MONEY AND BANKING

Money is anything that is generally acceptable as a means of exchange for goods and in
the settlement of debts in a given period of time.
Before the present form of money goods were exchanged for goods and this is called
barter system of exchange.

Barter system of exchange. This is where commodities are exchanged for commodities
without money as a medium of exchange. It is the earliest form of exchange which involves
exchange of goods for goods, goods for services or services for services for example
chicken for salt, beans for sheep etc.
For barter system of exchange to be successful there should be a double coincidence of
wants. For example for you to exchange with another person he must have what you want
and he must want what you have.
NB: Due to the many challenges especially lack of double coincidence of wants, barter
trade was with time abandoned by many societies and a generally acceptable
medium of exchange was developed and this is called money.

EVOLUTION OF MONEY
• Barter trade was the earliest form of exchange where goods were exchanged for
goods, services for services and goods for services .It was later discovered by people
that they were missing some characteristics of money.
• It was then decided that commodities of high value were to be used as a medium of
exchange. These included salt, tobacco, grains, hides and skins etc. These
commodities were used to determine the value of other commodities and also served
many purposes hence their ability to satisfy human wants/needs. However ,these
commodities could not measure well the value of all commodities because they were
bulky and perishable
• Later durable commodities were used and these included; gold, iron, silver, beads,
cowrie shells. After sometime, it was later discovered that some of these

1
 commodities were in plenty and they would not act as a good as good medium of
exchange.
• It was therefore decided that gold and silver should be the only ones to act as a
medium of exchange. However as time went on people were inconvenienced with
carrying metals, this prompted the emergency of goldsmith who would keep the
gold and issue receipts to the owners. The receipts had the same value as the gold
kept. This marked the beginning of paper money.
• Over time more developments have taken place and these include use cheques,
credit cards and most recently financial systems have evolved electronic money(E-
currency e.g. mobile money, E-accounts)
Advantages of money as a medium of exchange
• It enhances the monetary sector i.e. the use of money enables an economy to transform
from a subsistence sector to a commercial sector since individuals produce for
sale/exchange which increases their incomes.
• It allows division of labour and specialization. Individuals specialize in the production
of goods and services in order to obtain money which use in getting other commodities.
• Money facilitates the transfer of loans .This is mainly done from the financial
institutions to different sectors of the economy e.g. Agriculture, Industry, Tourism etc.
• The government transfer credit facilities/assistance to the public by use of money.
• Money allows deferred/ future payments. These are payments to be effected in future
and they can be easily estimated before hand by use of money.
• Money facilitates international trade. Countries can participate in international trade in
order to earn foreign exchange which helps them to purchase the goods that they do not
produce.
• Money act as an incentive/attraction for the factors of production .Many individuals
offer their factors of production in order to earn money e.g. labour is offered to earn
wages and salaries, land is offered to earn rent.

2
• Money is also used to demand for factors of production. This enables the production of
goods and services to take place which increase economic growth.
• It measures the value of goods. Money helps in valuing goods and services i.e. it
determines the quality and quantity of goods to be produced.
• Money can be used as a substitute/ a solution to problems encountered in barter trade.
It is a way in which societies try to overcome the problems encountered in barter trade.
• It encourages hard work and effort i.e. money encourages people to work harder to
accumulate more of it.
• It encourages proper allocation of resources i.e. this is where people produce those
commodities that are highly demanded.

Disadvantages of money as a medium of exchange

• Leads to misallocation of resource. Usually the rich individual dictates the goods to be
produced in their favour may leave out those goods demanded by the poor who are
always the majority.
• Money leads to overexploitation of resources in order to accumulate more of it thus
leading to their quick depletion.
• Money can lead to inflation. This is mainly experienced when there is too much money
in circulation.
• It leads to income inequality .This is because people earn differently such that some
individuals are earning more while others are earning less or nothing at all hence
creating a gap between the rich and the poor.
• Money encourages rural urban migration and its associated problems/evils. This is
mainly experienced when the labour force leaves rural areas to urban centers in search
of high incomes. However some individuals are mainly unemployed which results into
problems like congestion, creation of slums, robbery, prostitution etc.
• Money encourages corruption and embezzlement of funds. This comes about as
individuals ask for bribes and other steal funds to accumulate more money.

3
• Money can lead to pride and hatred among the people. This kills social cohesion/unity
in an economy
• Lack of money leads to poor standards of living, i.e. those who fail to earn enough
money live under poor conditions.

FUNCTIONS OF MONEY:
• It is a medium of exchange. Money makes it possible to determine the value and
quantity of commodities to be exchanged. It facilitates the day-to-day transactions and
enables people to easily get goods and services in exchange for money.
• It is a unit of account. Money permits pricing of goods and services, enables
accounting and auditing of business transactions.
• It is a store of value/wealth. Money makes it easy for people to store their wealth in
money terms.
• It is a measure of value. The relative value of goods and services or prices is
determined through the intermediary of money. It reflects the quality and quantity of
goods and services exchanged in the market.
• It is a standard of deferred payment. Money makes it easy for purchases to be made
without immediate payment. This means that money facilitates and encourages
international trade.
QUALITIES OF GOOD MONEY:
1 .It should be generally acceptable /Acceptability. This means that it should be
approved by everyone in the country as the official legal tender. This is to ensure
that it is accepted by everyone in the making of different transactions.
2. It should be portable/Portability. One should be able to carry money from one
place to another easily. This is to ensure security for money and its holder.
3 It should be divisible/Divisibility. Good money should be divisible into small
denominations so as to enable small transactions to take place.

4
4. It should be durable/Durability. Good money should be long lasting. It should be
made out of high quality papers and metals. This is to reduce the cost of replacing
the worn out money.
5. Homogeneity/Good money should be homogeneous. Money should be uniform
throughout the country i.e. one denomination should be as good as others. E.g. one
thousand notes should be similar to all one thousand notes used in the country.
6 Cognizability. Money should be easily seen and deduced with ease in relation to
material, colour and structure. It should not look like other forms of paper or coins.
7. Scarcity/ Good money should be relatively scarce. Money should be scarce as
compared to its demand so as to enable people maintain it or even work harder to
get it.
8. Malleability/ It should be malleable. Money should be hard or difficult to imitate
because if it is easy, it can easily be forged hence an increase in supply and its related
problems such as inflation.
9. It should be stable in value. It should maintain its value without over appreciating
or over depreciating. This is to maintain people’s confidence and trust in money

CONCEPTS USED IN CONNECTION WITH MONEY:

1. The gold standard
Gold standard is a monetary system in which the standard unit of a currency has a
fixed weight of gold. For example 1 ounce=$4.86. Or Gold standard is an
agreement set by countries to fix the price of their currencies in terms of gold.

2. The dollar standard. This is where the value of a country’s currency is defined in
terms of the dollar reserves held in the country.

5
3. Fiduciary issue (Representative money)
This is money/currency issued by central bank at its discretion and it’s not backed
by gold or foreign exchange reserves. .
4. Fiat money
Fiat money refers to money printed and issued by the central bank on government
orders and it is not backed by securities or gold. E.g. money printed to finance a
war.
Common money. This refers to bank notes and coins in circulation (hands of the
public), and it’s used to carry out day-to-day transactions.
5. Near /Quasi money. This refers to assets which can easily be turned into cash for
example treasury bills and government stocks, Cheques, foreign currency.
[Link] money. This refers to money (coins) whose metallic value is equal to
the face value.
7. Token money. This refers to money whose face value is greater than the value
of the metal used in making it.
8. Hot money
Hot money refers to short-term capital movements such as treasury bills,
commercial bills, and speculative purchase of foreign currency that can be moved
from one country to another.
9. Bank deposits. This refer to money deposited with financial institutions and can
be used to settle any financial obligations.
Bank deposits are of two types:
a. Sight (Demand) deposits. Sight deposits are those which are withdrawn on
demand by customers with current accounts.
b. Time deposits. Time deposits are those which are withdrawn subject to some
notice being given by customers of a bank.

10. Money market. This is one in which short-term financial assets (securities) are
exchanged.

6
 Money markets have got the following features:
• They are mainly urban based.
• They charge mainly high interest rates.
• They mainly operate on small scale basis.
• There are few participants in the markets.
• They deal in a limited variety of financial assets.
11. Capital market. This is one where long-term financial assets (securities) are
traded. It is a market for long-term company loan capital, share capital and
government bonds.
The institutions involved in the capital market include the central Bank, commercial
Banks, and saving-Investment institutions e.g. insurance companies.
The functions of a capital market
• Mobilising of savings.
• Encouraging investment.
• Regulating the prices of financial assets.
• Promoting easy convertibility of assets (from near cash to cash form).
12. Stock exchange markets. These are financial institutions where already issued
shares are sold and bought.
13. Treasury bill. This is a financial security issued by a country’s central bank as a
means for government to borrow money for short periods of time, for example treasury
bills of 90 days.

14. A bond. This is a financial security issued by businesses and government as

a means of borrowing long term funds, for example bonds for several years.

15. Loan. is a specified sum of money advanced to an individual or a firm by a

financial institution with a specified rate of interest over a given period of time.

7
 NB: (i) Soft loan is a loan having either no interest rate or a very low interest
rate and it has a long term repayment period
(ii) Hard loan is a loan with a very high interest rate and a very short
repayment period.
.
16. Collateral security. This refers to an asset of value that is mortgaged /pledged
against a loan given.
17. Overdraft. This is a short term financial assistance by commercial bank to the
current account holder where the customer is allowed to withdraw more money than
he/she has on the account.
18. Bank draft. This is a cheque issued by the commercial bank on behalf of bank
customer at a fee where by the payee is not willing to accept a personal cheque.

19. Bill of exchange. Bill of exchange is unconditional order issued by a person or

business directing the recipient to pay a fixed sum of money to a third party at a
future date.
20. Paper note. This is money made out of paper materials by the central bank of a
country e.g. a note of Shs. 1000.
21. Coins. This is money which is minted out of metallic materials e.g. a coin of
Shs.100.
22. Legal tender. This is money which according to the law must be accepted in
making of transactions in a country at a given time. Money is legal a legal tender in
its country of issue.
23. Currency. This refers to the paper notes and coins that are being used as money
in a country.
OR: Currency refers to the total stock of money in the country which includes
foreign currencies that are not legal tender to the country.
24. Dear Money. This is the money where the government deliberately keeps the rate
of interest very high in order to reduce borrowing from the commercial bank

8
 THE ROLE OF MONEY IN AN ECONOMY
1. It encourages specialisation in the economy associated with high level of output.
2. It promotes commercial production due to increased resource utilization and
reduces subsistence production.
3. It promotes development of credit markets for borrowing and lending which is
difficult with barter trade.
4. It promotes savings hence increased investments in an economy.
5 It encourages hard work by individuals so as to improve standard of living.
6. It makes it possible for the government to influence economic activities in the
country through monetary and fiscal policies.
7. Money provides a means through which price mechanism operates through pricing
of commodities.
8. Money enables the distribution of income among factor owners. The rewards to
factors of production are expressed in form of money making it possible to
determine distribution of income among them.

THE DEMAND FOR MONEY (LIQUIDITY PREFERENCE THEORY)

Demand for money is the desire by the public to hold wealth or assets in form of money.
Or Demand for money is the desire to hold wealth as money rather than interest earning
assets.
Determinants of liquidity preference/demand for money
1. Level of interest rate. High interest rate acts as an incentive for people to earn
much from their money which encourages them invest it hence a fall in liquidity
preference. On the other hand, low interest rate increases the level of liquidity
preference because people do not see much reward in investing their money to earn
interest.

9
2. The general price levels. High general price levels prices leads to high liquidity
preference as people tend to hold much money so as to enable them meet their needs
but as prices stabilize, the level of liquidity preference also tends to fall.
3. Availability of investment incentives. Provision of investment incentives such as
subsidies in a country leads to low liquidity preference as people invest their money
in different economic activities for a profit. On the other hand, limited provision of
investment incentives leads to high liquidity preference as people are reluctant to
invest in different economic activities due to low profit levels resulting from high
cost of production.
4. Knowledge of banking facilities. Awareness about banking facilities encourages
people to make use of them by keeping their money in banks thus low liquidity
preference. On the other hand, prevalence of ignorance about banking facilities
makes people hold much cash especially when they feel that they have to go through
much hustle to bank or withdraw their money thus high liquidity preference.
5. Level of transactions. High the level of transactions by customers leads to high
liquidity preference because there is much need by people to hold money so as to
have daily needs for survival. On the other hand, a fall in the level of transactions
leads to low liquidity preference since there is less need to hold money for purpose
of carrying out transactions.
6. Income levels. High level of income among people leads to low liquidity preference
since they can easily invest their money elsewhere to earn them interest both in the
short run and long run. On the other hand, people with low incomes tend to hold
most of their wealth in cash since they are likely to need it any time.
7. Level of speculation. High level of speculation in securities with high interest leads
to low liquidity preference as speculators invest their money in bonds and treasury
bills to earn a profit. On the other hand, low level of speculation in securities with
low interest leads to high liquidity preference as speculators prefer to have their
money in cash form rather than investing it in securities.

10
8. Level of development of financial institutions/Nature of distribution of
commercial banks. High level of development of financial institutions leads to low
liquidity preference as people make use of banks by keeping their money in them.
On the other hand, low level of development of financial institutions leads to high
liquidity preference because banking becomes an inconvenience
According to John Maynard Keynes, people do not demand for money for its own sake but
due to influence of some motives which include the following:
1. The Transaction motive. This is the desire to hold money in cash balances for
carrying out day-to-day transactions for example buying food, fuel, clothes, paying
for transport. The transaction motive is influenced by the following factors:
• The level of income
• The general price levels
• Level of monetization of the economy
• Level of economic activities
• The time it takes for one to receive money/income.

2. The precautionary motive. This is the desire to hold money so as to cater for
unforeseen circumstances for example, getting visitors, falling sick. The
precautionary motive is influenced by the following factors:
• The level of income of people.
• The cost of insurance and health facilities.
• Business opportunities for unexpected profitable deals.
• The level of inflation in an economy.
• The time it takes for one to receive money

3. The speculative motive. This is the desire to hold money in cash balances by people
so as to earn more incomes and profits in near future through speculation. The
amount demanded for this purpose depends on interest payable to treasury bills
and bonds i.e. at a high rate of interest speculators prefer to hold securities instead

11
 of money whereas at low rate of interest speculators prefer to hold money instead
of securities.

NOTE: The least (minimum) rate of interest below which people would rather hold
their money instead of investing it in bonds or stocks is known as Liquidity trap.
Liquidity trap is a situation where the interest rate is too low to induce people invest in
securities.
Or
Liquidity trap is a situation where the interest rate is too low to break the liquidity
preference.
The speculative motive is influenced by the following factors:
• The interest rate in financial institutions in relation to returns.
• The level of people’s income to buy securities.
• The business trends in the country whether favourable or unfavourable.
• The willingness of the public to buy securities

4. Finance (investment) motive. Finance motive is the desire to hold money in cash
balances in order to finance ongoing investments. The finance motive is influenced
by the following factors:
• Marginal efficiency of capital.
• Availability of investment incentives/Government policies towards
investment
• The political climate.

MONEY SUPPLY
Money supply refers to the total amount of money in circulation and on demand deposit on
current Accounts at a particular time.
There are two types of money supply:
• Exogenous money supply:

12
 This is where the amount of money supplied by the mintinting authority like the
central bank, ministry of finance or any other authourised monetary authority is
independent of the economic activity in the country.
• Endogenous money:
This is a type of money supply which depends on the level of economic activities
within an economy e.g. output, interest, interest rate, price levels
Factors that influence the money supply in an economy:
• The level of economic activities. In an economy where there is a policy of expanding
economic activities e.g. agriculture, tourism, etc more money is required leading to
an increase in supply. However, where there is limited expansion of economic
activities which requires little money result onto low money supply.
• Level of Inflow and outflow of funds High level of inflow of funds (by foreign
investors, remittances by nationals living abroad, by tourists) from abroad leads to
high the level of money supply. On the other hand, high level of outflow funds in
form of profit and income repatriation, expenditure on imports, investing in the
outside economy leads to low level of money supply.
• Government monetary policy through the central bank. An expansionary monetary
policy leads to high level of money supply because the intention is to increase the
amount of money in circulation. On the other hand, restrictive monetary policy leads
to low level of money supply because the intention is to reduce the amount of money
in circulation.
• Level of liquidity preference. High level of liquidity preference leads to high money
supply because people prefer holding money rather than assets. On the other hand,
low level of liquidity preference leads to low money supply because people prefer
holding assets other than money itself.
• The Interest rate. High interest rate means low rates of borrowing which eventually
leads to low level of money supply. On the other hand, low interest rate means high
rate borrowing which eventually leads to high level of money supply.

13
• Level of monetization in the economy/size of the subsistence sector. The economy
that is highly monetized, the level of money supply is high since production is for
commercial purpose and more money is required for exchange. On the other hand,
the economy with a big subsistence sector, the level of money supply is low because
production is for own consumption and not for sale, therefore less money is
required.
• Level of government expenditure. The higher the level of government expenditure
especially on productive projects the higher the money supplies. On the other hand,
the lower the level of government expenditure, the lower the money supplies.
• The level of credit creation. High level of credit creation implies that more money
is created which results into high money supply in an economy. On the other hand
low levels of credit creation, limits the amount of money/credit created leading to
low money supply.
• Government level of borrowing. This is mainly done through the buying of
securities i.e. when the public buys securities; money is borrowed by the
government which lowers the level of money supply in the economy. On the other
hand where the government/ the central bank buys back securities from the public
it leads to high money supply in the economy.
• The balance of payment position of a country. The balance of payment surplus in
an economy leads to increase in money in circulation leading to high levels of
money supply, this due to the increased foreign exchange inflow. While a balance
of payment deficit leads to low amount of money in circulation leading to low levels
of money supply in the economy, this is due to low foreign exchange inflow in the
country.
• The level of printing and issuance of currency. Excessive printing and issuance of
currency by the central bank increases the amount of money in circulation hence
increasing money supply. On the other hand limited printing and issuance of

14
 currency by the central bank reduces the amount of money in circulation hence low
levels of money supply.

THE QUANTITY THEORY OF MONEY: IRVING FISHER 1911

The quantity theory of money states that the general price level is determined by the
quantity of money in circulation assuming that the velocity of circulation of money (V)
and the level of transactions (T) are constant. The quantity theory of money is represented
by the Fisher equation,
𝐌𝐕
MV = PT or 𝑷 =
𝐓

Where;
M= Quantity of money in circulation
V= Velocity of circulation of money (average number of times each unit of a currency
changes hands in financing a transaction)
P= General Price level
T= Level of transactions (total amount of goods and services supplied.

Examples:
1. Given that the volume of money in an economy is £ 20 billion, total level of
transaction is £ 250million and the velocity of circulation is [Link] the general
price level in the economy.
2. Given that the quantity of money is Shs. 1million, Velocity of circulation is 20 and
the price level is Shs. 80000, calculate the volume of transaction.
3. Assuming Velocity of circulation and transactions made are held constant i.e. 10
and 50 respectively but money supply is doubled from Shs. 100 to Shs. 200,
calculate the new price level.

Assumptions of the quantity theory of money

15
• The theory assumes that, the velocity of circulation of money and the level of
transactions are held constant , this is to allow the money in circulation and the
general price level to change in the same proportions.
• The theory assumes that all the money received by the people is spent on goods and
services or it is for transctionary motive
• Prices are assumed to be determined by the amount of money supplied only.
• The theory assumes that there is no hoarding or saving of money because if money
supply is increased and volume of savings is also increased at the same rate, the
general price level would remain constant.
• The theory assumes that all transactions use money as a medium of exchange for
goods and services and ignores the barter trade system/Assumes that there is no
barter trade.
The theory is applicable in the sense that when money supply increases in most
cases prices of goods increase.
Limitations of the quantity theory of money
• The theory only attempts to explain changes in the value of money, but does not
show how the value of money is determined.
• The theory assumes that the demand for money is only for transaction motive,
ignoring other motives like precautionary and speculative motives.
• The theory does not take into account other factors that bring about a change in the
general price level other than money supply e.g. costs of production(cost push
inflation), forces of demand and supply(demand pull inflation), changes in foreign
exchange rates.
• The theory assumes that velocity of circulation (V) and the level of transactions (T)
are constant and this is not the case in real life as the two variables can change
according to changes in economic conditions.
• There is no general price level but rather a series of price levels given the fact that
price is responsive to forces of demand and supply.

16
• The theory ignores the influence of interest rate on the general price level and money
supply; this is because high interest rate discourages borrowing hence low money
supply.
• An increase in money supply may result into high level of savings if the marginal
propensity to save is high this reduces the velocity of circulation the rate at which
money changes hands) and then the prices may fall instead of increasing.

• In a situation where a country has many unemployed resources/idle resources the

increase in money supply leads to an increase in output of goods and services
which make prices fall or not change at all.
• Bargaining /haggling between buyers and sellers to reach agreeable price is not
taken into account by the theory, i.e. the buyer may be in a strong bargaining
position the price will not increase.

• Government price legislation /control in form of maximum price is not catered for
by the theory and yet the government may come in to lower prices

• The quantity theory of money is just an expression (truism) which merely shows the
relationship between four variables M, V, P, T but not a true theory.

• The four variables M, V, P and T are not independent of one another because a
change in one induces change in others.
• It ignores barter trade because it assumes that all transactions are effected by use of
money.
• It ignores the demand for money and only looks at money supply in an economy
and yet there could be genuine demand for money.

17
 CIRCUMSTANCES UNDER WHICH AN INCREASE IN MONEY SUPPLY
MAY NOT NECESSARILY LEAD TO AN INCREASE IN THE GENERAL
PRICE LEVEL;
• When there is a corresponding increase in the level of output of goods and
services in a country.
• If the increased money supply is used to purchase capital goods for
investment, prices will remain constant.
• When there is a high marginal propensity to save, the increased money
supply will not lead to inflation/ increase in price the money will be saved.
• Where there is government control over prices i.e. if the government fixes
the maximum prices.
• Where the interest rate on capital is high.

THE VALUE OF MONEY

Value of money refers to the amount of goods and services a unit of money can buy.
Or: Value of money refers to the purchasing power of a unit of money. If the volume of
goods and services is big from a fixed quantity of money, then the value of money is said
to be high and vice-versa.

Value of money can be categorized as:

• Nominal value. This refers to the face value of notes and coins irrespective of what
value it can command in terms of goods and services.
• Real value. This refers to the amount of goods and services that can be bought using
a given amount of money.
• Intrinsic value. This refers to value of paper or metal from which money is
obtained.

18
Factors influencing the value of money
• The price level/rate of inflation. High rate of inflation leads to a reduction in
purchasing power of money and a fall in value of money. On the other hand, low
rate of inflation leads to a rise in purchasing and value of money.
• The quantity of money in circulation. High level of supply of money leads to
excessive demand for goods and services which leads to an increase in prices hence
a fall in value of money. On the other hand, low level of supply of money leads to
a fall in aggregate which leads to a decrease in the general price levels hence a rise
in value of money.
• Availability of goods and services /level of transactions. High level of
transactions makes goods more available thereby increasing the value of money. On
the other hand, low level of transactions leads to a reduction in the volume of goods
available leading to an increase in price level and a fall in money value.
• The velocity of circulation of money. High velocity of circulation of money leads
to a fall in value of money because it leads to high price level. On the other hand,
low velocity of circulation of money leads to a fall in price level and high value of
money.
• Government policy of devaluation and revaluation. Under the devaluation policy
the government deliberately reduces the value of money, while with the revaluation
policy the government deliberately increases the value of money.

BANKING
Banking is a business activity of accepting and safeguarding money owned by
individuals and business entities, and then lending it out in order to earn a profit.
Banking is done by financial institutions which direct the flow of money to
productive use and investments.

FINANCIAL INSTITUTIONS (INTERMEDIARIES)

19
Financial institutions are specialized business units which are developed to provide finance
required in the modern sector.
These institutions deal in money as their commodity and they usually serve as channels
through which savings flow into productive investments, and they charge a price known as
interest. Financial institutions are broadly categorized as:
1. Banking Financial Intermediaries/Institution.
These are firms/organizations/financial institutions that receive deposits, give out
loans and create credit/create new deposits.
2. Non- Banking Financial intermediaries/Institutions.
These are firms/organization/financial institutions that receive deposits, give out
loans but do not create credit. Examples are: Development banks, state co-
operatives, Insurance Corporations, Housing finance companies, Post office savings
Banks etc.

DIFFERENCES BETWEEN BANKING AND NON-BANKING FINANCIAL

INTERMEDIARIES
• Banking financial institutions require high value assets as collateral security to
access to loans while non-banking financial institutions do not require a lot of high
value assets as collateral security for loans.
• Non-banking financial intermediaries are development oriented for instance
development banks unlike the banking financial institutions such as commercial
banks.
• Banking financial institutions only invest in less risky ventures or projects such as
certificate of deposits, savings accounts while non-banking financial institutions
undertake investments in risky projects such as mining, agriculture etc.
• Banking financial intermediaries have a high profit motive unlike the non-banking
financial institutions with low profit motive.

20
• Banking financial intermediaries create credit through use of cheques which is not
the case with non-banking financial intermediaries which obtain funds from
development oriented institutions such as IMF and World Bank.
• Banking financial institutions charge a high interest rate as they are profit motivated
while the non-banking financial institutions charge a low interest rate as they are
development oriented.
• Banking financial intermediaries carry out investments in financial assets like
treasury bills, bonds, stocks, foreign exchange while non-banking financial
intermediaries carry out investments in real assets like roads, houses, factories, and
railways.
• Banking financial institutions normally offer short-term loans to customers while
non-banking financial institutions offer long-term loans for capital development
expenditure.

THE ROLE OF NON- BANK FINANCIAL INTERMEDIARIES IN

DEVELOPMENT
• They mobilise savings in the country because they allow the public to deposit
their money with them.
• They facilitate investment in the economy by extending loans to the people
especially those dealing in long-term projects.
• They lead to development of infrastructures in the economy because they
participate in putting up of good infrastructure to enhance the running of their
business.
• They create employment opportunities for the public, because the public
secures jobs in different areas of the institutions.
• They provide revenue to the government through taxes that are imposed on
these institutions.

21
 • They promote the development of entrepreneurial skills through providing
investment resources that people use to start businesses.
• They provide for the social welfare of the people through pension schemes
by the social security institutions and the insurance companies.

• They promote trade and commercial activities by lending people for various
purposes.
• They act as capital markets where capital resources are obtained for long
term investments.

THE BANK
A bank is a business institution which accepts deposits from surplus spending units
in form savings especially from the public and then lends the same to deficit
spending units (investors) to earn a profit.
TYPES OF BANKS;

DEVELPOPMENT BANKS
This is a bank mainly created by a state or governments of neighbouring countries to
promote the development of infrastructure in the country or region.
They also promote industrial growth within the country or within the region the country
or within the region e.g. the East African development, Uganda development bank,
African Development Bank, Arab Bank for Economic Development in Africa.
Their sources of funding is mainly Africa Development Bank, OPEC fund, United States
Agency for Development, and the World Bank.

Development banks are development oriented non-bank financial institutions offering

long-term loans for investment at low interest rate, especially in agriculture, industry and
infrastructural development (roads, ports, power dam projects, irrigation schemes)

22
Development banks perform the following functions:
• They give out loans for investment purposes especially where commercial banks
cannot manage.
• They encourage growth of risky but developmental ventures like mining,
agriculture.
• They attract foreign technical assistance required in the development of vital areas
• They initiate long term lending to individuals, institutions whose projects are
deemed necessary for development of the country.

THE CENTRAL BANK

A central bank refers to a central monetary institution which is responsible for financial
management, and controlling other financial institutions in a country operating on non-
profit motive. Examples include: Bank of Uganda, Central Bank of Kenya, Bank of
England etc.
SPECIALISED BANKS
These are commercial banks which are set up to serve a special type of customers with
specific services. E.g. Housing Finance Bank, Development Finance Company of Uganda
(DFCU)
SAVINGS BANKS
These are banks which are set up to promote the culture of savings among people in the
country. They attract deposits of any size but limit the withdraw facilities.

COMMERCIAL BANKS
Commercial banks are financial institutions which carry out financial businesses by
accepting deposits from the public and lending out money on profit motive. Examples in
Uganda include; Standard Chartered Bank, Stanbic Bank, Centenary Bank, Diamond Trust
Bank etc.

23
FUNCTIONS OF COMMERCIAL BANKS/BANKING FINANCIAL
INSTITUTIONS
NB: (These are mandatory duties of commercial any commercial bank)

• Accepting deposits. . This is done by allowing customers to open different types of

accounts like, savings account, current account, fixed deposit, by doing so they
safeguard customers’ money.

• Advancing loans to trustworthy customers. This is done through offering different

loan products on short term and long term basis .Such loans help the customers with
financial difficulties e.g. a bank over draft is an example of a short term loan.
• Acting as custodians of their customers valuables/clients .Commercial banks
provide strong rooms to keep customers valuable items like academic documents,
land titles, important business agreements/contracts etc.
• Issuing of various forms of instruments credit/provide easy means of payment such
as cheques, drafts, credit and debit cards. They provide excellent means of enabling
payments. These facilitate the transfer of money from debtors to creditors
• Issuing letters of credit to and act as referees to their clients. Commercial banks act
as referees or guarantors’ on behalf of their clients who are buying goods on credit.

• Providing advice to the investors on possible investment choices. This is advice is

mainly financial or business related. E.g. they assist customers to make realistic
business proposal and business plans.
• Underwriting shares and debentures of companies as wells as discount bills of
exchange/ financial securities. Commercial banks trade in the issued securities as
primary dealers who sell them to other interested clients.

24
• Acting as trustees and executors of property and will of their deceased clients/
customers. Here they accept to manage the property or estates of their deceased
clients to benefit the deceased’s family.
• Exchanging of currencies of different countries .They buy and sell local and foreign
currencies, here they act as foreign exchange bureaus.
THE ROLE OF COMMERCIAL BANKS IN DEVELOPMENT
• They facilitate the process of investment by moblising savings from the public as
well as extending loans to people/public.
• They provide employment opportunities because commercial banks employ people
to perform different tasks in their different branches and departments e.g. accounts,
managers, cleaners security guards etc
• They facilitate/assist the government in implementation of the tools of the monetary
policy .i.e. they help the central bank in circulating the newly issued currency.
• They encourage monetisation of the economy by promoting exchange using money
they also lend money to people to carry out production for the market.
• They promote skills development by providing on job training to their employees.
• They facilitate and stimulate the development of infrastructures in the economy i.e.
they participate in the construction of buildings, roads, communication networks
in order to improve their services.e.g Mapeera house for centenary bank.
• They contribute to government revenue .This is because they pay different taxes to
the government.
• They facilitate and promote trade both internal and external by enabling traders to
transfer their money safely.
• They are instrumental in promoting capital accumulation process. This is because
of their capacity to mobilize savings from the public.
• They contribute investment capital in the country through buying shares from
various public limited companies.
• They assist potential investors by giving them advice on investment opportunities.

25
• They give recommendations and covering letters to potential investors which
facilitate internal and foreign and internal trade.
• They offer specialized and diversified services which are necessary for peoples
welfare and development e.g. issuing travellers’ cheques.

FOREIGN COMMERCIAL BANKS

These are banks established in the country i.e. Uganda by foreigners and they have their
headquarters in their mother countries.e.g. Barclays bank, Standard Chattered bank, Cairo
international bank etc.

Role of foreign commercial banks

Positive roles:
• They provide employment opportunities because commercial banks employ people
to perform different tasks in their different branches and departments e.g. accounts,
managers, cleaners security guards etc
• They promote good international relationships among countries i.e. between their
mother country and their host country and this promotes international peace.
• They facilitate investment in the private sector through the provision of loans to the
potential investors.
• They promote efficiency in the banking sector through creating stiff competition
with the local banks.
• They facilitate the process of international trade by exchanging the foreign
currencies for importers and exporters.
• They offer international banking services because government collects taxes from
the banks.
• They promote development of local managerial skills through demonstration effect
since the people employed learn a lot of from expatriates and in addition the banks
provide training banking skills.

26
• They increase the rate of monetisation of the economy because the loans they give
out help people to produce for commercial purposes.
• They contribute to the development of infrastructure in attempt to improve on their
services. They participate in construction of roads, buildings, extension of power
supply in rural areas etc.
• They facilitate technological development in the economy because transfer modern
methods of banking into the country. E.g. computerised banking services including
the use of Automated Teller Machines(ATM).
• They increase the rate of capital inflow into the country by facilitating the transfer
of money by citizens of the host countries.

Negative role of foreign commercial banks

• They worsen the balance of payment deficit because of the increased profit
repatriation.
• They create few employment opportunities in the country. This is because these
banks mainly use capital intensive technology which is labour saving and also they
have discriminating employment policies in that they prefer employing foreign
manpower especially at ranks jobs.
• They outcompete local banks because they have more finances and better
technology than the local banks.
• They worsen rural urban migration and its related evils since the banks are
concentrated in urban areas which attract people from rural areas to urban areas.
• They make the implementation of the monetary policy difficult because they do not
co-operate with the central bank since they have a lot of cash to inject in the
economy from their mother banks abroad. i.e. they rarely borrow from the central
bank.
• They discourage mobiliastion of savings because they require high initial deposit
which many people cannot afford.

27
PROBLEMS FACING COMMERCIAL BANKS IN DEVELOPING COUNTRIES
(UGANDA)
• The limited/small size of bank deposits because of the high level of poverty among
the people which limits the number of clients to the bank.
• The limited number of credit worthy customers/There are a few credit worthy
borrowers who can pay back the loans advanced to them hence limiting expansion
of the banking sector
• Political interference in the management of commercial banks and this makes it
difficult for banks to make decisions on their own, i.e. they are forced to function
according to the desires of the government.
• Political instability/ High levels of insecurity where people fear to borrow for
investment therefore funds remain underutilized in commercial [Link] cant
easily extend to rural areas for fear of losing property and depositors money.
• Limited skills among banking officials which makes them incompetent to run the
commercial banks, the inadequate supply of skilled manpower to manage the bank
forces the banks to hire foreign managers who are highly paid leading to a high cost
of production.
• Low levels of accountability or high level of corruption among banking officials
which makes commercial banks to incur huge losses leading to closure of many of
them.e.g managers and other workers steal funds from banks
• Stiff competition with other financial institutions such as microfinance institutions,
post office savings banks, savings,mobile money services and credit cooperatives
all of which make commercial banks earn little profit.
• High liquidity preference by the people which reduces savings with commercial
banks.
• Uneven distribution of commercial banks where the majority are urban based hence
neglecting the potential borrowers and savers in rural areas.

28
• Ignorance of the public/People about banking facilities, this limits the use of
commercial banks by the population resulting into low deposits.

MEASURES THAT MAY BE TAKEN TO IMPROVE THE PERFOMANCE OF

THE BANKING INDUSTRY IN DEVELOPING COUNTRIES (UGANDA)
• Encourage extension of banking services to rural areas
• Close the banks that do not meet the minimum requirements
• The central bank should Undertake close supervision of the commercial banks
• Sesnitise the public on the importance of banking
• Encourage training of more bankers
• Increase people’s incomes so as to increase their deposit with banks
• Government should reduce her interference in the activities of commercial banks
• Ensure political stability so as to promote economic activities which will motivate
people to borrow for investment purposes.

FEATURES OF COMMERCIAL BANKS IN UGANDA

• They are mainly urban based
• They are generally weak and underdeveloped
• Most are foreign owned
• Many have a weak capital base
• They mainly charge high interest and service fees
• They mainly offer few products(services)
• They have few branches.
• Many are privately owned

ASSETS AND LIABILITIES OF COMMERCIAL BANKS:

ASSETS OF COMMERCIAL BANKS

29
Assets are possessions of a bank and all other claims on other financial institutions and
customers. Assets include the following:
• Cash at hand in local and hard currencies.
• Reserves with central bank.
• Investment in securities including; treasury bills, bonds.
• Fixed assets in form of land, buildings etc.
• Loan advances and overdrafts to customers.
• Long-term investments.
• Deposits with other banks and non-bank financial intermediaries.
• Interest on loans advanced to customers.

LIABILITIES OF COMMERCIAL BANKS

Liabilities are claims against the assets of the bank by its creditors, depositors or what the
bank owes.
Liabilities include the following;
• Share capital.
• Customer deposits.
• Deposits by other banks.
• Government funds deposited in the bank.
• Dividends payable to shareholders.
• Reserve funds payable to the central bank.
• Bills discounted with the central bank.

CONFLICTING OBJECTIVES OF COMMERCIAL BANKS

Commercial banks are always faced with the dilemma of achieving various objectives of
liquidity , profitability and security. .g. if the banks increases lending so as to earn more

30
profits, it won’t meet the customers money demand which will make them lose confidence
in the bank and thereby depositing less of their money in the bank.
In the same way, when they maintain liquidity to attract confidence in the customer the
banks will not get profits and therefore there will be no funds for lending. Commercial
banks therefore have to find a way of reconciling the conflicting objectives.

How commercial banks ensure liquidity

Commercial banks undertake the following to ensure that they always have cash to give
their clients.
• By purchasing of short term securities that can be turned into cash easily e.g. buying
treasury bills.
• They lend out money in phases such that at all times there is some money to meet
the daily cash requirements.
• By maintaining the cash ratio. This is intended to have sufficient cash to meet the
daily demands of the customers.
• Maintaining a minimum balance on the different accounts of their customers.
• Commercial banks lend on short term basis such that the cash is easily restored
• They ensure that the borrower deposit a marketable security with the bank which
can be liquidated in case of failure to pay the loan.

How Commercial banks ensure profitability/Maintain profitability

The commercial banks undertake the following to ensure that they make profits,
• Advancing loans and overdrafts at a given interest. Here commercial banks charge
interest depending on the amount of money borrowed and the time taken. The
interest earned improves profitability.
• Undertaking investment in profitable projects. The commercial banks invest their
money in businesses/project that are highly profitable e.g. investing in real estates
and securities.

31
• They charge fees for their different services e.g. they have bank charges, ledger
management fees, charges on money withdrawals etc, such money is accumulated
to create profits for the banks.
• Charging a commission for services rendered to customers e.g. where they act as
custodians of estates of the deceased. The commission they earn improves their
revenue and profitability.
• By discounting bills of exchange and promissory notes at a fee.
• They buy shares in other companies like other members of the public. Commercial
banks buy shares floated by companies. From these they earn dividends annually
to improve their revenue and profits.

How commercial banks ensure security:

Commercial banks ensure security in the following ways;
• They demand for marketable collateral security to extend loan to their
customers.
• They spread their assets in different categories of liquid assets e.g. cash deposits
with other banks, fixed assets etc.
• They extend short term loans and avoid long term loans
• They put up strong buildings where they carry out their activities
• They employ security guards
• They take up insurance covers against various risks.

CREDIT CREATION:
Credit creation is the process by which commercial banks create excess deposits/
new deposits out of the initial deposits made by customers. This is through lending
out excess funds to credit worthy borrowers who deposit the borrowed funds at
different branches of the same bank.

Assumptions of credit creation

32
 • It assumes that there is a fixed cash ratio e.g. 10%
• It assumes a fixed initial deposit e.g. Shs. 100,000
• It assumes that there are several banks in the system (multi-bank credit
creation process) or there is only one bank with very many branches (Uni-
bank credit creation process).
• It assumes that when people get loans in form of cheques, such cheques are
deposited in other banks or in other branches of the same bank.
• It assumes that the public/ are willing to borrow money from commercial
banks.
• It assumes that the public should be credit worthy.
• It assumes the use of cheques i.e. there must be a large number of current
account holders so that commercial banks use the deposits to create credit.
• It assumes that there are many people willing to deposit money in the bank
therefore have confidence in the bank.
• It assumes that commercial banks are willing to give/lend money to the
public.

The basic terms used in credit creation

Bank deposit/ Credit Multiplier.
Credit multiplier is the number of times by which an initial bank deposit multiplies itself
to generate a final change in total credit created/total bank deposits
Total deposit 1 1
Credit multiplier = or ( )
Initial deposit r cash ratio
The size of the bank deposit depends on the following;
1. Level of liquidity preference
2. Interest rate on deposits
3. The willingness by the masses/public to borrow
4. The size of the cash ratio
5. Number of banks in the system

33
6. Size of initial deposit
• Cash ratio. This is the proportion/ fraction/percentage of commercial banks
deposits that must be kept/remain in the bank in cash form to meet the cash
demands of depositors.
• Reserve ratio. This refers to percentage/fraction of the commercial bank’s
total deposits which by law must either be kept with the commercial bank
or with the central bank.
Factors that influence the reserve ratio
1. The rate of inflation/The amount of money in circulation
2. The level of credit creation
3. Level of liquidity of the commercial bank
4. The level of uncertainty in the financial sector

Reasons for adoption of reserve ratio in an economy

1. To control inflation/reduce the amount of money in circulation.
2. To restrict credit creation by commercial banks.
3. To protect interests of depositors in times of crisis and financial instability.
4. To safe guard commercial banks against uncertainties i.e. during periods of
economic recession
• Liquidity ratio. This is the proportion of total deposits of a commercial bank
in form assets that can easily be turned into cash such as bank drafts, cheques

THE PROCESS OF CREDIT CREATION

1. Receiving an initial deposit of the first bank (Bank A) from customers/
depositors.e.g. Shs. 100000
2. Keeping a certain percentage of the initial deposit as cash ratio e.g. 30% or
shs.30, 000 as cash reserves.
34
3. Lending out the remaining percentage of the initial deposit as a loan to a trusted
borrower, for example shs.70, 000.
4. Receiving the money lent out as new deposit by another/the second bank
(Bank B) i.e. 70,000=
5. Keeping a percentage of the new deposit by the second bank as cash ratio, 𝑓𝑜𝑟
example 30% of shs.70, 000= or shs.21, 000=.
6. Lending out part of the new deposit to a trusted borrower by the second bank for
example, shs.49, 000=.
7. The process continues until the initial deposit defuses into the banking system.
8. At the end of process the total credit created is equal to initial deposit x Bank
multiplier.
Total credit created = Initial deposit x bank multiplier but bank multiplier is equal to 1/r
1
( ) = 100, 000 × 5
𝑐𝑎𝑠ℎ 𝑟𝑎𝑡𝑖𝑜

= shs.500, 000

ILLUSTRATION OF CREDIT CREATION

Given that Bank A has initial deposit of UgShs.100, 000, and the required cash ratio is
30%, credit is created as shown in the table below.
Banks/Branches Initial Deposit/ Cash Ratio (30%) Loanable funds
New deposits.
100,000= 30 x100,000= 30,000 100,000-30,000
100 = 70,000
B 70,000= 30x70,000= 21,000 70,000-21,000
100 = 49,000
C 49,000= 30x49,000= 14,700 49,000-14,700
100 = 34,300
D 34,300= 30x34,300= 10,290 34,300-10,290
100 = 24,010

35
E - - -
Up to n
NB. Total credit created for four banks = 100,000+70,000+49,000+34,300 = 253,300/=

FACTORS INFLUENCING THE PROCESS OF CREDIT CREATION

• Level of liquidity preference by individuals. High demand for cash implies that people
deposit less in commercial banks and this reduces the ability of commercial banks to
lend hence low credit creation, on the other hand low liquidity preference implies that
individuals make large deposits into commercial banks. This increases the funds
available for lending thus promoting the process of credit creation.

• Size of the cash ratio. The higher the cash ratio, the lower the level of credit creation
since banks retains much of the deposits which limit lending, however the lower the
cash ratio, the higher the level of credit creation since banks are able to retain less of
the customer’s deposits which limits the amount of money for lending.

• Interest rates on loans. High interest rate on loans lead to low demand for loans as
borrowing becomes expensive hence limiting credit creation, on the other hand low
interest rate on loans lead to high demand for loans as borrowing becomes cheap, thus
promoting the process of credit creation.

• Availability of collateral security. . Presence of collateral security encourages

commercial banks to lend out money to the public hence high level of credit creation.
On the other hand, absence of collateral security discourages commercial banks from
lending out money to the public thus low level of credit creation.
• Level central bank interference through the monetary policy. Restrictive monetary
policy by the central bank reduces the amount of money to be held by commercial banks
for lending hence limiting the process of credit creation, on the other hand, an

36
 expansionary monetary by the central bank increases the amount of money held by the
commercial banks for lending thus promoting the process of credit creation.
• Level of monetisation of the economy/Size of the subsistence sector. High level of
monetization of the economy leads to high level of credit creation because most
economic activities require use of money hence increased borrowing from commercial
banks. On the other hand, a large subsistence sector reduces the amount of credit created
as most of activities done do not require a lot of funds hence reduced borrowing from
commercial banks.
• Nature of distribution of commercial banks/Level of development of the banking
sector. Even distribution of commercial banks in a country promotes credit creation
as lending services are within the reach of the customers, alternatively even distribution
of commercial banks encourages saving thus increasing the size of bank deposits. On
the other hand, poor distribution of commercial banks limits the credit creation as
lending services are not wholly accessed by the public and at the same time it limits the
size of bank deposits.
• Level of awareness of people about the banking services. High level awareness
about banking services promotes the process of credit creation ,this is so because
many people are knowledgeable about the existence of bank loans and therefore go
for loans. On other hand limited knowledge about bank loans limit the process of
credit creation because few people go for bank loans.

• Availability of funds for lending/Size of bank deposit. A large amount of bank

deposits increases the loanable funds and there promotes the process of credit
creation On the other hand, a small amount of bank deposits reduces the loanable
funds which limits the process of credit creation
• Degree of accountability in the commercial banks. Transparency in commercial
banks promote the process of credit creation because bank officials do not ask for
bribes before advancing loans, thus encouraging the public to borrow, on the other
hand low level of accountability in commercial banks limits the process of credit
37
 creation because bank officials make it hard for customers to access loans since they
ask them for loans.
• Availability of investment opportunities. Existence of man investment promotes
borrowing since different people need money to take on such opportunities and this
leads to high level of credit creation, on other hand existence of few investment
opportunities in the country results into low demand for loans hence limiting the
process of credit creation.
• Availability of credit worthy borrowers/ customers. Existence of many
creditworthy customers promotes the process of credit creation because there are
many people qualify for bank loans, on other hand a small number of credit worthy
customers limits the process of credit creation because few people qualify for bank
loans.
• Political climate/Atmosphere ,political instability discourages borrowing and
lending and this limits the process of credit creation because people fear to lose their
lives and property, on the other hand political stability encourage borrowing and
lending which encourages investment because people are not scared of losing their
lives and property.

LIMITATIONS OF CREDIT CREATION

• High liquidity preference.
• High cash ratio
• Lack of collateral security (houses, gold, machinery, land titles, vehicles Limited
number of commercial banks.
• Limited number of commercial/poor distribution of commercial banks.
• Limited investment opportunities.
• Ignorance of the public about banking service
• High interest rates on loans.
• Restrictive monetary policy.

38
• Large subsistence sector/low levels of commercialization.
• Political instability/Political turmoil
• Low levels of accountability
• Limited number of credit worthy borrowers.
• Low level of bank deposits/Low level of savings

FACTORS THAT PROMOTE CREDIT CREATION

• Low level of liquidity preference.
• Low cash ratio
• Presence of collateral security (houses, gold, machinery, land titles, vehicles
Limited n
• High number of commercial banks/ Even distribution of commercial banks.
• Large number of investment opportunities.
• High level awareness of the public about banking services
• Low interest rates on loans.
• Expansionary monetary policy.
• Low level of subsistence sector/High levels of commercialization.
• Presence of political stability
• High levels of accountability
• Large number of credit worthy borrowers.
• High level of bank deposits/High level of saving
INTEREST RATE DETERMINATION
Interest is the cost of borrowing money from a lender for a given period of time.
OR; Interest is monetary reward /payment by a borrower to a lender for use of a sum of
money for a period of time.
Interest rate refers to the rate at which the interest on borrowed money accumulates. It
expressed in percentage form.
Reasons why interest is paid by borrowers to lenders

39
• Lending involves foregoing present consumption which is painful; therefore the
lender should be paid for this in form of interest.
• Capital cannot be accumulated without savings which involves a lot of sacrifices;
therefore interest is paid as a reward for savings.
• Lending involves risks; and the lender should be rewarded for undertaking such
risks.
• Different expenditures are incurred during lending for instance keeping proper
accounts which requires stationery, manpower, licenses, legal charges, which
implies that interest is charged as reward for proper management.
• It is a reward for inconveniencing the lender.
DETERMINANTS OF INTEREST RATE IN A COUNTRY:
• Supply of loanable of loanable funds. High supply of loanable funds leads to low
interest rate, this is because lenders to want make borrowing cheap so as to attract
borrowers. On other hand low supply of loanable funds leads to high interest rate,
this is so because there many bowers competing for the few funds and therefore the
lenders take advantage and hike the interest rate.
• Period of loan repayment. Long repayment period attracts high interest rate because
of the high risks involved. On the other hand, short repayment period attracts low
interest rate because of the low risks involved.
• Level of demand for loanable funds (investment capital). High level of demand for
loanable funds attracts high interest rate since customers show a lot of interest in
using loanable funds. On the other hand, low level of demand for loanable funds
reduces interest rate so as to attract customers to borrow money.
• Level of money supply in an economy. High level of money supply in an economy
leads to high interest rate high rate; this is because it is increased to reduce money
supply. On the other hand, low level of money supply attracts low interest rate in
order to attract borrowers and increase money supply

40
• The price levels/ rate of inflation. Inflation leads to high interest rate so as to
discourage people from borrowing due to maintain the encourage money value. On
the other hand, a deflation leads to low interest rate so to attract borrowers to
increases to increase the amount of money in circulation.
• Number of banking institutions/level of development of banking sector. High level
of development of banking institutions leads to low interest rates because there are
many banking institutions which compete for borrowers. On the other hand, low
level of development banking institutions leads to high interest rates because there
few banks and less competitions for borrowers.
• Government monetary policies. Restrictive monetary policy attracts high interest
rate because the central bank wants to reduce amount of money in circulation. On
the other hand, expansionary monetary policy attracts low interest rate because the
central bank wants to increase amount of money in circulation.
MORE CONCEPTS USED IN BANKING
1. Credit. This is a financial facility which enables an individual or firm to borrow
money to purchase products, raw materials over an extended period of time.

2. Instruments of credit. Instruments of credit are written documents which guarantee

payment in near future and they give the holder a right to receive money. Examples
of instruments of credit include: Cheques, Promissory notes, Bills of exchange,
Bank drafts, Bank overdraft, Travelers cheques, and Credit cards.

ADVANTAGES OF CREDIT
• It helps to develop trade and industry by providing working capital
• Facilitates the process of credit creation leading to increased investment
• It reduces the use of cash which helps to reduce inflation
• It encourages the development of entrepreneurship in the economy.

41
3. Liquidity. Liquidity refers to the extent to which an asset can quickly be converted
into currency notes and coins to be used as a medium of exchange. The level of
liquidity can be influenced by the following factors:
• Level of income
• Level of transaction
• Price levels
• Nature and duration of wage payment
• Monetary policy of the country
4. Credit crunch (squeeze or crisis)
A credit crunch is a reduction in the general availability of loans (credit). A credit
crunch is usually an extension of an economic recession. It makes it nearly
impossible for companies to borrow money because lenders are scared of
bankruptcies (defaults) which results into very high interest rates.
Causes of credit crunch in an economy
• Anticipated decline in the value of collateral used by banks to secure loans.
• The central government imposing direct credit controls on the banking
system.
• Sudden and unexpected increase in legal reserve requirements by the central
bank.
• Sustained period of careless and inappropriate lending which results into
losses for lending institutions.
• Reduction in market prices of previously over inflated assets/securities.

THE CENTRAL BANK. This refers to a central monetary institution which is

responsible for financial management, and controlling other financial institutions in a
country operating on non-profit motive. Examples include: Bank of Uganda, Central Bank
of Kenya, Bank of England etc

42
Functions of the central bank
• Printing and issuance of currency. It has the sole authority of issuing national currency
i.e. notes and coins which are sufficient to enable the public carry out transactions.
• It is a banker to the government and various government institutions by keeping
government funds. This is because the central bank keeps all the government money
.i.e. it manages the government treasury.
• It acts as banker to commercial banks and other financial institutions. The central bank
accepts deposits from commercial banks and commercial banks are required by law to
have an account in the central bank.
• It acts as a banker to International financial institutions such as international Monetary
Fund, World Bank. Each of these financial institutions operate an account in the central
bank for their operations in the country.
• It is a lender of last resort to the commercial banks, i.e. if commercial banks fail to raise
money to settle their customers’ demands from other sources; they borrow from the
central bank.
• It is the supervisor of other financial institutions especially the commercial banks to
ensure that they operate within the laws established. (to ensure financial soundness)
• It is responsible for management of foreign exchange reserves through enforcing
foreign exchange regulations and it acts as the chief custodian of all the currencies in
the country both local and foreign.
• It is the advisor to the government on good and sound monetary and economic issues
depending on the level of economic activities e.g. formulating the national budget,
taxation.
• The Central bank manages a country’s public debt it is involved in the acquisition,
utilisation, servicing and repayment of the public debt.
• It is a clearing house for all commercial banks i.e. they settle their indebtedness through
it.

43
• The central bank is the controller of credit in the economy i.e. it uses the monetary
policy tools to regulate the amount of money in circulation
MONETARY POLICY.
This refers to the deliberate attempt by the government through the central bank to
regulate the amount of money in circulation so as to attain certain or desired development
objectives ; such as price stability, stable economic growth rates, equitable distribution of
income etc.
Categories of monetary policy
• Restrictive/contractionary monetary policy. This is a deliberate government effort
through the central bank to control the level of economic activities by reducing the
amount of money in circulation.
• Expansionary monetary policy. This is a deliberate government effort through the
central bank to control the level of economic activities by increasing the amount
of money in circulation.
Objectives of monetary policy:
• To ensure price stability in the economy. During inflation a tight monetary policy
is used to reduce money supply to bring down prices and during a deflation an
expansionary money policy is adopted to increase the amount of money in
circulation so as to raise prices.
• To influence the level of employment/to ensure full employment of resources in the
country for both labour and other factors of production. Credit is expanded to allow
investors to more capital for investment.
• To influence balance of payments position. This is achieved through an
expansionary monetary policy which promotes domestic production and minimise
importation thus improve the balance of payment position.
• To ensure stability of exchange rates in a foreign exchange market. This is through
regulation of both local and foreign currencies to avoid fluctuations in exchange
rates.

44
• To influence the level of economic growth. This is achieved by encouraging the
production of goods and services through the expansionary monetary.
• To encourage growth of financial sector. This achieved through expanding credit
to enable investors expand production for the market.
• To influence the level and nature of investment. This is achieved through by
encouraging the commercial banks to offer credit facilities to the priority sectors
and limiting accessibility to credit by investors in non priority sectors.
• To help create a broad and continuous market for government securities such as.
treasury bills and bonds. The example sells securities to the public using the open
market operation.
TOOLS /INSTRUMENTS OF MONETARY POLICY
These are guidelines employed by the government through the central bank to
regulate the amount of money in circulation so as to achieve development
objectives.

The tools of monetary policy include:

1. Open market operation. This refers to the central bank action of selling and buying
back of government securities such as treasury bills and bonds to or from the public
with an aim of reducing or increasing the amount of money in circulation. To
increase the amount of money in circulation, the central bank buys back securities
from the general public and to reduce the amount of money in circulation, the central
bank sells securities to the general public with an intention of withdrawing money
from people.

2. Bank rate/Discount rate. This is the rate at which commercial banks borrow
money from the central bank. An increase in bank rate by the central bank
discourages commercial banks from borrowing money. Commercial banks
therefore increase interest rate on loans given to customers thereby discouraging the
public from borrowing money from commercial banks. However, to increase the
45
 amount of money in circulation, the central bank lowers its bank rate so that
commercial banks can be able to lower the interest rate hence encouraging
borrowing money by the public from commercial banks.

3. Legal reserve requirement. This is the minimum amount of money that

commercial banks are legally required to deposit/keep with the central bank. To
increase the amount of money in circulation, the central bank lowers the legal
reserve requirement so that commercial banks are left with enough money for
lending. However, to reduce the amount of money in circulation the central bank
increases the legal reserve requirement so that commercial banks have limited
amount of money to lend to the general public.
,
4. Variable reserve requirement /Cash Ratio. This is the proportion of commercial
bank’s total deposits/assets which it keeps in cash form to meet day-to-day
requirements of customers and other financial commitments. To increase the
amount of money in circulation, the central bank instructs commercial banks to
lower the cash ratio so as to increase the loanable funds, and to reduce the amount
of money in circulation, the central bank instructs commercial banks to increase
cash ratio so as to reduce the amount of money for lending.

5. Margin requirement. This is the difference between the value of collateral security
and the value of a loan to be advanced. The value of collateral security must exceed
the value of a loan to be advanced with the interest to be paid. Margin requirement
is increased to discourage people from borrowing money from commercial banks
thereby reducing on the amount of money in circulation. On the other hand, margin
requirement is reduced to encourage people to borrow money hence increasing the
amount of money in circulation.
Example: If a building worth 200, 000,000/= is presented as collateral security
against a loan of 150,000,000/=; margin requirement will be 50,000,000/=.

46
6. Rationing of credit. This is where the central bank allocates credit/loans to avoid
over borrowing from commercial banks by some sectors. In case of reducing the
amount of money in circulation, commercial banks are given little money by the
central bank in form loans hence reducing their lending capacity. On the other hand,
in case there is need to increase money in circulation, the central bank suspends the
rationing of credit such that the commercial banks have sufficient funds to lend to
the customers.
7. Selective credit control. This refers to situation where the central bank encourages
commercial banks to give loans to specific sectors of importance or priority like
agriculture, industry and denying other sectors from acquiring loans so as to reduce
the amount of money in circulation during inflation. On the other hand, in case the
central bank wants to increase lending, it suspends the policy of selective credit
control hence encouraging borrowing by all sectors of the economy.
8. Special deposits (supplementary reserve requirement). Special deposits are
those deposits that the central bank demands from commercial banks on top of legal
reserve requirement. During inflation the central bank calls for special deposits
which reduces the loanable funds, thus reducing the commercial banks capacity to
lend. On the other hand special deposits are given back to the commercial banks
when prices stabilise to increase their capacity to lend..

9. Moral suasion. This is a way of persuading or advising commercial banks about

dangers of too much money or too little money in circulation. During inflation the
central bank appeals to the commercial banks to reduce lending in order to reduce
money supply in the economy. On the other hand during low price levels, the central
banks appeals to the commercial to lend as much as they can an increase money
supply.

FACTORS INFLUENCING THE OPERATION OF MONETARY POLICY

47
1. Level of liquidity preference among the general public. High level of liquidity
preference among the public limits effective use of commercial banks and other
financial institutions as a lot money is in hands of the people thereby limiting
operation of monetary policy. On the other hand, low level of liquidity preference
means that a lot of money is deposited with commercial banks and other financial
institutions thereby making the monetary policy effective.
2. Level of development of the money markets and capital markets i.e. stock exchange
markets to do with securities through which the central bank can operate. High level
of development of money and capital markets leads to effective operation of
monetary policy because of the many people who trade in securities. On the other
hand, underdeveloped money and capital markets limit effective operation of
monetary policy as there are a few people who are aware and trade in securities such
as treasury bills and bonds.

3. Level of liquidity in commercial banks which influences their frequency of going

to the central bank. Excessive liquidity in commercial banks reduces the rate at
which they go to central bank to borrow. This makes them remain with a lot of
money for lending thereby limiting effective operation of monetary policy, in
particular the bank rate tool. On the other hand, low level of liquidity in commercial
banks increases the rate at which they go to the central bank to borrow thereby
making the monetary policy effective through implementation of the bank rate
policy..

4. The size of monetary sector/subsistence sector. Large commercial sector makes it

effective to implement the monetary policy, this is because when the central bank
wants to increase money supply many people to borrow to expand production. On
the other a large subsistence sector limits the operation of the monetary policy
because very few people to borrow even if the central bank wants to increase money
supply through lowering the bank rate.

48
5. The distribution of commercial banks/ Level of development of commercial banks.
Even distribution of commercial banks promotes the effective operation of the
monetary policy, because many people deposit their money in those several banks
hence enabling the central bank to control the many in those banks, yet uneven
distribution of commercial banks limits the effective operation of the monetary
policy since few people deposit their money in commercial banks, thereby making
it hard for the central bank to control such money.

6. Degree of political interference in central bank activities. High level of political

interference in central bank activities in terms of influencing lending policies leads
to excessive amount of money in circulation thereby failing the monetary policy.
On the other hand, low level of political interference in central bank activities,
allows the central bank to implement its policies according to its plans..

7. Level of accountability by the central bank officials especially in the

implementation of some tools like selective credit control. High level of
accountability by central bank officials ensures that central bank officials are not
bribed by commercial banks to issue loans to non priority sectors. On the other hand,
low level of accountability by central bank officials means that central bank official
is bribed by commercial banks and extends loans to non priority sectors, thereby
rendering implementation of monetary policy tools ineffective.
8. Level of coordination of government objectives. In a situation where government
has clearly stated objectives such as reducing the amount of money in circulation
without favouring certain sectors, the monetary policy becomes effective. On the
other hand, conflicting government objective limits the operation of the monetary
policy, because at the time when central bank wants to reduce money the
government comes up with other projects which increase money supply.

9. Level/Degree of effective in the use of commercial banks. High use of commercial

banks by the public in terms promotes the effectiveness of monetary policy, this is
49
 because many people do deposit their money in commercial banks which is easily
controlled by the central bank. On the other hand limited use of commercial banks
limits the operation of the monetary policy, because most people do not deposit their
money in commercial banks, therefore cannot be accessed by the central bank.
10. Degree of awareness of the public about facilities offered by commercial banks.
High degree of awareness of the public about the facilities offered by the
commercial banks promotes the implementation of the monetary policy; this is
because many people go for loans which make it easy for the central banks to
increase money supply when the need arises. On the other hand high level of
ignorance of the public about the facilities offered by the commercial banks limits
the operation of the monetary policy because very few people go for loans which
makes it hard for the central bank to increase money supply even when the need
arises.
FACTORS LIMITING THE EFFECTIVE OPERATION OF MONETARY
POLICY;
• High level of liquidity preference among the general public
• Low level of development of money market and capital markets.
• High level of liquidity in commercial banks
• Large subsistence sector
• Uneven distribution of commercial banks
• High degree of political interference in central bank activities
• Low level of accountability by central bank officials
• Conflicting government objectives
• Limited use of commercial banks
• High level of ignorance of the public about the facilities offered by
commercial banks
FACTORS PROMOTING THE EFFECTIVE OPERATION OF THE
MONETARY POLICY:

50
• Low level of liquidity preference among the general public
• High level of development of money market and capital markets.
• Low level of liquidity in commercial banks
• Large commercial sector
• Even distribution of commercial banks
• Low degree of political interference in central bank activities
• High level of accountability by central bank officials
• High level of coordination of government objectives
• High level of use of commercial banks
• High level of awareness of the public about the facilities offered by
commercial banks

51
 INTERNATIONAL TRADE

This refers to the buying and selling of goods and services among nations. It is a trade that goes
beyond the boundaries of a country. It involves exports and imports.

IMPORTS

These are goods and services that legally cross the borders from one country into another. There
are both visible and invisible imports.

Visible imports

These are tangible goods that are brought into a country from another country.

Invisible imports

These are services that are brought into a country from another country e.g. insurance, banking,
etc.

EXPORTS

These are goods and services that are locally produced and sold to other countries. They can also
be visible and invisible. Visible exports are tangible goods while invisible exports are services that
are produced locally and sold to other countries.

VISIBLE TRADE

Refers to the buying and selling of tangible goods among different countries

INVISIBLE TRADE

Refers to the exchange of services between countries

OR

Is the exchange of invisible exports and invisible imports of a country e.g. tourism, electricity.

International trade can also be bi-lateral or multi-lateral.

52
BI-LATERAL TRADE

This involves exchanging of goods and services between two countries.

MULTI-LATERAL TRADE

This involves exchanging of goods and services among more than two countries.

THE ROLE OF INTERNATIONAL TRADE IN THE DEVELOPMENT OF A

COUNTRY

POSITIVE ROLES

1. Enables the country to get what it does not produce.

2. Provides a variety of goods hence widening the consumers’ choice.
3. Increases the efficiency of domestic firms due to competition from imported goods hence
lowering average production costs.
4. Enables the country to dispose of the surplus output that would otherwise be wasted due to
widened markets beyond the country’s boundaries.
5. Promotes specialization and its benefits since there is existence of comparative advantage
among countries as each country specializes in the production of a commodity where it incurs
the least opportunity cost.
6. Enables a country to acquire new ideas and values especially on better production techniques
hence helping to transform the economies from subsistence to commercialized production.
7. Promotes international friendship and cooperation among countries participating in trade hence
promoting peace and stability among countries.
8. Leads to utilization of resources hence avoiding wastage. This is due to widened markets
beyond the country’s boundaries.
9. Promotes technology transfer i.e. shifting of new and efficient production methods from one
country to another especially from developed countries to underdeveloped countries. This
leads to effective exploitation of resources and production of better quality products.
10. Enables countries to acquire skilled labour from other countries as they trade together hence
leading to increased productive capacity among nations hence leading to higher economic
growth rates.

53
11. Promotes capital inflow/ foreign exchange from foreign investors and from goods being
exchanged hence helping to close the foreign exchange gap.
12. Provides revenue to the government. This is obtained mainly from taxes imposed on exports
and imports hence enabling the government to meet its expenditure needs.
13. Increased output hence economic growth. International trade leads to production of more goods
due to existence of a big market among different countries participating in trade hence
economic growth.
14. Provision of employment opportunities. This is arises due to enlarged investments as markets
expand calling for more workers. Also jobs are provided to those participating in importation
and exportation of goods and services hence enabling people get incomes thereby improving
their standards of living.
15. Increased quality of output due to competition. International trade leads to increased quality of
output being produced due to competition for market among different countries.
16. Promotes infrastructural development especially railway networks, bridges and roads so as to
allow easier and cheaper movement of goods and services being traded between countries
thereby promoting increased economic/ productive activities between countries.
17. Promotes entrepreneurship as investors engage in various investment activities to earn more
profits due to widened markets.
18. Enables countries to get supplies in times of emergencies e.g. natural calamities like droughts,
earthquakes, landslides, etc which would not be possible in absence of international trade hence
helping to save life.
19. Supplements domestic production (output) hence overcoming a problem of scarcity of goods.

NEGATIVE ROLES

1. Leads to exhaustion of non-renewable resources due to over exploitation as the market keeps
on growing.
2. Leads to cultural and moral erosion especially among low developing countries as people tend
to copy foreign cultures and lifestyles.
3. Leads to collapse of domestic firms as they find it difficult to compete with high quality goods
being imported into the country and sometimes at lower prices than the domestically produced
goods.

54
4. Leads to imported inflation which is as a result of importing goods from inflation prone
countries. This increases the cost of living in the country hence lowering peoples’ standards of
living.
5. Leads to poor terms of trade. This is as a result of exporting low quality and semi-processed
goods from low developing countries that command low prices in international markets while
importing expensive manufactured goods from developed countries.
6. Leads to balance of payments problems. This is arises due to high capital outflow in form of
profit and income repatriation by foreign investors working in the country and also due to
expenditure abroad on expensive manufactured goods being imported into the country.
7. Promotes dependence/ reduces self-sufficiency. This arises as countries expect to rely on goods
produced from other countries instead of surviving on their own. This erodes the political and
economic dependence.
8. Leads to importation of undesirable products such as pornographic material, indecent attires,
destructive drugs and other intoxicants. Such products negatively affect the health and morals
of people.
9. Leads to unemployment. This is arises due to technology transfer that tends to be more capital
intensive than labour intensive and due to collapse of domestic firms due to their out
competition.
10. Retards development of local skills. This arises because instead of the country struggling to
come up with its own technology, own products and training its own manpower; it hopes to
rely on technology and goods produced by other countries.
11. Leads to dumping with its negative effects such as closure of local firms due to their out
competition, underutilization of local resources among others.

BASIS OF INTERNATIONAL TRADE

1. Difference in resource endowment. Different countries have different natural resource

endowments in form of minerals, forests, etc. therefore there is need for countries to specialize
and exchange in order to get what they do not have through international trade.
2. Need to dispose of surplus output. Some countries produce more than what they can consume.
Therefore, there is need to sell off the excess output to other countries in order to avoid resource
wastage.

55
3. Difference in comparative advantage between countries. There is need for specialization
among countries in the production and exportation of commodities that they can produce at
lower costs than other countries and import commodities that they can produce at high cost
hence international trade.
4. Lack of self-sufficiency in terms of goods and services. No country can produce all what it
needs therefore countries trade together in order to get what they cannot produce locally.
5. The need to earn foreign exchange. There is need for international trade for countries to acquire
foreign exchange which can be used for import purposes.
6. Need to promote international relations among countries through international trade. In
addition, some countries need international trade in order to further their political and
economic ideologies.
7. Etc.

LIMITATIONS OF INTERNATIONAL TRADE

1. Poor infrastructures.
2. Low quality of goods produced for international markets.
3. Protectionism policies of importing countries.
4. Tendency for most LDCs to have similar comparative advantage/ production of similar
commodities.
5. Political instabilities in various countries e.g. Democratic Republic of Congo, Central African
Republic, Southern Sudan.
6. Absence of uniform/ same currency to be used among different trading partners.
7. Differences in languages hence limiting effective communication.
8. Differences in political ideologies between countries/ conflicts among leaders of different
countries.
9. High tariffs and non-tariff barriers on trading partners. This restricts the volume and direction
of trade.

56
 LIBERALISATION OF INTERNATIONAL TRADE (TRADE LIBERALISATION)

Trade liberalization refers to the removal of unnecessary restrictions on trade, hence giving people
liberty to trade without undue government interference so as to increase the volume and benefits
of trade.

OR

Trade liberalization refers to the removal of unnecessary restrictions on trade (so that trade can be
carried out with more freedom).

WAYS OF LIBERALISING TRADE

₤ Reduction of tariffs
₤ Removal of unnecessary subsidies to domestic firms.
₤ Abolition of quotas
₤ Privatization of state owned trading enterprises.
₤ Reduced bureaucratic/ administrative controls e.g. easing the process of acquisition of import
licenses.
₤ Liberalizing the foreign exchange markets i.e. using floating exchange rate.

IMPLICATIONS OF TRADE LIBERALISATION IN AN ECONOMY

POSITIVE IMPLICATIONS

1. Increases employment opportunities.

2. Increases the level of output hence economic growth.
3. Controls structural inflation since participation in international trade controls scarcity of goods
and services hence controlling structural inflation which arises as a result of supply rigidities.
4. Encourages resource utilization.
5. It encourages inventions and innovations/ leads to technological development.
6. Leads to efficiency of firms due to competition.
7. Leads to improved quality of goods being traded due to competition between local and foreign
firms.
8. Increases tax revenue.

57
9. Upholds consumer sovereignty. Widens consumers’ choices through increased variety of
goods being traded.
10. Fights corruption in government departments due to abolition of unnecessary controls on trade.
11. Encourages foreign investment/ promotes resource inflows.
12. Stimulates development of infrastructures.
13. Improves balance of payment position through increased foreign exchange mainly from
exports.
14. Reduces bureaucracy involved in trade due to reduced restrictions involved in international
trade.
15. Improves relations between countries as countries continue to trade together hence improving
peace and stability.
16. Promotes growth of entrepreneurship abilities due to widened markets hence leading to
increased production capacity of nations leading to faster economic growth rates.
NEGATIVE IMPLICATIONS
1. Leads to imported inflation.
2. Competition pushes out inefficient firms leading to unemployment
3. Increases inflow of demerit goods due to absence of trade restrictions hence endangering
peoples’ health.
4. Technological development and technology transfer worsen the unemployment problem due
to use of machines.
5. Promotes capital outflows in form of profit and income repatriation by foreign investors hence
limiting capital accumulation.
6. Leads to environmental degradation due to desire for more output and profits both for domestic
and foreign markets.
7. Leads to exhaustion of non-renewable resources due to their over exploitation.
8. Leads to dumping leading to suffocation of domestic industries.
9. Leads to economic dependence i.e. dependence on imported goods.
10. Leads to cultural and moral erosion.

GUIDING QUESTIONS

58
a) What is meant by “trade liberalization”? (1 mark)
b) State any three measures that have been taken to liberate trade in your country. (3 marks)
c) Examine the implications of trade liberalization on the economies of developing countries.
(16 marks)
THEORIES OF INTERNATIONAL TRADE
1. THE PRINCIPLE OF ABSOLUTE ADVANTAGE
The principle of absolute advantage states that “given two countries and two commodities
with the same amount of resources, one country can produce both commodities more
cheaply than the other.”
Study the table below showing output levels of two countries producing two countries with the
same amount of resources and state the country with absolute advantage in the production of
both commodities.
Commodities
Country Generators Coffee
X 400 600
Y 100 300

Country X has absolute advantage in the production of both commodities.

2. THE PRINCIPLE OF COMPARATIVE/ COMPETITIVE COST ADVANTAGE
The principle of comparative cost advantage states that “given two countries and two
commodities with a given amount of resources, a country should specialize in producing
a commodity where it has the least opportunity cost than the other.”
Using the above table, calculate the opportunity cost of producing each commodity in each
country. In which commodity should each country specialize?
Solution
𝐴𝑙𝑡𝑒𝑟𝑛𝑎𝑡𝑖𝑣𝑒 𝑓𝑜𝑟𝑔𝑜𝑛𝑒
𝑂𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝑐𝑜𝑠𝑡 =
𝐴𝑐𝑡𝑢𝑎𝑙 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛
Country X
600
𝑂𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝑐𝑜𝑠𝑡 (𝐺𝑒𝑛𝑒𝑟𝑎𝑡𝑜𝑟𝑠) = = 1.5
400
400
𝑂𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝑐𝑜𝑠𝑡 (𝐶𝑜𝑓𝑓𝑒𝑒) = = 0.67
600

59
 Country Y
300
𝑂𝑝𝑝𝑜𝑡𝑢𝑛𝑖𝑡𝑦 𝑐𝑜𝑠𝑡 (𝐺𝑒𝑛𝑒𝑟𝑎𝑡𝑜𝑟𝑠) = = 300
100
100
𝑂𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝑐𝑜𝑠𝑡 (𝐶𝑜𝑓𝑓𝑒𝑒) = = 0.33
300
Commodities
Country Generators Coffee
X 1.5 0.67
Y 3 0.33

Country X should specialize in the production of generators while country Y should

specialize in the production of coffee.
ASSUMPTIONS UNDERLYING THE PRINCIPLE OF COMPARATIVE
ADVANTAGE
₤ Assumes two countries
₤ Assumes two commodities
₤ Assumes existence of free trade
₤ Assumes no transport costs
₤ It assumes full employment of resources in both countries
₤ Assumes demand is elastic.
₤ Assumes homogeneity of factors of production.
₤ Assumes constant returns to scale/ no diminishing returns
₤ Assumes existence of barter trade as a medium of exchange
₤ Assumes constant comparative advantage in both countries.
₤ Assumes constant technology
₤ Assumes perfect mobility of factors of production internally and immobility of factors
externally
APPLICABILITY OF THE THEORY IN LDCS
1. Developing countries have tended to specialize in agriculture where they have the lowest
comparative cost.
2. There are barter trade arrangements in low developing countries making the theory applicable.

60
3. There is use of labour intensive technology which is abundant in LDCs, which is more static.
4. There is some degree of mobility of factors of production within the region as assumed by the
theory.
5. There are some cases of free trade in LDCs especially under common market arrangement.
INAPPLICABILITY/ LIMITATIONS OF THE COMPARATIVE COST THEORY
1. The simplicity of considering only two countries is unrealistic since trade is carried out by
more than two countries.
2. The simplicity of considering only two commodities is unrealistic since trade between
countries involves more than two commodities.
3. It assumes free trade yet in most countries there are trade barriers such as quotas, total ban,
quality controls among others.
4. It ignores transport costs which cause differences in costs between countries.
5. It wrongly assumes the possibility of full employment of resources yet LDCs experience high
levels of unemployment and underemployment.
6. It assumes that demand is elastic yet demand for agricultural products is inelastic.
7. It assumes homogeneity of factors of production yet these factors are heterogeneous.
8. It ignores the existence of diminishing returns as the principle assumes constant returns to
scale.
9. It assumes barter trade only yet there is also monetary exchange.
10. It ignores the existence of different currencies used by different countries.
11. It assumes static comparative advantage among countries yet sometimes this advantage
changes.
12. It ignores technological changes yet technology changes for example from labour intensive to
capital intensive.
13. There can be international mobility of factors of production but the theory assumes perfect
mobility of factors internally and immobility of factors externally.
14. It ignores the possibility of absolute advantage whereby a country can produce both
commodities more cheaply than the other.
15. It ignores the need for self-reliance among countries as it puts emphasis on specialization
between countries hence countries surviving on each other.
3. VENT FOR SURPLUS THEORY

61
 The theory states that “international trade provides opportunity for countries to utilize
formerly idle resources to produce output for the export markets.”

GUIDING QUESTIONS
1. a) State the principle of comparative cost advantage. (1 mark)
b) Give any three limitations of the above theory. (3 marks)
2. a) What is meant by “vent for surplus theory” used in international trade? (4 marks)
b) Assess the role of international trade in the development of your country. (16 marks)
3. a) Distinguish between comparative advantage and the law of absolute advantage.
(4 marks)
b) To what extent is the comparative cost theory applicable to developing countries?
(16 marks)
4. a) Study the table below.
Commodity
Country Coffee (Kg) Milk (Lr)
Kenya 4,000 7,000
Uganda 3,000 5,000
i) Calculate the comparative cost advantage of producing each commodity in the two
countries. (4 marks)
ii) State a commodity in which each of the two countries should specialize.
(2 marks)
b) Explain the limitations of the theory of comparative cost advantage in developing
countries. (14 marks)

TERMS OF TRADE

Terms of trade refers to the ratio of price index of exports to the price index of imports.

62
 OR

Terms of trade is the rate at which a country’s exports are exchanged for imports.

OR

Terms of trade is the purchasing power of a country’s exports in terms of imports.

Terms of trade can be expressed in two ways;

1. Barter terms of trade/ commodity terms of trade.

Is the ratio of the price index of exports to the price index of imports. It shows how much
exports are required to purchase a unit imports.
𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 𝑜𝑓 𝑒𝑥𝑝𝑜𝑟𝑡𝑠 𝑃𝑥
𝐵𝑎𝑟𝑡𝑒𝑟 𝑇. 𝑂. 𝑇 = =
𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 𝑜𝑓 𝑖𝑚𝑝𝑜𝑟𝑡𝑠 𝑃𝑚
𝑃𝑥
If > 1, the country is said to be experiencing favourable terms of trade
𝑃𝑚
𝑃𝑥
If < 1, the country is said to be experiencing unfavourable terms of trade
𝑃𝑚

Barter terms of trade can also be expressed as a percentage using the formula;
𝑃𝑥
𝐵𝑎𝑟𝑡𝑒𝑟 𝑇. 𝑂. 𝑇 = ( ) × 100
𝑃𝑚
𝑃𝑥
Barter terms of trade are favourable if (𝑃𝑚) × 100 is greater than 100% and unfavourable if
𝑃𝑥
(𝑃𝑚) × 100 is less than 100%.

2. Income (monetary) terms of trade.

Is the ratio of the value of exports to the price index of imports. It shows how much a country
can import using the revenue from exports.
𝑃𝑥
𝐼𝑛𝑐𝑜𝑚𝑒 𝑡𝑒𝑟𝑚𝑠 𝑜𝑓 𝑡𝑟𝑎𝑑𝑒 = ( ) × 𝑄𝑥
𝑃𝑚
= 𝐵𝑎𝑟𝑡𝑒𝑟 𝑇. 𝑂. 𝑇 × 𝑄𝑥
Where;
Qx = Quantity of exports
Px = Price index of exports
Pm = Price index of imports
If Px > Pm, → favourable terms of trade.

63
 If Px < Pm, → unfavourable terms of trade.
Example
Given that the price index of exports is 120 and the price index of imports is 130 and the
quantity of exports is 200kgs. Calculate;
a) (i) The barter T.O.T
(ii) The income T.O.T
b) Comment on the country’s terms of trade.
Solution
𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 𝑜𝑓 𝑒𝑥𝑝𝑜𝑟𝑡𝑠
a) (i) 𝐵𝑎𝑟𝑡𝑒𝑟 𝑇. 𝑂. 𝑇 = × 100
𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 𝑜𝑓 𝑖𝑚𝑝𝑜𝑟𝑡𝑠

120
= × 100
130
= 92.3%
(ii) 𝐼𝑛𝑐𝑜𝑚𝑒 𝑇. 𝑂. 𝑇 = 𝐵𝑎𝑟𝑡𝑒𝑟 𝑇. 𝑂. 𝑇 × 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑒𝑥𝑝𝑜𝑟𝑡𝑠
92.3
= × 200
100
= 184.6
b) The country is experiencing unfavourable terms of trade because the barter terms of trade
is less than 100%.
CAUSES OF UNFAVOURABLE TERMS OF TRADE IN LDCs (UGANDA)
1. Falling prices of exports.
2. Importation of expensive manufactured capital and consumer goods.
3. Increasing substitution of exports with synthetics produced by developed countries.
4. Exportation of semi-processed agricultural and mineral products. These have low value
added on them therefore command low prices on the world market yet imported goods are
highly manufactured and hence carry high prices.
5. Market flooding of raw agricultural products leading to fall in export prices. This is as a
result of production and exportation of similar products by developing countries.
6. Protectionist policies of developed countries in form of tariffs and non tariff barriers.
This is aimed at protecting their economies as a way of achieving self-sufficiency and self-
reliance. This greatly reduces the demand for exports from developing countries leading to a
fall in export prices.

64
7. Weak bargaining power of LDCs. In most cases, LDCs are price takers i.e. the prices of
their exports in foreign markets are dictated by MDCs. MDCs dictate low prices for LDCs’
products yet set high prices for their commodities causing unfavourable terms of trade.
8. Invention of raw-material saving techniques of production by MDCs. Developed countries
have invented technology which uses less raw-materials from LDCs thereby leading to a
reduction in demand for products from LDCs leading to low prices of LDCs’ exports yet
imported commodities are expensive causing unfavourable terms of trade.
9. Low income elasticity of demand for LDCs’ exports. This implies that even when incomes
increase worldwide, the demand for LDCs’ exports remains low because they are mainly
agricultural products thereby commanding low export prices yet import prices are high.
10. Low quality of exports from LDCs. This is partly due to limited skills and use of poor
techniques of production therefore commanding low prices on the world market yet import
prices are high.
11. Rising prices of imports. Generally, the rich in LDCs have a high marginal propensity to
import especially due to the snob effect and the goods demanded include expensive wines,
cars, mobile phones, jewelleries, etc. This enables developed countries to fix high prices on
their products yet LDCs export semi-processed products whose prices are low causing
unfavourable terms of trade.
12. Unfavourable exchange rates. This has resulted into undervaluation of LDCs’ exports yet
prices of imports remain higher causing unfavourable terms of trade.
NOTE
Emphasis should be on prices of exports being low or prices of imports being high, avoid “B.O.P”.
EFFECTS OF DETERIORATING TERMS OF TRADE
1. Leads to foreign exchange shortages due to low prices of export commodities.
2. Leads to imported inflation due to rising prices of imported commodities.
3. Worsens the country’s B.O.P position and balance of trade position since low prices of
exports result into low earnings from abroad while rising prices of imports increase the
country’s expenditure abroad.
4. Leads to low production due to low prices of exported commodities limiting the rates of
economic growth.

65
5. Causes unemployment. This is because low prices of export commodities discourage
production and investments.
6. Leads to reduction in level of investment since low prices of export commodities are
unattractive to investors.
7. Causes currency depreciation due to unfavorable exchange rates between the local currency
and foreign currencies.
MEASURES THAT SHOULD BE TAKEN TO IMPROVE TERMS OF TRADE
1. Process primary products to add value on them thereby commanding high prices on the
world market.
2. Adopt import substitution industrial strategy. This helps to produce formerly imported
goods thereby reducing importation of expensive manufactured goods.
3. Diversify export markets. LDCs should look for different markets in various parts of the
world for example through joining or strengthening regional cooperation. This increases the
demand for exports hence raising the export prices.
4. Strengthen commodity agreements. LDCs should enter commodity agreements with other
countries so that they can be offered fair and stable prices for the commodities they mainly
import.
5. Improve quality of exports for example through research, adoption of better production
techniques, training of labour to improve on its skills hence producing high quality exports that
command high prices on the world market.
6. Encourage importation from cheaper sources. This helps to overcome importation of
expensive manufactured goods thereby improving the country’s terms of trade.
7. Diversify products for export. This helps to increase on the variety of goods for exportation
so that when there is a fall in the price of some exports, other commodity prices remain high.
8. Stabilize foreign exchange rates for example through setting managed exchange rate to
ensure fair competition between exports and imports.
9. Negotiate for removal of trade barriers in export markets such as tariffs, total ban, quality
controls etc so as to raise demand for exports in the foreign markets which helps to raise prices
for exported commodities.

GUIDING QUESTIONS

66
1. a) Distinguish between barter terms of trade and income terms of trade. (02 marks)
b) State any two effects of unfavourable terms of trade in your country. (02 marks)
2. a) Account for unfavourable terms of trade in your country. (10 marks)
b. Discuss the measures that have been taken to improve terms of trade in your country.
(10 marks)
BALANCE OF TRADE

This is the difference between the value of a country’s visible exports and visible imports.

BALANCE OF PAYMENTS

Refers to the difference between a country’s receipts/ income from abroad and expenditure/
payments abroad during a given time

OR

It is a systematic record of a country’s receipts and payments in international transactions in a

given year.

OR

Refers to the difference between earnings/ incomes/ receipts from abroad and payments abroad
(visible and invisible trade and not capital transfers) of a country during a given time.

If the country’s receipts/ income from abroad exceed her expenditure/ payments abroad, the
country is said to have a balance of payment surplus and therefore it experiences favourable
balance of payments.

If the country’s expenditure/ payments abroad exceeds her receipts/ income from abroad, the
country is said to have a balance of payments deficit and therefore it experiences unfavourable
balance of payments.

COMPONENTS OF THE BALANCE OF PAYMENTS ACCOUNT

1. Current account. This is a summary of all transactions which involves movement of goods
and services between countries. The current account is divided into two i.e. the visible trade
account and the invisible trade account.

67
2. Capital account. This records all transactions which involve movement of capital in and out
of the country e.g. donations, grants, foreign investments, investments of nationals abroad, etc.
3. Monetary (cash) account. This is a record of a country’s foreign exchange reserves/ resources
from balance of payments current and capital accounts.
4. Errors and omissions account. This is also called a balancing item account. This part of the
B.O.P account records errors and omissions which may have been made in the process of
making the B.O.P account. The balancing item is added or subtracted on any side of the B.O.P
account for purposes of balancing.
CAUSES OF BALANCE OF PAYMENTS DEFICITS IN LDCs/ UGANDA
1. Low volume of exports. The volume of exports in LDCs is generally low hence low foreign
exchange earnings.
2. Exportation of low quality products. These are less competitive in the export markets
resulting into low earnings from them.
3. Exportation of mainly primary products such as agricultural raw materials. These
command low prices on the world market resulting into low foreign exchange earnings yet
expenditure abroad is high.
4. High propensity to import/ high preference for goods from other countries. Most people
in LDCs prefer buying goods from other countries as opposed to locally produced items. This
increases the country’s expenditure abroad yet earnings from abroad are low hence balance of
payments deficit.
5. Heavy expenditure on importation of military hardware. This is due to political instability
and destructive demonstrations existing in the country forcing government to spend heavily on
importing fire arms yet earnings from abroad are low causing B.O.P deficit.
6. Importation of highly priced (manufactured consumer and capital) good. LDCs are highly
dependent on imports hence high expenditure abroad leading to shortage of foreign exchange
hence B.O.P deficit.
7. High expenditure on payments/ servicing external debts. Government is highly indebted
and therefore has to service and repay external debts. This leads to high capital outflow yet
earnings from abroad are relatively low hence causing shortage of foreign exchange hence
B.O.P deficit.

68
8. Trade restrictions in export markets. MDCs are the major buyers of exports from LDCs but
put restrictions on them e.g. total ban, quotas making it difficult to export more commodities
to MDCs resulting into low foreign exchange earnings hence causing B.O.P deficit.
9. Heavy government expenditure abroad e.g. on diplomatic missions, contributions to
international organizations, etc. a lot of government foreign exchange reserves are in such
cases leading to shortage of foreign exchange hence B.O.P deficit.
10. High level of profits and wages repatriation by foreigners working within the country.
11. Market flooding/ limited markets abroad. This is due to exportation of similar products by
developing economies.
12. Prices of exports are externally determined. Prices of exports of LDCs are dictated by
MDCs and they fix low prices for those exports yet charge high prices for their commodities
leading to low foreign exchange earnings causing B.O.P deficits.
13. Limited variety of exports. Exports of LDCs are mainly agricultural with few manufactured
goods hence resulting into low earnings from abroad yet they heavily import which raises the
country’s expenditure abroad causing B.O.P deficit.
EFFECTS OF BALANCE OF PAYMENTS DEFICIT IN DEVELOPING
COUNTRIES
NEGATIVE
1. Reduces the volume of imports.
2. Limited employment opportunities due to reduced investments.
3. Discourages investments
4. May lead to inflation due to shortage of essential goods
5. Encourages currency depreciation.
6. Retards economic growth.
7. Leads to low savings and investments.
8. Leads to depletion of foreign reserves.
9. Leads to high taxation levels in order to raise revenue for government expenditure.
10. Promotes trade protectionism which results in retaliation.
POSITIVE EFFECTS
1. Promotes regional economic cooperation.
2. Promotes import substitution industrialization strategy hence growth of the industrial sector.

69
3. Encourages diversification of exports.
4. Encourages improvement in quality of exports.
5. Stimulates effort to increase volume of exports
6. Promotes development of local skills to reduce dependence on imported labour expatriates.
MEASURES THAT SHOULD BE TAKEN TO IMPROVE B.O.P POSITION IN
DEVELOPING COUNTRIES
1. Use of trade restrictions to discourage imports e.g. import quotas, import duties, total ban on
some imports thereby reducing the volume of imports thus cutting down the country’s
expenditure abroad.
2. Adopt import substitution industrialization strategy. This helps to produce goods that were
formerly imported so as to reduce the volume of imports hence cutting down the country’s
foreign exchange.
3. Creation of peaceful, stable and conducive political climate. This helps to reduce huge
foreign exchange expenditure on military hardware thereby saving foreign exchange.
4. Diversification of exports. This is involves production of a variety of exports which raises the
country’s earnings from abroad hence improved B.O.P position.
5. Negotiate for debt conversion and debt cancellation. This is reduces capital outflow on debt
servicing hence leading to growth in output for exports hence increasing foreign exchange
earnings and it also reduces expenditure on imports.
6. Undertake export promotion industrialization strategy. This increases the volume of
exports hence increased export earnings.
7. Devaluation of the domestic currency. This makes exports cheaper becoming more
competitive in foreign markets thus increasing foreign exchange earnings while making
imports more expensive which reduces their demand hence reduced expenditure abroad.
8. Strengthen commodity agreements. This helps to raise bargaining power of LDCs which
increases the prices of LDCs’ exports hence increased export earnings hence improving B.O.P
position.
9. Training of local manpower to reduce dependence on imported skilled labour. This
increases on output and reduces profit and wages repatriation.

70
10. Restructuring foreign missions and diplomatic travels e.g. having one ambassador to
serve in a number of countries thus reducing on unnecessary foreign travels. This helps
to save on foreign exchange of a country hence improving the country’s B.O.P position.
11. Improve quality of exports for example through research, adoption of better production
techniques, training of labour to improve on its skills hence producing high quality exports
that command high prices on the world market hence fetching high revenues from abroad thus
improving the balance of payments position.
12. Diversify export markets mainly through regional cooperation. This helps to widen market
for the country’s exports hence raising the country’s foreign exchange earnings.
13. Encourage barter trade. This helps to minimize the use of foreign exchange and cut down
foreign exchange expenditure hence improving the country’s B.O.P position.

GUIDING QUESTIONS
1. a) Distinguish between “Balance of trade” and “Balance of payments”. (02 marks)
b. State any two effects of balance of payments deficits in your country. (02 marks)
2. a) Account for the balance of payments problem in developing countries. (10 marks)
b. Suggest measures that should be taken to improve balance of payments position in
developing countries. (10 marks)
3. What are the components of the balance of payments account?

COMMERCIAL POLICY

Is the deliberate government policy meant to influence and direct the value, volume and direction
of trade in an economy.

INSTRUMENTS OF COMMERCIAL POLICY

₤ Taxation/ tariffs on imports/ import duty.

₤ Subsidization of local firms.
₤ Total ban/ trade embargo/ trade sanctions.
₤ Foreign exchange control.
₤ Quality control e.g. thorough U.N.B.S
71
₤ Administrative controls e.g. licensing, physical checks, etc.
₤ Import quotas.
₤ Liberalization of the economy.
₤ Devaluation of local currency.
₤ Allowing the local currency to depreciate in value.

PROTECTIONISM
Is the economic policy of restricting trade between nations, through methods such as tariff on
imported goods, import quotas and a variety of other restrictive government regulations.
DIFFERENT FORMS OF PROTECTIONISM USED IN INTERNATIONAL TRADE
1. Tariff barriers/ import duty. This is the use of taxes on imports to limit their volume of flow
into the country.
2. Total ban/ trade embargo/ trade sanctions. This refers to complete prohibition of
importation of certain goods.
3. Import quotas. These are quantitative restrictions on goods being imported into the country.
4. Quality controls. These help to restrict low quality cheap goods capable of competing with
domestically produced goods. This is achieved by setting high quality requirements imports
must meet before being imported into the country. In Uganda, quality control measures are set
by Uganda National Bureau of Standards (U.N.B.S).
5. Use of tight administrative controls like licensing, tight bureaucratic processes hence
discouraging some importers/ participants in international trade.
6. Foreign exchange control. Trade is limited by allocating only a small amount of foreign
exchange to importers so that they do not buy imports which are not essential.
7. Subsidization of domestic firms. Government may support local producers by giving them
money to help them lower the production costs hence making their goods more competitive
than the imported ones.
8. Encouraging regional integration/ state trading. International trade can be restricted by
forming regional cooperation in which trade to non-member states is restricted and not
restricted between member states.
9. Provision of tax incentives such as tax holidays tax exemptions to local firms to help them
lower the production costs.

72
 NOTE
1. A tariff is a tax/ duty imposed/ levied on either exports or imports.
2. Tariff barriers are restrictions put to control international trade (free trade) by the use of taxes
e.g. import and export duties.
3. Non-tariff barriers are restrictions put to control international trade (free trade) by using other
means other than taxation e.g. total ban/ trade embargo/ trade sanctions, administrative controls
such as licensing, quality control measures, manipulation of exchange rates, provision of
subsidies to local firms, etc.
BENEFITS/ MERITS/ POSITIVE IMPACT OF PROTECTIONISM
1. Protects infant/ domestic industries from foreign competition thus enabling them to grow.
2. Discourages dumping of foreign goods by imposing heavy duties on dumped goods hence
making them expensive.
3. Improves the country’s balance of payments position by reducing the country’s foreign
exchange expenditure on imports.
4. Reduces external resource dependence/ promotes self-sufficiency. This is achieved through
protecting domestic industries.
5. Raises revenue for the government through taxation by imposing tariffs on substitute imports.
6. Protects domestic employment through protecting home industries.
7. Discourages importation of demerit goods especially drugs, spirits, pornographic materials by
either use of heavy tariffs on such products or even imposing a total ban on them.
8. Controls imported inflation through discouraging imports. This encourages investment in the
country.
9. Encourages utilization of local resources by encouraging domestic production instead of
relying on imported goods.
10. Improves the country’s terms of trade through restriction of highly priced imports.
11. Encourages investment in the economy leading to increased output hence economic growth.
12. Minimizes political control by foreigners which enables the country to achieve its political
objectives.
NOTE
For reasons, apply “To” e.g.

73
 To protect infant/ domestic industries…
DEMERITS/ DANGERS/ ARGUMENTS AGAINST PROTECTIONISM
1. It subjects nationals to consumption of highly domestic priced goods.
2. It subjects the nationals to consumption of poor quality domestic goods due to absence of
competition.
3. Limits the variety of goods in the domestic market hence limited consumer choices.
4. Protectionism is an expensive exercise since it calls for subsidization of local firms by the
government.
5. It encourages monopoly tendency with it associated negative consequences because local
producers are protected from competition from imported goods.
6. Encourages trade malpractices such as smuggling which leads to loss of government revenue.
7. Results into loss of government revenue from import duties especially where the country uses
quotas and total ban which restrict importation of goods that would have been taxed.
8. Encourages retaliation from other trading partners which limits the benefits of international
trade.
9. Protected industries have a tendency of remaining infant because they are always subsidized
and protected by the government.
10. It encourages inefficiency in the protected firms due to absence of competition from imported
goods.
FREE TRADE
Free trade is the economic policy of carrying out trade between countries without any trade
barriers such as tariffs, quotas, total ban or any other variety of other restrictive government
regulations.
MERITS OF FREE TRADE
1. Leads to improvement in quality of goods produced since it forces countries to carry out
research and compete favourably.
2. Enables a country to enjoy low priced goods since tariffs like import duties are eliminated.
3. Helps to mobilize and raise inflow of foreign resources e.g. technological capital, foreign skills
etc due to a widened market and improved investments.
4. Avails a wide variety of goods thereby widening the consumers’ choices.

74
5. Leads to creation of more employment opportunities since more resources are exploited and
the market base expands.
6. Increases foreign exchange earnings as countries freely export without restrictions hence
helping to close the foreign exchange gap.
7. It encourages specialization between countries as trading partners are able to specialize in
commodities where they incur the least opportunity cost.
8. Discourages trade malpractices such as smuggling.
9. Raises the level of economic growth since more resources are exploited due to a widened
market.
10. Prevents rise of monopoly since goods can be imported ort exported without any restrictions.
11. Promotes international cooperation as goods and other resources can freely move to different
countries without restrictions.
12. Encourages faster expansion of infant firms due to competition from foreign substitute
commodities.

DEMERITS OF FREE TRADE

1. Local industries are outcompeted. This arises due to importation of low priced goods that have
no restrictions exposing a lot competition to locally produced goods.
2. Results into unemployment due to domestic industries being out competed by foreign goods
and technology transfers and development.
3. It encourages dumping leading to suffocation of domestic industries.
4. It results into increased external economic dependence since the economy cannot be self-
sustaining hence being forced to adopt foreign decisions from other countries and having to
rely on foreign resources for survival.
5. May result into imported inflation especially when the country is over relying on imports
leading to low standards of living.
6. Results into low tax revenue from imports since tariffs on imported goods are eliminated.
7. Worsens the country’s balance of payments position due to excessive expenditure on imported
goods.
8. Results into low levels of exploitation of local resources. This is due to over importation
thereby resulting into low levels of economic growth.

75
9. Leads to importation of undesirable goods with their negative effects on nationals since
restrictions such as quality control no longer exist.
10. May worsen the country’s terms of trade since imported goods in most cases are highly priced
yet export commodities have low prices due to their low quality.
ASSIGNMENT
1. Why may protectionism by avoided in an economy?
Solution
A student needs to be well versed with costs of protectionism or benefits of free trade.
₤ To save nationals from highly priced domestic goods.
₤ To save nationals from consuming poor quality domestic goods due to absence of competition.
₤ To provide a variety of goods from both foreign and domestic markets.
₤ To reduce costs of administration incurred by the government in supporting local firms and
enforcing protectionist policies.
₤ To control domestic monopoly arising due to protectionism.
₤ Fear of trade malpractices such as smuggling which leads to loss of government revenue.
₤ Fear of losing revenue from taxes obtained from international trade.
₤ To promote competition between domestic firms and foreign producers hence promoting
growth, innovations and inventions.
₤ Fear of retaliation effects/ beggar my neighbour policies which limit the benefits from
international trade.
₤ To increase efficiency in domestic firms due to competition from imported goods.

2. “Protectionism rather than free trade should be adopted if countries are to benefit from
international trade.” Discuss.
GUIDING QUESTIONS
1. a) What is meant by the term “protectionism”? (01 mark)
b) Give any three reasons why there is need for protectionism in your country.
(03 marks)
2. a) Distinguish between trade liberalization and free trade/
Distinguish between protectionism and commercial policy (02 marks)
b) Mention any two forms of protectionism used in international trade. (02 marks)

76
3. a) Explain the methods used for restricting imports in your country. (06 marks)
b) Examine the effects of imports restrictions in your country. (14 marks)

DUMPING
This refers to the selling of commodities I external/ foreign markets at lower prices than those
charged at home (local market).
REASONS FOR DUMPING
₤ To expand market for the producers.
₤ To earn foreign exchange.
₤ To dispose of surplus output at home
₤ To outcompete domestic producers thereby enjoying monopoly power.
EFFECTS OF DUMPING IN THE RECIPIENT COUNTRY
₤ Local producers are outcompeted/ closure of industries.
₤ Cheap goods are availed to consumers.
₤ There is provision of a variety of goods to consumers hence increased consumer choices.
₤ Inferior goods may be sold to consumers.
₤ Increased revenue to the government through taxation.
₤ It perpetuates the problem of external economic dependence.
₤ It leads to unemployment.
₤ Leads to underutilization of local resources.
₤ Discourages local initiatives/ investment.
₤ Distorts the balance of payments position of the country/ increased import expenditure.

DEVALUATION

This refers to the legal/ official reduction in the value of a country’s currency in relation to other
currencies.

OBJECTIVES OF DEVALUATION

₤ To improve B.O.P position of the country.

₤ To increase the volume of exports.

77
₤ To discourage dumping
₤ To encourage local production/ to protect domestic industries.
₤ To meet/ fulfill IMF conditionality.
₤ To retaliate to other countries those have devalued.
₤ To reduce importation by making imports expensive.
QUESTION
Given that the exchange rate is 1 £ = 1000 [Link]. Calculate the new exchange rate after
devaluation of the shilling by 20%
Solution
Given that;
Old exchange rate; 1 £ = 1000 [Link]
Devaluation = 20%
120
New exchange rate; 1 £ = ( × 1000) Ug. shs
100
1 £ = 1200 Ug. shs

HOW DEVALUATION HELPS TO IMPROVE B.O.P POSITION

After devaluation, exports become cheaper. The country exports more and therefore earns more
foreign exchange.
After devaluation, the country’s currency becomes of less value compared to other countries’
currencies.
After devaluation, imports become more expensive. The country imports less and therefore
reduces foreign exchange expenditure.
CONDITIONS NECESSARY FOR DEVALUATION TO BE SUCCESSFUL
1. The price elasticity of demand for exports must be elastic. In such a case, a small decrease
in price resulting from devaluation leads to a very big rise in quantity demanded of exports
therefore more foreign exchange being earned.

78
2. The price elasticity of demand for imports must be elastic. In such a case, a small
increment in the price of imports due to devaluation leads to a very big decrease in the volume
of goods imported.
3. The supply of exports must be price elastic i.e. there should not be supply rigidities in the
production of exports.
4. The supply of imports must be price elastic so that an increase in the price imports leads to
a drastic reduction in the supply of imports.
5. Other competing countries producing similar goods must not devalue their currencies
at the same time. If they do, no benefits are enjoyed i.e. there should not be retaliation by
other countries.
6. There should be no inflationary tendencies in the country carrying out devaluation. This
is because even after devaluation, exports will remain expensive therefore being unattractive
in the foreign markets.
7. A country devaluating its currency should not be at full employment so that when the
demand for exports increases, the country can increase production to meet the market
requirements.
8. The country intending to devalue her currency must be the major producer or exporter
of commodity/ commodities within the region.
9. There should be no trade restrictions in the importing countries (countries buying exports
from the devaluing country) otherwise when there are restrictions such as tariffs, total ban,
quotas, etc the intended objectives of devaluation cannot be achieved.

REASONS WHY DEVALUATION MAY FAIL TO ACHIEVE ITS OBJECTIVES

1. The demand for exports in LDCs is price inelastic. This is majorly due to the fact that LDCs
produce majorly agricultural commodities whose demand is inelastic.
2. Demand for imports in exchange is price inelastic meaning that even when the price for
imports increases, quantity demanded remains more or less the same therefore less foreign
exchange is saved.
3. The supply of exports in exchange is also price inelastic i.e. even when the demand for
exports in foreign markets increases, LDCs cannot easily increase supply because they have a
lot of supply rigidities/ difficulties.

79
4. Other countries are also devaluing their currencies i.e. retaliation effect. Therefore the
exports from the devaluing country appear more expensive therefore having less demand in
the foreign markets.
5. The supply of imports in LDCs is price inelastic. This means that supply is not highly
affected even when prices increase after devaluation.
6. There are a lot of trade restrictions in MDCs where LDCs export their commodities. Such
restrictions include quality controls, quotas and tariffs among others. This limits the demand
for LDCs’ exports thereby having less foreign exchange earned.
7. LDCs are experiencing high rates of inflation and therefore prices of exports continue to
rise before and after devaluation therefore not being attractive in the foreign markets leading
to low foreign exchange earned.
8. The devaluing countries in LDCs are not the major producers or exporters in the region
therefore cannot maximize the benefits of devaluation.
9. There is a high marginal propensity to import in LDCs due to existence of limited economic
activities and high demonstration effects therefore the demand for imports still remains high
which increases the country’s expenditure on imports and therefore devaluation fails to
improve the country’s B.O.P position.
10. There are a lot of trade malpractices in LDCs especially smuggling therefore commodities
continue to be imported in the country using illegal means which increases foreign exchange
expenditure on imports.
11. Exportation of mainly low quality products by LDCs. This implies that those products
cannot compete favourably on the world market and have low price therefore foreign exchange
earning obtained from them even when devaluation takes place is low.

ECONOMIC INTEGRATION
Refers to the coming together of two or more countries in a given region for the sake of mutual
(economic) benefit of all member states
OR
Refers to the merging to various degrees the economies and economic policies of two or more
countries in a given region for the mutual benefit of member states
OBJECTIVES OF ECONOMIC INTEGRATION
1. To expands markets for products of member states.

80
2. To increase the volume and benefits of trade by removing trade restrictions.
3. To control unnecessary competition and duplication of services in the region.
4. To increase specialization among member countries hence increased benefits of trade.
5. To increase job opportunities in the region.
6. To enable member states undertake joint development projects which may require huge capital
e.g. railway networks.
7. To strengthen political and economic relationships between member states.
8. To increase the level of resource utilization/ exploitation i.e. vent for surplus theory of
international trade.
9. To increase the bargaining power of member states producing similar goods on the world
market.
10. To foster balanced development of the region among member states.
11. To strengthen and regulate industrial and commercial relationships.
12. To fight neo-colonialism of MDCs by reducing dependence of LDCs on developed countries.
13. To improve T.O.T of member states through trade creation.
14. To encourage industrial development in the region through widened markets and exports.
15. To increase access to foreign resources especially through the World Bank and IMF that can
easily be given to integrating countries than individual countries.
STAGES OF INTEGRATION
Economic integration has different stages and they include;
1. Preference trade area (PTA)
2. Free trade area (FTA)
3. Customs union
4. Common market
5. Economic union
1. PREFERENTIAL TRADE AREA (PTA)
This is where countries reduce tariffs between or among themselves on selected commodities.
2. FREE TRADE AREA (FTA)
This is where countries eliminate all tariffs between or among themselves but continue to
charge different tariffs on goods that are imported from non-member countries.

81
3. CUSTOMS UNION
This is where countries eliminate all tariffs between or among themselves and in addition,
they adopt a common tariff structure on commodities from non-member countries.
Features of a customs union
₤ Free movement of goods and services among member states/ absence of internal tariffs.
₤ Common external tariff structure.
4. COMMON MARKET
This is where countries eliminate tariffs between or among themselves, adopt common
external tariff structure and in addition, there is free movement of factors of production
amongst themselves/ within the region.
Features of a common market
₤ Free movement of goods and services among member states/ absence of internal tariffs.
₤ Common external tariff structure.
₤ Free mobility of factors of production among member states.
₤ Free movement of goods and services among member states/ absence of internal tariffs.
₤ Common external tariff structure.
5. ECONOMIC UNION/ COMMUNITY/ FEDERATION
This is where countries eliminate tariffs between or among themselves, adopt common
external tariff structure, allow free mobility of factors of production amongst themselves and
in addition , countries institute joint ownership of certain enterprises like railways, banks,
roads, dams, etc, all economic policies of countries are harmonized and there is establishment
of a common currency.
Features of an economic union
₤ Free movement of goods and services among member states/ absence of internal tariffs/
free trade within the union
₤ Common external tariff structure.
₤ Free mobility of factors of production among member states.
₤ Joint ownership of certain enterprises like railway, roads, banks, dams, etc.
₤ Harmonious economic, fiscal and political policies.
₤ Use of a common currency.

82
 ₤ Strong regional institutions.
CONDITIONS NECESSARY FOR THE SUCCESS OF ECONOMIC
INTEGRATION
1. Close proximity/ geographical proximity/ nearness to each other. The countries should be
in the same region or share common borders.
2. Political stability among the member states. The member states should be politically stable
so as to implement what they have discussed and agreed upon.
3. Similar political and ideological policies. Intending member countries should have same
political and economic ideologies.
4. Uniform of common currency to facilitate trade. Intending countries should be ready to use
the same currency e.g. Euro under European Union.
5. Relatively common language/ traditions and cultures. Intending countries should establish
a common language to ease communication and facilitate trade.
6. Relatively at the same level of development. The countries intending to integrate must be at
relatively the same level of development to ensure equal distribution of economic benefits.
7. Ability to specialize in different commodities or services/ differences in comparative cost
advantage.
8. All the countries intending to integrate must be free from external intervention or
policies.
9. The countries should preferably be of equal size (market size) so as to contribute equally
to the economic development of each member country.
10. There should be well developed infrastructure in all countries intending to integrate.
11. Political will or massive support. There should be political support and commitment among
people in the countries intending to integrate.
MERITS/ BENEFITS OF ECONOMIC INTEGRATION
1. Leads to production of high quality products due to increased competition among producers
of different countries.
2. Reduces costs of production. Economic integration allows member countries to conduct
research and collect information jointly at lower costs.
3. It increases gains from international trade and reduces costs of duplication e.g. one
industry in one country to serve the whole group

83
4. Controls imported inflation (trade creation effect). Trade shifts from high cost non-member
states to low cost member states.
5. Creates political cooperation and understanding among member states.
6. Leads to increased employment opportunities due to free mobility of factors of production
and a bigger market that leads to expansion of production and investment in general.
7. Widens consumers’ choice due to production of a variety of goods.
8. It leads to transfer of knowledge and skills among member states.
9. It improves bargaining power of member states for their exports on the world market.
10. Promotes vent for surplus theory. The resources formerly idle are utilized because of the
widened market.
11. Increases specialization and its advantages.
12. Stimulates establishment and expansion of manufacturing industries.
13. Provides easy access to foreign resources e.g. financial bodies such as World Bank and IMF
can easily lend to integrated countries other than individual countries.
14. Leads to increased economic growth due to increased production of goods as the market size
expands.
15. May lead to use of one currency hence facilitation of trade.
16. Enables firms among member countries to enjoy economies of scale due to a wider market
and production on a large scale.
17. Promotes use of same services. Economic integration leads to joint provision of infrastructure
such as railway networks, roads hence reducing costs of operation.
18. Etc.
DISADVANTAGES OF ECONOMIC INTEGRATION
1. Leads to trade diversion i.e. countries under economic integration shift trade from low cost
non-member countries to high cost member countries forcing citizens to buy expensive goods
from within the region yet they would be in position to buy similar goods cheaply from non-
member countries.
2. It leads to sacrifice of national interests/ independence especially under economic union
where countries have to use the same currency and are under one leader.
3. Leads to loss of government revenue especially from imports from member countries since
tariffs are abolished on certain commodities traded within the region.

84
4. Leads to uneven distribution of industries because free movement of goods and services
may be in one direction especially from the poor to relatively richer countries but within the
same union hence poor countries do not maximize the benefits of integration.
5. It compels member countries to consume poor quality goods produced by member states
as cooperation restricts them from trading with non-member countries.
6. It promotes misunderstandings among countries especially when industries are not fairly
distributed.
7. All countries in the region may be producing similar goods leading to surplus production
in the region hence resource wastage.
8. It involves high costs of staffing e.g. employing regional coordinators, ministers from
regional cooperation making it expensive to manage.
9. Worsens international inequalities especially for strong regional groupings which have a
strong bargaining power compared to the weaker government.
10. It leads to loss of political and economic independence especially in the last two stages of
economic integration where member states harmonious economic, fiscal and political policies.
11. It leads to sacrifice of economies of scale in distributing of industries. This is because
countries have to specialize in certain products while giving up other products to other
countries.
12. It leads to sabotage and foreign interference especially from developed countries which
want to exercise their supremacy on LDCs by dictating prices for their exports hence struggle
to weaken regional cooperation among LDCs.
FACTORS LIMITING ECONOMIC INTEGRATION IN DEVELOPING
COUNTRIES
1. They tend to produce similar goods. This limits the market and lowers the volume of trade
making the comparative advantage benefit limited.
2. Fear of not gaining from integration. This is due to absence of a mechanism to facilitate
equitable sharing of gains of cooperation.
3. Fear of loss of customs revenue. This limits member states to reach certain stages of economic
integration because they still want to obtain revenue through taxing imported goods.

85
4. Existence of political instabilities in some countries. Wars in some countries discourage
economic activities and trade in general and sometimes those instabilities are sponsored by
member states of economic integration hence hindering the success of cooperation.
5. Difference in the level of development. This leads to unequal distribution of benefits hence
limiting economic integration.
6. Differences in the social factors e.g. culture, religion, language, etc. This makes it difficult
to harmonize policies in their region.
7. Conflicts among leaders. Some heads of states are unable to sit on the same negotiating table
with others mainly due to political conflicts and greed for resources of the country.
8. Differences in currencies. This discourages smooth running of trade among member states
hence discouraging economic integration.
9. Differences in political ideologies. This makes it difficult to harmonize policies in their
region.
10. External interference/ sabotage. MDCs tend to influence certain members to withdraw from
economic integration hence weakening regional economic integration.
11. Poor infrastructure among countries. E.g. poor roads and railway networks. This limits
movement of goods and factors of production among member states.
12. Differences in economic policies. Some countries believe in capitalism while others believe
in socialism and others are mixed hence failure to adopt similar economic policies.
13. Lack of political support/ will. This is mainly due to ignorance of the people about the
benefits of economic integration.
14. Limited geographical proximity between countries i.e. some intending countries do not
share the same borders. This limits effective preferential treatment and construction of the
necessary joint infrastructure to link all member states.
15. Differences in the size of the market / population. This limits equal contribution to the
economic development of each member country.
16. Difference in infrastructural development.
NOTE
Trade creation
Is where economic integration results into a shift of trade from high cost non-member countries
to low cost member countries.

86
 Trade diversion
Is where economic integration results into a shift of trade from low cost non-member countries to
high cost member countries.
Disadvantages of trade diversion
♫ Consumption of poor quality goods
♫ People are forced to buy high priced goods
♫ Reduced government revenue.
♫ Limited variety of products.

GUIDING QUESTIONS
1. a) Define the term economic integration (01 mark)
b. Give any three merits of economic integration. (03 marks)
2. a) Distinguish between a customs union and a common market. (02 marks)
b. State any two advantages of common market. (02 marks)
3. a) What are the features of an economic union? (06 marks)
b. Explain the factors that limit economic integration among developing countries.
(14marks)
4. a) Explain the various forms of economic integration. (10 marks)
b. Explain the conditions necessary for the success of economic integration. (10 marks)

OTHER CONCEPTS USED IN INTERNATIONAL TRADE

FOREIGN EXCHANGE

Foreign exchange refers to currencies of other countries that a given country keeps.
FACTORS WHICH DETERMINE THE DEMAND AND SUPPLY OF FOREIGN
CURRENCY
1. Price of imports. The higher the prices of imports, the higher the demand for foreign currency
and the lower the price of imports, the lower the demand for foreign currency.
2. Volume of imports. High volumes of imports lead to high demand for foreign exchange to
purchase to those imports and low volumes of imports lead to less demand for foreign currency.

87
3. Debt servicing requirements. When there is high demand for debt servicing requirements,
the demand for foreign currency is high and when there is less debt servicing requirements, the
demand for foreign currency is low.
4. Government’s external obligation. When government has many external obligations, the
demand for foreign currency is high to accomplish these external obligations and the demand
is low with less external government obligations.
5. Central bank intervention in foreign currency markets. When the central bank intervenes
through use of restrictive measures, the supply of foreign currency is low and when the central
bank relaxes the policies, the supply of foreign currency is high.
6. Price of exports. The higher the price of exports, the higher the supply of foreign currency
since the producers are going to supply more and the lower the prices of exports, the lower
supply of foreign currency because lower prices of exports discourage supplies since they get
less foreign exchange.
7. Volume of exports. The higher the volume, the higher the supply of foreign currency and the
lower the volume of exports, the lower the supply of foreign currency.
8. Need to accumulate reserves. The higher the need to accumulate foreign reserves, the lower
the supply of foreign currency and the lower the need to accumulate foreign reserves, the higher
the supply of foreign currency.
9. Level of capital inflow. The higher the capital inflow, the higher the supply of foreign
currency and the lower the capital inflow, the lower the supply of foreign currency.
10. Level of inflow of grants/ donations. The higher the inflow of grants/ donations, the higher
the supply of foreign currency and the lower the inflow of grants, the lower the supply of
foreign currency.

FOREIGN RESERVES
Foreign reserves refers to the total value of all gold, foreign currencies and special drawing
rights held by a country as both reserves and a fund from which international payments can be
made.
Importance/ uses of foreign reserves
 used for covering trade deficits
 used for covering balance of payments deficit

88
  An indicator of performance of an economy in international trade.
 Provides reserves for future payments for example meeting debt obligations.\determine the
value of domestic currency.

How foreign reserves are acquired

 From a balance of payments surplus

 Capital inflow especially from foreign investors.
 Borrowing externally from the World Bank and IMF.
 Remittances of nationals living and working abroad.
 Disinvestment that is the sale of government assets abroad.

FOREIGN EXCHANGE EARNINGS

Foreign exchange earnings refer to a country’s income from other countries (mainly through
exportation).
Net foreign exchange earnings refer to the total sum of all foreign currency receipts less
expenditure in a given fiscal year
FOREIGN EXCHANGE MARKET

Foreign exchange market is a market where foreign exchange/ foreign currencies are traded at
a price that is expressed by the exchange rate.
EXCHANGE RATE
Exchange rate refers to the rate at which a country’s currency is exchanged with other
currencies in the foreign exchange market.
OR
This is the price of the domestic currency in terms of the foreign currency
Factors that determine the exchange rate in money market
(Factors that influence the strength of a country’s currency relative to other currencies
1. Volume of domestic output. The higher the volume of domestic output, the stronger the
currency and the lower the volume of domestic output, the weaker the currency.
2. Volume of exports. The higher the volume of exports, the stronger the currency and the lower
the volume of exports, the weaker the currency.

89
3. Rate of domestic money supply. The higher the rate, the weaker the currency and the lower
the rate, the stronger the currency.
4. The level of foreign exchange reserves. The higher the volume of foreign exchange reserves,
the stronger the currency and the lower the volume, the, weaker the currency.
5. The level of capital inflow and outflow. High capital outflow leads to appreciation of
domestic currency while high capital outflows lead to depreciation of the domestic currency.
6. The rate of inflation in a country. High inflation rates discourage investments and exports
weakening the local currency while low inflation rates encourage investments and exportation
making the currency strong.
7. Political climate. A favourable political climate encourages investments, stimulates
production and inflow of foreign exchange making the currency stronger while unfavourable
political climate discourages investors and production in general hence weakening the
currency.
8. Volume of imports. The higher the volume of imports, the weaker the currency and the lower
the volume of imports, the stronger the currency.

FOREIGN EXCHANGE RATE CONTROL

This is the state regulation of the rate at which the local currency can be exchanged for foreign
currencies.
OBJECTIVES OF FOREIGN EXCHANGE CONTROL
1. To raise revenue for the government.
2. To retaliate against another country
3. To protect domestic industries.
4. To ensure price stability/ control inflation.
5. To improve terms of trade.
6. To improve B.O.P position.
7. To control capital flight.
8. To create employment.
9. To discourage importation and consumption of harmful products.
10. To ensure stability of exchange rate.
11. To encourage investment.

90
12. To encourage long-term planning.
13. To ensure availability of foreign exchange to facilitate trade.
14. To acquire foreign exchange for servicing the country’s external debt.

TYPES OF FOREIGN EXCHANGE RATE SYSTEMS

There are different types of foreign exchange rate systems i.e.
1. Flexible/ floating/ free exchange rate system.
2. Fixed exchange rate system
3. Dual exchange rate system
4. Managed exchange rate system
5. Pegged exchange rate system
FLOATING EXCHANGE RATE SYSTEM
This is an exchange rate system where the rate at which the local currency is exchanged with other
currencies is determined by inter-play of market forces of demand and supply of foreign currency.
Advantages
₤ It preserves the autonomy/ independence of the domestic monetary authority.
₤ It saves the country the burden of holding large official foreign exchange reserves.
₤ It is cheap to administer.
₤ It gives the most realist value of the local currency in terms of other currencies.
₤ Provides automatic mechanism for correcting B.O.P disequilibrium.
₤ It encourages investment.
₤ It leads to generation of adequate foreign exchange through exports, loans and grants.
₤ Discourages emergence of illegal or parallel foreign exchange market.
Disadvantages
₤ It encourages speculation in the foreign exchange market.
₤ It makes planning very difficult especially for export and import sectors
₤ May lead to imported inflation.
₤ It subjects a lot of uncertainties to the investors since it keeps on fluctuating hence discouraging
capital inflow.
₤ It encourages the operation of parallel foreign exchange markets e.g. smuggling.

91
 FIXED EXCHANGE RATE SYSTEM
This is an exchange rate system where the rate at which the local currency is exchanged with other
currencies is fixed/ determined by the monetary authority.
Advantages
₤ It induces production and promotes economic growth.
₤ It encourages long term capital inflows
₤ It stabilizes prices in the economy i.e. it checks on inflationary tendencies.
₤ It encourages long term planning or contract trade.
₤ It helps to stabilize the value of the domestic and foreign currencies.
₤ It reduces speculation in the foreign exchange market due to limited depreciation and
appreciation of currencies.
₤ It encourages exporters and importers to engage in international trade without concern about
exchange rate movements of the currency to which their local currency is linked.
₤ It minimizes capital outflows.
Disadvantages
₤ It does not provide an automatic mechanism for correcting imbalances in trade and B.O.P
position.
₤ It discourages foreign investors.
₤ It makes the country unable to pursue an independent monetary policy free from external
influence.
₤ It requires the country to hold large official reserves of foreign exchange for the policy to
succeed.
₤ It limits the amount of foreign exchange generated by the government through transactions.
₤ Requires exchange control administration which is costly (it is expensive to enforce)

PEGGED EXCHANGE RATE

Is one which is fixed/ determined by the monetary authority in relation to a particular foreign
currency e.g. Ugandan shilling being pegged or fixed to US dollar like 1$ = 1000 Ug. Shs. Such
that the values of other currencies are determined according to the shilling dollar relationship

NOTE

92
For merits and demerits of pegged exchange rate, refer to those for fixed exchange rate.

MANAGED EXCHANGE RATE SYSTEM

(Mixed/managed float/ dirty float/ adjustable peg)
This is an exchange rate system where the inter-play of market forces of demand and supply of
foreign currency determine the rate at which the local currency is exchanged with other currencies
but within certain limits set by the monetary authority.

Advantages
₤ It controls fluctuations of exchange rates and avoids undervaluation or overvaluation of the
local currency.
₤ It safeguards imports and exports from rapid and constant fluctuations which cause losses.
₤ It ensures that there is a favourable exchange rate in the foreign exchange market.
₤ It controls the actions of speculators.
₤ The monetary authority maintains some control over the exchange rate.
₤ It regulates the flow of funds in and out of a country.
₤ It promotes international trade due to easy access to foreign exchange.
₤ It provides an automatic mechanism of correcting trade imbalance.
Disadvantages
₤ It reduces the volume and value of international trade.
₤ It is expensive for the government to administer.
₤ It worsens the debt burden of a country.
₤ It requires maintenance of large foreign reserves.
₤ It makes long term planning difficult due to uncertainty and instability in foreign exchange
earnings.
₤ It encourages speculation in the foreign exchange market.
₤ It leads to depreciation of the local currency.
₤ It causes imported inflation.
₤ It leads to Balance of Payments problems.

93
 DUAL EXCHANGE RATE SYSTEM
This is a situation where there are two official exchange rates in the country one being favourable
to cater for essential or priority sectors and the other for non essential areas and each of the
exchange rates is determined by the monetary authority.
OR
This is where there is co-existence of two parallel exchange rates within the country.

NOTE
1. In absence of “system” under exchange rate, avoid using “where, is a process, is a situation
when” because all those define a system and not a rate.

CURRENCY UNDERVALUATION
This is the fixing of the value of the country’s exchange rate by the monetary authority below
the equilibrium exchange rate above which it is illegal to trade/ exchange foreign currency.
An undervalued exchange rate is one fixed by the monetary authority below the equilibrium
exchange rate above which it is illegal to trade foreign currency.
Effects of currency undervaluation
 Increases exportation
 Reduces imports
 Encourages domestic production.
 Reduces imported inflation.
 Improves B.O.P position.
 Worsens external debt burden
CURRENCY OVERVALUATION
This is the fixing of the value of the country’s exchange rate by the monetary authority above
the equilibrium exchange rate below which it is illegal to trade foreign currency.
An overvalued exchange rate is one fixed by the monetary authority above the equilibrium
exchange rate below which it is illegal to trade foreign currency.
Effects of currency overvaluation
 Reduces exportation
94
 Increases importation
 Discourages domestic production due to reduced demand.
 Worsens Balance of Payment position.
 Reduces the external debt burden
 Leads to imported inflation.
 Promotes trade malpractices for example black market.

CURRENCY REVALUATION
This is the legal/ official increase in the value of the country’s currency in relation to other
currencies.
CURRENCY APPRECIATION
This is the increase in the value of a country’s currency in terms of other currencies due to
inter-play of market forces of demand and supply of foreign currency.
Effects of currency appreciation
 Encourages investment
 Reduces revenue from import duties
 Leads to low pay for export producers
 Exports become less competitive
 Worsens competition against local producers.
 Worsens balance of payments position
 Disorganises exporters because they are paid less in local currency.

CURRENCY DEPRECIATION
This is the fall in the value of the country’s currency in terms of other currencies due to the
inter-play of market forces of demand and supply of foreign currency.
OR
It is the reduction/ loss in value of domestic currency against foreign currencies under free
exchange rate system.
Causes of currency depreciation
₤ Low earnings from exports on the world market.

95
₤ Increased importation of goods and services.
₤ Rising inflation in the domestic market.
₤ Heavy debt servicing
₤ Increase in fuel prices on the world market
₤ Decline in the service sector
₤ Increase in demand for foreign currencies.
₤ Deteriorating terms of trade.

Effects of currency depreciation

Positive

₤ It encourages foreign investment/ increases foreign capital inflow

₤ Imports become very expensive
₤ Makes exporters receive higher local currency value
₤ Increases the volume of exports

Negative

₤ Leads to rise in the price of domestic products/ leads to inflation

₤ Discourages investment
₤ Projected planning is made difficult.
₤ It encourages speculation.
₤ Worsens the external debt burden
₤ Leads to loss of confidence in the country’s currency

96