MONETARY THEORY AND POLICY BAF 4107

FINANCIAL SYSTEMS

I) A 'financial system' is a system that allows the exchange of funds between lenders, investors,
and borrowers. Financial systems operate at national and global levels. Financial systems are
made of intricate and complex models that portray financial services, institutions and markets
that link depositors with investors.

What is a Financial System?

ii) A financial system is a collection of institutions which allow the exchange of funds, such as
banks, insurance companies, and stock exchanges. The financial system exists in the corporate,
national, and global level.

Borrowers, lenders, and creditors are exchanging current funds to finance ventures, either for
consumption or productive investment and seeking returns on their financial assets. Furthermore,
the financial system includes sets of laws and policies used by creditors and lenders to determine
which projects are funded, who fund the projects, and scope of financial deal.

Understanding the Financial System

Financial markets include arranging loans and other deals with creditors, lenders, and investors.
The economic good traded on both sides in these markets is usually some form of money: current
money (cash), claims on future money (credit), or claims on the potential for future income or
real asset value (equity). These include derivative instruments as well.

The Five Parts of the Financial System

They includes the following

1) Money

2) Financial instruments

3) Financial markets

4) Financial institutions

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5) Central bank.ie regulator

6) financial intermediaries

1. Money.

Define money

i) Money is any item or verifiable record that is generally accepted as payment for goods and
services and repayment of debts, such as taxes, in a particular country or socio-economic
context.

ii) Money is anything generally accepted as a medium of exchange. A medium of exchange is virtually
anything used to pay for goods and services or settle debts. Thus, the distinguishing future of money is
that society widely accepts it to settle transactions. Throughout the history of humankind, numerous
things have served as money, including shells, stones, and beads, sacks of grain, gold, cigarettes, paper
bills and checks. Money is not synonymous with wealth or income.

Functions of money
i) A medium of exchange
ii) measure of value
iii)A unit of account
iv) A store of value
iv) A standard of deferred payment
i)Medium of exchange
When money is used to intermediate the exchange of goods and services, it is performing a function as a
medium of exchange. It thereby avoids the inefficiencies of a barter system, such as the "coincidence of
wants" problem. Money's most important usage is as a method for comparing the values of dissimilar
objects.
ii)Measure of value
A unit of account (in economics) is a standard numerical monetary unit of measurement of the market
value of goods, services, and other transactions. Also known as a "measure" or "standard" of relative
worth and deferred payment, a unit of account is a necessary prerequisite for the formulation of
commercial agreements that involve debt.
Money acts as a standard measure and common denomination of trade. It is thus a basis for quoting and
bargaining of prices. It is necessary for developing efficient accounting systems.
iii) A Unit of Account:

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An attribute of money is that it is used as a unit of account. The implication is that money is used to
measure and record financial transactions as also the value of goods or services produced in a country
over time. The money value of goods and services produced in an economy in an accounting year is
called gross national product. According to J. R. Hicks, gross national product is a collection of goods and
services reduced to a common basis by being measured in terms of money.
iv)Store of value
To act as a store of value, money must be able to be reliably saved, stored, and retrieved – and be
predictably usable as a medium of exchange when it is retrieved. The value of the money must also
remain stable over time. Some have argued that inflation, by reducing the value of money, diminishes the
ability of the money to function as a store of value.
v)Standard of deferred payment
A "standard of deferred payment" is an accepted way to settle a debt – a unit in which debts are
denominated, and the status of money as legal tender, it may function for the discharge of debts. When
debts are denominated in money, the real value of debts may change due to inflation and deflation, and
for sovereign and international debts via debasement and devaluation.
Qualities of a Good Money Material
1. General acceptability: A good money material must be generally acceptable. People should not
hesitate to exchange their goods for the material. Precious metals like gold and silver are always
acceptable.

2. Portability: A satisfactory money material must be of high value for its bulk. Since it has to be
moved about from place to place, it must be possible for us to carry it from one place to another
without difficulty, expense, or inconvenience. Precious metals such as gold and silver are
satisfactory in this regard. Even paper money is ideal in this regard. Iron, for instance, would not
be satisfactory in this respect.

3. Cognizability: The material used as money should be easily recognizable. Gold and silver, for
example, can be easily recognized by their color and heavy weight for small bulk.

4. Durability: The material used as money should not deteriorate. The early forms of money such as
corn, fish, and skin were unsuitable in this regard. Gold coins will last many hundreds of years.

5. Divisibility: The material must be capable of division without difficulty and without loss of value
on account of division. Metals have this advantage.

6. Homogeneity: All coins of the material should be of the same quality. One coin should not be
superior to another.

7. Malleability: A material must be capable of being moulded without much difficulty. Even if a
material is divided into a number of pieces, they must be capable of being reunited without loss.
Gold is excellent for such purposes.

8. Stability of value: This is another important quality of a good money material. Commodities,
which are subject to violent changes in supply and demand, are unfit for money. For, the value of

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 money, like any other thing, is determined by its supply and demand. If there are violent changes
in its supply and demand, its value is not likely to be stable. Since money is used as a store of
value and standard of deferred payments, it cannot perform these two functions well, if there is no
stability of value for money. If money goes on losing its stability of value, it will not be accepted
as money.

2. Financial Instruments. Written legal obligations of one party to transfer something of

value to another party at some future date under certain conditions. These obligations usually
transfer resources from savers to investors. Examples: Stocks, bonds, insurance policies.

Financial instruments are monetary contracts between parties. They can be created, traded,
modified and settled. They can be cash (currency), evidence of an ownership interest in an entity
(share), or a contractual right to receive or deliver cash (bond).

Types financial instrument.

i) Equity: It represents the ownership of a company. Equities are traded in stock markets. In
India, share trading actively happens in stock exchanges.

It is one of the best options to invest in equities over an extended period as it will fetch good
returns. It is also subject to market-related risk and proper research should be done before
trading.

2. Mutual Funds: Mutual Funds is also a good option because initial investment amount is very
less and the risk is diversified. Mutual funds allow a group of individuals to invest their money
together.

3. Bonds: Are fixed income instruments which are issued to raise working capital. Both private
and public companies issues bonds. Government bonds carries lower rate of risk but guarantees
returns. The bonds issued by private institutions have high risks.

4. Deposits/cash: In bank and post-office. Here the risk is low and guarantee returns.

Characteristics of financial instruments

i) Moneyness .The moneyness of the financial assets implies that they are easily convertible to
cash within a defined time and determinable value.

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ii) Divisibility & Denomination. The divisibility of such near money refers to the minimum
monetary value in which a financial asst can be liquidated or exchanged for money by the
holder.eg par value of shares

iii) Return/cash. This refers to the return that an investor will derive from holding a financial
asset, eg the dividends

iv) Maturity period. This is the time a certain asset is used before the cash is paid back eg for
bond

v) Convertibility. This characteristic implies that a financial asset or instrument can be

converted into another class of asset e.g. the time it would take to convert preference shares to
ordinary shares

vi) Liquidity. Liquidity is concerned with how well can an asset be converted to cash,some
financial instruments are not easily convertible so they are illiquid,one must hold them for long
to mature

3. Financial Markets. Markets where financial instruments are traded. Examples: New York
Stock Exchange, Chicago Board of Trade and Nairobi Stock exchange.

FINANCIAL MARKETS

An Introduction to the Financial Markets

Financial markets are where traders buy and sell assets. These include stocks, bonds, derivatives,
foreign exchange and commodities.

Functions of Financial Markets

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i) Mobilization of Savings into more Productive Uses. the uselessly lying finance in the form
of cash to places where it is really needed.eg buy shares

ii) Fixing of the security prices. The financial market is helpful to the investors in giving them
proper price

iii) It Provides Liquidity to Financial Assets. They can also convert their investment into
money whenever they so desire.

iv) Reduces the Cost of Transactions. The financial market makes available every type of
information without spending any money. In this way, the financial market reduces the cost of
transactions

iv) It saves the time, money and efforts of the parties, as they don’t have to waste resources to
find probable buyers or sellers of securities. Further, it reduces cost by providing valuable
information, regarding the securities traded in the financial market.

Types of Financial Markets

i) Capital market. A capital market is one in which individuals and institutions trade long term
financial securities which includes sale of securities - stocks and bonds

Capital market consists of primary markets and secondary markets. Primary markets deal with
trade of new issues of stocks and other securities, whereas secondary market deals with the
exchange of existing or previously-issued securities. Another important division in the capital
market is made on the basis of the nature of security traded, i.e. stock market and bond market.

ii)The money market. The money market is a segment of the financial market in which
financial instruments with high liquidity and very short maturities are traded e.g. commercial
paper e.g. commercial paper (unsecured promissory notes)

iii) Derivative markets a derivative is a contract, but in this case the contract price is determined
by the market price. E.g. forwards, futures, options, swaps

iv) Forex and the Interbank Market interbank trading is performed by banks on behalf of large
customers

v) Stock market

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vi) Commodity markets

I) CAPITAL MARKET

Capital Market is used to mean the market for long term investments that have explicit or
implicit claims to capital. Long term investments refer to those investments whose lock-in period
is greater than one year.

In the capital market, both equity and debt instruments, such as equity shares, preference shares,
debentures, zero-coupon bonds, secured premium notes and the like are bought and sold, as well
as it covers all forms of lending and borrowing.

Capital Market is composed of those institutions and mechanisms with the help of which
medium and long term funds are combined and made available to individuals, businesses and
government. Both private placement sources and organized market like securities exchange are
included in it.
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Functions of Capital Market

i) Mobilization of savings to finance long term investments.

ii) Facilitates trading of securities.

iii) Minimization of transaction and information cost.

iv) Encourage wide range of ownership of productive assets.

v) Quick valuation of financial instruments like shares and debentures.

vi) Facilitates transaction settlement, as per the definite time schedules.

vii) Offering insurance against market or price risk, through derivative trading.

viii) Improvement in the effectiveness of capital allocation, with the help of competitive price
mechanism.

Capital market is a measure of inherent strength of the economy. It is one of the best source of
finance, for the companies, and offers a spectrum of investment avenues to the investors, which
in turn encourages capital creation in the economy.

Types of Capital Market

The capital market is bifurcated in two segments, primary market and secondary market:

i) Primary Market: Otherwise called as New Issues Market, it is the market for the trading of
new securities, for the first time. It embraces both initial public offering and further public
offering. In the primary market, the mobilisation of funds takes place through prospectus, right
issue and private placement of securities.

Economic Advantage of Primary Markets

1. Raising capital for business.

2. Mobilising savings

3. Government can raise capital through sale of Treasury bonds

4. Open market operation to effect monetary policy of the government i.e control of excess
liquidity in the economy
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5. It is a vehicle for direct foreign investment

ii) Secondary Market: Secondary Market can be described as the market for old securities, in
the sense that securities which are previously issued in the primary market are traded here. The
trading takes place between investors, that follows the original issue in the primary market. It
covers both stock exchange and over-the counter market.

Economic Advantage/Role of Secondary Markets in the Economy

1. It gives people a chance to buy shares hence distribution of wealth in economy.

2. Enable investors realize their investments through disposal of securities.

3. Increases diversification of investments

4. Improves corporate governance through separation of ownership and management. This

increases higher standards of accounting, resource management and transparency.

5. Privatisation of parastatals e.g. Kenya Airways. This gives individuals a chance for
ownership in large companies.

6. Parameter for health economy and companies

7. Provides investment opportunities for companies and small investors.

Capital market instruments

The most common capital market instruments in use include:

1. Corporate Stocks

2. Mortgages

3. Corporate bonds

4. Marketable long-term Gov securities

5. State and Local government bonds

6. Bank Commercial loans

7. Consumer Loans

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1. STOCKS

These are equity claims on the net income and assets of a corporation. They confer on the holder,
a number of rights as well as risks. There are two types of Corporate stocks:

a) Common stock &

b) Preferred (or preference) share.

Common Stock

Common stock is a security that represents ownership in a corporation. Holders of common

stock exercise control by electing a board of directors and voting on corporate policy. Common
stockholders are at the bottom of the priority ladder in terms of ownership structure; in the event
of liquidation, common shareholders have rights to a company's assets only after bondholders,
preferred shareholders and other debt holders are paid in full.

Common stockholders have a number of general rights, including the following:

i) Dividend rights. Stockholders have the right to share equally on a per-share basis in any
distribution of corporate earnings in the form of dividends.

ii) Asset rights. In the event of a liquidation, stockholders have the right to assets that remain
after the obligations to the government (taxes), employees, and debt holders have been satisfied.

iii) Preemptive rights. Stockholders may have the right to share proportionately in any new
stock sold. For example, a stockholder who owns 20 percent of a corporation’s stock may be
entitled to purchase 20 percent of any new issue.

iv) Voting rights. Stockholders have the right to vote on stockholder matters, such as the
selection of the board of directors.

What are Preferred Shares?

Preferred shares (also known as preferred stock or preference shares) are securities that represent
ownership in a corporation, and that have a priority claim, over common shares, on the
company’s assets and earnings. The shares are more senior than common stock but are more
junior relative to bonds in terms of claim on assets. Moreover, holders of preferred stock are
prioritized over holders of common stock in dividend payments.
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Features of Preferred Shares

i) Preferred shares have a special combination of features that differentiate them from debt or
common equity. Although the terms may vary, the following features are common for most
preferred shares:

ii) Preference in assets upon liquidation: The shares provide its holders with priority to claim the
company’s assets upon liquidation.

iii) Dividend payments: The shares provide dividend payments to shareholders. The payments
can be fixed or floating based on the interest rate benchmark such as LIBOR.

iv) Preference in dividends: Preferred shareholders have a priority in dividend payments over the
holders of the common stock.

v) Non-voting: Generally, the shares do not assign voting rights to its holders. However, some
preferred shares allow its holders to vote on extraordinary events.

vi)Convertibility to common stock: Preferred share may be converted to a predetermined number

of common shares. Some preferred shares specify the date at which the shares can be converted,
while others require the approval from the board of directors for the conversion.

vii)Callability: The shares can be repurchased by the issuer at specified dates.

Types of Preferred Stock

Preferred stock is a very flexible type of securities. They can be:

i) Convertible preferred stock: The shares can be converted to a predetermined number of

common shares.

ii) Cumulative preferred stock: If an issuer of shares misses a dividend payment, the payment
will be added to the next payment.

iii) Perpetual preferred stock: There is no fixed date on which the shareholders will receive
back the invested capital.

Advantages of Preferred Shares

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i) Preferred shares offer advantages to both issuers and holders of the securities. The issuers may
benefit in the following way:

ii) No dilution of control: This type of financing allows issuers to avoid or defer the dilution of
control as the shares do not provide voting rights or limit these rights.

iii) No obligation for dividends: The shares do not force issuers to pay dividends to shareholders.
For example, if, currently, the company does not have enough funds to pay dividends, it may just
defer the payment.

iv) Flexibility of terms: The company’s management enjoys the flexibility to set up almost any
terms for preferred shares.

v)Preferred shares can also be an attractive alternative for investors. The investors may benefit in
the following way:

II) MONEY MARKET

The money market is where financial instruments with high liquidity and very short maturities
are traded. It is used by participants as a means for borrowing and lending in the short term, with
maturities that usually range from overnight to just under a year. Among the most common
money market instruments are Eurodollar deposits, negotiable certificates of deposit (CDs), banker's
acceptances, U.S. Treasury bills, commercial paper, municipal notes, federal funds
and repurchase agreements (repos).

Money Market Instruments

They are short-term dated securities. Because of their short terms to maturity, they undergo the
least price fluctuations and are therefore the least risky instruments.

Financial Instruments in Money market include:

1. Commercial paper

2. Treasury bills

3. Bills of exchange

4. Promissory notes

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5. Bank overdrafts

6. Bankers certificate of deposit

1. Treasury Bills:

Treasury bills are a security issued government. When you buy one, you are essentially lending
money to the government. Here, the term security means any medium used for investment, such
as bills, stocks or bonds.

Treasury bills have a face value of a certain amount, which is what they are actually worth. But
they are sold for less. For example, a bill may be worth $10,000, but you would buy it for
$9,600. Every bill has a specified maturity date, which is when you receive money back. The
government then pays you the full price of the bill

Characteristics of treasury bills

i) Minimum bid. With a minimum investment requirement of just $100, they are accessible to a
wide range of investors.

ii) Issue price: T-bills are issued at a discount, but redeemed at par.

iii) Repayment: The repayment of the bill is made at par on the maturity of the term.

iv) Availability: Treasury bills are highly liquid negotiable instruments, that are available in both
financial markets, i.e. primary and secondary.

v) Method of the auction: Uniform price auction method for 91 days T-bills, whereas multiple
price auction method for 364 days T-bill.

vi) Day count: The day count is 364 days, in a year, for treasury bills.

Types of Treasury Bills

There are several types of bills that are issued by governments which may include the following

i) 91 days T-bills: The tenor of these bills complete on 91 days. These are auctioned on
Wednesday, and the payment is made on following Friday.

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ii) 182 days T-bills: These treasury bills get matured after 182 days, from the day of issue, and
the auction is on Wednesday of non-reporting week. Moreover, these are repaid on following
Friday, when the term expires.

iii) 364 days T-bills: The maturity period of these bills is 364 days. The auction is on every
Wednesday of reporting week and repaid on the following Friday after the term gets over.

iv) 14 days T-bills: These treasury bills get matured after 182 days. These are only issued to the
State government.

Commercial Paper

Commercial Paper or CP is defined as a short-term, unsecured money market instrument, issued

as a promissory note by big corporations having excellent credit ratings. As the instrument is not
backed by collateral, only large firms with considerable financial strength are authorised to issue
the instrument

Features of Commercial Paper

i) Commercial paper is a short-term money market instrument comprising usince promissory

note with a fixed maturity.

ii) It is a certificate evidencing an unsecured corporate debt of short term maturity.

iii) Commercial paper is issued at a discount to face value basis but it can be issued in interest
bearing form.

iv) The issuer promises to pay the buyer some fixed amount on some future period but pledge no
assets, only his liquidity and established earning power, to guarantee that promise.

v)Commercial paper can be issued directly by a company to investors or through banks/merchant

banks.

Advantages of Commercial Paper

i) Simplicity: The advantage of commercial paper lies in its simplicity. It involves hardly any
documentation between the issuer and investor.

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ii) Flexibility: The issuer can issue commercial paper with the maturities tailored to match the
cash flow of the company.

iii) Easy To Raise Long Term Capital: The companies which are able to raise funds through
commercial paper become better known in the financial world and are thereby placed in a more
favorable position for rising such long them capital as they may, form time to time, as require.
Thus there is in inbuilt incentive for companies to remain financially strong.

iv) High Returns: The commercial paper provides investors with higher returns than they could
get from the banking system.

v) Movement of Funds: Commercial paper facilities securitization of loans resulting in creation

of a secondary market for the paper and efficient movement of funds providing cash surplus to
cash deficit entities.

Disadvantages of commercial paper:

i) Its usage is limited to only blue chip companies.

ii) Issuances of commercial paper bring down the bank credit limits.

iii) A high degree of control is exercised on issue of Commercial Paper.

iv) Stand-by credit may become necessary

Money Market Instruments

Money market instruments are the investment vehicles that allow banks, businesses, and the
government to meet large, but short-term, capital needs at a low cost. The duration is overnight, a
few days, weeks or even months, but always less than a year. Meeting longer-term cash needs is
fulfilled by the financial or capital markets.

Characteristics Money Market Instruments

Money market instruments give businesses, financial institutions and governments a means to
finance their short-term cash requirements. Three important characteristics are:

i) Liquidity - Since they are fixed-income securities with short-term maturities of a year or less,
money market instruments are extremely liquid.

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ii) Safety - They also provide a relatively high degree of safety because their issuers have the
highest credit ratings.

iii) Discount Pricing- A third characteristic they have in common is that they are issued at
adiscount to their face value.

iv) Variety Money market instruments are many in number wchich includes the following

Money market instruments include short-term bank certificates of deposit (CDs), municipal
bonds, Treasury bills and other government securities. Individual investors most commonly
invest in money market deposit accounts and money market mutual funds.

Types of money market instruments

i) Treasury Bills

Treasury bills (T-bills) are short-term notes issued by the U.S. government. They come in three
different lengths to maturity: 90, 180, and 360 days. The two shorter types are auctioned on a
weekly basis, while the annual types are auctioned monthly. T-bills can be purchased directly
through the auctions or indirectly through the secondary market.

ii) Federal Agency Notes

Some agencies of the federal government issue both short-term and long-term obligations. These
obligations are not generally backed by the government, so they offer a slightly higher yield than
T-bills, but the risk of default is still very small. Agency securities are actively traded, but are not
quite as marketable as T-bills. Corporations are major purchasers of this type of money market
instrument.

iii) Short-Term Tax Exempts

These instruments are short-term notes issued by state and municipal governments. Although
they carry somewhat more risk than T-bills and tend to be less negotiable, they feature the added
benefit that the interest is not subject to federal income tax. For this reason, corporations find that
the lower yield is worthwhile on this type of short-term investment.

iv) Certificates of Deposit

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Certificates of Deposit: Banks can raise short-term cash by issuing certificates of deposit for one
to six months. It pays the holder higher interest rates the longer the cash is held.The certificate
constitutes the bank's agreement to repay the loan. The maturity rates on CDs range from 30 days
to six months or longer, and the amount of the face value can vary greatly as well. There is
usually a penalty for early withdrawal of funds, but some types of CDs can be sold to another
investor if the original purchaser needs access to the money before the maturity date.

v) Commercial Paper

Asset-backed commercial paper is a derivative based upon commercial paper. This is the most
popular money market instrument. Commercial paper refers to unsecured short-term promissory
notes issued by financial and nonfinancial corporations. Commercial paper has maturities of up
to 270 days (the maximum allowed without SEC registration requirement).

Unlike some other types of money-market instruments, in which banks act as intermediaries
between buyers and sellers, commercial paper is issued directly by well-established companies,
as well as by financial institutions. Banks may act as agents in the transaction, but they assume
no principal position and are in no way obligated with respect to repayment of the commercial
paper. Companies may also sell commercial paper through dealers who charge a fee and arrange
for the transfer of the funds from the lender to the borrower.

iv) Bankers' Acceptances

A banker's acceptance is an instruments produced by a nonfinancial corporation but in the name

of a bank. It is document indicating that such-and-such bank shall pay the face amount of the
instrument at some future time. The bank accepts this instrument, in effect acting as a guarantor.
To be sure the bank does so because it considers the writer to be credit-worthy. Bankers'
acceptances are generally used to finance foreign trade, although they also arise when companies
purchase goods on credit or need to finance inventory. The maturity of acceptances ranges from
one to six months.

v) Repurchase Agreements

Repurchase Agreements: Banks raise short-term funds by selling securities but promising at the
same time to repurchase them in a short period of time (often the next day), with a little added

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interest. Even though it's a sale, it's booked as a short-term collateralized loan.Repurchase
agreements—also known as repos or buybacks—are Treasury securities that are purchased from
a dealer with the agreement that they will be sold back at a future date for a higher price. These
agreements are the most liquid of all money market investments, ranging from 24 hours to
several months. In fact, they are very similar to bank deposit accounts, and many corporations
arrange for their banks to transfer excess cash to such funds automatically.

III) DERIVATIVES MARKET

What is derivatives market?

Derivatives market is a market where contracts are traded which derive their value from a
different underlying asset.To understand this market you should first have knowledge of actual
stock, commodity or currency market.In a stock market we trade stocks by picking up good
companies and buying and selling their stocks and making profit.

Types of Derivative Instruments:

Derivative contracts are of several types. The most common types are forwards, futures, options
and swap.

i) Forward Contracts

A forward contract is an agreement between two parties – a buyer and a seller to purchase or sell
something at a later date at a price agreed upon today. Forward contracts, sometimes called
forward commitments , are very common in everyone life. Any type of contractual agreement
that calls for the future purchase of a good or service at a price agreed upon today and without
the right of cancellation is a forward contract.

ii) Future Contracts

A futures contract is an agreement between two parties – a buyer and a seller – to buy or sell
something at a future date. The contact trades on a futures exchange and is subject to a daily
settlement procedure. Future contracts evolved out of forward contracts and possess many of the
same characteristics. Unlike forward contracts, futures contracts trade on organized exchanges,
called future markets. Future contacts also differ from forward contacts in that they are subject to

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a daily settlement procedure. In the daily settlement, investors who incur losses pay them every
day to investors who make profits.

iii) Options Contracts

Options are of two types – calls and puts. Calls give the buyer the right but not the obligation to
buy a given quantity of the underlying asset, at a given price on or before a given future date.
Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying
asset at a given price on or before a given date.

iv) Swaps

Swaps are private agreements between two parties to exchange cash flows in the future
according to a prearranged formula. They can be regarded as portfolios of forward contracts. The
two commonly used swaps are interest rate swaps and currency swaps.

a) Interest rate swaps: These involve swapping only the interest related cash flows between the
parties in the same currency.

b) Currency swaps: These entail swapping both principal and interest between the parties, with
the cash flows in one direction being in a different currency than those in the opposite direction.

Advantages of Derivatives:

i) They help in transferring risks from risk adverse people to risk oriented people.

ii) They help in the discovery of future as well as current prices.

iii) They catalyze entrepreneurial activity.

ivThey increase the volume traded in markets because of participation of risk adverse people in
greater numbers.

v) They increase savings and investment in the long run.

IV) FOREX MARKET

What is the Forex Market

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The forex market is the market in which participants can buy, sell, exchange, and speculate on
currencies. The forex market is made up of banks, commercial companies, central banks,
investment management firms, hedge funds, and retail forex brokers and investors. The currency
market is considered to be the largest financial market with over $5 trillion in daily transactions,
which is more than the futures and equity markets combined.

The foreign exchange market is not dominated by a single market exchange, but a global
network of computers and brokers from around the world. Forex brokers act as market makers as
well, and may post bid and ask prices for a currency pair that differs from the most competitive
bid in the market.

The forex market is made up of two levels; the interbank market and the over-the-counter (OTC)
market. The interbank market is where large banks trade currencies for purposes such as
hedging, balance sheet adjustments, and on behalf of clients. The OTC market is where
individuals trade through online platforms and brokers.

Types of forex market

They includes the following

i)The Forex Spot Market

the different types of forex markets spot trading at currency booth Out of all the different types
of Forex markets, the spot market is the largest and is what you will trade as the retail Forex
trader. Currency is bought or sold for instant delivery, or at least in the very near future. The
word ‘spot’ comes from the ‘on the spot’ type trading.

ii) The Futures MarketFutures are traded in contacts. the currency or commodity is scheduled
for delivery on a specified ‘future’ date at a specified price on the contract. The contract future
date is also known as the expiration price.

The Futures market is centralized so all contracts are opened with a central exchange.

Although retail traders and hedge funds do trade the futures markets for profit, it is more utilized
for commercial purposes.

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Example 1: A wheat farmer might sell some wheat future contacts set to expire in 3 months. So
the farmer has a guaranteed buyer for when his crop is ready to be harvested in about 3 months’
time.

The farmer and the buyer have agreed on a set price set by the futures contract.

This is an advantage to the farmer because he doesn’t want fresh crops sitting around while he
tries to find a buyer and run the risk of “stock going bad”.

Example 2: Apple is planning to launch its new iPhone, the next big thing to hit the market.

To manufacture enough in time for the launch, Apple needs to order parts from some Japanese
manufactures, which they have specified 4 months is needed to produce the goods.

iii) The Forward Market

Forward markets are another contract based transaction, one that’s similar to the Futures market
in most aspects.

Forward contracts can even go past their expiration date and are valid until one of the parties
closes the contract.

The uses of the forward market are very similar to Futures contracts, except forward contracts
can be more customized, or tailored to the customer’s requirements.

So the Spot market, Futures and Forwards contract markets make up the majority of the Foreign
Exchange market.

Operating hours

From Monday morning in Asia, to Friday afternoon in New York, the forex market is a 24-hour
market, meaning it does not close overnight. This differs from markets such as equities, bonds,
and commodities, which all close for a period of time, generally in the New York late afternoon.
However, as with most things there are exceptions. Some emerging market currencies closing for
a period of time during the trading day.

The foreign exchange market is unique because of the following characteristics:

21
i) Its huge trading volume, representing the largest asset class in the world leading to high
liquidity;

ii) Its geographical dispersion;

iii) Its continuous operation: 24 hours a day except weekends, i.e., trading from 22:00 GMT on
Sunday (Sydney) until 22:00 GMT Friday (New York);

iv) the variety of factors that affect exchange rates;

v) The low margins of relative profit compared with other markets of fixed income; and

vi) The use of leverage to enhance profit and loss margins and with respect to account size

Players in the Forex Market

"Forex Players" are the entities that drive exchange rates. It's just a way of answering the
question "Who has money in foreign currencies?" The most simple categorizations would be:
governments, banks, corporations, institutions, and individuals. Each of these will have different
motives as well as entry and exit tactics for currency markets.

i) Governments: A Government's involvement in the currencies market is motivated by the

long-term economic goals of their country. Each government has a central bank tasked with the
responsibility of managing the country's money. The footprint made by a government in the
Forex market can be anything but subtle. For example, immediately following a major
earthquake and tsunami in Japan in 2011, the Japanese government did several things to
dramatically increase economic value in an attempt to offset negative impact. This drove the
relative value of the Yen (JPY) higher very quickly for that time period. Governments tend to
gain reputations in the foreign exchange markets for their distinct personalities in the
distinguishable influence they have. At the same time, a government's central bank has its own
game plan and may seek to work for itself or with other banks to influence exchange rates.
(Example: The United States government, who's central bank is called the Federal Reserve)

ii) Banks: Most banks have bought and sold currency for their customers as part of their standard
financial services. In fact, the currency market as we experience it today primarily evolved from
the development of the "over-the-counter" market. That's why it is often referred to as the
"interbank market." Additionally, banks will move portions of their own assets to currencies that

22
are strengthening and limit their exposure to currencies that are weakening. (Example: Wells
Fargo)

iii) Corporations: Because the market for goods and services is now a global scene, payments
are made across borders constantly. These payments changing currencies do affect exchange
rates. Corporations often hedge their own risk in transacting foreign business by holding assets in
other currencies, as well. (Example: Toyota)

iv) Institutions: An institution is an entity controlling large assets, usually. Money managers
direct the funds available in institutions. These managers have large amounts of resources
available to them, which they tend to manage actively and with a focus on shorter-term results
when compared with governments and banks. (Example: Quantum Funds)

v) Individuals: Individual speculators attempt to ride the waves of the market getting in and out
with what they personally see. Individuals typically don't have a lot of money to use, so they
don't particularly contribute much to the market's overall volume on their own; however, there
are so many individuals that, as a collective, they greatly increase liquidity. (Example: Your
neighbor!)

vi) Speculators Another class of participants in forex is speculators. Instead of hedging against
changes in exchange rates or exchanging currency to fund international transactions, speculators
attempt to make money by taking advantage of fluctuating exchange-rate levels.

vii) Hedgers Some of the biggest clients of these banks are international businesses. Whether a
business is selling to an international client or buying from an international supplier, it will
inevitably need to deal with the volatility of fluctuating exchange rates.

If there is one thing that management (and shareholders) hate, it's uncertainty. Having to deal
with foreign-exchange risk is a big problem for many multinational corporations. For example,
suppose that a German company orders some equipment from a Japanese manufacturer that
needs to be paid in yen one year from now. Since the exchange rate can fluctuate in any direction
over the course of a year, the German company has no way of knowing whether it will end up
paying more or less euros at the time of delivery.

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V THE STOCK EXCHANGE MARKET
The Idea and Development of a Stock Exchange
Stock exchange (also known as stock markets) are special “market places” where already held
stocks and bonds are bought and sold. They are, in effect, a financial institution, which provides
the facilities and regulations needed to carry out such transactions quickly, conveniently and
lawfully.
The need for this kind of market came about as a result of two major characteristics of joint stock
company (Public Limited Company), shares.
1.First of all, these shares are irredeemable, meaning that once it has sold them, the company can
never be compelled by the shareholder to take back its shares and give back a cash refund, unless
and until the company is winding up and liquidates.
2. The second characteristic is that these shares are, however, very transferable and can be
bought and resold by other individuals and organizations, freely, the only requirement being the
filling and signing of a document known as a share transfer form by the previous shareholder.
The document will then facilitate the updating of the issuing companies shareholders register.
These two characteristics of joint company shares brought about the necessity for an organized
and centralized place where organizations and private individuals with money to spare
(investors), and satisfy their individual needs. Stock exchanges were the result emerging to
provide a continuous auction market for securities, with the laws of supply and demand
determining the prices.
Functions of the Nairobi Stock Exchange
The basic function of a stock exchange is the raising of funds for investment in long-term assets.
While this basic function is extremely important and is the engine through which stock
exchanges are driven, there are also other quite important functions.
1. The mobilization of savings for investment in productive enterprises as an alternative to
putting savings in bank deposits, purchase of real estate and outright consumption.
2. The growth of related financial services sector e.g. insurance, pension and provident fund
schemes which nature the spirit of savings.
3. The check against flight of capital which takes place because of local inflation and
currency depreciation.
4. Encouragement of the divorcement of the owners of capital from the managers of capital;
a very important process because owners of capital may not necessarily have the expertise to
manage capital investment efficiently.

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5. Encouragement of higher standards of accounting, resource management and public
disclosure which in turn affords greater efficiency in the process of capital growth.
6. Facilitation of equity financing as opposed to debt financing. Debt financing has been
the undoing of many enterprises in both developed and developing countries especially in
recessionary periods.
7. Improvement of access to finance for new and smaller companies. This is futuristic in
most developing countries because venture capital is mostly unavailable, an unfortunate
situation.
8. Encouragement of public floatation of private companies which in turn allows greater
growth and increase of the supply of assets available for long term investment.
There are many other less general benefits which stock exchanges afford to. Individuals,
corporate organizations and even the government. The government for example could raise long
term finance locally by issuing various types of bond through the stock exchange and thus be less
inclined to foreign borrowing.
Stock exchanges, especially in developing countries have not always played the full role in
economic development.
THE ROLE OF STOCK EXCHANGE IN ECONOMIC DEVELOPMENT
1. Raising Capital for Businesses
The Stock Exchange provides companies with the facility to raise capital for expansion through
selling shares to the investing public.
2. Mobilising Savings for Investment
When people draw their savings and invest in shares, it leads to a more rational allocation of
resources because funds which could have been consumed, or kept in idle deposits with banks
are mobilized and redirected to promote commerce and industry.
3. Redistribution of Wealth
By giving a wide spectrum of people a chance to buy shares and therefore become part-owners
of profitable enterprises, the stock market helps to reduce large income inequalities because
many people get a chance to share in the profits of business that were set up by other people.
4. Improving Corporate Governance
By having a wide and varied scope of owners, companies generally tend to improve on their
management standards and efficiency in order to satisfy the demands of these shareholder. It is
evident that generally, public companies tend to have better management records than private
companies.
5. Creates Investment Opportunities for Small investors

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As opposed to other business that require huge capital outlay, investing in shares is open to both
the large and small investors because a person buys the number of shares they can afford.
Therefore the Stock Exchange provides an extra source of income to small savers.
6. Government Raises Capital for Development Projects
The Government and even local authorities like municipalities may decide to borrow money in
order to finance huge infrastructural projects such as sewerage and water treatment works or
housing estates by selling another category of shares known as Bonds. These bonds can be
raised through the Stock Exchange whereby members of the public buy them. When the
Government or Municipal Council gets this alternative source of funds, it no longer has the need
to overtax the people in order to finance development.
7. Barameter of the Economy
At the Stock Exchange, share prices rise and fall depending, largely, on market forces. Share
prices tend to rise or remain stable when companies and the economy in general show signs of
stability. Therefore their movement of share prices can be an indicator of the general trend in the
economy.
Advantages of Investing In Shares
1. Income in form of dividends
When you have shares of a company you become a part-owner of that company and therefore
you will be entitled to get a share of the profit of the company which come in form of dividends.
Furthermore, dividends attract a very low withholding tax of 5% only.
2. Profits from Capital Appreciation
Shares prices change with time, and therefore when prices of given shares appreciate,
shareholders could take advantage of this increase and set their shares at a profit. Capital gains
are not taxed in Kenya.
3. Share Certificate can be used as a Collateral
Share certificate represents a certain amount of assets of the company in which a shareholder has
invested. Therefore this certificate is a valuable property which is acceptable to many banks and
financial institutions as security, or collateral against which an investor can get a loan.

4. Shares are easily transferable

The process of acquiring or selling shares is fairly simple, inexpensive and swift and therefore an
investor can liquidate shares at any moment to suit his convenience.
5. Availability of Investment Advice

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Although the stick market may appear complex and remote to many people. Positive advise and
guidance could be provided by the stockbrokers and other investment advisors. Therefore, an
investor can still benefit from trading in shares even though he may not be having the technical
expertise relevant to the stock market.
6. Participating in Company Decisions
By buying shares and therefore becoming a part-owner in an enterprise, a shareholder gets the
right to participate in making decisions about how the company is managed. Shareholders elect
the directors at the Company’s Annual.
General meetings, whereby the voting power is determined by the number of shares an investor
holds since the general rules is that one share is equal to one vote..
TRADING MECHANISM AT NSE
1. An investor approaches a broker who takes his bid/offer to the trading floor.
2. At the trading floor, the buying and selling brokers meet and seal the deal.
3. The investor is informed of what happened/transpired at the trading floor through a
contract note. The note is sent to buying and selling investors.
The note contains details such as:
 Number of shares bought or sold
 Buying/selling price
 Charges/commission payable etc.
4. Settlement is made through the brokers.
5. Old share certificate is cancelled (for selling investor) and a new one is issued in the
name of buying investor.
Factors to Consider when Buying Shares of a Company
1. Economic conditions of the country and other non-economic factors e.g. unfavourable
climatic conditions and diseases which may lead to low productivity and poor earnings.
2. State of management of the company e.g are the B.O.D. and key management personnel
of repute? They should be trusted and run the company honestly and successfully.
3. Nature of the product dealt in and its market share e.g is the product vulnerable to
weather conditions? Is it subject to restrictions?
4. Marketability of the shares – how fast or slowly can the shares of the firm be sold?
5. Diversification i.e does the company have a variety of operations e.g multi-products so
that if one line of business declines, the other increases and the overall position is profitable.
6. Company’s trading partners (local and abroad) and its competitors.

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7. Prospects of growth of the firm due to expected growth in demand of products of the
firm.
Note
Stock broker can give all the above advice when buying shares.
Factors Affecting/Influencing Share Prices
All sorts of influences affect share prices. These influences include:
1. The recent profit record of the company especially the recent dividend paid to
shareholders and the prospects of their growth and stability.
2. The growth prospects of the industry in which the company operates.
3. The publication of a company’s financial results i.e. Balance Sheet and profit and loss
statement.
4. The general economic conditions situations e.g boom and recession e.g during boom,
firms would have high profits hence rise in prices.
5. Change in company’s management e.g entry and exit of prominent corporate
personalities.
6. Change on Government economic policy e.g spending, taxes, monetary policy etc. These
changes influence investors’ expectations.
7. Rumour and announcements of impending political changes eg. General elections and
new president will cause anxiety and uncertainty and adversely affect share prices.
8. Rumours and announcement of mergers and take-over bids. If the shareholders are
offered generous terms/prices in a take-over, share prices could rise.
9. Industrial relations eg strikes and policies of other firms.
10. Foreign political developments where the economy heavily depends on world trade.
11. Changes in the rate of interest on Government securities such as Treasury Bills may make
investors switch to them. Exchange rates will also encourage or discourage foreign investment
in shares.
12. Announcement of good news eg that a major oil field has been struck or a major new
investment has been undertaken. The NPV of such investment would be reflected in share
prices.
13. The views of experts e.g articles by well-known financial writers can persuade people to
buy shares hence pushing the prices up.
14. Institutional buyers such as insurance companies can influence share prices by their
actions.

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15. The value of assets and the earnings from utilization of such assets will also influence
share prices.
LEVEL OF TRADING ACTIVITIES IN THE NAIROBI STOCK EXCHANGE
The activities in NSE are normally low due to:
1. Few Listed companies
2. Economy is made up of small firms which are family owned or sole proprietorship.
3. Level of awareness among the population is low
4. Few instruments traded
5. Low dividend payout to those already holding shares.
STOCK EXCHANGE INDEX (SEI)
Stock Exchange Index is a measure of relative changes in prices of stocks from one period to
another indices.
Nairobi Stock Exchange 20 - share Index (20 companies) (Daily basis) Stanchart Index - From
25 most active companies in a given period (weekly basis) Computation of price index.
Uses of Stock Exchange Index
1. To gauge price (wealth movement) in the stock market
2. To assess overall returns in the market portfolio
3. To assess performance of specific portfolio using SEI as a benchmark.
4. May be used to predict future stock prices
5. Assist in examining and identifying the factors that underlie the price movements.
Limitations/Drawback of NSE index
1. The 20 companies sample whose share prices are used to compute the index are not true
representatives.
2. The base year of 1996 is too far in the past
3. New companies are not included in the index yet other firms have been
suspended/deregistered e.g. ATH, KFB etc.
4. Dormant firms – Some of the 20 firms used are dormant or have very small price
changes.
5. Thinness of the market – small changes in the active shares tend to be significantly
magnified in the index
6. The weights used and the method of computation of index may not give a truly
representative index.
When is a share price said to be unfair?
 Where the price is not determined by demand and supply forces.
 If the price is not consistent with the activities of the firm e.g a decline in share
price of a firm with very good growth prospects.
 Price is not compatible with the price of other similar shares of firms in the same
industry
 If there is insider trading:

29
This situation arises where individuals within the firm in privileged positions e.g top
management and director take advantage of the information available to them which has not been
released to the public.
They may use such information to dispose off share to make capital gains or avoid capital loss
Example – where individuals (insiders) are aware that a firm has made a loss in a year and such
information, if released to the public, would cause a crash on share price, the information may be
leaked to certain people who could sell the shares in advance.
TIMING OF INVESTMENT A STOCK EXCHANGE
The ideal way of making profits at the stock exchange is to buy at the bottom of the market
(lowest M.P.S) and sell at the top of the market (highest M.P.S). The greatest problem however
is that no one can be sure when the market is at its bottom or at its top (prices are lowest and
highest).
Systems have been developed to indicate when shares should be purchased and when they should
be sold. These systems are Dow theory and Hatch system.
1. Dow Theory
This theory depends on profiting of secondary movement of prices of a chart. The principal
objective is to discover when there is a change in the primary movement.
This is determined by the behaviour of secondary movement but tertiary movements are ignored.
Eg in a bull market, the rise of prices is greater than the fall of prices.
In a bear market the opposite is the case ie the fall is greater than the rise
In a bear market, the volume of the business being done at a certain stage can also be used to
interpret the state of the market.
Basically, it is maintained that if the volume increases along with rising prices, the signs are
bullish and if the volume increases with falling prices, they are bearish.
2. Hatch System
This is an automatic system based on the assumption that when investors sell at a certain % age
below the top of the market and buys at a certain percent above the market bottom, they are
doing as well as can reasonably be expected. This system can be applied to an index of a group
of shares or shares of dividends companies eg Dow Jones and Nasdaq index of America.
Illustration 1
An investor uses the hatch system to determine when to buy and sell his shares. He sells the
shares when prices are 15% less of the top price and buy the shares when prices are 15% less of
the top price and buy the shares when prices are 15% more of the bottom price. At the beginning
of January, the share price was 200/=. At the end of the year the share price was Shs.320.

30
i) Determine the buying and selling price of the shareholders
ii) If the shareholder had 10,000 shares, determine the amount of capital gain on these
shares.
iii) The investor had D.P.S of 3.00 at the end of the year. Compute his shilling return in %.
Rules for floatation of new shares on NSE
1.
The company must have an issued share capital of at least Kshs.20 M.
2.
The company must have made profits during the last 3 years.
3.
At least 20% of issued capital (capital to be issued) should be offered to the public
4.
The firm must issue a prospectus which will give more information to investors to enable
them to make informed judgement
5. The market price of the companies share must be determined by the market forces of
demand and supply
6. The company should be registered under Cap. 486 with registrar of companies.
Note
 A prospectus is a legal document issued by a company wishing to raise funds
from the public through issue of shares or bonds.
 It is prepared by directors of the company and submitted to CMA and NSE for
approval
 The CMA has issued rules relating to the design and contents of the prospectus, in
addition to those contained in the Companies Act.

It must provide details on

1. Number of shares to be issued
2. Offer/issue price per share
3. The dates during which the other is valid or open
4. Financial statements of the firm showing EPS and DPS for the last 5 years
5. Action report etc.
6. Action may be taken against the directors if the prospectus is fraudulent.
The Advantages and Disadvantages of a Listing
Advantages
1. It facilitates the issue of securities to raise new finance, making a company less
dependent upon retained earnings and banks.
2. The wider share ownership which results will increase the likelihood of being able to
make rights issues.
3. The transfer of shares becomes easier. Less of a commitment is necessary on the part of
shareholders. For this reason the shares are likely to be perceived as a less risky investment and
hence will have a higher value.

31
4. The greater marketability and hence lower risk attached to a market listing will lead to a
lower cost of equity and also to a weighted average cost of capital.
5. A market-determine price means that shareholders will know the value of their
investment at all times.
6. The share price can be used by management as an indicator of performance, particularly
since the share price is forward looking, being based upon expectations, whilst other objectives
measures are backward looking.
7. The shares of a quoted company can be used more readily as consideration in takeover
bids.
8. The company may increase its standing by being quoted and it may obtain greater
publicity.
9. Obtaining a quotation provides an entrepreneur with the opportunity to realize part of his
holding in a company.
Disadvantages
1. The cost of obtaining a quotation is high, particularly when a new issue of shares is made
and the company is small. This is because substantial costs are fixed and hence are relatively
greater for small companies. Also, the annual cost of maintaining the quotation may be high due
to such things as increased disclosure, maintaining a larger share register, printing more annual
reports, etc.
2. The increased disclosure requirements may be disliked by management.
3. The market-determined price and the greater accountability to shareholders that comes
with its concerning the company’s performance may not be liked by management.
4. Control of a particular group of shareholders may be diluted by allowing a proportion of
shares to be held by the public.
5. There will be a greater likelihood of being the subject of a takeover bid and it may be
difficult to defend it with wide share ownership.
6. Management conditions, management employees give themselves more salaries due to
prosperity obtained.
STOCK MARKET INSTRUMENTS

Capital market instruments are longer term financial instruments in the form of debt or equity
that are traded either on a securities exchange or directly between investors and borrowers. We
provide an overview of the different types of instrument available which includes the following;

1.Debt Instruments

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A debt instrument is used by either companies or governments to generate funds for capital-
intensive projects. It can be obtained either through the primary or secondary market. The
principal sum invested, is repaid at the expiration of the contract period with interest either paid
quarterly, semi-annually or called a annually. The interest stated in the trust deed may be either
fixed or flexible. E.g. Debenture, Industrial Loan or Corporate Bond

Different types of bonds/bond structures

Not all corporate bonds are traditional bonds which pay a fixed income at regular intervals
before they are redeemed at a fixed maturity date. The structure of bonds can vary with regard to
the coupon intervals, type of coupon, redeemability, convertibility and many other features.
These are the most important variations:

a reference rate at periodically set ‘refix’ dates. Typically the interest payment is a fixed spread
over a three-month or six-month reference rate. At the beginning of the coupon period, the
spread is added to the reference rate of that particular day to determine the coupon. While the
spread or margin remains constant the reference rate is variable. Some special FRNs have
maximum or minimum coupons, called capped and floored FRNs.

i) Index-linked bonds

Similar to a floating rate note, index-linked bonds have a variable coupon depending on an
underlying index, such as the consumer price index or a commodity price or stock index. The
coupon paid is a set margin above the reference index.

ii) Zero-coupon bonds

As the name indicates, zero-coupon bonds do not have a coupon. The return for the investor is
achieved by selling the bond at a significant discount to the nominal value of the bond which is
due at a fixed maturity.

The only cash flows in the life of the zero-coupon bond are the purchasing price and the
repayment of the nominal value or principal at maturity.

As there are no interest payments, the investor is not exposed to any reinvestment risk, the risk
that interest rates and hence reinvestment rates for coupon payments have fallen. As a result,
investors may accept a slightly lower yield for a zero-coupon bond.

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iii) Strips

When a bond is stripped, the cash flows of a bond, ie each coupon payment and the payment of
principal, are separated and can then be traded as individual zerocoupon bonds. STRIPS is an
acronym for ‘Separate Trading of Registered Interest and Principal Securities’ but also relates to
the actual tearing off of interest coupons from paper securities.

iv) Perpetual bonds

A perpetual bond does not have a redemption date and is redeemed only if the issuer goes into
liquidation. This means perpetual bonds pay coupons indefinitely. Interest is fixed for the initial
period or for the life of the bond. Perpetual bonds tend to have a call option, but in most cases
this option can only be exercised after 10 years or more. Most perpetual bonds are issued by
financial institutions.

v) Convertible bonds

Some corporate bonds have the option to convert the bond into a specified number of shares at
any point before the maturity date. The types of convertible bonds may be more attractive to
investors, as an increase of the share price will increase the value of the bon

vi) Floating rate note (FRN)

A floating rate note (FRN) is a bond with a variable coupon. Interest payments are based on
floating interest rates, for example EURIBOR, which are used as Bonds

Any security that promises to pay a fixed coupon at regular intervals until medium- or long-term
maturity is considered a bond. There are however many different forms of bonds which are
modifications of the basic principles. Domestic, foreign and Eurobonds

2. Equities (also called Common Stock)

This instrument is issued by companies only and can also be obtained either in the primary
market or the secondary market. Investment in this form of business translates to ownership of
the business as the contract stands in perpetuity unless sold to another investor in the secondary
market. The investor therefore possesses certain rights and privileges (such as to vote and hold
position) in the company.

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3.Preference Shares

This instrument is issued by corporate bodies and the investors rank second (after bond holders)
on the scale of preference when a company goes under. The instrument possesses the
characteristics of equity in the sense that when the authorized share capital and paid up capital
are being calculated, they are added to equity capital to arrive at the total. Preference shares can
also be treated as a debt instrument as they do not confer voting rights on its holders and have a
dividend payment that is structured like interest (coupon) paid for bonds issues.

4. Derivatives

A derivative is an instrument whose value is derived from the value of one or more underlying,
which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc. Four
most common examples of derivative instruments are Forwards, Futures, Options and Swaps.

35
THE CENTRAL BANK OF KENYA
A central bank is a financial institution given privileged control over the production and
distribution of money and credit for a nation or a group of nations. In modern economies, the
central bank is usually responsible for the formulation of monetary policy and the regulation of
member banks. Article 231 of the Kenyan Constitution establishes the Central Bank, otherwise
known by the alternative corporate name of the Banki Kuu ya Kenya.
The main functions of the Central Bank of Kenya are formulating monetary policy, promoting
price stability, issuing currency and performing other functions conferred on it by an Act of
Parliament.
Governance
The board of directors
The Board of Directors provides oversight of the Bank’s functions by formulating policies, other
than the formulation of monetary policy, and reviewing performance. The Board comprises
eleven members consisting of-
 a Chairperson;
 a Governor;
 the Permanent Secretary to the Treasury or their representative who shall be a non-voting
member;
 eight other non-executive directors.
The President should appoint the chairperson and the eight non-executive directors with the
approval of Parliament. The chairperson and the non-executive directors should hold office for
four years but should be eligible for re-appointment for one further term of four years.
The members of the Board should be appointed at different times so that the respective expiry
dates of the members’ terms of office should fall at different times.
A member of the Board may resign from office by writing under their hand addressed to the
President which resignation should take effect one month from the date of receipt of the letter of
resignation by the President.
If the Chairperson, the Governor or a director dies or resigns or otherwise vacates office before
the expiry of their term of office, the President should appoint another person in their place.
Where the Chairperson, the Governor or a director is unable to perform the function of their
office due to any temporary incapacity which is likely to be prolonged, the President may
appoint a substitute for that member of the Board to act with the full powers of the member until
the President determines that their incapacity has ceased.

36
A person should be eligible to be appointed a Director if they –
 are a citizen of Kenya; and
 are knowledgeable or experienced in monetary, financial, banking and economic matters
or other disciplines relevant to the functions of the Bank.
Duties of the Board of Directors
The Board of Directors of the Bank, subject to the provisions of the Central Bank Act, are
responsible for –
 determining the policy of the Bank, other than the formulation of monetary policy;
 determining the objectives of the Bank, including oversight for its financial management
and strategy;
 keeping under constant review the performance of the Bank in carrying out its functions;
 keeping under constant review the performance of the Governor in discharging the
responsibility of that office;
 keeping under constant review the performance of the Governor in ensuring that the Bank
achieves its Objectives;
 determining whether the policy statements made under section 4B (of the Central Bank
Act) are consistent with the Bank’s primary function and policy objectives under section
4; and
 keeping under constant review the use of Bank’s resources
FUNCTIONS OF THE CENTRAL BANK OF KENYA
The functions of the Central Bank of Kenya are as follows:
1. monetary policy
Monetary policy consists of decisions and actions taken by the Central Bank to ensure that the
supply of money in the economy is consistent with growth and price objectives set by the
government.
Monetary policy is concerned with the changes in the supply of money and credit. It refers to the
policy measures undertaken by the government or the central bank to influence the availability,
cost and use of money and credit with the help of monetary techniques to achieve specific
objectives. Monetary policy aims at influencing the economic activity in the economy mainly
through two major variables, i.e., (a) money or credit supply, and (b) the rate of interest.
Monetary Policy Tools
To accomplish its monetary policy objective, the Central Bank can use a mix of direct and
indirect policy tools to influence the supply and demand of money.

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Direct policy tools
These tools are used to establish limits on interest rates, credit and lending. These include direct
credit control, direct interest rate control and direct lending to banks as lender of last resort, but
they are rarely used in the implementation of monetary policy by the Bank.
 Interest rate controls –
The Bank has the power to announce the minimum and maximum rates of interest and other
charges that domestic banks may impose for specific types of loans, advances or other credits
and pay on deposits. Currently, the Bank does not set any interest rate levied by domestic banks
except for the minimum interest rate payable on savings deposits. The Bank has opted not to use
this as a tool of monetary policy but to let market forces determine interest rate.
 Credit controls –
The Bank has the power to control the volume, terms and conditions of domestic bank credit,
including installment credit extended through loans, advances or investments. The Bank has not
exercised such controls in its implementation of monetary policy.
 Lending to domestic banks –
The Bank may provide credit, backed by collateral, to domestic banks to meet their short-term
liquidity needs as lender of last resort. The interest is set at a punitive rate to encourage banks to
manage their liquidity efficiently.
 Reserve Requirement

The reserve requirement refers to the money banks must keep on hand overnight. They can either
keep the reserve in their vaults or at the central bank. A low reserve requirement allows banks to
lend more of their deposits. It's expansionary because it creates credit.

A high reserve requirement is contractionary. It gives banks less money to lend. It's especially
hard for small banks because they don't have as much to lend in the first place. That's why most
central banks don't impose a reserve requirement on small banks. Central banks rarely change the
reserve requirement because it's difficult for member banks to modify their procedures.2

 Discount Rate

The discount rate is the rate that central banks charge their member banks to borrow at
its discount window. Because it's higher than the fed funds rate, banks only use this if they can't
borrow funds from other banks.

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Using the discount window also has a stigma attached. The financial community assumes that
any bank that uses the discount window is in trouble. Only a desperate bank that's been rejected
by others would use the discount window.

 Interest Rate on Excess Reserves

The fourth tool was created in response to the 2008 financial crisis. The Federal Reserve, the
Bank of England, and the European Central Bank pay interest on any excess reserves held by
banks.If the Fed wants banks to lend more, it lowers the rate paid on excess reserves. If it wants
banks to lend less, it raises the rate.

Interest on reserves also supports the fed funds rate target. Banks won't lend fed funds for less
than the rate they're receiving from the Fed for these reserves

 Open market operations –

The conduct of open market operations refers to the purchase or sale of government securities
by the Bank to the banking and non-banking public for liquidity management purposes. When
the Bank sells securities, it reduces domestic banks’ reserves (monetary base), and when it buys
securities, it increases banks’ reserves..
OBJECTIVE OF MONETARY POLICY
As the objective of monetary policy varies from country to country and from time to time, a brief
description of the same has been as following:
(i) Stability of exchange rates
(ii) Price stability
(iiiFull Employment
(iv) Economic Growth
(v) Equilibrium in the Balance of Payments.
(vi) Neutrality of money

i. Exchange Stability:
the main objective of monetary policy is to maintain stability in the external equilibrium of the
country. In other words, they should try to eliminate those adverse forces which tend to bring
instability in exchange rates.

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(i) It leads to violent fluctuations resulting in encouragement to speculative activities in the
market.
(ii) Heavy fluctuations lead to loss of confidence on the part of domestic and foreign capitalists
resulting in adverse impact in capital outflow which may also result in capital formation and
growth.
(iii) Fluctuations in exchange rates bring repercussions in the internal price level.
2. Price Stability:
The objective of price stability has been highlighted during the twenties and thirties of the
present century. In fact, economists like Crustar Cassels and Keynes suggested price stabilization
as a main objective of monetary policy. Price stability is considered the most genuine objective
of monetary policy. Stable prices repose public confidence because cyclical fluctuations are
totally eliminated.
It promotes business activity and ensures equitable distribution of income and wealth. As a
consequence, there is general wave of prosperity and welfare in the community. Price
stability also impedes economic progress as there is no incentive left with the business
community to increase production of qualitative goods.
It discourages exports and encourages imports. But it is admitted that price stability does not
mean ‘price rigidity’ or price stagnation’. A mild increase in the price level provides a tonic for
economic growth. It keeps all virtues of a stable price.
3. Full Employment:
During world depression, the problem of unemployment had increased rapidly. It was regarded
as socially dangerous, economically wasteful and morally deplorable. Thus, full employment
assumed as the main goal of monetary policy. In recent times, it is argued that the achievement
of full employment automatically includes prices and exchange stability.
However, with the publication of Keynes’ General Theory of Employment, Interest and Money
in 1936, the objective of full employment gained full support as the chief objective of monetary
policy. Prof. Crowther is of the view that the main objective of monetary policy of a country is to
bring about equilibrium between saving and investment at full employment level.
Similarly, Prof. Halm has also favoured Keynes’ view. Prof. Gardner Ackley regards that the
concept of full employment is ‘slippery’. Classical economists believed in the existence of full
employment which is the normal feature of an economy. Full employment, thus, exists when
all those who are ready to work at the existing wage rate get work. Voluntary, frictional
and seasonal unemployed are also called employed.
According to their version, full employment means absence of involuntary unemployment.
Therefore, it implies not only employment of all types of labourers but also includes the
employment of all economic resources. It is not an end in itself rather a pre-condition for
maximum social and economic welfare.

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Keynes equation of income, Y = C + I throws light as to how full employment can be secured
with monetary policy. He argues that to increase income, output and employment, it is necessary
to increase consumption expenditure and investment expenditure simultaneously. This indirectly
solves the problem of unemployment in the economy. Since the consumption function is more or
less stable in the short period, the monetary policy should aim at raising investment expenditure.
After achieving the objective of full-employment, monetary policy should aim at exchange and
price stability. In short, the policy of full employment has the far-reaching beneficial effects.
(a) Keeping in view the present situation of unemployment and disguised unemployment
particularly in more growing populated countries, the said objective of monetary policy is most
suitable.
(b) On humanitarian grounds, the policy can go a long way to solve the acute problem of
unemployment.
(c) It is useful tool to provide economic and social welfare of the community.
(d) To a greater extent, this policy solves the problem of business fluctuations.
4. Economic Growth:
In recent years, economic growth is the basic issue to be discussed among economists and
statesmen throughout the world. Prof. Meier defined “Economic growth as the process whereby
the real per capita income of a country increases over a long period of time.” It implies an
increase in the total physical or real output, production of goods for the satisfaction of human
wants.
In other words, it means utilization of all the productive natural, human and capital resources in
such a manner as to ensure a sustained increase in national and per capita income over time.
Therefore, monetary policy promotes sustained and continuous economic growth by maintaining
equilibrium between the total demand for money and total production capacity and further
creating favourable conditions for saving and investment. For bringing equality between demand
and supply, flexible monetary policy is the best course.
In other words, monetary authority should follow an easy or tight monetary policy to suit the
requirements of growth. Again, monetary policy in a growing economy, has to satisfy the
growing demand for money. Thus, it is the responsibility of the monetary authority to circulate
the proper quantity and quality of money.
6. Equilibrium in the Balance of Payments:
The balance of payments (also known as balance of international payments and abbreviated
BOP or BoP) of a country is the difference between all money flowing into the country in a
particular period of time (e.g., a quarter or a year) and the outflow of money to the rest of the
world

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Equilibrium in the balance of payments is another objective of monetary policy which emerged
significant in the post war years. This is simply due to the problem of international liquidity on
account of the growth of world trade at a more faster speed than the world liquidity.
It was felt that increasing of deficit in the balance of payments reduces, the ability of an economy
to achieve other objectives. As a result, many less developed countries have to curtail their
imports which adversely effects development activities. Therefore, monetary authority makes
efforts that equilibrium should be maintained in the balance of payments.
6. Neutrality of Money:
Economists like Wicksteed, Hayek and Robertson are the chief exponents of neutral money.
They hold the view that monetary authority should aim at neutrality of money in the economy.
Any monetary change is the root cause of all economic fluctuations. According to neutralists, the
monetary change causes distortion and disturbances in the proper operation of the economic
system of the country.
They are of the confirmed view that if somehow neutral monetary policy is followed, there will
be no cyclical fluctuations, no trade cycle, no inflation and no deflation in the economy. Under
this system, money is kept stable by the monetary authority. Thus the main aim of the monetary
authority is not to deviate from the neutrality of money. It means that quantity of money should
be perfectly stable. It is not expected to influence or discourage consumption and production in
the economy.

2. Financial Markets
It is the role of the Central Bank of Kenya to implement monetary policy decisions, manage the
country’s foreign exchange reserves and manage the government’s domestic debt.
foreign exchange reserves
The Central Bank of Kenya (CBK) holds Foreign Exchange reserves that are a national asset
held as a safeguard to ensure the availability of foreign exchange to meet the country’s external
obligations, including imports and external debt service. The primary objective in the
management of these reserves is, therefore, capital preservation.
The Central Bank of Kenya Act requires the Bank to maintain adequate official foreign exchange
reserves equivalent to the value of four months imports and manage them prudently.
The reserves are used for:
 servicing government external debt and non-debt government external obligations.
 intervention when deemed necessary to smoothen erratic movements of the exchange
rates and CBK external payments.
 cushioning against external crises.

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The size of official reserves serves as a confidence signal to potential investors, rating agencies
and those contemplating capital flight.
Capital flight is a large-scale exodus of financial assets and capital from a nation due to events
such as political or economic instability, currency devaluation or the imposition of capital
controls.
Government Domestic Debt
At the beginning of each fiscal year, the National Treasury determines the budgetary gap to be
financed from the domestic market. The Central Bank then comes up with a borrowing plan
which it implements through auctions of Treasury bills and bonds.
In addition, the Central Bank manages the registry (Central Securities Depository) and maintains
the database for domestic debt and contributes to the development of the secondary market for
government securities. Commercial banks, pension funds, insurance companies and corporate
entities, individuals or retail market also invests.
Forex
The exchange rate released by the Central Bank of Kenya is an indicative rate, meant to help
those exchanging currencies gauge the value of the shilling on any given day.
The Central Bank does not set the exchange rate; it is determined by the market, or supply and
demand. Individual forex bureaus and commercial banks set their rates, which are held to
reasonable levels of variance and margins due to competition in the market.
Typically, consumers looking to exchange smaller amounts will find more favourable rates at
forex bureaus, while those looking to exchange larger amounts through foreign accounts will
find better rates at commercial banks.
3. Bank Supervision
One of the statutory objects of the Central Bank of Kenya under the Central Bank Act (Cap 491)
is the promotion of financial stability through the maintenance of a well-functioning banking
system.
One of the mandates of the Central Bank of Kenya is to foster the liquidity, solvency and proper
functioning of a market-based financial system. This is achieved through the following:
 developing appropriate laws, regulations and guidelines that govern the players in the
banking sector.
 continuous review of the banking sector laws, regulations and guidelines to ensure that
they remain relevant to the operating environment. These include the Banking Act (Cap
488), Microfinance Act (2006), Central Bank of Kenya Act (Cap 491) and Prudential
Guidelines and Regulations issued thereunder.

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  licensing banks, non-bank financial institutions, mortgage finance companies, credit
reference bureaus, foreign exchange bureaus, money remittance providers and
microfinance banks.
 inspection of commercial banks, microfinance banks, non-bank financial institutions,
mortgage finance companies, building societies, credit reference bureaus, foreign
exchange bureaus, money remittance providers and representative offices of foreign
banks to ensure that they comply with all the relevant laws, regulations and guidelines
and protect the interests of depositors and other users of the banking sector.
 analysis of financial reports and other returns from banking sector players to ensure
compliance with the relevant laws, regulations and guidelines.
 contributing to initiatives that promote financial inclusion.
Solvency is the long-term ability to meet debt obligations while liquidity is the short-term ability
to meet debt obligations using current assets.
4. National Payments System
A payments system refers to a system or arrangement that enables payments to be effected
between a payer and a beneficiary, or facilitates the circulation of money, and includes any
instruments and procedures that relate to the system.
According to the Bank of International Settlements (BIS), a payment system “consists of a set of
instruments, banking procedures and, typically, interbank funds transfer systems that ensure the
circulation of money.” They are a major channel by which shocks can be transmitted across
domestic and international financial systems and markets.
Therefore, National Payments Systems are the conduits through which buyers and sellers of
financial products and services make transactions and are an important component of a country’s
financial system.
In Kenya, participants comprise the Central Bank of Kenya, the Government, Commercial
Banks, Financial Institutions and Payment System Providers. National Payments Systems in
Kenya are classified into two categories; Large Value (Wholesale) and Low Value (Retail)
Payment Systems. The classification is based on the throughput ( the amount of material or items
passing through a system or process) in terms of values and volumes processed.
5. Banking Services
The Central Bank is the banker for the national government and the county governments. The
banking role encompasses the national government and its ministries, departments and agencies
(MDAs) and the county governments. These institutions hold a variety of accounts with the
Central Bank, depending on their needs, which allow them to receive deposits and make
payments.
The Central Bank monitors these accounts to ensure that the institutions aren’t at risk of
overdraft and also advises the institutions on financial matters.

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The Central Bank of Kenya maintains various accounts for Government Ministries, which
include:
 Recurrent Accounts
 Development Accounts
 Deposit Accounts
 Projects Accounts
 Donor funded Accounts
 Treasury Accounts
 Public Entities accounts, that is, Parastatals.
The government Departments that hold accounts in the Central Bank for funding by the
Exchequer Accounts include;
 The Judiciary
 Directorate of Public Prosecutions (DPP);
 Ethics and Anti-Corruption Commission (EACC);
 Independent Electoral and Boundaries Commission (IEBC);
 Teachers Service Commission (TSC);
 Public Service Commission of Kenya (PSC);
 Commission on Revenue Allocation (CRA);
 Parliamentary Service Commission (PSC).
6. Currency Services
By law, the Central Bank of Kenya is the only institution in the country that can issue currency.
The Central Bank ensures that it procures adequate and secure currency for distribution to meet
the country’s needs.
The Central Bank of Kenya is the only institution in Kenya with full discretion and sole rights to
issue currency notes and coins. The mandate derives from the Central Bank of Kenya Act,
Section 4 A (1) f. This mandate involves the following responsibilities:
 planning, forecasting, procuring and distributing currency notes and coins;
 setting up suitable currency distribution mechanisms;
 safeguarding the integrity of Kenyan currency as a medium of exchange;
 developing policies for proper handling.

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The Bank supplies banknotes and coins to the economic system in Kenya in bulk. It also destroys
banknotes and coins that are no longer in use selected from what the commercial banks have
deposited to the Bank. The Bank also manages the design of its currency and follows through the
printing (for banknotes) and minting (for coins) process from the time orders are placed
7. Currency authority or bank of issue: Central bank is a sole authority to issue currency in the
country. Central Bank is obliged to back the currency with assets of equal value (usually gold coins, gold
bullions, foreign securities etc.,)
Advantages of sole authority of note issue:
a. Uniformity in note circulation
b. Better supervision and control
c. It is easy to control credit
d. Ensures public faith
e. Stabilization of internal and external value of currency
12. Lender of Last Resort: When commercial banks have exhausted all resources to supplement their
funds at times of liquidity crisis, they approach central bank as a last resort
13. Clearing house: - Since the Central Bank holds the cash reserves of commercial banks it is easier and
more convenient to act as clearing house of commercial banks ie the commercial banks clear cheques qith
central bank.
14) Foreign debt. Paying foreign debts on behalf of the government.

MONEY DEMAND AND SUPPLY

Money demand
Introduction

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The demand for money occurs from two significant roles of money. The prime factor is that money
performs as a medium of exchange and the next is that it is a store of value. Therefore, individuals and
businesses wish to keep money a portion in cash and in the form of assets.
Factors Affecting the Supply of and Demand for Money (Financial Economics)
The supply of money in a modern economy and financial system is determined by three key factors:
1. “Open market operations” – this is effectively the same as Quantitative Easing. The Central
Bank buys government bonds, effectively creating money

2. The “reserve requirement” imposed on banks – this is the % of deposits made by customers at
the bank that the bank must keep hold of rather than lending it out

3. The policy interest rate set by the central bank – the rate of interest will influence how many
households and businesses are willing and able to borrow. Most money in a modern economy is
created by commercial bank lending so the rate of interest ultimately does have a bearing on the
supply of money

Key factors affecting the demand for money

1. The rate of interest on loans

2. The number / value of monetary transactions that we expect to carry out

3. The extent to which we also want to hold other financial assets, such as bonds, property, saving
(this is also influenced by the rate of interest) – this is known as the speculative motive for
holding money

4. Changes in GDP

5. The extent to which it is possible to use debit cards / credit cards i.e. the pace of financial
innovation

6. The extent to which we might have to pay out large unexpected payments, for example, for i.e.
the precautionary motive

7. The rate of anticipated inflation

Approaches to Demand for money

1. The Classical Approach
2. The Keynesian Approach or Liquidity Preference
The Classical View on Money:
In the classical system, money is neutral in its effects on the economy. It plays no role in the
determination of employment, income and output. Rather, they are determined by labour, capital stock,
state of technology, availability of natural resources, saving habits of the people, and so on. In the
classical system, the main function of money is to act as a medium of exchange.

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It is to determine the general level of prices at which goods and services will be exchanged. The quantity
theory of money states that the price level is a function of the supply of money. Algebraically, MV=PT,
where, M, V, P and T are the supply of money, velocity of money, price level, and the volume of
transactions (or total output) respectively.
The equation tells that the total money supply, MV, equals the total value of output, PT, in the economy.
Assuming V and T to be constant, a change in M causes a proportionate change in P. Thus money is
neutral. It is simply a ‘veil’ whose main function is to determine the general price level at which goods
and services exchange.
Limitations:
i) It does not explain how a change in M changes P
ii) P is regarded as a passive factor which is unrealistic
iii) Not only M determines P but also P determines M.
The Classical Theory

The fundamental principle of the classical theory is that the economy is self‐regulating. Classical
economists maintain that the economy is always capable of achieving the natural level of real GDP or
output, which is the level of real GDP that is obtained when the economy's resources are fully employed.
While circumstances arise from time to time that cause the economy to fall below or to exceed the natural
level of real GDP, self‐adjustment mechanisms exist within the market system that work to bring the
economy back to the natural level of real GDP. The classical doctrine—that the economy is always at or
near the natural level of real GDP—is based on two firmly held beliefs: Say's Law and the belief that
prices, wages, and interest rates are flexible. According to Say's Law, when an economy produces a
certain level of real GDP, it also generates the income needed to purchase that level of real GDP. In other
words, the economy is always capable of demanding all of the output that its workers and firms choose to
produce. Hence, the economy is always capable of achieving the natural level of real GDP.
The achievement of the natural level of real GDP is not as simple as Say's Law would seem to suggest.
While it is true that the income obtained from producing a certain level of real GDP must be sufficient to
purchase that level of real GDP, there is no guarantee that all of this income will be spent. Some of this
income will be saved. Income that is saved is not used to purchase consumption goods and services,
implying that the demand for these goods and services will be less than the supply. If aggregate demand
falls below aggregate supply due to aggregate saving, suppliers will cut back on their production and
reduce the number of resources that they employ. When employment of the economy's resources falls
below the full employment level, the equilibrium level of real GDP also falls below its natural level.
Consequently, the economy may not achieve the natural level of real GDP if there is aggregate saving.
The classical theorists' response is that the funds from aggregate saving are eventually borrowed and
turned into investment expenditures, which are a component of real GDP. Hence, aggregate saving need
not lead to a reduction in real GDP.
Consider, however, what happens when the funds from aggregate saving exceed the needs of all
borrowers in the economy. In this situation, real GDP will fall below its natural level because investment
expenditures will be less than the level of aggregate saving. This situation is illustrated in Figure .

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Aggregate saving, represented by the curve S, is an upward‐sloping function of the interest rate; as the
interest rate rises, the economy tends to save more. Aggregate investment, represented by the curve I, is a
downward‐sloping function of the interest rate; as the interest rate rises, the cost of borrowing increases
and investment expenditures decline. Initially, aggregate saving and investment are equivalent at the
interest rate, i. If aggregate saving were to increase, causing the S curve to shift to the right to S′, then at
the same interest rate i, a gap emerges between investment and savings. Aggregate investment will be
lower than aggregate saving, implying that equilibrium real GDP will be below its natural level.
Flexible interest rates, wages, and prices. Classical economists believe that under these circumstances,
the interest rate will fall, causing investors to demand more of the available savings. In fact, the interest
rate will fall far enough—from i to i′ in Figure —to make the supply of funds from aggregate saving
equal to the demand for funds by all investors. Hence, an increase in savings will lead to an increase in
investment expenditures through a reduction of the interest rate, and the economy will always return to
the natural level of real GDP. The flexibility of the interest rate as well as other prices is the self‐adjusting
mechanism of the classical theory that ensures that real GDP is always at its natural level. The flexibility
of the interest rate keeps the money market, or the market for loanable funds, in equilibrium all the
time and thus prevents real GDP from falling below its natural level.
Similarly, flexibility of the wage rate keeps the labor market, or the market for workers, in equilibrium
all the time. If the supply of workers exceeds firms' demand for workers, then wages paid to workers will
fall so as to ensure that the work force is fully employed. Classical economists believe that any
unemployment that occurs in the labor market or in other resource markets should be considered
voluntary unemployment. Voluntarily unemployed workers are unemployed because they refuse to
accept lower wages. If they would only accept lower wages, firms would be eager to employ them.
Graphical illustration of the classical theory as it relates to a decrease in aggregate demand. Figure
considers a decrease in aggregate demand from AD 1 to AD 2.

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The immediate, short‐run effect is that the economy moves down along the SAS curve labeled SAS 1,
causing the equilibrium price level to fall from P 1 to P 2, and equilibrium real GDP to fall below its
natural level of Y 1 to Y 2. If real GDP falls below its natural level, the economy's workers and resources
are not being fully employed. When there are unemployed resources, the classical theory predicts that the
wages paid to these resources will fall. With the fall in wages, suppliers will be able to supply more goods
at lower cost, causing the SAS curve to shift to the right from SAS 1 to SAS 2. The end result is that the
equilibrium price level falls to P 3, but the economy returns to the natural level of real GDP.
3.1.2 Keynes’s view of money demand
The Keynesian View: Monetary Equilibrium:
The Keynesian theory assigns a key role to money. It contends that a change in the money supply can
permanently change such real variables as the interest rate, the levels of employment, output and income.
Keynes believed in the existence of unemployment equilibrium in the economy.
The existence of unemployment equilibrium implies that an increase in money supply can bring about
permanent increases in the level of output. The ultimate influence of money supply on the price level
depends upon its influence on aggregate demand and the elasticity of the supply of aggregate output.
The Keynesian chain of causation between changes in the quantity of money and in prices is an indirect
one through the rate of interest. So when the quantity of money is increased, its first impact is on the rate
of interest which tends to fall. Given the marginal efficiency of capital, a fall in the rate of interest will
increase the volume of investment.
The increased investment will raise effective demand through the multiplier effect thereby increasing
income, output and employment. Since the supply curve of factors of production is perfectly elastic in a
situation of unemployment, wage and non-wage factors are available at constant rate of remuneration.

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There being constant returns to scale, prices do not rise with the increase in output so long as there is any
unemployment. Under the circumstances, output and employment will increase in the same proportion as
effective demand, and the effective demand will increase in the same proportion as the quantity of money.
But “once full employment is reached, output ceases to respond at all to changes in the supply of money
and so in effective demand.
The elasticity of supply of output in response to changes in the supply, which was infinite as long as there
was unemployment falls to zero. The entire effect of changes in the supply of money is exerted on prices,
which rise in exact proportion with the increase in effective demand”. Thus, so long as there is
unemployment, output will change in the same proportion as the quantity of money, and there will be no
change in prices; and when there is full employment, prices will change in the same proportion as the
quantity of money.
Therefore, Keynes stresses the point that with increase in the quantity of money, prices rise only when the
level of full employment is reached, and not before this.The modern view of money demand owes much
to the work of John Maynard Keynes in the 1930s. while classical economists tended to emphasize the
use of money in making transactions, Keynes identified three motives for holding money.
1. Transaction motive
It is the demand for money to meet daily transactions. It depends directly on the level of income.People
hold money because it is useful in making purchases. Naturally the transaction motive for holding money
would give rise to money demand that is positively related to income. People with higher incomes
typically make transactions and thus will hold more money. In fact, like the classical economists, Keynes
viewed money held for transaction purposes as being proportional to income.
2. Precautionary motive.
It is the demand for money for meeting future contingencies. This depends directly on the level of
income.People hold money to meet unexpected expenditure requirements, such as for emergencies or the
proverbial rainy day. This is a refinement of the store of wealth function of money. Keynes also viewed
money held for precautionary purposes as being proportional to income.
3. Speculative motive
Speculative Motive (L2): In a dynamic society there is no certainty regarding future. In such a situation,
the store of value function is more important. This leads to speculative motive for hoarding money.The
most novel/new idea in Keynes‟s theory of money demand was the speculative motive, which implies
money demand depends on interest rates. In this respect people may choose to keep ready money to take
advantage of profitable opportunities that may arise in financial markets such as to invest in bonds which
may arise or they may sell bonds for money when they fear a fall in bonds market prices.
Liquidity Trap:
Keynes visualized conditions in which the speculative demand for money would be highly or even totally
elastic so that changes in the quantity of money would be fully absorbed into speculative balances. This is
the famous Keynesian liquidity trap. In this case, changes in the quantity of money have no effects at all
on prices or income. According to Keynes, this is likely to happen when the market interest rate is very
low so that yields on bond, equities and other securities will also be low.

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At a very low rate of interest, such as r2, the Ls curve becomes perfectly elastic and the speculative
demand for money is infinitely elastic. This portion of the Ls curve is known as the liquidity trap. At such
a low rate, people prefer to keep money in cash rather than invest in bonds because purchasing bonds will
mean a definite loss. People will not buy bonds so long as the interest rate remain at the low level and
they will be waiting for the rate of interest to return to the “normal” level and bond prices to fall.
According to Keynes, as the rate of interest approaches zero, the risk of loss in holding bonds becomes
greater. “When the price of bonds has been bid up so high that the rate of interest is, say, only 2 per cent
or less, a very small decline in the price of bonds will wipe out the yield entirely and a slightly further
decline would result in loss of the part of the principal.” Thus the lower the interest rate, the smaller the
earnings from bonds. Therefore, the greater the demand for cash holdings. Consequently, the Ls curve
will become perfectly elastic.3.2 Money supply

MONEY AND INFLATION

Inflation is the rising price of goods and services over time. It's an economics term that means you have to
spend more to fill your gas tank, buy a gallon of milk or get a haircut. Inflation increases your cost of
living. Inflation reduces the purchasing power of each unit of currency. As prices rise, your money buys
less. That's how inflation reduces your standard of living over time.

Types of infaltion

Classified On the Basis of Causes:

(i) Currency inflation:

This type of inflation is caused by the printing of currency notes.

(ii) Credit inflation:

Being profit-making institutions, commercial banks sanction more loans and advances to the public than
what the economy needs. Such credit expansion leads to a rise in price level

iii) Deficit-induced inflation:

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The budget of the government reflects a deficit when expenditure exceeds revenue. To meet this gap, the
government may ask the central bank to print additional money. Since pumping of additional money is
required to meet the budget deficit, any price rise may then be called the deficit-induced inflation

iv) Cost-push inflation:

Inflation in an economy may arise from the overall increase in the cost of production. This type of
inflation is known as cost-push inflation (henceforth CPI). Cost of production may rise due to an increase
in the prices of raw materials, wages, etc. Often trade unions are blamed for wage rise since wage rate is
not completely market-determined. Higher wage means high cost of production. Prices of commodities
are thereby increased.

v) Demand-pull inflation

An increase in aggregate demand over the available output leads to a rise in the price level. Such inflation
is called demand-pull inflation (henceforth DPI). But why does aggregate demand rise? Classical
economists attribute this rise in aggregate demand to money supply. If the supply of money in an
economy exceeds the available goods and services, DPI appears. It has been described by Coulborn as a
situation of “too much money chasing too few goods

Classified of On the Basis of Speed or Intensity

(i) Creeping or Mild Inflation:

If the speed of upward thrust in prices is slow but small then we have creeping inflation. What speed of
annual price rise is a creeping one has not been stated by the economists? To some, a creeping or mild
inflation is one when annual price rise varies between 2 p.c. and 3 p.c.

ii) Walking Inflation:

If the rate of annual price increase lies between 3 p.c. and 4 p.c., then we have a situation of walking
inflation. When mild inflation is allowed to fan out, walking inflation appears. These two types of
inflation may be descry bed as ‘moderate inflation’.

iii)Galloping Inflation: According to Prof. Samuelson, if prices rise by dual or triple digit inflation rates
like 30% or 400% or 999% yearly, then the situation can be termed as Galloping Inflation. When prices
rise by more than 20%, but less than 1000% per annum (i.e. Between 20% to 1000% per annum),
Galloping Inflation occurs. Jumping Inflation is its another name.

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IV) Running Inflation: A rapid acceleration in the rate of rising prices is called Running Inflation. It
occurs when prices rise by more than 10% in a year. Though economists have not suggested a fixed range
for measuring running inflation, we may consider a price increase between 10% to 20% per annum
(double-digit inflation rate) as a Running Inflation.

V) Hyperinflation refers to a situation where the prices rise at an alarming high rate. The prices rise so
fast that it becomes very difficult to measure its magnitude. However, in quantitative terms, when prices
rise above 1000% per annum (quadruple or four-digit inflation rate), it is termed as Hyperinflation

CAUSES OF INFLATION:

I) Demand-Pull Inflation Theory:

DPI originates in the monetary sector. Monetarists’ argument that “only money matters” is based on the
assumption that at or near full employment excessive money supply will increase aggregate demand and
will, thus, cause inflation.

ii) Cost-Push Inflation Theory: In addition to aggregate demand, aggregate supply also generates
inflationary process. As inflation is caused by a leftward shift of the aggregate supply, we call it CPI. CPI
is usually associated with non-monetary factors. CPI arises due to the increase in cost of production. Cost
of production may rise due to a rise in cost of raw materials or increase in wages.

iii) Paper money inflation. This type of inflation is caused by the printing of currency notes.

iv) Imported inflation. Assuming country y is trading with country x.y is facing inflation then x will be
forced to buy from y at high price leading to inflation in x

v) Natural calamity. Whenever there is natural calamity such as drought, that will lead to lower
production of goods and services causing scarcity in the economy hence the price level will go up.

vi) Social evil inflation. The businessmen can collectively agree to hoard goods e.g. petroleum products
which will create an artificial shortage in the economy this will make price levels to rise

Effects of Inflation

Positive Effects of Inflation

Not all outcomes of inflation are bad. In fact, maintaining a healthy rate of inflation is good for the
economy. Here are five positive effects of inflation:

1. Attractive Savings Account interest Rates

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Investors with short-term goals might invest in a high-interest savings account .Increased inflation often
prompts the Federal Reserve to raise interest rates. So investor benefit from a better return on money
sitting in your cash or savings account.

2. It’s Cheaper to Travel Abroad

Inflation and higher interest rates push the American dollar higher. Yes, things cost more at home, but
inflation also makes purchases in foreign countries cheaper when you pay with U.S. dollars. This includes
the cost of travel, hotel and food, as well as purchasing items while you’re abroad. So celebrate inflation
by taking a trip outside the U.S.

3. It Offsets Negative Effects of Deflation

The opposite of inflation is deflation, which results in lower prices on many things, like grocery items.
Deflation might sound good on the surface because it increases the value of your money. In reality,
however, deflation leads to sluggish sales for the grocers and retailers, which in turn impacts the share
price of these companies, part of our overall stock market and economy. A little inflation to keep
deflation at bay is a good thing.

4. Wages Will Be Higher

As inflation pushes the price of goods and services higher, it’s also positively correlated with higher
wages. A tight job market might lead to wage growth, which is seen as one of the causes of inflation.

Not only do companies find they need to offer better salaries to new hires, they’ll also have to pay more
attention to fairly compensating their existing employees in order to retain the talent they already have.
This means if you’ve been looking around for a new job as inflation is rising, you could get paid more at
a new company, but you might also have an increased opportunity for a raise.

5. You’ll get Cost-of-Living Adjustments

Even if you don’t have the money to invest in stocks, gold or other assets that might be positively
impacted by rising inflation, a little inflation could still benefit your financial situation. Recipients
of Social Security and Supplemental Security Income could see an increase in their monthly payments
when the Consumer Price Index, one of the inflation measures, goes up. This is called a cost-of-living
adjustment, and it means you’ll have a few more dollars to cover your monthly budget.

Negative Effects of Inflation

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Along with the good, there are also some bad outcomes of inflation. Here are five negative effects of
inflation:

1. Stuff Costs More

With inflation, prices of pretty much everything start to rise. Medical care and prices for prescription
drugs could increase, and your rent could also go up. And unless your paycheck goes up at least as much
as the inflation rate, you’ll be trying to pay for the increased costs of items on the same income, so
inflation can be tough on the wallet — especially during hyperinflation.

2. Borrowing Money Is More Expensive

Many Americans borrow money from a lender at some point in their lives whether it’s in the form of
a student loan consolidation, car loan or a mortgage. And when inflation rises, the Federal Reserve might
take it as a cue to increase rates for banks.

3. Adjustable-Rate Mortgage Rates Might Go Up

Borrowers who have an adjustable-rate mortgage might find that an uncomfortable effect of inflation is a
higher interest rate when their mortgage is “adjusted.” This is because ARMs are usually priced according
to the 10-year Treasury bill.

4. Hoarding Could Result

People have a tendency to hoard goods especially during periods of hyperinflation. This is because the
monetary value of goods might be more tomorrow than it is today, so consumers want to buy up as much
as they can afford at today’s prices before the prices rise. Hoarding might cause immediate shortages in
food and household goods, so you could be facing long lines and empty shelves at your local shops.

5. Long-Term Savings Might Erode

For investors who count long-term, conservative investments as a significant part of their net assets,
inflation can be a dirty word. This is because these traditionally safe investments, like bonds, often
require investors to lock into a guaranteed rate for a long time. Inflation creates a situation where these
long-term investments that pay a low interest rate have decreased buying power because inflation pushes
up the price of goods and services.

METHODS TO CONTROL INFLATION

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Inflation is generally controlled by the Central Bank and/or the government. The main policy
used is monetary policy (changing interest rates). However, in theory, there are a variety of tools
to control inflation including:

1. Monetary policy – Higher interest rates reduce demand in the economy, leading to lower
economic growth and lower inflation.

2. Control of money supply – Monetarists argue there is a close link between the money
supply and inflation, therefore controlling money supply can control inflation.

3. Supply-side policies – policies to increase the competitiveness and efficiency of the

economy, putting downward pressure on long-term costs.

4. Fiscal policy – a higher rate of income tax could reduce spending, demand and
inflationary pressures.

5. Wage controls – trying to control wages could, in theory, help to reduce inflationary
pressures. However, apart from the 1970s, it has been rarely used.

Fiscal policy can be used to control inflation through various measures aimed at reducing
aggregate demand in the economy. Here are some ways fiscal policy can be used to control
inflation:

1. Reducing Government Spending: By reducing government spending, the government

can lower aggregate demand, which can help reduce inflationary pressures. This can be
achieved through cuts in government programs or projects.
2. Increasing Taxes: Increasing taxes can reduce disposable income and consumer
spending, which can help lower aggregate demand and control inflation. Taxes can be
increased on income, consumption, or wealth, depending on the government's fiscal
objectives.
3. Adjusting Public Investment: The government can adjust its level of public investment
to control inflation. By reducing or postponing public investment projects, the
government can reduce aggregate demand and help lower inflation.
4. Improving Fiscal Discipline: Ensuring fiscal discipline and avoiding budget deficits can
help control inflation. High budget deficits can lead to increased government borrowing,
which can fuel inflationary pressures.
5. Targeted Subsidies: Targeted subsidies can be used to mitigate the impact of rising
prices on essential goods and services. This can help control inflation while ensuring that
vulnerable groups are not disproportionately affected.
6. Managing Public Debt: Managing public debt effectively can help control inflation.
High levels of public debt can lead to inflationary pressures, as governments may resort
to printing money to finance their debt.

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Monetary Policy

In a period of rapid economic growth, demand in the economy could be growing faster than its
capacity to meet it. This leads to inflationary pressures as firms respond to shortages by putting
up the price. We can term this demand-pull inflation. Therefore, reducing the growth of
aggregate demand (AD) should reduce inflationary pressures.

The Central bank could increase interest rates. Higher rates make borrowing more expensive and
saving more attractive. This should lead to lower growth in consumer spending and investment.
See more on higher interest rates

A higher interest rate should also lead to a higher exchange rate, which helps to reduce
inflationary pressure by:

 Making imports cheaper. (lower price of imported goods)

 Reducing demand for exports.

 Increasing incentive for exporters to cut costs.

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Interest rates were increased in the late 1980s / 1990 to try and control the rise in inflation.

Inflation target

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 UK
inflation target set in 1998.

As part of monetary policy, many countries have an inflation target (e.g. UK inflation target of
2%, +/-1). The argument is that if people believe the inflation target is credible, then it will help
to lower inflation expectations. If inflation expectations are low, it becomes easier to control
inflation.

Countries have also made Central Bank independent in setting monetary policy. The argument is
that an independent Central Bank will be free from political pressures to set low-interest rates
before an election.

Fiscal Policy

The government can increase taxes (such as income tax and VAT) and cut spending. This
improves the government’s budget situation and helps to reduce demand in the economy.

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Both these policies reduce inflation by reducing the growth of aggregate demand. If economic
growth is rapid, reducing the growth of AD can reduce inflationary pressures without causing a
recession.

If a country had high inflation and negative growth, then reducing aggregate demand would be
more unpalatable as reducing inflation would lead to lower output and higher unemployment.
They could still reduce inflation, but, it would be much more damaging to the economy.

Other Policies to Reduce Inflation

Wage Control

If inflation is caused by wage inflation (e.g. powerful unions bargaining for higher real wages),
then limiting wage growth can help to moderate inflation. Lower wage growth helps to reduce
cost-push inflation and helps to moderate demand-pull inflation.

However, as the UK discovered in the 1970s, it can be difficult to control inflation through
incomes policies, especially if the unions are powerful.

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Monetarism

Monetarism seeks to control inflation by controlling the money supply. Monetarists believe there
is a strong link between the money supply and inflation. If you can control the growth of the
money supply, then you should be able to bring inflation under control. Monetarists would stress
policies such as:

 Higher interest rates (tightening monetary policy)

 Reducing budget deficit (deflationary fiscal policy)

 Control of money being created by the government

However, in practice, the link between money supply and inflation is less strong.

Supply Side Policies

Often inflation is caused by persistent uncompetitiveness and rising costs. Supply-side policies
may enable the economy to become more competitive and help to moderate inflationary
pressures. For example, more flexible labour markets may help reduce inflationary pressure.

However, supply-side policies can take a long time, and cannot deal with inflation caused by
rising demand.

Ways to Reduce Hyperinflation – change currency

In a period of hyperinflation, conventional policies may be unsuitable. Expectations of future

inflation may be hard to change. When people have lost confidence in a currency, it may be
necessary to introduce a new currency or use another like the dollar (e.g. Zimbabwe
hyperinflation).

Ways to reduce Cost-Push Inflation

Cost-push inflation (e.g. rising oil prices can lead to inflation and lower growth. This is the worst
of both worlds and is more difficult to control without leading to lower growth.

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