money and banking notes

MONEY AND BANKING 1

Compiled by: Seetal Daas Contact: [email protected] BBA(Hons)-2k13 © All Rights Reserved. University of Sindh Laar Campus @ Badin

SECTION-I (MONEY) CHAPTER # 1

THE NATURE AND FUNCTION OF MONEY

What is Money?

Money is the wonderful invention of man. The pity is that it has no precise definition. Money has been defined differently by economist, so these definitions are given below.

1) Descriptive definition: ‘Anything that is generally acceptable as a means of exchange and that at the same time acts as a measure and store of value’.

2) Legal definition: ‘Anything which is declared by the state as money is money’. The general acceptable principles along with legal support are essential for a thing to serve as money.

3) General acceptability definition: ‘Money is anything that is generally accepted in payments for goods and services or repayment for debts.’

Money is different from Wealth & Income:

Money is paid for exchange of goods & services, while wealth includes all scarce resources which are owned by an individual or firm or nation, such as land, property, shares.

Characteristics of Wealth:

i) It has utility ii) It consist of scarce goods iii) It is transferable and iv) It is external to human being, e.g. Skill of a doctor, musician etc., are internal qualities and cannot be transferred, so they are not included in Wealth.

Money and Near Money:

Assets which are can be easily and quickly transferred into money without loss in value are called Near Money. It is cannot be directly used for making payments. E.g. treasury bills, government securities, saving bonds etc.

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Stages in development of Money:

1) Commodity Money: Commodity money is the money which is made up of precious metals like gold, silver or any valuable commodity like wheat, skin, arrows etc. A large number of items have served as commodity money at various time and places. E.g. Agriculture stage, domestic animal like cattle, goats, horses, cows sheep, rice grains etc. were used as money.

2) Metallic Money or Coins: The use of gold and silver as commodity money created problem in exchange of goods. The quality and quantity of precious metals were mixed with cheaper coins; the coins were stamped on both sides by a competent authority called coinage. The coinage guaranteed both the amount and the quality of metal.

3) Paper Currency: The next development in the payment system was paper currency. Paper made of paper and function as medium of exchange. Initially the paper currency promised that it was convertible into a fixed quantity of precious metals like gold and silver. Today, the paper notes are inconvertible notes.

3.1 Fiat Money: Fiat money consists of paper money. It accepted as money because the government says it is money; it is issued by the government without any backing of gold, silver or government securities.

4) Credit Money or Bank Money: Another step in the evolution of payment system is the use of credit money or bank money. Bank money is the use of cheques as medium for transactions are mostly received and made through cheques. The use of cheques or credit money is that it has made easier and possible for making transaction for large amount.

5) Electronic Banking Stage: Electronic Banking is the modern system of transferring funds using electronic communications. With the development of computers and advanced communication technology, paper work in payment system is reduced and electronic funds transfer system is taking place, now payment are made through magnetic strip cards, viz. bank debit cards, credit cards, telephone cards, smart cards, etc.

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BARTER SYSTEM

Exchanging goods with goods is called Barter System. The direct exchange of surplus commodity for commodity with another person without the use of money is termed as Barter in Economics.

Inconvenience/demerit of Barter System:

1) Double Coincidence of Wants: The exchange can only be effective if a person is willing to offer what the other person wants and at the same time needs what the other can spare. This double coincidence, as is obvious, is very difficult to attain in this civilized world especially where the range of human wants is very wide. The transaction costs of double coincidence of wants are very high.

2) Lack of common Measure: For instance, a man has a horse with him and the other a cow and both are willing to trade. A man who has a horse assign the value of one horse has two cows. The other who has a cow design the value of one cow as one horse and both stick to their respective valuation. In the absence of common measure of value, the exchange between the two parties cannot take place unless both of them assign the same value to different commodities which they posse.

3) Lack of Sub-division: For instance, a person has a cow with him and he wishes to get 40kg of wheat. It is clear the value of the cow is much more than the value of 40kg of wheat. What part of the cow should be given in exchange for 40kg of wheat? So the exchange may not take place between two parties.

4) Lack of store of value: Another demerit of barter system is to storing the commodities for longer time period because they lose their value as time passes.

5) Specialization not possible: Under the barter economy each person is a jack of all trades and master of none. A high degree of specialization cannot be achieved under barter system.

6) Payments in the future: it is very inconvenient to lend goods to other people, with the lapse of time. The value of commodities may fall. So it becomes difficult to make payments in the future.

7) Difficulties of Transfer of Wealth: This also major drawback of barter system to transferring the goods from one place to another place. E.g. a person wants to

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send 100 sacks of flour from Karachi to Peshawar, how much difficulty would he faces?

8) Difficulties in Tax collection: Another difficulty is that the tax cannot be collected in the form of goods. If the commodities are collected from the tax payers, they will not only lose value as time passes on but are difficult to store also.

How money has removed the difficulties of barter system?

1) Money is accepted as medium of exchange both by buyers and sellers. It has removed the difficulties of double coincidence of wants.

2) Money has a high degree of acceptability in the country. It, therefore, serves as a yardstick (unit of account) for measuring the value of all goods and services. The prices of goods are now quoted in money.

3) Money retains purchasing power overtime. It therefore, has removed the difficulties of store of value. The money store as wealth can be used in future as and when needed.

4) Under barter system time spent in exchange of goods for goods was very high (called transaction cost). The money stored as wealth can be used in future as and when needed.

5) Commodities were difficult to transport from one place to another. Money has made the transfer value of money easier and safer.

6) In barter system the process of development was very slow. With the use of money, division of labor, specialization has taken place. Technology has developed. Researches are being carried out. In monetary economy there is all round economic progress.

FUNCTIONS OF MONEY

A-Primary Functions of Money

1) Money as a medium of Exchange: money is used to pay for goods and services. A person now can sell his goods to another person for money and then he

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can spend that money to purchase the goods he wants from others. Money has made the exchange of goods easy.

2) Money as a unit of account: It serves as a common measure of value. The value of goods and services can be expressed in terms of units of money. The use of money as unit of account has greatly reduced transaction costs.

3) Money as standard of deferred payments: The advantage of selling goods on credit by the seller or making the payment on a certain date in future by the buyer is only workable and acceptable in a money economy and least in a barter economy. Money is the only unit of account which is easy to borrow and easy to lend. The function of money as standard of deferred payment is better served if the value of money more or less remains stable.

4) Money as a store of value: When the goods were used as money, there were problems in storing wealth in the form of cattle, grains etc. They used to deteriorate and were costly to handle. Money has removed this difficulty of store wealth.

B-Secondary function of Money

1) Aids of specialization, production and Trade: The use of money has helped in removing the difficulties of barter. The market mechanism, production of commodities, specialization, expansion, diversion of trade etc, have all been facilitated by the use of money.

2) Influence on income and consumption: The use of money has a direct bearing on the levels of income and consumption in the country. All production takes place for the market and the factor payments (rent, wages, interest and profits) are made in money. The higher the production, the higher are the remunerations to the factors and vice versa.

3) Money as instrument of making loans: People save money and deposit it in banks. The banks advance these savings to businessmen and industrialists. Money is thus the instrument by which savings are transferred into investments.

4) Money as a tool of monetary management: Money is an important tool of monetary management. If the money is effectively used, it helps in increasing

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output and employment. Money is also an important factor in determining the distribution of income and wealth among the members of the society.

5) Instrument of economic policy: Money is an important instrument of economic policy of the government. In order to achieve growth, reduce unemployment and maintain regular expansion of economic activity, money is the most powerful factor.

C- Contingent of Functions

1) Distribution of national Income: Money facilitates the distribution of national income among the various factors of production. It also helps in bringing justice in distribution.

2) Basis of credit system: Banks create credit on the basis of their cash reserves with Central Bank. Any change in the volume of money is brought about mainly by an increase or decrease in money supply.

3) Measure of marginal productivity: The marginal productivity of each factor of production is measured with the help of money. Money also helps in equalization of marginal utility in expenditure.

4) Liquidity of property: Money gives a liquid form to wealth. A property can be converted into liquid form with the use of money.

Qualities of Good Money

a) General Acceptability: The essential quality of a good money material is that it would be acceptable to all without any hesitation in exchange for goods and services.

b) Stability of Value: Good money material is that it should be fairly stable in value. Money is that standard by which we measure the value of all other commodities and if the standard itself is influenced by changes in its demand and supply.

c) Transportability: The commodity chosen should be easily transportable without any depreciation, if should have a large value in small bulk.

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d) Storability: Another requisite of good money material is that it should be storable without depreciation. If the commodity chosen as money is perishable, then that cannot serve as good money material.

e) Divisibility: The commodity chosen as money should be capable of being re-united without losing its value.

f) Homogeneity: The commodity selected as money should be a uniform quality and capable of standardization.

ROLE OF MONEY IN A CAPITALISTIC ECONOMY

Money is the sovereign queen of all delights. For her the teacher teaches, the lawyer pleads, the dancer dances, the soldier fights.

1) Production Decisions: Production has been greatly facilitated by the introduction of money. Money makes possible the accumulation of wealth in those hands which are able to organize the production. The decision of what, where, when and how much to produce are all guided by the amount of money offered in exchange of goods and services.

2) Pattern of Consumption: According to Adam Smith ‘Consumption is the sole and purpose of economic activity. With the introduction of money, the exchange of goods has become easy; people can sell their goods and services for money and can obtain the assortment of goods which they need by parting with money.

3) Exchange Transactions: The use of money has successfully removed the uselessness of barter. Money, by acting as medium of exchange, has greatly stimulated the exchange of goods. It splits up exchange process into two parts, sale and purchase and thus facilitates flow of goods and services from producer to consumer.

4) Distribution of National Dividend: As money is generally acceptable as medium of exchange and at the same time acts as measure and a store of value, therefore the distribution of national dividend through the medium of money greatly facilitates the processes of distribution.

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5) Money in the Field of Public Finance: Money is renders a very valuable service in the field of public finance in recent times aims at increasing the rate of economic activities and reducing inequalities of income. It also acts as an instrument of economic and social justice of country. Money helps the state in the achievement of objectives.

6) Money in the Sphere of Banking: The general confidence of in the purchasing power of money makes it the chief form of credit. The debtor can safely borrow money for consumption purpose or for production purposes. This has led to the building up of huge superstructure of banking and credit system.

7) Attainment of High Level of Production of Employment: if the money is properly managed, it ensures rising level of productions employment and real income in the country. In case, the delicate instrument in not properly handled, it leads to decline in the prices, output and job opportunities.

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CHAPTER # 2

FORMS OF MONEY

1) Metallic Money: consist of coins, made of gold, silver, copper or nickel. Metallic Money varies in weight, fitness and value. The Metallic Money is the full bodied money. The full bodied money whose face value is equal to the value of metal contain in it.

1.1) Standard Money: represent the money of account. By money of account is the meant the monetary unit in terms of which prices and other transaction are expressed.

1.2) Token Money: is subsidiary money. Its face value is higher than its intrinsic value. The total amount of coins depends on the needs of people.

The usage of token coins in the country has the following merits:

a) Token coins are of small denominations and so they meet the needs of the people for payment in small amount.

b) They can be easily converted at face value with the other currency of the country.

c) They cannot be smuggled out of the country because their metallic value is much less than their intrinsic value.

d) There are very few chances of their being hoarded or melted with the rise of prices as the intrinsic worth of the coins is very less than their face value.

2) Paper Money: The terms paper refers to the notes issued by the State or by a Bank, usually the Central Bank (SBP).

a) Representative Paper Money: is that money which is fully backed by equivalent metallic reserves, bank note can easily get it converted into metallic money on demand.

b) Convertible Paper Money: paper money which is convertible into coins on demand is called convertible paper money.

c) Fiat Paper Money: is that which is not convertible into gold or silver on demand. It is been declared legal tender by the issuing authority and has general acceptance as a medium of exchange.

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3) Bank Money: The term bank money applies to that near money which is not legal tender currency but is accepted as a medium of exchange on account of confidence in the issuing authority. Bank Money chiefly consists of cheques, bills of exchange and drafts.

a) Cheque: is merely an order on a bank by its client to pay a sum of money to himself or third party on demand. There are 3 kinds of cheque are given below;

i) Bearer Cheque: is that which can be cashed from a bank by any person who presents it at the counter.

ii) Order Cheque: if the word bearer is removed from the cheque, writing the name of person/company to whom to pay, it then becomes an order cheque, it is safe mode of payment because it is paid to the right person.

iii) Crossed Cheque: if two parallel lines are drawn across the face of the cheque and the word ‘payee’s account only’ are written between them, it becomes a crossed cheque. The payment is made by the crossed cheque is the safest form because a cheque can only be deposited in the payee’s account.

b) Bill of Exchange: is an order from a drawer to a drawee to pay a sum of money mentioned on the bill to the former or to the bearer at a fixed further time. It has two types i) sight bill: which is payable on demand ii) time bill: which can be paid after a certain specified period. If it is used for foreign trade is called foreign bill of exchange.

c) Draft: is a cheque drawn by the person named in it from one branch to another branch of same bank. It is the cheapest method remitting money to person both inside and outside the country.

Two other types of money are mentioned below (by: J.M. Keynes):

1) Commodity Money: is composed of actual units of a particular, free obtainable, non-monopolized commodity.

2) Managed Money: it shall have a determinate value in terms of an objective standard. It is similar to Fiat Money, except that the State undertakes to manage the conditions of its issue.



COINAGE OF MONEY

By coinage of money is meant by the process of manufacturing metals into certain shape so that the uniformity in weight and size is maintained in all the coins of the coins of the same kind. Before the advent of coinage, the metals like gold and silver were used to as medium of exchange. The sole power of coinage money has been taken over by the Government.

Standardized coinage has the following advantages:

a) It has become a useful commodity as a medium of exchange and comparing of values.

b) The stamped coins become historical documents of the state.

Types of Coinage

1.(a) Free Coinage: called as free coinage because if the people are allowed to take metals to the mint for being converted into standard coins without limit. People are not bound to make lots of coins they can make as they want.

b) Limited Coinage: called as limited coinage when people are bound to make more coins because limit is imposed on free coinage, government sometimes charges fee for converting metals into coins, face value of limited coins is higher than its intrinsic value, it is accepted as medium of exchange due to convertible into standard coins.

2.(a) Gratuitous Coinage: Government does not charge any fee for minting coins, the coinage is known as gratuitous. Gratuitous coinage is practised when the intrinsic value of bullion is to be brought at par with its face value.

b) Non-Gratuitous Coinage: Coinage is called non-gratuitous when government charges fee for converting metal into coins.

3) Debasement of Coins: When there is difference between a standard value of precious metals fixed by law and the real value of the metal used as a coin, it is then a case of debasement. Pakistani Rupee in accordance with Pak Coinage Act should contain 4 grains of silver and 6 grains of alloy, this ratio now has been changed and the silver content has been reduced by 2 grains without amending the Coinage Act. The Pakistani Rupee is thus a debased coin.



COINAGE IN PAKISTAN

History of coinage can be traced back to history of coinage in the undivided India. The search of Moen Jo Daro has led the discovery of much worn out gold coins whose history runs back into antiquity. The Nishka(old coins of gold) in early civilization in India the chief metals were used as gold, silver and iron. As the time passed on and technology developed, the shape and execution of the coins improved. An attempt was made by King Altamash, he introduced new coins round shape silver weighting 173 grains. With the fall of Mughal empire the country split up into small states, they has their own coins of different shape, size etc. during the WW-II people began to melt the silver coins as the intrinsic value of the rupee exceeded its face value. There was no central bank in Pakistan at the time of partition in 1947, the Government of Pakistan authorized the Reserve Bank of India to issue currency notes and the coins till June 30, 1948. The new coins issued by the Government of Pakistan are pure nickel rupee, half rupee and quarter rupee.

DECIMAL COINAGE IN PAKSITAN

Decimal coinage introduced in Pakistan on January 1, 1961. With the introduction of decimal coinage in Pakistan, the rupee has been divided into 100 units. The new unit has been named as new paisa, therefore, there should be no confusion in the conversion of old coins with the new ones.

Merits of decimal coinage;

a) There are no breaks in the circulations.b) The quick and easy calculations in all transaction save time and energy.c) The working of banking has been greatly improved as totally, subtracting and

multiplying becomes easy.d) The adoption of decimal coinage has facilitated the preparation of pay bills,

telephone bills, electricity bills, and the maintaining of cash books and ledgers.

Demerits of Decimal coinage;

a) There was confusion in the conversion of old coins with the new ones with illiterate people.



b) Some people indulged in profiteering by paying less new money in exchange with the old coins due to the ignorance of the customer.

c) The prices of the commodities were also raised by a few paisa for the purpose of rounding off the figure only.

d) The old counting machines were discarded with the introduction of decimal coinage and that was national loss.



CHAPTER # 3

MONETARY STANDARD

MONETARY STANDARD

Monetary standard is an economic unit by which all kinds of economic values are measured.

Classes of Monetary Standard

1) Commodity Standard: is that monetary unit which has its standard value equal to the value of a designated quantity of a particular commodity. The commodity standard can be established in gold or silver or in both gold and silver.

2) Fiat Standard: The unit of money which is neither equal to nor convertible at a fixed ratio with a particular commodity used as a medium of exchange is called Fiat Standard.

BI-METALLIC STANDARD

The monetary system where both gold and silver are standard metals and their ratio of exchange is fixed and maintained by law and they are also unlimited legal tender and is called Bi-Metallism.

Brief History of Bi-Metallism:

Bi-Metallism was adopted by France in 1803, the two metals, gold and silver served well as monetary units. For the smooth running and better functioning of bi-metallism, France, Belgium, Italy, Switzerland formed Latin Monetary Union in 1866. Monetary Union of 6 countries could not succeeded and finally collapsed in 1874. America adopted bi-metallism in 1792 and abandoned bi-metallism in 1900.

Advantages of Bi-Metallism:

a) Stability of Price Level: if one metal say gold or silver, is used as money, it will not ensure price stability in the country, because when one metal exceeds or falls short of currency requirements, that leads to rising or falling prices in the country.



b) Another advantage claimed for bi-metallism is that it helps in arresting the fall in the price of the value of the depreciated metal.

c) Bi-Metallism facilitates international trade because ratio of exchange between gold and silver can be established easily with all countries of the world which are on gold or silver standard.

d) When there are two metals used as joint standard, the government can easily meet its requirement of cash.

e) It makes easy for the banks to keep the necessary cash reserves against liabilities.

MONOMETALLISM

The monetary system of a country is called monometallism when the value of the monetary unit is fixed and maintained in terms of one standard metal only. If the standard monetary unit is gold, the country is said to have a gold standard, if the standard monetary unit is silver so it is on silver standard.

SILVER STANDARD

Under silver monetary standard the monetary unit is a given fixed quantity of silver and all other forms of money are maintained by making it convertible into silver at the fixed rate. Silver is allowed to move freely in and outside the country.

GOLD STANDARD

The system which exists in its fully developed form when the unit of money is exclusively defined by law as a certain amount of gold, of specified weight and fineness and when all forms of money within a monetary system are kept at a parity with this amount of gold in the world’s free gold markets.

Essentials of Gold Standard

a) The unit of account is defined by law as equal to a certain quantity of gold of specified weights and fineness.

b) The gold bullion can readily be converted into the standard money at a fixed price and vice versa.

c) All other types of money are kept at parity with standard money.



d) The monetary authority buys and sells gold in unlimited amounts at a fixed price per ounce (a unit of measuring weight) of other unit.

e) There is free import and export of gold in the world’s free gold markets.

Different Forms of Gold Standard

Full Gold Standard/ Gold Currency Standard: The standard monetary units of a country are full bodied gold coins. People are allowed to get the bullion converted in unlimited quantity into standard gold coins with or without charge. They can import, export, thus unlimited purchase/ sale of gold is allowed in country. When the WW-I broke out, this system could not be maintained due to the shortage of gold so finally given up.

Gold Bullion Standard: After the WW-I, all the countries except U.S.A could not obey the discipline of the gold standard and so had to abandon this monetary system. Restored gold standard was named as gold bullion standard. The gold bullion’s holder is not entitled to get it converted into gold coins. Government buys and sells all offerings of gold at a fixed price.

MECHANISM OF FREE GOLD STANDARD

The gold is allowed to move freely from one country to another country. The rates of exchange among the gold standard countries are established close to the gold parties. The inflow and outflow of gold from the country sets in motion a mechanism to restore equilibrium.

Rules of Gold Standard:

Firstly, there should be high degree of freedom of trade between countries. If any country impose restrictions on the import/ export of commodities, it will create a problem in movement of gold into or out of a country, thus gold standard will not work properly.

Secondly, the economic structure of the countries on gold standard should be highly elastic so that prices and wages react quickly to changes in gold movements.



Thirdly, if there is an outflow of gold, the prices of the commodities and the wage level should be allowed to fall. Similarly, if there is an inflow of gold, the price level should be allowed to rise.

Why Gold Standard Broke Down

1) Not obeying the Rules: almost all receiving countries did not play the game of the gold standard. Gold was not allowed to go into circulation and tone the internal price level.

2) Short term Investment: Before the WW-I, people used to invest abroad in long term investment but after the WW-I, most of the countries preferred to keep their funds for short term investment for safety reasons.

3) Repatriation/Repayment and War debts: another obstacle which hindered the smooth working of gold standard was the repayment of war debts. The debtor countries were willing to make the payments in the form of goods but the creditor countries demand that payment should be made in the form of gold only.

4) A Fair Weather Standard: another weakness of this standard is that it cannot bear pressure on its delicate working. It is always liable to fall down in crisis. It is thus a fair weather standard only.

5) Elastic Economic Structure: another factor which led to fall down of the gold standard was that gold standard could not keep the economic structure of their countries fairly elastic. Inflow of gold, a policy of inflation was not adopted. Gold standard can work successfully only when prices and wages respond to gold movements.

Merits of Gold Standard

1) Stability of External Value: it ensures stable exchange rate of all the countries on gold standard. If at any time there are different kinds between the market rate of exchange, it is automatically corrected by import and export of gold.

2) Stability of the Internal Value of the Currency: As the volume of a country’s currency depends on its stock of gold, so there cannot be over issue of bank notes.



3) Self-Regulative Character: The deficit or surplus in the balance of payments is automatically brought into balance by import or export of gold.

4) Universally Acceptable Currency: One very important merit of the gold standard is that it provides a country with a currency which is universally acceptable.

5) Facilitates International Trade: In International dealings, gold standard provides stability of exchange rates. This inspires confidence amongst the traders and encourages international trade.

6) Objective Standard: Gold Standard is an objective; it cannot secretly interfere with by the government or the currency authority.

7) Inspires Confidence: If a country is on Gold Standard, it inspires confidence in the people and contributes to the national prestige.

8) Simple Working: The working of Gold standard is so simple that it can be easily understood by a layman (one have not knowledge) also. It does not involve any complication like the modern currency system.

Demerits of Gold Standard

1) Adoption of Independent Monetary Policy: One very serious defect of the gold standard is that it makes it impossible for a country to pursue an independent monetary policy.

2) Automatic Standard: It is an automatic standard provided its rules are fully observed. It has been seen that prices and wages do not respond to changes in gold movements.

3) Change in Gold Output: The changes in output of gold caused variation in price from time to time.

4) Internal Stability: Another drawback with the gold standard is that it sacrifices internal stability/ strength to external stability. A country must adjust its internal prices to the prices prevailing in other countries.

5) Fair Weather Friend: One very serious charge leveled at Gold Standard is that it is a fair weather standard. It is always liable to collapse.



CHAPTER # 4

INFLATION, DEFLATION AND STAGFLATION

What is Inflation?

Inflation is a process in which there is continuous increase in the general price level and the money is continuously losing its value. Or Inflation is persistent and appreciable rise in general level or average of prices.(by: Gradner Ackley)

Causes of Inflation

1) Demand Pull Inflation: is also called Aggregate Demand Inflation. When aggregate demand increases faster than aggregate supply of goods and services, the prices of goods tend to rise.

1.1) Demand Pull Inflation and Full employment: If the country’s resources are fully employed and there is an increase in aggregate demand for goods, it will lead to an upward movement in prices.

1.2) Demand Pull inflation at less than full employment: An increase in aggregate demand can result in a rise in the general price level at less than full employment. The rise in price level occurs when output cannot be increased in proportion to the rise in aggregate demand.

2) Cost Push Inflation: a situation where the process of rising prices in initiated and sustained by rising costs which push up the general price level. The main sources of increased costs are following.

a) Increase in money wage rates: When the cost of living goes upward, workers demand the increases in wages. The increase in wages raises the cost of production of goods and push up price level.

b) Profit push Inflation: When few powerful firms increase the profit margins, the smaller firms also increase their profit margin. Therefore, inflate price level increase.

c) Material push Inflation: If there is increase in the prices of some basic materials such as gas, oil, steel, chemical etc. which are used directly or indirectly



in almost all industries, it cause increase in the cost of production and hence in the general price level.

d) Higher taxes: If the government imposes new taxes or raises the rates of old taxes, the producers generally shift the burden of taxes on to the consumers in the form of indirect taxes. The increases in the selling prices of commodities push up the inflationary in the economy.

e) Rise in import prices: If prices of imported goods increase, it also contributes towards inflation.

Remedies of Inflation

1) Monetary Policy: is a policy that influences the economy through changes in the money supply and available credit. Monetary policy is adopted by Central bank of country. Monetary measures which are used to control are; i) Quantitative Control ii) Qualitative Control.

2) Fiscal Policy: It is budgetary policy of the government relating to taxes, public expenditure, public borrowing and deficit financing. It can be measured as under;

i) Changes in Taxation: If the govt. of a country brings about changes in tax rates, it can help in stabilization of prices in the country.

ii) Changes in Govt. expenditure: If the inflation is at or above the level of full employment in the country, the govt. can bring down the price level by its own unproductive expenditure.

iii) Public Borrowing: Public borrowing is another effective method of controlling inflation. Public borrowing reduces the aggregate demand for goods and hence price level.

iv) Balanced Budget Changes: A balanced budget decrease has an effect on national income and hence on bringing down the price level.

v) Control of deficit financing: The bank borrowing and printing of new notes increases the money supply in the country and pushes up the price level. Deficit financing therefore, should be avoided to control inflation.



DEFLATION

A situation where price level falls causing major increase in unemployment, reduction in output and decrease in the income of the people.

Causes of Deflation

When the level of money income falls relatively to the current supply of goods and services, it may occur due to fall in the private investment unfavorable balance of payments , sudden increase in output, or by action of the central bank to raise discount rate or by selling securities or due to the combined effect of all these factors.

Measures to control Deflation

Deflation can be controlled both by fiscal and monetary measure. The task of increasing the demand for goods and services could be done by government by increasing public spending, by reducing taxes, by stimulating private investment or private consumption or a combination of all these.

Effect of deflation on various sections of society

a) Over production: When the prices are falling the producers buy material and other inputs at higher prices and are forced to sell the products at lower prices, it finally results in over production of commodities.

b) Traders lose: During deflation, the traders purchase goods at higher prices and have to sell later on at lower prices due to the deflationary trend.

c) Investing Class: The equity holders lose during deflation and debenture holders gain when prices fall.

d) Fixed income group: The prisoners, wage earners, gain during deflation as the wages, pensions etc. do not decrease with the fall in the prices.

e) Consumers: When the prices of the commodities fall, the consumers, whose debtors is fixed gain.

f) Tax Payers: The tax payers lose during deflation as the value of money rises in this period.



g) Private Sectors Unit: The private sector units suffer when their price of goods falls.

REFLATION

A situation of a moderately rising general price when efforts are made by the government to lift the economy out of depression. The inflation and reflation both, the money supply increases.

DISFLATION

The process through which prices are brought down without causing unemployment and reducing output is called disinflation.

STAGFLATION

Stagflation involves inflationary rise in prices and wages at the same time. The people are unable to find jobs and firms are unable to find customers for what their plants can produce.

Causes of Stagflation

i) Resource Costs: Reduction in aggregate supply may be due to rise in resource costs, price of raw materials, rise in wage rates, imported material. The rise in resource cost leads to rise in prices and reduction in output.

ii) Reduction in labor supply: Reduction in labor supply adversely affects output of goods. If the reduction in labor supply is caused by a rise in money wages on account of strong union or by a rise in the legal minimum wage rate, there will be a fall in output and employment and the price level rises.

iii) Increase in Taxes: If there is rapid increase in indirect taxes, it will raise costs and prices of domestic goods and reduce output and employment.

Measures to control Stagflation

a) The government should make every effort that minimum wages are not raised during stagflation.

b) The increase in money wages should be linked with increase in productivity.



c) The personal and business taxes should be reduced to bring down the costs or goods.

d) Through manpower training, the supply of labor should be upgraded. This will help in reducing unemployment.

e) Transportation should be improved to provide facilitates for searching out jobs in production areas.

f) The government itself should take up development programs to creative jobs in the country.

KINDS OF INFLATION

1) On the basis of Rate of Inflation

i) Creeping Inflation: is a situation in which the rise in general price level is at a very slow rate over a period of time. Under creeping inflation, the price level rises up to a rate of 2 percent per annum.

ii) Walking Inflation: Walking Inflation is a marked increase in the rate of inflation as compared to creeping inflation. The price rises in around 5 percent annually.

iii) Running Inflation: Under running inflation, the price increase is about 8 to 10 percent per annum.

iv) Galloping or Hyper Inflation: Galloping inflation is called full inflation. It is a stage of inflation which starts after the level of full employment is reached; here price level rises very rapidly within a short period.

2) On the Basis of Degree of Control

i) Open inflation: It is a stage when the rise in price level gets out of control.

ii) Suppressed Inflation: Under this type of inflation, the government makes efforts to check and control the rise in price level through price control and rationing. When the price level is suppressed by the above short term measures, it results in many evils such as black marketing, corruption and profiteering.

3) Inflation on the Basis of Causes



i) Demand Pull Inflation: inflation caused by increase in aggregate demand, not matched by aggregate supply of goods, resulting in rise of general price level, is called demand pull inflation. Simply, occurs when the demand for goods and services in the country is more than their supply.

ii) Cost Push Inflation: Cost push inflation occurs when the increasing cost of production pushes up, the general price level. Cost Push Inflation occurs when the economy is below full employment with prices rising even though there is no shortage of goods.

iii) Profit Induced Inflation: Profit Induced Inflation is in fact categorized under cost push inflation. When entrepreneurs, due to their monopoly position raise the profit margin on goods, it may cause profit push inflation.

iv) Budgetary Inflation: When the government of a country covers the deficits in the budgets through bank borrowing and creating new money, the purchasing power of the community increases without an increase in the production of goods.

v) Monetary Inflation: Inflation is caused by a too rapid increase in the money supply and by nothing else.

vi) Multi Casual Inflation: inflation has a number of causes. It may be caused by increase in money supply, excessive wage demands, excess aggregate demand for goods, shortage of goods etc. The chief cause of inflation in one year may not be in the next year. Since inflation is multi casual, therefore, a variety of policy measures are needed to deal with it.

INFLATION IN PAKISTAN

In Pakistan, the general price level is persistently rising since Partition of the Subcontinent. Prices remained volatile during the decade of 1990s ranging from 5.7% to 13% mainly because of declining economic growth. The inflation rate started declining from 1998 onward due to improved supply position of goods. Inflation rate based on the CPI (consumer price index) has averaged 4.6% during 2003-04. However, during 2007-08 (July-April) inflation increased to 10.3%, during 2008-09 inflation increased to 22.3%.



Causes of Inflation in Pakistan

1) Demand Pull Inflation: is generated when aggregate demand for goods for all purposes- consumption, investment and government expenditure exceeds the supply of goods at current prices.

i) Rapid Monetary expansion: In Pakistan, the rate of growth in monetary assets is much higher than the rate of growth in GDP. The easy monetary policy is adopted to kick start the economy is a major factor responsible for price hike in Pakistan.

ii) Deficit Financing: Due to the lack of resources for economic development , the government has been restoring to deficit financing over the years. The excessive growth in money supply compared increase in output has resulted inflation.

iii) Consumption habits: Pakistanis living in urban and rural areas are mostly money waster. They are proud of spending money on the goods which are used by the people in advanced countries of the world, as expenditure on clothes, foods, cosmetics etc. have added much to the inflationary pressure to the economy.

iv) Construction Houses: Since 1970, people are spending their savings mostly on the purchasing land and constructing houses. The unproductive expenditure on the construction of houses, plaza etc.

v) Population explosion: The population is increasing at the rate about 1.9% in Pakistan, the pressure of population has increased the aggregate demand for commodities thus pulling up the general level of prices in the country.

vi) Black Money: it is generated through smuggling, tax evasion, price control etc. It is estimated that annual generation of black money is about 25% of GNP of the country. This huge amount pushes up the prices of land, houses, car , air-conditioners and other expensive items.

2) Cost Push Inflation: the rise in general price level is also caused by rising costs of the factors of production, it is called cost push inflation.

i) Increase in wages: in Pakistan one the factors leading to cost push inflation is the rise in wages not backed by increase in productivity. The compensatory wage



increase and the rise in prices are chasing each other at quite a rapid speed causing persistent rise in the level of prices.

ii) Rising prices of imported goods: the import prices of chemicals, fertilizer, non-electrical machinery, etc. have gone up in the world market. The cost and so the prices of commodities using the imported items have gone up in the country.

iii) Increase in indirect taxes: For increasing the revenue, the government is heavily depending on indirect taxes. The increase in the indirect taxes every year has given the general price level an inflationary push.

iv) Rise in POL, Excise duty, Gas: The multiplier effect of the rise in POL, gas prices and sales tax on number of items has greatly contributed to the cost push effect.

vii) Rise in support prices of agriculture crops: The Government raised the support prices of cotton, wheat, sugarcane to protect the interests of the farmers. This also has an inflationary impact on the economy.



SECTION-II (BANKING) CHAPTER # 5

ORIGIN AND GROWTH OF BANKING

Banking: the business activities of banks.

Evolution of banking

It has not decided as to how the word ‘Bank’ originated. Some authors state that this word is derived from the words’ Bancus or Banque’ which means a bench. When the business was failed, the ‘Bancus’ was destroyed by the people. Other authors opinion that the word ‘Bank’ is derived from the German word ‘Banc’ which means ‘joint stock fund/firm’. Yes not confirm what the correct opinion is.

Early Growth

Banking is fact is as primitive as human society. Perhaps it were Babylonian who developed the banking system. It was evident that the temples of Babylonians were used as banks because of prevalent respect.

King Hamurabi was the founder of Babylonian empire, he draw a code where he laid down standard rules of procedure for banking operation by temple and great land owners. He got his code inscribed on blocks of diorite about 8 feet tall, containing 150 paragraphs which was dealing with all aspects of loans, interest pledge, natural accidents, loss.

It is not certain who invented money, but history records suggested that King Lydia casted electrum( natural alloy of gold and silver) ingots of identical shape and uniform weight were formulated.

Also in Greece the temples of Ephesus and Delphi were the biggest banks of their time were people were depositing their money and other valuables for safety. The Roman though did not organize state banking nevertheless the conduct of private banks in such a way the utmost confidence was created in them.

Early bank was the public lank called Bank of Venice was established. Seeing the demand these money lenders starting to organize themselves, the banking was started to come at sea port in southern Europe.



In 1401 German public Bank was established comprising on the operation of discounting, depositing, and transfer of money.

In order to stream line banking organization and techniques, conference was held in from 1548 to 1551, it was agreed commercial interest of time needed a bank facilities growth and transfer but it should not run by private individuals.

Modern Banking

Banking in its modern form and structure started in Britain when many Lombardy merchant came in England now called Lombard Street. They were so much resourceful.

The Business of changing was so lucrative that king Edward-II establish the Royal exchange of changing foreign money at a profit for the benefit of the crown.

The discovery of America brought riches to Britain and gave a fruitful boost to foreign trade. Consequently, the business was taken by Gold smith upto that time they were dealing with gold and silver.

Over the time period, Gold Smiths discovered the large sum of money were left in the custody, since they issued loans to customers.

In 1672, however, Britain faced a great crisis when Charles-II borrowed huge sum of money from gold smith later he refused to return it. Therefore, a number of gold smith bankers formed themselves into corporation in 1665, known as Bank of England £12,000,00 at 8% interest to William-III, who in return allowed them number of privileges to the bank.

By the year 1700, the bank of England was only issuing notes but also conducting accounts of customers. The Joint Stock bank was dissolved into private banks.

Types of Banks

1) Commercial Banks: are those banks which are engaged in performing the routine duties of banking business. They collect surplus money from the people. They make loans and advances in the form of overdraft, cash credits, discounting bill of exchange. E.g. HBL, NBP,UBL, etc.



2) Merchant Banks: are those banks which have mainly financing the domestic and international trade in country.

3) Saving Banks: are those banks which collect and keep the small savings of the public. The saving banks invest the funds in the safest government securities. E.g. Post Office Saving bank, Saving Account at National Saving Organization.

4) Consumer Banks: are those banks which provide finance for purchasing consumption goods for the use of the borrowers. E.g. Consumer Finance Companies, Sales Finance companies, Credit Unions etc.

5) Mortgage Banks: are those banks mainly deals with the providing loan on the basis of submitting securities for mortgage for construction purpose or other. E.g. Loan associations, Farm-Loan associations etc.

6) Investment Banks: are those banks which assist the business houses and the governmental bodies to raise money through the sale of stock and bonds for usually long term purposes.

7) Agricultural Banks: are set up to provide financial assistance to the agriculturalist. The Agricultural banks provide short term credit and medium term advances to the farmers for the purchase of seeds, manure, tractor etc. E.g. Agricultural Development Bank of Pakistan etc.

8) Industrial Banks: are those banks which mainly provide medium and long term credit to the industries. E.g. Industrial Development Bank of Pakistan.

8) Cooperative Banks: These are banks established to provide short and medium term loans for rural development in general. E.g. Federal Bank of Cooperative etc.

9) Eximp Banks: These are the banks which provide finance for promotion of imports and exports to trade, commerce and industry. These banks are contributing mainly toward the expansion of international trade.

10) Central Bank: Central banks occupy unique position in the banking structure of a country because they have been entrusted with the responsibility of controlling the money supply, interest rates and financial market of the country for the purpose of economic development. E.g. State Bank of Pakistan, Bank Of England, Reserve Bank of India, Reserve Bank of U.S.A. etc.



Banking in Indo-Pakistan

The Indian society was quite familiar with banking right from beginning. When money became the medium of exchange. Informal banking practices were continuing in those days.

The Vedic Epics clearly mention about giving and taking credit and also contract of debts. These are also sufficient evidence to show during the 5 th century people were accustomed to use hundies as the credit instrument, the land revenue was collected generally in kind, services were generally paid in cash. Bankers enjoyed banking while offering loans to different communities.

Banking Rule in India

The Muslim rulers, therefore, provided encouragement to the farmers by giving them interest free loans and grants in cash on one hand, and allowing them to pay the land revenue in cash or kind on other hand. Muslim historians of the 12th

century have also mentioned some bankers known as ‘Multani’ and ‘Shroffs’ who were acting as agents to the government to collect revenue as also to change money to government.

Muhammad Tughlaq was the first king to have introduced token currency in India. He issued metal coins as well as paper currency from the Royal Mints.

Akbar established mints all over the country to prepare and issue currency. Though the Muslim rulers did not establish any ‘Bank’ as such, yet they revolutionized the entire financial and monetary structure in India wherein the old ‘Sahokars’ and ‘Mahajans’ were not only eliminated but the Government introduced reforms were effective that these classical bankers were pushed into the past.

Banking in Pakistan

Commercial Banking facilitates were provided fairly well in Pakistan. There were 487 offices of scheduled banks in the territories now constituting Pakistan. After the independence of Pakistan the committee recommended that the Reserve Bank of India should continue to function in Pakistan until 30th September 1948, so the problems of time and demand liability, coinage, and currencies exchange etc. are settled in India and Pakistan.



This system run one year, thereafter, Government of Pakistan decided to establish a full-fledge Central Bank. Consequently, the Governor General of Pakistan and Father of Pakistan Quaid-e-Azam founded the State Bank of Pakistan on July 1,1948.

The first important task which the State Bank of Pakistan had to issue of currency notes and withdrawal of Reserve Bank of India notes with overprinting, then Pakistan’s currency circulated in the country.

THE STATE BANK OF PAKISTAN

After Partition, the newly born state was faced with a serious banking situation due to the wholesale migration of banking staff to India. Rather created further difficulties by refusing to give Rs.55 crore which Pakistan was entitled to share the cash balance of the undivided India.

Therefore, decided to establish its own currency authority earlier than it was mutually agreed upon. The Reserve Bank of India was relieved of its functions in Pakistan from the first day of July, 1948. The Governor General Quaid-e-Azam Muhammad Ali Jinnah order for the establishment of State Bank of Pakistan on 1 st

July 1948. The Bank is entrusted with the duty of ‘regulating the issue of bank notes and keeping of reserve’ with a view to seeking monetary stability in Pakistan.

The original share capital of the Bank is three crore rupees divided into three lac fully paid up shares of Rs.100 each. Of the total share capital 51% were owned by Government Sector while 49% were owned by private sector. The State Bank of Pakistan has 14 departments, and employing over 5000 employees.

Functions of State Bank of Pakistan

1) Bank of Issue: the State Bank of Pakistan has sole right to issue notes except one rupee coin and subsidiary coins which are issued by the Government of Pakistan. This system of note issue is known as Minimum Reserve System.

2) Framing and organizing of monetary policy: Monetary policy is conducted by the SBP to regulate and control the volume of money and credit supply in the



country in order to achieve specific economic objectives such as price stability, reducing employment etc.

3) Regulation and Supervision of Bank: The State Bank of Pakistan has full powers to supervise and control the banking system in the country. The regulatory powers relate to the licensing of banks, and their branch expansion, liquidity of assets of banks, management and methods of working of the banks.

4) Foreign Exchange Management: The State Bank of Pakistan acts as a custodian of foreign exchange reserves manages exchange control and external value of the rupee and acts as the agent of the government in respect of Pakistan’s membership of the IMF.

5) State Bank as a Clearing House: The State Bank of Pakistan acts as a clearing house for the commercial banks. A clearing house is a place where the representative of commercial banks meets each day to exchange cheques drawn on each other and then settle the difference owned to each other.

6) Adviser of Government: The SBP also acts as adviser to government in all financial matters. Since the SBP is directly involved in the money and foreign exchange markets, it, therefore, tenders advice on all economic matters.

7) Lender of Last resort: The State Bank of Pakistan is the lender of last resort for the commercial banks. If at any time, the banks are short of cash reserves, the SBP comes to their rescue. It provides cash to commercial banks.

8) State Bank and Economic Growth: The State Bank playing a significant role in facilitating economic development and growth of the banking system and other financial institutions in the country.



CHAPTER # 6

SPECIALIZED CREDIT INSTITUTIONS

1) International Monetary Fund (IMF): The need for economic recoveries of countries devastated after WW-II, the United States of America invited 44 countries of the world to the United Nations Monetary and Financial Conference in Bretton Woods, decided upon the agreement of the fund which was signed by 27 countries on December 27, 1945; funds operations started May, 1946.

2) International Bank for Reconstruction and Development/ World Bank: The economic and financial experts recognized the necessity of relief and physical reconstruction of economies immediately after the WW-II, then representative of 28 countries signed the Articles of Agreement and the Bank was established on December 27, 1945.

3) International Finance Corporation (IFC): The activities of World Bank did not cover all needs of development financing, the World Bank formally submitted a proposal Charter, and 31 countries signed the Article of Agreement in April 1955, bringing the International Finance Corporation came into being in July, 1956, as an affiliate of the World Bank.

4) International Development Association ( IDA): The Board of Governors of the World Bank at its annual meeting in 1959 approved a United States resolution calling upon the Executive Directors of the Bank to draft Articles of Agreement for IDA, and submitted to the Member-Countries in January, 1960 and it is established.

5) Multilateral Investment Guarantee Agency (MIGA): This agency established in 1998, as an affiliate of the World Bank, but it is legally and financially separate from the world Bank. Its basic object is to encourage the flow of investment in productive purpose in its member countries.

6) Islamic Development Bank ( IDB): The conference of Finance Ministers of Muslim Countries held in Jeddah in December, 1973 issued a Declaration of Intent and the Islamic Development Bank was subsequently established and commenced operations in October,1975. With the object at the economic development , and social progress of member-countries and Muslim Communities.



7) Asian Development Bank (ADB): The Asian Development Bank commenced operation in December, 1966, with its headquarter in Manila (Philipines). The aim to raise funds from private sources then it provides financial and technical assistance for development purposes in the Asian region.



CHAPTER # 7

THE BANKER’S FUND, BANK CREDIT, INSTRUMENT OF CREDIT

The fund available to a banker for the purpose of his business comprise of the following;

i) Banker’s own paid-up capital, the reserve fund, and liquid assets.

ii) Money received from depositors in current, fixed and term deposits.

a) Bank’s Capital: The amount with which a banking company in Pakistan has been registered is called Nominal or Authorized Capital. It is further divided into paid-up capital and subscribed capital. Paid-up Capital is that portion of capital which the banking company has actually received from the public, while the subscribed capital is that part of the issued capital which is applied for by the public, including the shares issued to the vendors or promoters.

b) The Reserve Bank: This fund consists of accumulated un-divided trading profits set aside to provide for possibility and any unusual call upon the bank’s resources. In this case many Pakistani banks the reserve fund has approached in amount more than the paid-up capital.

CREDIT

The word ‘credit’ is derived from the Latin word ‘Credo’. The word ‘Credo’ means ‘I trust you’. Defined as: An exchange which is complete after the expiry of certain period of time after payment.

Functions of Credit

1) Economy in the Use of Metal: Credit instrument are used as medium of exchange in place of metallic coins. There is thus a saving of precious metals.

2) Provision of Working Capital: If an industrialist is short of spending power when the production is going on, he can finance the industry by obtaining credit from the banks.



3) Sales and Bonds: If the prospects of invested capital are bright and the profits are being earned left and light, the firm can obtain possession of funds even by selling bonds.

4) Case of Young Firm: Credit enables the entrepreneur of a young firm to develop its resources at a rapid speed which otherwise would not have been possible.

5) Large Scale Production: The institutions of credit have provided a ready flow of money to the industrialist. When the requirements of capital accumulation are met, the production is increased on large scale.

6) Purchase of Goods: Credit makes it easy and convenient to the consumers to purchase or hire durable goods. A consumer can acquire flour, cloth, radio, telephone, car, house, washing machine, etc. from the dealer s with an obligations to pay in future either by installments or in lump sum.

7) International Payments: International Payments, especially through the bills of exchange, have been greatly facilitated. There is no need now to import or export gold for settlement of international business transactions.

8) State Revenue: If government expenditure is in excess of its current revenue, it can meet the deficit by the sale of bonds. Thus the timely needs of the state are satisfactorily met through credit.

Dangers of Credit

1) Over-issue of Credit: The expansion of credit beyond safe limits usually results in over investment, over production, and the rise in prices. The contraction of credit generally leads to recession and depression in the economy.

2) Bad Debts: If an individual consumer, a businessman or a nation is not careful in the use of borrowed money and rash enterprises are undertaken which prove failure; the loans will not be paid to credit institutions which will create panic in the monetary circle.

3) Insufficient Business Concern: Another inherent danger of credit is that money may accumulate in the hands of those entrepreneurs who are financially weak and running uneconomic concerns.



4) Monopolistic Exploitation: If large amount of money is placed at the disposal of individuals or companies, then there is danger of combines and monopolistic exploitation. The monopolistic can adopt unfair methods in business dealings.

5) Borrowing by Government: A government may spend borrowed money in lavish manner. If the citizens are vigilant, they will lose confidence in the credibility of the state.

INSTRUMENT OF CREDIT

1) Pay roll Credit: is also called oral agreement. Some credit extended to individuals, friends, business associates without keeping any record or documents. The agreement to pay back the money is purely oral. If a borrower refuses to pay the money, the creditor cannot prove the existence of any obligation. Oral agreements are mostly confined to small loans.

2) Open Book Accounts or Book Credits: Open book account merely consists of entries on the books of business concerns. These entries appear as an account receivable on the books of lender and as an account payable on the books of the borrower. The main advantage claimed for the book account is that it is very simple and speedy way of carrying on the business transaction.

3) Documentary Credit Instruments: However, most of the credit is evidenced by a written contract. The instruments of credit or debit exhibit the existence and terms of debt, identity of the debtor, the amount of the debt, the rate of interest, the time of the maturity of the loan etc. When the instruments of credit or debt are evidenced by records and documents, they eliminate doubts about the nature and terms of loans.

NEGOTIABLE INSTRUMENT

A written document which entitles a person to receive a sum of money. The kinds of negotiable instruments are; i) Promissory Note, ii) Bill of Exchange and iii) Cheque.

Characteristic of negotiability

1) Transferable by delivery: it is transferable from one person to another by delivery or endorsement.



2) Entitled to receive money: The legal holder of the instrument is entitled to receive money mentioned in it.

3) Filling a suit: The holder of negotiable instrument has the right to file a suit in his name for payment from all or any of the concerned parties.

4) Transferee is not affected by defective title: If the transferee has accepted the negotiable instrument in good faith, then he is not affected by the defective title of the transferor in any way. In other words, he is protected against all defects of title of persons from whom he receives the payment.

money and banking notes

Documents