- Explain the steps in the evolution of money.
- Identify the advantages and disadvantages of barter trade.
- Identify the various types, qualities and functions of money.
- Explain the motives of holding money according to Keynes.
- State and solve Fisher’s equation of exchange.
- Distinguish between M1, M2 and M3.
- Identify factors determining money supply, the types and factors that influence interest rate.
- Assess the impact of barter trade in an economy.
- Analyse the functions of money in an economy.
- Compare and contrast the barter economy and the monetary economy.
- Describe with illustrations the motives for holding money according to Keynes.
- Examine the applicability of Fisher’s equation of exchange in Least Developed Countries (LDCs).
- Describe the determining factors of money supply in Rwanda.
- Calculate interest rates and discuss factors that influence interest rates.
- Advocate for the regulation of demand and supply of money to maintain its purchasing power/value and stability in an economy.
- Choose the best type of interest rate to be used.
5.1 Money
5.1.1 Meaning of money
Money is defined as anything that is generally accepted as a medium of exchange for the goods and services and
in settlement of obligations. This abstract definition of money avoids identifying money with a particular object which
may at one time or another be used as money.
All sorts of articles or objects have served as money throughout the ages. These include, among others, beads, salt,
stones, gold, silver, paper and cattle.
Activity 1
Using photographs in Figure 1 below, respond to the following questions:
1. What do the photographs below show?
2. Explain the meaning of the term money.
3. Describe how money evolved from the past to the present.
4. What type of transaction was being used before the introduction of money?
5. What problems did the means of transaction talked about in (4) above have?
6. What qualities should good money have and what is its function?
5.2 Evolution of money
Money was not invented overnight. It is as a result of a process of evolution through several hundreds of years.
Money has passed through numerous historical stages such as barter, commodity, paper and bank money.
It can be seen below how money evolved to the present:
1. Barter trade:This was the first form of exchange where commodities were exchanged for commodities.
For example, cassava for sheep.
2. Commodity money: This replaced barter trade and consisted of commodities of high value such as salt,
tobacco, cattle, etc.
3. Durable commodities: These included iron, copper, and cowrie shells, among others.
However, these were too common, hence they could not act as good money.
4. Precious metals such as gold and silver replaced commodity money because they were found to have qualities
of good money. Such metals were later cut into small pieces of different shapes called coins. At first, the metal value
of the coin was equal to its face value and such coins were called full bodied money. Later coins whose real value was
less than the real value were called token money.
5. Paper money: This started with goldsmiths as receipts for gold banked with them for safety. Such receipts stated the
name of the owner and the amount of gold deposits kept. Later, these were used as money because they were as good
as the gold kept. After some time, the goldsmith started issuing notes in excess of the gold reserves kept and this money
not backed by gold is known as fiduciary issue.
6. Banknotes: From the experience of the goldsmith, Britain and America started printing bank notes of smaller
denominations of 10, 20, etc. which could be used for transactions.
5.3 Barter trade
Barter is a system where people exchange products or services directly. It depends on double coincidence of wants,
a situation where two traders are willing to exchange their goods directly.
Normally, it involved exchanging what one person had with what he or she wanted although it was a bit hard to find
someone who wanted what you had and at the same time wanted what you had. Sometimes, the process involved
moving long distances to acquire different products.
The problems encountered during the process created the need for a commodity that would be generally accepted as
a medium of exchange. Commodities started being used as mediums of exchange. Among them were sea shells,
bananas, cattle, land and metal.
Conditions of barter trade
• There must be two parties that are willing to exchange commodities.
• There must be commodities that are to be exchanged.
• There is no general medium of exchange.
• There must be individuals that need commodities that some people have to exchange.
Advantages of barter system
• Barter system is very simple, without any complications and suitable in international trade when countries
exchange commodities for commodities.
• In this system the shortage of foreign exchange and imbalance in trade does not occur.
• In a barter system, there is no wastage which occurs in monetary economy because goods are not overproduced
or underproduced. Only the required quantity is produced.
• The economic power is not concentrated at one particular place in the barter system because people do not gather wealth.
Disadvantages of barter system
• Problem of portability: It was difficult to transfer certain items from one place to another. For instance, it would be difficult
moving around with sheep looking for market.
• Limited production: Large scale production was limited since demand for goods was never certain.
• Needs differentiate from man to man. If either party gets what they need, then it is double coincidence. If not, it is a trouble
as they do not get what they need.
• In the barter system, it was difficult to divide and sub-divide goods.Possibility of exchanging one’s good for only one good
not for two or more.
• The value of the goods could not be distributed equally as there was no measure during that period.
• The exchange of goods worth a service of a person was impossible as it was inconvenient to measure it.
The barter system cannot exchange goods for services.
• Perishable goods could not serve as wealth for their future expenses. The economy could not contribute anything
towards capital formation of the country, too.
• There was a lot of cheating during the transaction. This was because there was no standard means of measurement.
For instance, it was cheating when one exchanged a cow with a sack of cassava.
5.4 Types of money
Commodity money
This was the first form of money that was used because of its intrinsic value. Historical examples included sea shells,
cattle, salt, tobacco, etc. In the long-run, precious metals such as silver, gold etc. were used as money because of their
scarcity. These were later minted into the coins that have been common of late.
Convertible paper money
The inventiveness of goldsmiths and their clients led to the origin of convertible paper money. People would always
deposit their gold with the goldsmith and in return the goldsmith would give them receipts promising to give them the
gold on demand.
When a depositor wanted to make a large purchase, he would go to the goldsmith and withdraw the gold then give
it to the seller.
If the people knew the goldsmith to be reliable, there was no need to go through the tiresome and risky business of physically carrying the gold. The buyer needed only to transfer the goldsmith’s receipts to the seller who would accept it as long as he was confident that the goldsmith would pay the gold when need arose. People, therefore, started transferring receipts from the goldsmith when buying goods from others, hence leading to the development of the convertible paper money.
Fractionally backed paper money
This is money issued by the bank that is more redeemable in gold than the amount of gold that it held in its vaults.
The notes issued are in excess of gold reserves held by the bank or goldsmiths.
Fiat money
This is money that is not backed by reserves of another commodity. The money itself is given value due to an authority
such as the government acting like it has value. This type of money is issued on the directives of the government
irrespective on the level of activities.
Deposit money
This is defined as money held by the public in the form of deposits in commercial banks that can be withdrawn on
demand. Such deposits are called demand deposits, the most important of which are savings and current accounts.
Cheques, unlike bank notes, do not circulate freely from hand to hand, hence they are not currency.
Near money or quasi money
These are assets which can easily be converted to cash. These other currency and demand deposits can readily be
converted into currency and demand deposits. Examples include: cheques, treasury bills, bonds, etc. These assets
serve as temporary stores of value but may not directly perform the medium of exchange function. They can, however,
be converted into cash or demand deposits. Because these assets are so closely related to money, economists called
them near money.
Token money
This is money whose real value is less than the face value.
Full bodied money
This is money whose real value is equal to the face value.
Advantages of using money
Money confers the following advantages to the user:
• It widens the scope for individuals to maximise their satisfaction from a given amount of expenditure.
An individual who receives his income in monetary form can exchange it for the assortment of goods,
which would give him maximum satisfaction.
• Money facilitates distribution: In a modern society, money is a mechanism through which most goods and
services are distributed through the pricing mechanism.
• Transfer of immovable property: Money can facilitate the physical transfer of property, for example a building
from one place to another.
• It facilitates division of labour. Division of labour generates specialisation whose sustenance requires exchange.
In the absence of money as a medium of exchange, specialisation would require exchange on barter terms, which
need the double coincidence of wants.
• Money facilitates lending. The use of money facilitates the development of deferred payments. Without the use of
money, deferred payment would be impossible. By foregoing consumption today in favour of the future, an individual
would be able to build up a stock of fund for future expenditure.
5.5 Qualities of good money
Acceptability: Good money should be acceptable by everyone as a medium of exchange. This is the prime requirement
for money. The use of money is based on confidence. One is prepared to accept money provided one is confident that
others will also accept it.
Durability: The goods that are used as money should be durable. It would not be acceptable if it could deteriorate.
For instance, if a metal is used, it should not wear away. It should be noted that the money’s durability lies in its value.
Scarcity: Good money should be scarce because if it is common, it would lose value due to increase in demand.
Its supply must be less than the demand but it must be available.
Homogeneity: Good money should be similar. The features on the same denominations should be the same as on
another denomination. Varying degrees of quality will lead to confusion and uncertainty in the public and eventually
there will be loss of confidence.
Divisibility: Good money should easily be divisible in small units. Whatever physical commodity is being used as money,
it must be capable of being divided into smaller amounts to make possible smaller transactions.
Portability: One should be able to carry good money from one place to another. It must not be heavy in relation to its value.
It must be transportable in terms of bulk and weight. Modern money consists of coins, bank notes, cheques and bank drafts
and these can easily be carried without attracting attention.
Difficult to forge: Good money should be hard to forge. It should be made of features and quality that cannot be easily
forged. Otherwise, forged money will increase money in an economy which leads to inflation and in turn money will lose
value. Money which is forged is called counterfeit money.
5.6 Functions of Money
Medium of exchange: All transactions are made through the use of money. Previously in the old ages, there was use of commodity and barter system of exchange. The introduction of money eased the system of exchange because of its good qualities such as portability, divisibility, among others. Therefore, it is used as a medium of exchange.
Measure of value: The value of goods and services and factors of production are expressed in terms of money.
Determining the value of a commodity is based on how much an individual is prepared to pay for it. The higher the
amount paid for a commodity, the more valuable it is; and the lower the amount paid, the less the value, other factors
remaining constant.
Store of value or wealth: Wealth or goods can be stored for future use in form of money than assets. It is easy for Musoni
in Musanze District to sell his Irish potatoes and store one million FRW for a period of one year than storing one hundred
sacks of Irish potatoes. For example, it is easier to store one million FRW than storing one cow.
Standard of deferred payments: Many transactions are conducted on the basis of credit where goods and services are sometimes given out on credit. When paying for the goods, it is more convenient to express these future obligations in terms
of money.
Distribution: In a modern society, money is a mechanism through which most goods and services are distributed through
the pricing mechanism. Goods can be moved from one area to another mainly from areas of low price to areas of high
price through a process called arbitrage. All this can only be done through price mechanism which uses money.
Transfer of immovable property: Money can facilitate the physical transfer of property. For example, it may be hard to
move a building from Nyamaseke to Gisenyi but the owner can sell the building and easily moves with his money to the
new area of location.
Unit of account: All business transactions and accounting are made possible by use of money. When computing business transactions, statistics of national income, to mention but a few, money is the most suitable medium. It may be easy to record the amount got after selling a commodity than recording the actual commodity.
Money enables specialisation to take place by ascertaining the demand for goods and services. People are able to carry out specialisation basing on the level of incomes that they possess.
5.7 Demand for money
Activity 2
Mukabalisa, an entrepreneur working in Karongi, needed money to carry out many activities for business and also for her
own welfare. When her income increased, she would demand for more goods and in the end, the prices would go up.
This made her disappointed in the activities she was doing.
Using the case study above, describe the following:
1. The need for money by Mukabalisa is known as..............
2. Explain reasons why Mukabalisa demanded for money.
3. Explain what happened when Mukabalisa increased demand for the goods.
4. Examine the relationship between
money supply and price of the commodities.
Facts
The demand for money arises from the fact that it is an asset for its holders. Since it is acceptable to all, people hold it
not only for paying debts but as a particular form of asset that can easily be converted into other goods and services.
The demand for money is, therefore, called liquidity preference. It is the desire by the people to hold money in cash or
near cash form rather than investing it.
Keynesian theory of demand for money
According to Keynes, people demand for money because of the three main motives as explained below:
Transactions motive: According to this motive, people demand for money so as to carry out everyday transactions
such as buying food and clothes, among others, needed in the everyday life. You can also keep an inventory of money
in form of deposits at the bank to make transactions such as paying rent, water and other bills. Keynes argued that the
demand to hold money to make transactions is determined by the level of income and by institutional factors.
Precautionary motive: According to this motive, people demand for money to cater for unforeseen circumstances such
as sickness and travel, among others. For instance, if a person plans to travel for a long distance, he will expect to spend money on a travel ticket, lodging and food, among others, but still he may need to have some money aside for instances
that may come unknowingly such as sickness on the way and increase in the travel tickets.
Speculative motive: According to this motive, people demand for money in anticipation of future trends in the business
so as to profit from them. Normally, a change in prices in future will help the business people to benefit when they buy at
lower prices and sell in future when the prices increase. Speculation helps business people to make abnormal profits in the future.
Keynes assumed that individuals can hold their wealth in two ways.
• In cash balances in excess of those needed to meet transactions demands; and
• In bonds.
5.8 Interest rate
Activity 3
Research about the following:
1. Definition and types of interests.
2. Reasons why interest is paid.
3. Determinants of interest.
Facts
Interest is a payment for use of capital, or it refers to the cost of borrowing capital or money (principle).
It can also be defined as a percentage that is paid on deposits by the banks. When people borrow money
from financial institutions, they are supposed to pay a certain rate of interest.
Interest rate is usually expressed as a percentage of the principle. It varies from time to time and from bank to bank.
Most of the banks in Rwanda pay between 17- 19%. Interest is paid because of different reasons.
5.8.1 Types of interest
There are four main types of interest, namely:
• Simple interest;
• Compound interest;
• Real interest; and
• Nominal interest.
Simple interest
This is interest calculated based only on the principal amount or on that portion of the principal amount
which remains unpaid.
Simple interest = PxRxT/100
Where P = Principal amount borrowed
R = Rate of interest
T = Duration of payment
Compound interestThis arises when interest is added to the principal so that from that moment on,the interest that
has been added also itself earns interest. This addition of interest to the principal is called compounding.for example
if a loan of 30,000 FRW earns interest of 30% per month, after the first month, the total amount due will be the principal
of 30,000 FRW plus the interest of 9000FRW, which totals 39,000Rwf. The interest for the second month will be calculated basing on the new amount 39,000Rwf.
Compound interest = A-P
Where P = Principal amount borrowed
A = The amount accumulated which is calculated using the formula
A = P( 1+ r)r = Rate of interest
t = Duration of repayment
Nominal interest
This is interest expressed in monetary terms. For example suppose you deposit 30,000 FRW into a bank account for
1 year and you receive interest of 6000 FRW at the end of the year, the nominal interest rate, will be 20% per annum.
Nominal interest rate is the rate of interest before any adjustment for inflation.
Real interest
This is the interest rate that expresses the cost of borrowed funds after adjusting for the expected depreciation of the
value of those funds due to inflation. For example if the interest received is 20% but during that time inflation has risen
by 12%, the real interest is 8%. Much as you earn 20%, its purchasing power has been reduced by 12% because of
inflation and so the real value of money is just 8%.
5.8.2 Reasons why interest is paid
Reward for saving to those people who postpone consumption: Normally, some people postpone consumption
and put their money in financialinstitutions, which money is also lent out to some other people. The person who
deposited money, therefore, is entitled to an interest.
Payment for parting with cash: People part with cash that they would have used for carrying out activities.
Price for use of credit: Interest is paid for use of loanable funds. This is interest charged by lenders on borrowers.
Reward for management: Interest is paid to the lender so that he can meet the expenses of lending. These may be administrative such as calling and photocopying.
Reward for risk bearing because parting with cash involves risks of losing it. Sometimes the borrower may refuse to pay money lent to them. The lender, therefore, may have to include an interest in case of failure to pay.
Reward for inconveniences to the lender: Normally lending money involves inconveniences. The lender may also have purposes for the use of the money but then he or she decides to lend it out to an individual. So, an interest has to be paid for inconveniencing the lender.
To cater for time value of money because money loses value as time goes on. There is a saying that money today is not equal to money tomorrow. This is because the amount of goods and services that for example 1000 FRW can buy today will
be more than what the 1000 FRW will buy in one month’s time. The purchasing power of the 1000 FRW will have fallen.
When one lends you money today, when paying back in a month’s time, it will not have the same value, so an interest is needed to cater for the loss in value.
5.8.3 Determinants of the rate of interest
Amount of money in circulation: The higher the amount of money in circulation, the lower the interest; and the lower the money, the higher the interest.
Duration of the loan: In commercial banks, the longer the time of payment, the higher the interest; and the sooner the payment period, the lower the interest.
Size of the loan: The bigger the loan, the smaller the interest; and the smaller the loan, the bigger the interest.
Competition among financial institutions: If there is competition among financial institutions, there will be a lower interest than where there is no competition.
Risks involved in lending: If there are high risks in lending, there will be a high interest than when there are low risks.
Rate of productivity of capital: If productivity of capital is high, interest paid will be high compared to when the productivity is low.
5.9 The quantity theory of money
Activity 4
Research about the following:
1. Meaning of quantity theory of money.
2. Assumptions and criticisms.
Facts
The quantity theory of money was first put forward by classical economists.It was later revised by Irving Fisher, an American economist. As developed by Fisher, the quantity theory of money explains the determinants of the value of money.
In his book, “The purchasing Power of Money” (1911), he stated that the value of money in a given period of time depends on the quantity of money in circulation in the economy. Other things remaining unchanged, as the quantity of money in circulation increases, the price level also increases in direct proportion and the value of money decreases and vice versa.
If the quantity of money is doubled, the price level will also double and the value of money will be one half. If the quantity of money is reduced by one half, the price level will also be reduced by one half and the value of money will be twice.
According to this theory, the value of money depends on the following factors:
1. The quantity of money in circulation, i.e. an increase in the quantity of money in circulation would bring about a
proportionate increase in the prices.
2. The velocity of circulation of money.
3. The number of transactions that take place in the economy.
Irving Fisher’s theory, therefore, states that; the general price level is determined by the quantity of money in circulation (M) assuming that the velocity of circulation (V) and the level of transaction (T) are held constant.As modified by Fisher, the quantity theory of money can be expressed by the equation below:
MV = PT Or P = MV / T
Where; M = Quantity of money
V = Velocity of circulation of money, i.e. number of times one unit of money is used to make transactions
T = number of transactions
P = General Price Level
Example
Assume V and T remain constant, if the quantity of money is increased, the price level will go up but the value of
money will fall and vice versa. Assume that:
M = 100
V = 10
T = 50
P = MV/T = 100x10/50 = 20
If M = 200, then P = 200x10/50 = 40
If M = 50, then P = 50x10/50 = 10
5.9.1 Assumptions of Fisher’s approach
Fisher’s theory is based on the following assumptions:
• Price is a passive factor in the equation of exchange which is affected by other factors.
• Velocity is assumed to be constant and is independent of changes in money in circulation.
• Number of transactions also remains constant and is independent of other factors such as money in circulation and velocity.
• It is assumed that the demand for money is proportional to the value of transactions.
• The supply of money is assumed as an exogenously determined constant.
• The theory is applicable in the long-run.
• It is based on the assumption of the existence of full employment in the economy.
• There is no hoarding of the increased
money supply but it must be spent on buying goods and services.
5.9.2 Criticism of the theory
Truism
According to Keynes, “The quantity theory of money is a truism.” Fisher’s equation of exchange is a simple truism
because it states that the total quantity of money (MV) paid for goods and services must equal their value (PT).
But it cannot be accepted today that a certain percentage change in the quantity of money leads to the same
percentage change in the price level.
Other things not equal
The direct and proportionate relation between quantity of money and price level in Fisher’s equation is based on the
assumption that “other things remain unchanged”. But in real life, V and T are not constant. Rather,all elements in Fisher’s equation are interrelated and interdependent. For instance, a change in M may cause a change in V. Consequently, the price level may change more in proportion to a change in the quantity of money.
Constants relate to different time
Prof. Halm criticises Fisher for multiplying M and V because M relates to a point of time and V to a period of time. The former is a static concept and the latter a dynamic. It is, therefore, technically inconsistent to multiply two non-comparable factors.
Failure to measure value of money
Fisher’s equation does not measure the purchasing power of money but only cash transactions, that is, the volume of business transactions of all kinds or what Fisher calls the volume of trade in the community during a year. But the purchasing power of money (or value of money) relates to transactions for the purchase of goods and services for consumption. Thus, the quantity theory fails to measure the value of money.
Weak theory
According to Crowther, the quantity theory places a misleading emphasis on the quantity of money as the principal cause of changes in the price level during the trade cycle. According to him, prices may not rise despite increase in the quantity of money during depression; and they may not decline with reduction in the quantity of money during boom. Further, low prices during depression are not caused by shortage of quantity of money, and high prices during prosperity are not caused by abundance of quantity of money.
Neglect of interest rate
One of the main weaknesses of Fisher’s quantity theory of money is that it neglects the role of the rate of interest as one of the causative factors between money and prices. Fisher’s equation of exchange is related to an equilibrium situation in which rate of interest is independent of the quantity of money.
Unrealistic assumptions
Keynes in his General Theory severely criticised the Fisherian quantity theory of money for its unrealistic assumptions. First, the quantity theory of money is unrealistic because it analyses the relation between M and P in the long-run. Thus, it neglects the short-run factors which influence this relationship. Keynes also does not believe that the relationship between the quantity of money and the price level is direct and proportional.
Velocity is not constant
Further, Keynes points out that when there is underemployment equilibrium, the velocity of circulation of money V is highly unstable and would change with changes in the stock of money or money income. Thus, it was unrealistic for Fisher to assume V to be constant and independent of M.
Neglect of store of value function
Another weakness of the quantity theory of money is that it concentrates on the supply of money and assumes the demand for money to be constant. In other words, it neglects the store-of-value function of money and considers only the medium-of-exchange function of money. Thus, the theory is one-sided.
Neglect of the role of government
The theory ignores the role of government in price control. There can be increase in
money supply but the government fixes the prices, hence there will not be price increase.
5.10 Value of money
Activity 5
Research about the following:
1. Meaning of value of money.
2. Determinants of value of money.
Facts
Value of money can be defined as the amount of goods and services that money can buy. Or it can be defined as the purchasing power of money. We know that money can either be:
(a) Nominal: which is money expressed in units such as francs, shillings and dollars, among others, and
(b) Real which is the purchasing power of nominal money
Value of money depends on the time at which the money is used. Is it used to buy goods now or to buy them in a future?
The main importance of time value of money is that the value of 1000 FRW now is more than the value of 1000 FRW after some time. That is, the value of money today is more than the value of money after some time. Therefore, money available at the present time is worth more than the same amount in the future because of potentiality of future earnings.
5.10.1 Determinants of time value of money
There are several determinants which are used to calculate the actual value of the money.
Four commonly used determinants are:
• Consumption preference of a person
• Uncertainty of future
• Inflation of the economy
• Investment opportunity
Consumption preference of a person
People prefer current consumption to future consumption if there is the same level of satisfaction. Most of the people are ready to sacrifice the current consumption if they find that in the future, they will be able to consume more than the present. A higher rate of return that is more than the required rates of return mainly leads them to take the decision to sacrifice current consumption. Some people think that the future is uncertain so it is better to consume now although they are not concerned about the benefit of the future.
Uncertainty of future
The future is always uncertain. Nobody knows what will happen in the future. So, it is better to consume now rather than consume in the future if current consumption rate is more. People would like to compensate for uncertain future cash flow against certain cash flow.
Inflation of the economy
Inflation is related to the purchasing power of money. With time, the purchasing power of money decreases. Every economy has inflation but the rate is different from country to country. If there is higher inflation, then the required rates of return of investor is higher. For a higher inflationary economy, consumers prefer current consumption rather than future consumption.
Investment opportunity
Time value of money considers the idea of re-investment, that is, if an investment generates cash inflow periodically, then this periodic return can be re-invested which will generate higher return. If the cash flow comes now, it can be invested and generate additional cash flow, therefore, whatever may be the cash flow now. The future cash flow is more than its present cash
Basing on Activity 2, when Mukabalisa demanded for money, there was an increase in the amount to the extent that everyone in her area had a lot of money. Buying of goods increased and Mukabalisa’s sales revenue increased. However, with time, the prices increased and demand reduced because things became expensive.Describe the following:
1. The increase in the amount of money in circulation is known as..............
2. Explain factors that may have increased money in supply.
3. Explain the effects that increase in
money supply can lead to an economy.
Facts
Money supply refers to the total amount of money in circulation together with that money held by commercial banks plus quasi money. It comprises of the total currency notes, coins and demand deposits with the banks, held by the public.
In modern economies,
money supply is divided into three levels, namely:
1.
M1 (Narrow money): This is
money supply that involves cash( i.e. notes and coins) and demand deposits.
It looks at money as a medium of exchange.
2. M2 (Broad money): This is money supply that involves cash ( i.e notes and coins), demand deposits and time deposits
(deposits that require notice before withdrawn). That is M2= M1+ time deposits
3. M3 (Broader money): This involves cash ( i.e. notes and coins), demand deposits, time deposits and money market
instruments such as certificates of deposit. That is M3= M2+ fixed deposits.
This is
money supply which is fixed and determined by issuing authority such as central bank. Such
money supply is fixed regardless of the economic activities.
This is the
money supply determined by the level of economic activities. The higher the level of economic activities, the higher the
money supply; and the lower the activities, the lower the
money supply.
Level of economic activities: The higher the level of economic activities, the higher the money supply; and the lower the activities, the lower the
money supply.
Buying and selling of security by the central bank. When the central bank buys security such as bonds from the public, it increases money but when it sells, it reduces
money supply.
Balance of payment surplus: When the export earnings are greater than the import expenditure, the money increases in supply but when they are low,
money supply will be low.
Rate of printing money: When more money is printed, it increases money in circulation. This is called financial accommodation.
Rate of capital inflow and outflow:When the rate of inflow such as from tourists is high, there will be high
money supply while high capital outflow reduces
money supply.
Level of monetarisation of the economy: When the economy uses money as a medium of exchange,
money supply will increase while use of barter leads to low money in supply.
Rate of credit creation by commercial banks: Where there is a high rate of credit creation, there will be increase in
money supply while a low credit creation leads to low
money supply.
Rate of government borrowing: High rate of government borrowing increases money supply while low government borrowing leads to low
money supply.
Positive effects
• It encourages investment if it is channelled through bank as loans.
• It increases demand for commodities by expanding the purchasing power of the public.
• It increases employment by expanding production opportunities.
• It checks on a depression/recession by increasing aggregate demand.
• It increases tax revenue (if there is no inflation).
• It can increase the stock of assets, as people prefer to keep fixed assets other than money.
• It can result into inflation.
• It leads to increase in interest rates as banks try to adjust interest rates to match inflation.
• It reduces the external value (exchange rate) of the currency and increases prices of imports.
• It reduces the portability of money. To buy a commodity, one has to carry a lot of paper and coins.
• The country shifts to barter trade as people lose confidence in the currency.
• It reduces lending by banks as there is fear to be paid back in an inflated currency.
• It reduces local production as producers shift resource to production of exports whose prices are stable in the world market.
• It reduces the real value of tax revenue, i.e. inflation reduces the purchasing power of tax revenue.
• It increases the cost of production and eventually reduces production
Unit assessment
1. (i) What would make a good 5000 francs note?
(ii) Why do people demand for money?
2. How is Rwandan currency important in the economy?
5.12 Glossary
- Barter trade: A system of exchange where goods are exchanged for goods and services for services or goods are exchanged for services.
- Capital market: One where long-term securities are traded.
- Demand for money:The desire by the people to hold money in cash or near cash form rather than investing it.
- Exogenous (Discretionary) money supply: Money supply which is fixed and determined by issuing authority such as central bank.
- Endogenous (automatic) money supply:The money supply determined by the level of economic activities.
- Full bodied money: Money whose real value is equal to the face value.
- Fiduciary issue: Money issued by the bank to settle debts and obligation but not backed by gold.
- Fiat money: Money issued on the directives of the government irrespective of the level of economic activities.
- Hard loan: One which is given at a market interest rate with a short repayment period.
- Liquidity preference: The desire to hold money in cash or near cash form than investing it.
- Money:Anything that is generally accepted as a medium of exchange for the goods and services and in settlement of obligations.
- Money supply: The total amount of money in circulation together with that money held by commercial banks plus quasi money.
- Money market: One in which short-term financial assets are exchanged.Nominal money: Money expressed in units such as francs, shillings and dollars, among others.
- Optional money:Money which is generally accepted by the public e.g. cheques.
- Quasi/ near money: Assets which can easily be converted to cash.e.g. cheques, treasury bills, bonds etc.
- Real money: The purchasing power of nominal money. Or the amount of goods and services that nominal money can buy.
- Soft loan: A loan which is given at a lower interest rate than the rate at the market and usually with a long repayment period of time.
- Token money:Money whose real value is less than the face value.
Unit summary
• Meaning and evolution of money
• Barter trade
• Meaning
•
Conditions
• Advantages and disadvantages
• Money types
• Qualities of good
money
• Functions
• Demand for money
• Keynes theory
• Quantity theory of
money
• Fisher’s theory
• Value of money
• Determining
interest rate
According to Keynes, people demand for money because of the three main motives as explained below:Transactions motive: According to this motive, people demand for money so as to carry out everyday transactionssuch as buying food and clothes, among others, needed in the everyday life. You can also keep an inventory of moneyin form of deposits at the bank to make transactions such as paying rent, water and other bills. Keynes argued that thedemand to hold money to make transactions is determined by the level of income and by institutional factors.Precautionary motive: According to this motive, people demand for money to cater for unforeseen circumstances suchas sickness and travel, among others. For instance, if a person plans to travel for a long distance, he will expect to spend money on a travel ticket, lodging and food, among others, but still he may need to have some money aside for instancesthat may come unknowingly such as sickness on the way and increase in the travel tickets.Speculative motive: According to this motive, people demand for money in anticipation of future trends in the businessso as to profit from them. Normally, a change in prices in future will help the business people to benefit when they buy atlower prices and sell in future when the prices increase. Speculation helps business people to make abnormal profits in the future.Keynes assumed that individuals can hold their wealth in two ways.• In cash balances in excess of those needed to meet transactions demands; and• In bonds.
