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IDL, 2011 All rights reserved. No part of this book may be reproduced or utilized in any form or by any means, electronic or mechanical, including photocopying, recording or by any information storage and retrieval system, without the permission from the copyright holders. For any information contact: Dean Institute of Distance Learning New Library Building Kwame Nkrumah University of Science and Technology Kumasi, Ghana
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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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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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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
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 2-6: 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
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.
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.
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.
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.
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.
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.
1.
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
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.
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
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
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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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.
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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).
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.
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?
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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
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
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
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
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 =
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.
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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
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
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
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.
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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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
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
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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
r LM r2 r1
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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.
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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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.
Answer tips
According to Keynesian theory monetary changes can affect output but only indirectly via changes in interest rates
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
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
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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.
Answer tips
1. Read unit again!
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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.
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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.
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.
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.
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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
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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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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.
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.
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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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.
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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Name: ____________________________________ Learning Centre: _________________ Contact: Tel. __________ Email: ________________ Emergency Name/Phone: __________ Important numbers: Student number ____________ Examination number _______________ Program: ___________ Year: _______ Course code/title: ____________________________ Course objectives: ___________________________________________________________ ___________________________________________________________________________ Course dates/Semester No ( ): Starts___________________ Ends ____________________
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2. Please give your reactions to the following items based on your reading of the course Items Excellent Very Good Poor Give specific examples, if good poor Presentation quality Language and style Illustrations used (diagrams, tables, etc.) Conceptual clarity Self assessment Feedback to SA
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