Topic One:
Introduction to Money and Banking;
Purpose: to introduce the learner to origins of money and banking and the types and
functions of money. This will enable the learner appreciate the role of money and banks
in economic development.
Specific Objectives
By the end of the lesson the learner should:
(i) Explain the meaning of money
(ii) Explain the origin of banking
(iii) Trace the development of money
(iv) Describe the functions of money
(v) Explain types of money
Meaning of Money;
A standard definition of money is anything generally accepted for payment of a
debt. A debt is an obligation incurred when a business transaction takes place. Money is
a medium of exchange sought for the purpose of transacting exchange of commodities /
services / goods. A commodity chosen as money cannot be used for other purposes rather
ensuring that business transaction takes place. This then implies that a commodity taken
as money must be universally accepted by the users if it has to retain its value.
The Origin of Banking:
The definition of “bank‟ is not an easy task. The search for a definition of a “bank‟ in
statute and case law, illustrates this difficulty. Much of the difficulty has arisen from the
circularity of the traditional definition – that a bank is a person or body authorized to
carry on or recognized as carrying on the business of banking. What constitutes the
business of banking is a complex question. The modern term “bank‟ comes from the
“banco” or merchants’ bench in the marketplaces of medieval Italy: money dealing was
conducted from a portable bench, which would be publicly broken in the event of failure
of the merchant’s business the origins of the concept of bankruptcy.
But banking as an activity is much older. In ancient times the temple was likely to be the
location of much of what is recognized as banking business. In Mesopotamia, money
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could be borrowed at interest from the temple; in Greece, sanctuaries and temples were
often the store house or place of safe custody for bullion and valuables; and in Jerusalem
money-changers located in the temple would exchange currency and allow interest on
deposits with them. The code of laws devised by Hammurabi, King of Babylon, between
2081BC - 2084 BC included references to charging interest on loans and a right of
privacy in lending transactions.
These early examples include some of the ingredients of what have come to be regarded
as the key characteristics of banking: taking money on deposit and lending. And the
location within temples would have provided another important ingredient - an air of
security. Recognizable „bankers‟ appeared again in the Middle Ages, financing trade
and wars. It was not until comparatively modern times that the deposit of funds by the
wider community with a banker who was then expected to use the funds at his or her
discretion that led commercial lending.
Development of Money
Most early societies at the down of civilization, operated on a barter trade whereby goods
were exchanged for goods. However, barter suffered major drawbacks.
a) Difficult to estimate the value of one good in terms of another e.g., wheat in
term of meat.
b) It depended upon double coincidence of wants between the trading parties e.g.,
if the wheat farmer desires meal for consumption, then the cattle rustler must be in
need of wheat to make bread.
c) Perishability. Some commodities such as vegetables are highly perishable thus
cannot be stored long for future use.
d) Divisibility. It was not easy to divide goods into smaller quantities desired by
individuals e.g., cattle could not be subdivided into smaller quantities affordable
by individuals.
e) Portability. Difficult to transport bulky goods over long distances in search of a
market.
For these reasons a barter economy could not develop into a modern economy in which
the buying and selling of goods/services lakes place on a continuous process. The use of
barter is now restricted to underdeveloped regions of some countries e.g., the
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indigenous
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inhabitants of the Brazian tropical rain forest. To overcome the restricted nature of barter,
most societies sought one special commodity as a mean of measuring the value of all
other goods / services. Such a commodity once accepted performed the role of medium of
exchanging and could be regarded as money. The commodities might have been hides,
tobacco, salt or precious metal, cowry shells etc so long as it was accepted as a mean of
discharging obligations.
Money has to be something that is widely accepted for settlement of debts. The key
requirement is acceptable of whatever commodity is chosen as money in a society.
Money is also a claim in that it gives the holder command over goods / services in the
markets place. The possession of a huge sum of money entitles the individual to purchase
goods and services in abundance. Finally, the use of money enables societies and
nations to benefit from a greater exchange of commodities and a more specialized
labour force and both of these factors result in higher living standards.
The Functions of Money:
In any society / economy money has five main functions which must be fully accepted
these are: medium of exchange, unit of account, store of value credit standard and
influence to economic activities.
Medium of exchange the existence of money gives the consumer greater freedom of
choice that could never ever exist under barter system. Provided money is generally
accepted a person would take in exchange for goods / services he/she sells since no
difficulty will be encouraged in the use of the money to purchase other goods / services.
Money thus facilitates trade and specializations two key conditions for economic
advancement of any society / nations.
Unit of account it is used as a common denominator in which the value of things can be
expressed in the market. It enables a price system to operate and facilitate the production
and exchange of goods. Without money some other means to measure the value of goods
against each other would have to be used. This may introduce many relative prices which
will be hard to determine.
Store of value in a non-monetary economy, wealth is measured in terms of persons
tangible possessions e.g., how many cattle one has. Such wealth may be acceptable to
others in return for goods / services. However, things like jewellery may be stolen,
cattle
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may die and grains deteriorate in quality due to passage of time. Thus, wealth in
these forms is inherently risky and to a certain extend illiquid i.e., not suitable for
instant transfer or use.
In modern economy liquid wealth is held in the form of money by the use of banks notes
and more importantly bank deposits. This provides a temporarily certainty of purchasing
power for the holder which it is both convenient and certain. It facilitates savings which
is essential for economic progress of any nation. Before money is accepted as a store of
value two conditions must be satisfied.
a) Money must retain its value otherwise people will get rid of it in exchange of real
commodities.
b) Goods and services must be available in the future. If there is no guarantee of
goods and services in the future individuals will want to acquire these now instead
thus money will lose its function as store of value.
Credit s t a n d a r d the existence of money is essential to the modern systems of
production which depends upon the granting of credit to those who undertake the
manufacturing of goods in expectation of sales. It enables capital investment
(acquisition of plant and machinery) to take place. A manufacturer can thus borrow funds
to purchase raw materials, machinery and hire labour to produce in order to sale later in
the market. The resultant receipt (money) being used to repay the loans. Thus, where a
person borrows or enters a contract involving some future form of payments this will be
expressed in money terms. Thus, the effective and efficient use of money as a credit
standard requires it not to lose its value due to inflation. When money is falling in value
borrowers‟ gain at the expense of lenders because this money is worth more than
tomorrow’s money. Consequently, borrowing cannot be encouraged unless savers in the
economy demand high interest rates for the use of their funds. Otherwise, savers
could spent or invest in commodities less likely to lose value than money. Such actions
tend to make inflation worse. During deflation the opposite occurs, prices fall and the
value of money rises and as a result there is reluctance to borrow and spent which
accelerates the price fall and lowers the levels of economic activity to a country.
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Influence on economic activity Money has a dynamic function in that a government by
controlling its supply may influence the level of economic activity (employment, output
and prices). The dynamic function of money arises from the fact that it represents
purchasing power which when exercised stimulates producing of goods / services.
The regulation of money supply may be used by government to achieve specific
economic objectives e.g., full employment and price stability. It’s important to appreciate
that money markets and price mechanism determine the allocation and utilization of
resources in both developed and developing economies. Money also facilitates the
payment of taxes implying it's an indispensable tool for a modern state/nation.
Types of Money:
An incredible diversity of items has served as money at various times and in various
places. However, all of these moneys can be classified as either:
a) Commodity money
b) F i a t money
The simplest differentiation between these types of money is that commodity money has
substantial value a part from what it will buy while flat money is important only because
of its uses as money (legal tender). Ultimately the use of flat money is driven by faith and
acceptability of the item being used. Flat money also depends on stability of the
government that issues it. One can further classify money into 3 major categories.
a) Real money-full bodied money
b) T o k e n money
c) Representative money
Real money C o m p r i s e s of items that have intrinsic value. This includes gold and
other precious metals and stones. Even today’s modern world settlement of indebtedness
between countries is frequently done in gold. Full bodied money or real money tends to
have its monetary value equal to its component stuff. Its value as a coin is the same as its
value as a metal. Full bodied money is either metallic or represents money.
Token money is an item which is accepted for value in excess of its real / intrinsic value.
This implies that its base is higher that its market value. It’s made up of cheap material
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and its official purchasing power is higher than the value of its metallic contents. Due to
relatively scarce supply of gold and difficult in dividing into very small units, other coins
of inferior value emerged. Gradually the metal content value of these coins reduced far
below their printed face value e.g., the metal content of a 5-shilling coin is much less
than
5 shilling. These coins however remain acceptable by the general public because laws
have been enacted making it legally binding for people to accept it for face value. Token
money is said to be a real tender – value of a token money is at the discretion of currency
authority that issues it.
Representative or optional money Besides currently notes and coins there are other forms
of paper performing the function of money e.g., cheques, bill of exchange, bank draft,
travelers’ cheques or IOU documents. These instruments however, not being legal tender
can be refused. They infact represent money lying elsewhere e.g., cheques represent bank
deposit.
Monetary Standards:
Refers to the characteristics which must be possessed by money in order to carry out its
functions. There also called the attributes of good money materials. Many materials in the
past have been used as money e.g., cattle/goat skins, copper, gold, silver, cowry
shells etc., but with time those materials have lost their usefulness as monetary standards.
For a material to be used as a monetary standard it must possess the following
characteristics.
1. General acceptability - The material must be acceptable by the public. This general
acceptability should not be tied to alternate uses.
2. Portability material should be portable so that one can transport it from one point to
another without loss or depreciation.
3. Durability - Material should be capable of storage without depreciation.
4. Homogeneity – Item used should be of the same type and uniform in quality. It should
be capable of being standardized.
5. Divisibility – money material should be capable of being divided without losing
value. The sum of the parts should be equal to the undivided whole.
6. Cognoscibility – capable of being recognized and not confused with other materials
by touch, hear and see.
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7. Stability of value – the money material should be stable in order to ensure stable
prices. The money material should not fluctuate with time. It should remain constant in
terms of value in order to ensure a stable micro-economic growth.
Gresham’s Law:
It states that “bad money drives out good money”. People tend to hold new money as they
spend the old one. They consider the new money to have some form of utilities by having it.
This because the old money is either mutilated or debased to an extend that individuals
start lacking confidence in the old money. Hence central monetary authority is expected to
ensure that the dirty money is removed from circulation.
Gresham law is applicable majorly in the cross-border trade where old coins and notes tend to
be scarcely used for facilitating exchange. The old notes seize to be acceptable for
international payment. A major reason why people then hold new coins is to use the new
money to pay for foreign indebtedness. This then makes new money to disappear from the
domestic markets leaving the old money.
Review Questions:
1. Give a brief history of the development of money and banking
2. The limitations of barter trade led to the development of money. Discuss
3. Explains the functions of money in any economy
4. Describe the different types of gold standards
5. Describe different types of money
6. Describe Gresham’s Law
References:
Frederic s. Mishkin (2001), the economics of money, banking, financial markets, sixth edition.
Keynes, J. M. 1936, The General Theory of Employment, Interest, and Money, Macmillan
Friedman, M. ed.1956. Studies in the Quantity Theory of Money, The University of Chicago
Press.