2).

C (r2) R R2 F R1 E R0 0 B C (r0) G C (r1)

Risk (T)

B0 M0 B1 B2 Wh Fig.2.2. Portfolio Balance Theory Tobins theory implies that the demand for money as an asset will depend negatively on the level of the rate of interest. Tobins theory of portfolio behavior apparently Shows why there is a demand for money as a store of wealth; 15 M1 M2 D

Explains the phenomenon of portfolio diversification; and Is a formal rationalization of the inverse relation between money demand and interest rate?

Self Assessment 1-2 1. What are the differences between the Fisher and Cambridge versions of the quantity theory of money?

Answer tips 1. Read the notes on differences between Fisher and Cambridge versions of quantity theory of money under 1-2.

Learning Track Activities

Unit Summary
Congratulations on successful completion of Unit 2. In this unit we learnt that The classical economists stressed that money had no intrinsic value The Keynesian theory of money demand considers three motives for holding money; Transactions motive, Precautionary motive and Speculative motive Portfolio Balance Theory: Shows why there is a demand for money as a store of wealth; Explains the phenomenon of portfolio diversification; and Is a formal rationalization of the inverse relation between money demand and interest rate?

Key terms/ New Words in Unit

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1. Portfolio Balance: how to spread your investments so as to reduce the risk of losing all your investment or money.

Discussion Question:
Money is more important in the Keynesian system than in the classical system. Do you agree? Or would you maintain that the opposite is true?

Unit Assignments 2
1. What are the three motives of holding money according to Keyness theory of money demand? Explain each motive.

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Unit

THE SUPPLY OF MONEY


Introduction Money supply refers to the aggregate quantity of money in an economy at a particular pint in time. It is composed of financial assets that serve the functions of money as a means of exchange, a store of value, a unit of account and a means of deferred payment. Money supply is therefore composed of currency outside depository institutions plus deposits created in these depository institutions.

Learning Objectives
After reading this unit you should be able to: 1. Describe and explain a model of money for supply. 2. Explain the money supplies in Ghana. 3. State and explain Monetary Policy in Ghana.

Unit content
SESSION 1-3: A MODEL OF MONEY SUPPLY 1-3.1: Money Supplies in Ghana 1-3.2: Monetary Policy in Ghana

SESSION 1-3: A MODEL OF MONEY SUPPLY


Money supply has different definitions. These are: 1. M1- also known as narrow money, consists of currency plus demand deposits (current account balances). 2. M2- also known as broad money, consists of M1 plus time/ fixed deposits and savings deposits 3. M2+- comprised the M2 plus foreign currency deposits. Traditional Literature assumes money supply to be exogenously determined. However, in modern sense money supply is assumed endogenous since it is determined not only by monetary (authority) policy, but also by the behavior of individuals who hold money and of banks in which money is held. The model, thus, has three exogenous variables: 18

1. The monetary base (B) is the total number of cedis held by the public as currency (C) and by the banks as reserves (R). It is directly controlled by the Central Bank. 2. The reserve- deposit ratio (rr) is the fraction of deposits that banks hold in reserve. 3. The currency deposit ratio (cr) expresses the preferences of the public about how much money to hold in the form of currency (C) and how much to hold in the form of demand deposits (D). We begin with the definition of the money supply: M=C+D Dividing through by D
M C D = + D D D

M = (cr + 1) D and rearranging terms


D= M ..3.1 cr + 1

This equation shows that the quantity of demand deposits is proportional to the money supply. By definition the monetary base is the sum of currency and bank reserves: B = C + R Dividing through by D
B C R = + D D D

B = (cr + rr) D and rearranging terms


D= B 3.2 cr + rr

This equation shows that the quantity of demand deposits is proportional to the monetary base. Equating 3.1 and 3.2 to solve for the money supply,
M B = cr +1 cr + rr

M =(

cr + 1 ) B .3.3 cr + rr

In (3.3), m =

cr + 1 is called the money multiplier. The monetary base is sometimes called cr + rr

high-powered money. Equation [3.3] shows how the money supply depends on the three exogenous variables: That is, a) The money supply is proportional to the monetary base. Therefore, an increase in the monetary base leads to the same percentage increase in the money supply. b) The lower the reserve- deposit ratio, the more loans banks make, and the more money banks create from every cedi of reserves. Therefore, a decrease in the reserve- deposit ratio raises the money multiplier and the money supply. c) The lower the currency deposit ratio, the fewer cedis of the monetary base the public holds as currency, the more base cedis banks hold as reserves, and the more

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money banks can create. Therefore, a decrease in the currency deposit ratio raises the money multiplier and the money supply.

1-3.1 Money Supply in Ghana


In Ghana, money supply is defined to include currency with non-bank public and demand, savings, and time deposits with the banking sector. The supply of currency is the prerogative of the government acting through the Central Bank, whilst the banking sector is in control of the supply of deposits through credit creation. In fact, the banking sector manages a large proportion of the money stock in the Ghanaian economy. CREDIT CREATION PROCESS Money is created by the activities of commercial banks and other financial institutions. We will use the term banks to refer to all depository institutions. What the banks create is deposits and they do so by making loans with their excess reserves. The process is limited by the reserve deposit ratio (rr). The smaller rr the more credits they can create. In describing this process it will be convenient to begin by making some simplifying assumptions: 1 The banking system maintains a reserve deposit ratio 25% 2 Any cash withdrawn from the banking system returns to the banking system. 3 There are many banks. The process is as follows: Paris, a customer of GCB, decides to put GH100,000 in his deposit account at the bank. Suddenly, GCB has excess reserve of GH75,000 which it plans to lend to another customer. Papee, a customer at the same bank, borrows GH75,000. Papee uses this loan to buy a jacket from Angelparis multiventures. To undertake this transaction, he writes a cheque on his account with the GCB and Angelparis multiventures deposits the cheque in its account with Ecobank. The total amount of money supply is now GH75,000 higher than before. The Ecobank retains GH18,750 (i.e.25% of GH 75,000) and lends the excess reserve, GH 56,250, to Chelsea who uses the loan to buy DVD player from Charlie. Chelsea writes a cheque on her account at the Ecobank, which Charlie deposits in his account at the SSB Bank. The SSB Bank now has new deposits of GH56,250, so the amount of money has increased by a lot of GH131,250 (i.e. the GH 75,000 lent to Papee and paid to Angelparis multiventures plus the GH56,250 lent to Chelsea and paid to Charlie) All other things being equal, the process will continue, through other banks, until as much as additional credit of GH300,000 is created. The transactions just described are summarized in Table 3.1

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Table 3.1 Creating Money by Making Loans: Many Banks BANK DEPOSITOR BORROWER NEW NEW DEPOSIT LOAN (GH) (GH) GCB Paris Papee 100,000 75,000 ECOBANK Angelparis Chelsea 75,000 56,250 multiventures SSB Charlie Connie 56,250 42,188 NTH 0 0 TOTAL BANKING SYSTEM 400,000 300,000

INCREASE IN MONEY(GH) 0 75,000 56,250 0 300,000

In this example where the reserve deposit ratio is 25%, bank deposits have increased by four times (
1 1 ) the initial deposit, where rr rr

is known as the deposit (or reserved)

multiplier. Increase in bank deposit = 4(100,000) = GH400,000. The ability of banks to create money does not mean that they can create an indefinite amount of money. The amount that they can create depends on 1. The size of their reserves (R) 2. The reserve-deposit ratio (rr) 3. The publics demand for cash

1-3.2 Monetary Policy in Ghana


Economic policy is defined as the specification of prescribed course of actions intended to achieve certain macroeconomic goals employing various instruments. Basic economic policies include fiscal, monetary, external, and structural and institutional policiesagricultural pricing and marketing, state enterprises and labour market. Basic economic goals also include full employment, price stability, rapid economic growth, balance of payments equilibrium, and equitable distribution of economic resources and output. Monetary policy entails the control of the level of money supply by the Central Bank using various instruments in order to achieve economic goals. That is, monetary policy consists of the set of government measures aimed at regulating credit and for that matter the money supply in the economy, and are implemented through the Bank of Ghana. The primary objectives of monetary control may be summarized as follows: 21

To achieve economic growth: Following Keynes, the role of money in the economy is transmitted through interest rates, whereby an increase in money supply will result in a fall in interest rates, which will in turn lead to an increase in investment and hence in production. According to the monetarists transmission mechanism of monetary policy, an increase in money supply will lead to an increase in the demand for real assets, which will in turn lead to an increase in the production of goods and services where unemployed resources exist. To achieve price stability: To reduce inflation, restrictions on monetary expansion are necessary. The ability of commercial banks to create credit may be reduced through increases in rediscount rate, base rate, lending rates, credit controls, etc. To achieve external stability: Monetary measures such as devaluation, exchange controls, etc. are necessary to conserve foreign exchange and thereby strengthen the balance of payments position of the country. To help mobilize savings for development : This is done through changes in interest on deposit accounts.

Self Assessment 1-3

Monetary policy may be accurately defined as deliberate action taken by the Central Bank, on behalf of the government, to alter the equilibrium in the money market. TRUE or FALSE? Explain your answer.

Answer tips
TRUE. The Central Bank is responsible for the implementation of monetary policy in Ghana, which it does on behalf of the government. This is done by altering the money supply, the general level of interest rates, or both.

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Learning Track Activities

Unit Summary

Thank you once again for completing this unit as well. In Unit 3 we learnt that 1. In the model of money supply, there are three exogenous variables: The monetary base (B) is the total number of cedis held by the public as currency (C) and by the banks as reserves (R). It is directly controlled by the Central Bank. The reserve- deposit ratio (rr) is the fraction of deposits that banks hold in reserve. The currency deposit ratio (cr) expresses the preferences of the public about how much money to hold in the form of currency (C) and how much to hold in the form of demand deposits (D). 2. In Ghana, money supply is defined to include currency with non-bank public and demand, savings, and time deposits with the banking sector 3. Monetary policy consists of the set of government measures aimed at regulating credit and for that matter the money supply in the economy, and are implemented through the Bank of Ghana

Discussion Question:
Discuss the view that James Tobins theory of portfolio behavior apparently Show why there is a demand for money as a store of wealth, Explains the phenomenon of portfolio diversification, and Is a formal rationalization of the inverse relation between money demand and interest rate?

Unit Assignments 3
Specify a money supply model for Ghana and attempt a justification of the variables in your model

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Unit

MONEY MARKET EQUILIBRIUM


Introduction
In this unit we will look at the equilibrium in the money. That is to look for the level of income and interest rate that will bring about equilibrium in the money market.

Learning Objectives
After reading this unit you should be able to: 1. Calculate income and interest rate levels that equilibrate the money market. 2. Describe growth and inflation. 3. Explain the role of money in growth and inflation.

Unit content
Session 1-4 Demand for Money 1-4.1: IS-LM Model Session 2-4: Money in Growth And Inflation 2-4.1: The Role of Money in Growth 2-4.2: The Role of Money Inflation

SESSION 1-4 DEMAND FOR MONEY


1-4.1 IS-LM Models
Money market equilibrium relates to DEMAND FOR MONEY. This unit will help us to find the values of the interest rate (r) and level of income (Y) that equilibrates the money market. In fig.4.1 three separate demand for money schedules are drawn corresponding to three successively higher levels of income, Y0, Y1, and Y2. As money increases from Y0 to Y1, then from Y1 to Y2 the money demand curve shifts to the right and upwards when plotted against the interest rate.

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The vertical line, Ms0, represents the value of the fixed money stock. The points where the money demand schedules intersect the vertical line are points of equilibrium for the money market. The income interest rate combinations, at which equilibrium occurs, (Y0, r0), (Y1, r1) (Y2, r2) are points along the money market equilibrium curve. These points are plotted in Fig. 4.2.

r r2

Ms0

Md (Y2) r1

r0

Md (Y1) Md (Y0) 0 M

Fig.4.1 Money Market Equilibrium

r LM r2 r1

r0 Y 0 Fig. 4.2 The LM Curve Y0 Y1 Y2

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(The IS/LM model is a macroeconomic tool that demonstrates the relationship between interest rates and real output in the goods and services market and the money market. The intersection of the IS and LM curves is the "General Equilibrium" where there is simultaneous equilibrium in all the markets of the economy. IS/LM stands for Investment Saving / Liquidity preference Money supply). The schedule of such points is termed the LM schedule since along this schedule money demand for which we use the symbol L, is equal to the money stock (M). The LM curve shows the combinations of real income and the interest rate at which the quantity of real money demanded equals the quantity of real money supplied. Note that the LM curve slopes upward to the right. At higher levels of income, equilibrium in the money market occurs at higher interest rates. It can easily be verified that the LM curve will: 1. Be relatively flat (steep) if the interest elasticity of money demand is relatively high (low). 2. Shift downward (upward) to the right (left) with an increase (decrease) in the quantity of money supplied. 3. Shift downward (upward) to the right (left) with a shift in the money demand function, which decreases (increases) the amount of money demanded at given levels of income and the interest rate. In the Keynesian model we expressed the money demand function in linear form as Md = c0 +c1Y +c2r Where Y is real income and c0>0, c1 >0 and c2<0. Assuming money supply is constant, that is Ms = m0, the equation of the LM curve may be stated as C0+c1Y+c2r = m0 or c1Y +c2r = m0 c01 Equation [1] involves two variables, Y and r. Since the number of equations is less than the number of variables, the system is indeterminate. To establish a determinate system, we consider another relationship between real income and interest rate from the product market equilibrium. That is, the IS relationship which shows combinations of real income and the interest rate at which aggregate planned expenditure equals real income. Consider the following model of a closed economy: Y = C+I C = b0 + b1Y I=a0 +a1r Where Y is real income, C is consumption, I is investment, a0 >0, a1<0, b0>0 and 0<b1<1 The equation of the IS curve may be stated as Y= b0+b1Y+a0+a1r or (1-b1)Y a1r = b0+a0 26

Where a0> 0, a1<0, b0> 0 and 0<b1 <1 Equations [1] and [2] can be used to determine equilibrium real income (Y) and the interest rate (r). Example 1 Given the following information about a closed economy Consumption C = 100+0.8Y Investment I = 1200 30r Where r is the rate of interest. Precautionary and transactions demand for money MD1 = 0.25Y Speculative demand for money MD2=1375-25r Money supply (in GHm) Ms = 2500 i) (a) Derive the IS and LM equations (b) Find the equilibrium values of Y and r. ii) Assume that a budget is now introduced into the system and that consumption given by C=100+0.75Yd Where Yd is disposable income, ie Yd = Y T and taxes T = 20 + 0.2Y If government expenditure G = 935, (a) Find the equilibrium levels of income (Y) and interest rate (r) Solution (i) (a) Y = C+I for a closed economy without Government activity. Thus Y = 100+0.8Y+1200 30r OR 0.2Y+ 30r = 1300 which gives the IS equation. Y=6500-150r.1 The money market is in equilibrium when Ms = M D, but MD=MD1+ MD2 =MD1 +MD2 in equilibrium. So 0.25Y+1375 25r = 2500 Or 0.25Y 25r = 1125 which is the LM equation. Y=4500+100r2 thus MS

(b) From equations (1) and (2) 6500-150r = 4500 + 100r 2000 =250r r=8% 27

Substitute r=8 into equation 2 gives Y=4500 + 100 (8) Y = 5300m (ii) (a) Income model is Y = C+I+G and C= 100 +0.75(Y-T) = 100 +0.75Y 15 - 0.15Y = 85+0.6Y Thus Y = 85+0.6Y +1200 -30r +935 Or 0.4Y + 30r = 2220 . IS curve (new) Y = 5550 - 75r3 Recall 0.25Y 25r = 1125 LM curve Y = 4500 + 100r4 From equation (3) and (4) we have 5550 75r = 4500 + 100r 1050= 175r r=6% Now substitute r=6 into equation 4 Y = 4500 + 100 (6) Y= 5100m

1.

Self Assessment 1-4

What factors determine the magnitude of the slope of the LM schedule; that is, what factors determine whether the curve is steep or flat? 2. What variables will shift the position of the LM schedule? Explain the way in which a change in each variable will shift the schedule (to the left or to the right).

Answer tips 1. The interest elasticity of money demand and changes in the quantity of money supplied. 2. Shift downward (upward) to the right (left) with an increase (decrease) in the quantity of money. Shift downward (upward) to the right (left) with a shift in the money demand function, which decreases (increases) the amount of money demanded at given levels of income and the interest rate.

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SESSION 2-4: MONEY IN GROWTH AND INFLATION


2-4.1 The Role Of Money In Growth
We are interested in whether money, has a role in economic activity: Does money affect output? Briefly stated, the classical theory relegates money to the background; it is argued that monetary changes do not affect movements in real variables especially, output and employment; but only in nominal variables especially price level. Money is a veil, according to classical writers. The primary role of money is a medium of exchange, its purpose being to determine the general price level at which transactions of goods and services take place. Classical theory is essentially a long run theory with full employment and full production being the norm. According to Keynesian theory, however monetary changes can affect output but only indirectly via changes in interest rates. Monetary changes lead to substitutions among financial and real assets in response to changes in their prices. The link between changes in money supply and output is however indirect because of the intervening role of interest rates. Since interest rates may not be driven down sufficiently by increases in money supply, or even if they did, investment may not be sufficiently interest elastic. Monetarist theory contends that monetary changes have a direct link to output changes. It is argued, however, that money can affect output in the short run, but only nominal magnitudes in the long run. According to monetarist theory, money and real assets are the closest substitutes and monetary changes lead to direct substitutions for real assets with interest rates playing no intervening role. It is now generally believed that (i.e. modern view) money has a role to play in economic activity. Money is regarded more or less as both a consumer and producer good. On both accounts, monetary changes should have some effects on economic activity. An increase in money supply will lead to higher demand for real assts, resulting in higher prices and stimulating production. On the other hand, higher money holdings of producers will serve as a direct input in the production process as it will enable them increase their capital stock, generating higher production. Money certainly has a role in the economy. Its effect would, however be greatly enhanced if structural weaknesses of LDCs are minimized.

2-4.2 The Role Of Money Inflation


Inflation is a persistent and appreciable rise in the general level of prices, usually measured by CPI, or GNP/GDP Deflator. Inflation theories are numerous, the diversity being due to the fact that no single theory is capable of explaining all inflation that have occurred in various countries throughout history. The different theories are not necessarily mutually exclusive one normally draws on a number of them to explain particular inflation. In general, sources of inflation at any one time may differ in DCs and LDCs, in countries with strong labour organizations and those with weak ones, in countries with predominantly 29

monopolistic/oligopolisitc market structures and those with more competitive ones, and in relatively closed economies relative to more open ones. Principal inflation theories may be classified as either demand or supply theories, or in more familiar terminology as demandpull or cost put theories. Monetary theory of inflation belongs in the former (demand pull) category. Simply stated, it is proposed that inflation is too much money chasing too few goods. This propositions is demonstrated by both the simple (classical) and modern versions of the quantity theory which assigns primary responsibility for inflation to money. Friedman has said that only the government, which has got the printing press, causes inflation. Inflation will result from money supply increases beyond full employment, or, in general, if money supply increases faster than output. More technically, monetary theory attributes inflation to domestic monetary disequilibrium or excess money supply, and any money supply in excess of demand is spent directly on real assets pushing up their prices.

Self Assessment 2-4


1. According to Keynesian theory, how does a monetary change affect output? 2.

Answer tips
According to Keynesian theory monetary changes can affect output but only indirectly via changes in interest rates

Learning Track Activities

Unit Summary

Congratulations once again my dear. You have done really well. In this unit we learnt 1. How to calculate income and interest rate levels that equilibrate the money market 2. We also learnt about the role money plays in both growth and inflation. 3. We looked at the role of money from classical theorists, Keynesian and Monetarists perspectives

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Discussion Question:
How relevant is the monetarist explanation of inflation for LDCs? What do you think constitute the important forces behind the recent inflation in Ghana?

Unit Assignments 4
1. Given the following information about a closed economy

Consumption C = 250 + 0.7Y Investment I = 1200 35r Precautionary and transactionary demand for money is given by Md1 = 0.35Y Speculation demand for money is given by Md2 = 1115 22r Money supply in (GHMillions) Ms = 1750 where Y is income (millions of Ghana cedis) and r is rate of interest (a) Derive the IS and LM equations (a) Find the equilibrium values of Y and r
2. Assume the demand for money function is Md = 0.6Y 30r, where Y =

900 is income (million) and r is the rate of interest. If the money supply (which is exogenously determined) stands at 180 (in million), what is the equilibrium rate of interest?

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Unit

THE BUSINESS OF BANKING (BANKING IN GHANA)


Introduction
In this unit we are going to learn about what the central bank does and look at the general functions of commercial banks. We will also learn about non-bank financial institutions.

Learning Objectives
After reading this unit you should be able to: 1. Define and explain what banks are. 2. State and explain the functions of Bank of Ghana 3. Explain the major functions of Commercial (Universal) banks.

Unit content
Session 1-5: What Banks Are 1-5.1: Ghanas Banking System Session 2-5: The Central Bank of Ghana (Bank of Ghana) 2-5.1: Bank Of Ghana Bill 2000, Part 1- The Bank of Ghana, Its Objects and Capital 2-5.2: Objects and Functions of the Central Bank 2-5.3: Commercial (Universal) Banking 2-5.4: General Functions of Commercial (Universal) Banks 2-5.5: Importance of Commercial (Universal) Banks

SESSION 1-5: WHAT BANKS ARE


Banks are financial intermediaries that accept deposits and give out loans. Banks are an important financial intermediary since they serve all types of surplus and deficit units. They provide opportunity for surplus units to deposit any amount to their funds for the period of time they want. They also repackage the funds received from the deposits to provide loans of the amount and duration that the deficit units desire.

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The American Heritage College Dictionary (1993) defines a bank as a business establishment where money is kept for saving or commercial purposes or is invested, supplied for loans, or exchanged.

1-5.1 Ghanas banking system


The banking industry in Ghana is comprised of the central bank (Bank of Ghana), twenty five (25) major banks, ARB Apex bank that services the rural banks, 129 rural and community banks and 45 non-bank financial institutions (NBFIs). Prior to the year 2000, there were about twelve banks. Before 2007, banks in Ghana were classified as commercial banks, merchant banks or development banks. After 2007 most banks are now licensed to operate as universal banks. Financial Services Industry Comprises: 1. Bank of Ghana (Central Bank) 2. Commercial Banks 3. Development Banks 4. Merchant Banks 5. Insurance Companies (SIC, Provident, etc) 6. Rural/Community Bank 7. Mortgage Finance Institutions 8. Discount House 9. Stock Exchange 10. Informal Financial Institutions

Self Assessment 1-5


1. In your own words define and explain what a bank is.

Answer tips
1. Read unit again!

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SESSION 2-5: THE CENTRAL BANK OF GHANA (BANK OF GHANA)


Ghana's financial system is based on a number of banks and non-bank financial institutions, including the Bank of Ghana, which, as the Central Bank, has the responsibility of advising the government on the implementation and control of monetary policies The Central Bank of the country, the Bank of Ghana was established in March 1957 under the Bank of Ghana Ordinance of 1957.

2-5.1 Bank of Ghana Bill 2000, Part 1The Bank of Ghana, Its Objects And Capital
1. The Bank of Ghana in existence immediately before the commencement of this Act shall, subject to this Act, continue to be in existence as a body corporate with perpetual succession and a common seal and may sue and be sued in its corporate name. 2. The Bank referred to in subsection (1) shall be the Central Bank of Ghana and may, in relation to its business purchase, hold, manage and dispose of movable and immovable property and may enter into a contract or a transaction as may be expedient. 3. The application of the common seal of the Bank shall be authenticated (a) By the Governor; or (b) In the absence of the Governor, by a Deputy Governor, and two directors all of whom shall certify the validity of the authentication and that signing shall be independent of the signing by any other person who may sign the instrument as a witness.

2-5.2 Objects and Functions of the Central Bank


1. The objects of the Bank are to (a) Promote and maintain the stability of the currency of Ghana and direct and regulate the currency and payment system in the interest of the economic progress of Ghana; and (b) Encourage and promote economic development and the efficient utilization of the resources of Ghana through effective and efficient operation of a banking and credit system in Ghana. 2. The Bank shall for the purposes of subsection (1) perform the following functions (a) Promote by monetary measures the stabilization of the value of the currency within and outside Ghana;

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(b) institute measures which are likely to have a favourable effect on monetary stability, the balance of payments, movement of prices, the state of public finances and the general development of the national economy; (c) Regulate and direct the credit and financial system and support the general economic policy of the Government independent of instructions from the Government; (d) Establish, operate, promote and supervise the payment, fund transfer, clearing and settlement systems; (e) Issue and redeem bank notes and coins; (f) Ensure effective maintenance and management of Ghana's external reserves; (g) License, regulate and supervise non-banking financial institutions specified by law; (h) Act as banker and financial adviser to the Government; (i) Promote and maintain relations with international banking and financial institutions; (j) To do all other things that are incidental or conducive to the efficient performance of its functions under this Act and any other enactment. 3. The Bank may in writing authorize any person to exercise its power to regulate and supervise non-banking institutions. 4. The Bank shall be the sole custodian of the state funds both in and outside Ghana, and may be notice published in the Gazette authorize any other person or institution to act as custodian of any such funds as may be specified in the notice that the Bank may specify 5. The banker for Government (a) The Bank shall receive, collect, pay and remit money, bullion and securities on behalf of the Government. (b) The Bank shall accept custody of all securities, documents and other valuable objects belonging to the Government (c) The Bank may act as banker to any Government institution or agency. (d) In a place where the Bank does not have a branch, the Bank may appoint a banking institution to act as its agent for the collection and payment of Government moneys (e) An agent who collects money for and on behalf of the Bank under sub-section (f) shall as soon as practicable, remit the money to the Bank. (f) Interest shall not be paid by the Bank on amounts deposited in a Government account. (g) Except as otherwise determined by agreement with the Minister, the Bank shall not receive from the Government remuneration for its services under this section. (h) Subject to this section, the Bank may undertake and transact a business which the Government may entrust to the Bank. 35

6. Credit Control (a) Report on unusual movement in supply of money (b) Where the Board considers that there are unusual movements in the money supply and prices detrimental to a balance growth of the national economy, it shall subject to this Act, make as soon as practicable a report of this to the Minister specifying the causes which in its opinion led to the situation (c) The Bank, in counteracting unusual movements in the money supply and prices in the country shall, after consultation with the Minister, use any of the instruments of control conferred upon it under this Act or under any other enactment to maintain and promote a balanced growth of the national economy. 7. Managing the monetary and banking system Without prejudice to sub-section (2) of section 31, the Bank may, for the purposes of monetary management. (a) Alter the minimum ratio of reserve to deposits or the minimum capital adequacy ratio which each banking institution shall maintain (b) Alter the discount and interest rates of the Bank to be applied in credit operations with banking institutions; (c) Buy or sell in the open market commercial bills, Government bonds and securities or bonds and securities guaranteed by the Government; (d) issue, sell, re-purchase or redeem Bank of Ghana securities; (e) Impose ceiling on the level of bank credit or the rate of growth of bank credit; (f) Expand or contract credit facilities to the banks; (g) Determine the maximum lending period by banking institutions, the kind of collateral and amount of loan against that collateral; (h) grant loans to banks for, on-lending to institutions engaged in industrial, commercial or agricultural projects repayable on demand or on the expiry of a fixed period and on any other terms and conditions that the Board may determine; (i) Authorize a banking institution that it considers fit to accept deposits for the Government or order the transfer of Government deposits with any bank; (j) Impose special requirements on deposit with banking institution that it may determine; (k) Impose such other measures as the Board may in consultation with the Minister determine.

2-5.3 Commercial (Universal) Banking


Commercial banks, primarily, provide a safe place for the deposit of cash and other valuables by customers, and advance money to customers when they are in need. The first commercial bank to start business in Ghana is the Standard Chartered Bank [Ghana] Limited in 1896- a subsidiary of a multinational banking group established in 1853 in London, Great Britain. Barclays Bank of Ghana Limited followed in 1917. It was not until 1953 that the Ghana Commercial Bank was established. These three primary banks have commanding shares of the banking business in Ghana. 36

As the economy expanded, secondary banks were established to further promote the development of agricultural, industrial and commercial activities. These include: The National Investment Bank (NIB) was incorporated in 1963. It was the first development bank to be established in Ghana. It was established, primarily, to promote and strengthen rapid industrialization in all sectors of the Ghanaian economy. In 1975, the role of NIB was broadened to include commercial banking activities. The Agricultural Development Bank was incorporated in 1965 under the name Agricultural Credit and Co-operative Bank and was charged to develop credit and other banking facilities to promote the developmental role in the area of agricultural financing, NLCD 182 of 1967 changed the name of the institution to Agricultural Development Bank. The Merchant Bank (Ghana) Limited, commenced business in March 1972 as the first Merchant Bank in Ghana. The bank provides a comprehensive range of corporate banking services to its clients. The SSB Bank Limited was established in 1976 as a wholly owned subsidiary of SSNIT and at the time was called Social Security Bank (SSB). The bank commenced business in 1977 and operated for 17 years as a government-controlled bank. In 1994, the Social Security Bank merged with the National Savings and Credit Bank. The banks shares were floated to divest government interest in it in 1995. In 1998, the banks name was changed to SSB Bank Ltd to reflect its new image and changed ownership. SSB Bank is a depository institution as well as an investment intermediary. The banks core area of business is commercial banking. Now SG-SSB LTD (Societe Generale) Ecobank Transitional Incorporated (ETI), the parent company, commenced operations with its first subsidiary in Togo in March 1988. New subsidiaries were opened in Nigeria, Cote dIvoire, and Ghana in 1989, Benin in 1990 and Burkina Faso in April 1997. Today, the Ecobank Group is a full-service regional banking institution with over 120 branches and offices in 11 countries across West Africa. The Ghanaian subsidiary of ETI, Ecobank Ghana Limited, was set up as a privately owned merchant bank. The Prudential Bank Limited was incorporated as a private limited liability company in November 1993. The bank was, however, opened for business on August 15, 1996. the bank was established for the development of industry and export. The First Atlantic Merchant Bank Limited was incorporated in 1994 and commenced operations in 1995. The bank is aimed at creating a unique merchant bank. The Rural/ Community banks are unit banks that are sited in rural areas to help monetize the rural economy. Specifically, the banks facilitate the mobilization of rural savings, and the 37

extension of credit to small-scale farmers and other small-scale entrepreneurs. The first rural bank in Ghana was established in July 1976 at Agona Nyakrom. By the end of 2010, there were over 129 rural/ community banks in Ghana.

2-5.4 General Functions Of Commercial (Universal) Banks


Functions of the banking system The banking system provides a number of functions including: Financial intermediation Enhancing payment systems Acting as agents of government policy Trust and advisory services 1. Accepting customers deposit Lending money (Financial intermediation) Banks provide intermediation role by bringing supplier of funds and users of funds together. They transfer funds between suppliers and users of funds. Banks have access to large amounts of money and they are able to attract funds by selling bank products such as demand deposits, savings and time deposits which they give out as loans to those in need of funds. 2. Enhancing payment systems Banks play an important role in the payment system by keeping peoples money in safety and ensuring the payment of goods and services. They also facilitate effective working of the payment system when payments are made by cheques, electronic funds transfer, ATM, EZWICH. 3. Acting as agents of government policy Banks give out loans to government so that governments activities can get going, even if government is short of funds. Government can increase or decrease the amount of money in the hands of customers and investors in order to try to control price levels. This is done through the use of monetary policy tools. Banks therefore aid in the implementation of monetary policies. 4. Provision of safe custody for customers valuables (Trust and advisory services) Banks provide financial advice to customers and offer trust services to both individuals and businesses. They manage the financial affairs of their customers such as investing funds, safe keeping of valuable assets, and acting as agents for companies, selling shares on behalf of companies, and selling/buying bills on behalf of government for a fee. 38

5. Banks and Economic Activity Banks are very important in facilitating economic activity in the sense that: 1. They facilitate the expansion of economic activity by granting credit to businesses 2. They facilitate trade by acting as guarantors to their customers when they open letters of credit 3. They facilitate fund raising by underwriting bankers acceptances (acting as guarantors to their customers in the home country). 4. They also help in the efficient allocation of resources by transferring funds from surplus unit to productive deficit units 5. Special Customer services i) Receiving payments (salaries, rent etc) on behalf of customers ii) Making payments on standing order for regular periodical payments such as insurance premium. iii) Issuing of bankers draft.

2-5.5 Importance of Commercial (Universal) Banks


1. Provision of saving facilities and payment of interest encourages savings resulting in the mobilization of financial resources for economic development; 2. Provision of funds in the form of loans for the establishment and expansion of agricultural and industrial firms; 3. Facilitation of external trade, internal trade and exchange transactions; 4. Direct investment in industrial and agricultural ventures; 5. Managerial and financial advice given to entrepreneurs; 6. Promotion of sports; 7. Housing schemes for their workers; 8. Offer of employment and training to workers; 9. Contribute to public revenue through tax payments. NON-BANKING FINANCIAL INSTITUTIONS These financial institutions perform highly specialized operations in particular financial markets. The institutions include: Social Security and National Insurance Trust (SSNIT) First Ghana Building Society Ghana Stock Exchange National Trust Holding Company Insurance Companies SIC, PAC, Star Assurance, etc. Home Finance Company Informal Financial Institutions Credit Unions, Savings and Loans Companies etc. LEASING COMPANIES

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Leasing Companies: Though 'hire purchase' activities were conducted by the banks it was not until 1992 that a leasing law was enacted in Ghana. Since then, over three leasing companies have emerged and they are offering among others equipment leasing in Ghana. These include Ghana Leasing Company Limited, General Leasing Company Limited and LeaseAfric. VENTURE CAPITAL Venture Capital provides capital for start-ups and high risk ventures. Ghana's first official venture capital fund is the Ghana Venture Capital Fund Limited (GVCF) - is managed by the Venture Fund Management Company. The Commonwealth Development Corporation is the lead investor and was joined by a few local banks and other foreign financial institutions. It has focused mainly on medium-sized, indigenous growth companies with expansion projects and shied away from start-ups because of the higher risks entailed. MORTGAGE FINANCING Mortgage Financing: The Home Finance Company (HFC) is the leading secondary mortgage financing institution in Ghana. HFC was established in 1990 as the implementing agency for a housing finance pilot scheme component for an Urban II Project provided to the Republic of Ghana by the International Development Association (World Bank). The IDA was joined by Social Security and National Insurance Trust (SSNIT), Merchant Bank and a number of insurance companies. DISCOUNT HOUSES Discount Houses: In a bid to improve financial intermediation in the country, the non-bank financial institutions comprising the insurance and trust companies have joined forces with the banking institutions to establish discount houses in order to bring into a single market institution with cash balances for their intensive and effective use. These include the Consolidated Discount House and the Securities Discount Company, Gold Coast Securities Limited, and National Trust Holding Company (NTHC). INSURANCE COMPANIES Insurance Companies: There are over twenty four (24) insurance companies currently operating in Ghana

Self Assessment 2-5


1. List and explain five functions of the central banks. 2. Explain four reasons why you think that commercial banks are important in the economic development of Ghana.

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Learning Track Activities

Unit Summary

Thank you for completing this unit as well. You are doing really well my dear. In this unit 1. We learnt that a bank is a business establishment where money is kept for saving or commercial purposes or is invested, supplied for loans, or exchanged. 2. We learnt about the functions and object of the Bank of Ghana 3. We also looked at the functions of universal banks as well as non-bank financial institutions.

Discussion Question:
Discuss the importance of the following institutions in the Ghanaian economy; a) Rural Banks, e) Development Banks, b) Ghana Stock Exchange, f) Forex Bureaus, c) Commercial Banks, g) Informal Financial Institutions, d) Central Banks, h) Insurance Companies.

Unit Assignments 5
Go out there and get the names of all the banks as well as all the non-bank financial institutions in Ghana

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Unit
Introduction

INFLATION
In this unit we will learn about inflation and what causes inflation. We will then look the tools that the central bank uses to control inflation (money supply).

Learning Objectives
After reading this unit you should be able to: 1. Define inflation and explain the causes of inflation. 2. Calculate inflation rates. 3. Explain the tools of monetary control.

Unit content
Session 1-6: Definition and Causes of Inflation 1-6.1: Definition of inflation 1-6.2: Cost Push Inflation 1-6.3: Demand Pull Inflation 1-6.4: Inflation Measurement 1-6.5: Hyperinflations 1-6.6: Effects of Inflation Session 2-6: Tools/Instruments the Central Bank Uses To Control Inflation 2-6.1: Open Market Operations (OMO) 2-6.2: The Rediscount Rate 2-6.3: Reserve Requirements 2-6.4: Direct Credit Control 2-6.5; Moral Suasion

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SESSION 1-6: DEFINITION AND CAUSES OF INFLATION


1-6.1 Definition of Inflation
Inflation is a phenomenon of continuous rise in the general price level of goods and services. Inflation is not a rise in the prices of one or just few goods, and it is also not a just one-time rise in the prices of most commodities. During inflationary periods, prices of few goods may fall, but prices of most goods rise. Inflation can also be defined as a decline in the value or purchasing power of cedi. If the supply of dollar (money) rises faster than the supply of goods and services in the country, one would expect a decline in the value of cedi. Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects erosion in the purchasing power of money a loss of real value in the internal medium of exchange and unit of account in the economy. The main measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time. Inflation's effects on an economy are various and can be simultaneously positive and negative. Negative effects of inflation include a decrease in the real value of money and other monetary items over time, uncertainty over future inflation may discourage investment and savings, and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future. Positive effects include ensuring central banks can adjust nominal interest rates (intended to mitigate recessions), and encouraging investment in non-monetary capital projects, such as agricultural production (cassava, plantain, maize) Thus, an increase in money supply can be a reason of inflation. But, there may be other reasons too. If the demand for goods and services continuously rises faster than their supply, prices of goods and services shall rise too. This is called demand-pull inflation. On the other hand, a continuous fall in supply of goods and services or a continuous rise in cost of production pushes up the general price level. This is called cost-push inflation.

1-6.2 Cost Push Inflation


Cost-push inflation occurs when businesses respond to rising production costs, by raising prices in order to maintain their profit margins. There are many reasons why costs might rise: Rising imported raw materials costs perhaps caused by inflation in countries that are heavily dependent on exports of these commodities or alternatively by a fall in the value of the cedi in the foreign exchange markets which increases the Ghana price of imported inputs. Rising labor costs - caused by wage increases which exceed any improvement in productivity. This cause is important in those industries which are labour-intensive. Firms may decide not to pass these higher costs onto their customers (they may be able to achieve 43

some cost savings in other areas of the business) but in the long run, wage inflation tends to move closely with price inflation because there are limits to the extent to which any business can absorb higher wage expenses. Higher indirect taxes imposed by the government for example a rise in the rate of excise duty on alcohol and cigarettes, an increase in fuel duties or perhaps a rise in the standard rate of Value Added Tax or an extension to the range of products to which VAT is applied. These taxes are levied on producers (suppliers) who, depending on the price elasticity of demand and supply for their products, can opt to pass on the burden of the tax onto consumers. For example, if the government was to choose to levy a new tax on aviation fuel, then this would contribute to a rise in cost-push inflation.

1-6.3 Demand Pull Inflation


Demand-pull inflation is likely when there is full employment of resources and when ShortRun Aggregate Supply (SRAS) is inelastic. In these circumstances an increase in AD will lead to an increase in prices. AD might rise for a number of reasons some of which occur together at the same moment of the economic cycle. A reduction in direct or indirect taxation. If direct taxes are reduced consumers have more real disposable income causing demand to rise. A reduction in indirect taxes will mean that a given amount of income will now buy a greater real volume of goods and services. Both factors can take aggregate demand and real GDP higher and beyond potential GDP. The rapid growth of the money supply perhaps as a consequence of increased bank and building society borrowing if interest rates are low can cause inflation. Monetarist economists believe that the root causes of inflation are monetary in particular when the monetary authorities permit an excessive growth of the supply of money in circulation beyond that needed to finance the volume of transactions produced in the economy. Rising consumer confidence and an increase in the rate of growth of house prices lead to an increase in total household demand for goods and services. would

1-6.4 Inflation Measurement


Inflation in any year t (t) is measured as the percentage change in price index from the previous period: If P0 is the current average price level and P 1 is the price level a year ago, the rate of inflation during the year might be measured as follows:

Or

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t =

PI t PI t 1 x100% PI t 1

Example: Let us assume for the sake of simplicity that the index consists of one item (say a pair of shoe) and that one item cost 2.85 in 2010. If today that same item (a pair of shoe) costs 3.55, the index can be calculated as follows: =
3.55 2.85 X 100% = 24.56% 2.85

1-6.5 Hyperinflation
Hyperinflation is a run-away or out of control inflation, a very rapid and high growth rate of prices. There is no universally accepted cut-off rate of inflation for hyperinflation. Some economists consider 50 percent or higher monthly inflation as hyperinflation, whereas some other economists consider an annual inflation rate of 200% or more as hyperinflation. Effects of Inflation People engaged in the business of lending and borrowing generally spend time and other resources in predicting inflation, to form a judicious anticipation of future inflation to appropriately determine nominal interest rate. In a world of low or no inflation, scarce resources do not need to be wasted in such predictions. Therefore, controlling inflation is often an objective of macro policy makers. Suppose nominal interest rate in a transaction is fixed at 8%, expecting inflation rate of 3% and to have a real interest rate of 5%. But, if actual inflation during the period of lending/borrowing exceeds the expected rate, the actual real interest rate earned by the lender would be lower than 5%. The lender thus loses, whereas the borrower gains, whenever actual inflation is higher than expected. On the other hand, borrower loses and lender gains when actual inflation is below the anticipated rate. Thus, unanticipated inflation redistributes income between lenders and borrowers. If unanticipated inflation tends to remain high and uncertain, lenders may hesitate from lending, which may retard investment in the economy, because investment often is carried out with borrowed funds. Instead, people start to accumulate assets in the form of gold, real estate, and such other real goods to protect themselves from unanticipated inflation.

Year 1980 1981 1982

Inflation (%) 50.005 116.504 22.296

Year 1990 1991 1992

Inflation (%) 37.259 18.031 10.056 45

Yea Inflation (%) r 2000 25.151 2001 32.906 2002 14.815

1983 1984 1985 1986 1987 1988 1989

122.875 39.665 10.305 24.565 39.815 31.359 25.224

1993 1994 1995 1996 1997 1998 1999

24.96 24.87 59.462 44.357 24.838 19.215 12.446

2003 2004 2005 2006 2007 2008 2000

26.677 12.629 15.113 10.913 19.583 18.9 25.151

Source: International Monetary Fund - 2008 World Economic Outlook

Self Assessment 1-6


1. Define inflation and explain the factors that cause it.

Answer tips Inflation is the persistent rise in the general price levels. Explain cost-push and Demand-pull inflation and how they cause inflation

SESSION 2-6: TOOLS/INSTRUMENTS THE CENTRAL BANK USES TO CONTROL INFLATION (MONEY SUPPLY)
2-6.1 Open Market Operations (OMO)
The term refers to the action of the Central Bank in either buying (when it is desired to expand liquidity) or selling (when it is desired to reduce liquidity) of securities or bills on the open market. To reduce money supply during an inflationary period, the BOG may sell securities to the public including the commercial banks. On the other hand, if it is desired to expand money supply and thereby increase the level of economic activity, the BOG may buy securities from the public and will result in an increase in the commercial banks excess reserves since the BOG will pay the public through their banks. Such open market purchases and sales of securities provide a flexible means of controlling bank reserves. OMO are the most important of the Central Banks tools of monetary control, and they have been used effectively after liberalization to control liquidity.

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2-6.2 The Rediscount Rate


The BOG lowers or raises this rate to regulate the volume of such loans to banks. The BOG influences commercial banks lending rates through adjustments in the bank (base) rate. To reduce the level of liquidity in the system as a means of abating inflation, the BOG may adjust the rate upwards. This will discourage the commercial banks from borrowing from the BOG. The BOG can encourage banks to borrow and increase their reserves by lowering the base rate.

2-6.3 Reserve Requirements


The commercial banks are by convention or law required to keep some ratio of their deposits in reserve in their volts. Variations in the reserve deposit ratio may either restrict or encourage expansion of liquidity. Furthermore, as an instrument of monetary policy intended to freeze liquidity, the commercial banks can be instructed to keep some ratio of their total deposits, in reserve with the BOG.

2-6.4 Direct Credit Control


This is the imposition of credit ceilings on commercial banks lending to the public. There are two types of ceiling: global and selective ceiling. Selective controls have the advantage of channeling the permissible credit into the productive sectors of the economy. In the context of liberalization, and the fact that the tool is ineffective and inefficient due to lack of proper supervision, the BOG has stopped using credit controls as a means of controlling money supply.

2-6.5 Moral Suasion


The BOG usually endeavors to influence the policy of commercial banks by means of informal persuasion. In times of crisis such as the emergence of galloping inflation, these banks may have to be persuaded into reducing lending to non-priority sectors of the economy.

Self Assessment 2-6


1. Moral suasion is a term that refers to a situation when the authorized money market dealers are persuaded to give short-term loans to banks with liquidity problems. True or false? Justify briefly

Answer tips

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FALSE. Moral suasion is a term that refers to the process whereby the Central Bank attempts to influence the behaviour of financial intermediaries via informal discussions.

Learning Track Activities

Unit Summary
Congratulations. You have finally finished the Course. You can now talk with Authority when it comes to Money and Banking. In this unit: 1. We were able to learn that inflation is a phenomenon of continuous rise in the general price level of goods and services 2. We also looked at the causes of inflation and how inflation rates are calculated. 3. We also learnt that when there is high inflation/deflation in the economy, the central bank uses the tools of monetary policy to regulate money supply and hence control inflation.

Discussion Question:
Inflation rates in Ghana have been falling from 2010 to 2011 yet the prices of goods and services are going up. Discuss and explain the reasons to your grandmother who does not know anything about inflation.

Unit Assignments 6
If the Central Bank adopts an expansionist open-market operations policy then it will buy securities from banks and the general public. True or false? Explain your answer.

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