business form 4 topics- for form 3 purple/pink

 INTRODUCTION

Money: Money refers to anything that is generally accepted as a medium of exchange for goods and services. Money is in the form of notes and coins.

Banking: Banking refers to all activities carried out by financial institutions involving money. Financial institutions include the central bank, commercial banks and non-banking financial institutions.

BARTER TRADE

Barter trade is a system of trade where goods and services are exchanged with other goods and services. This is a system of trade that was used in African traditional societies though barter trade is still used in modern societies e.g. where a person works in exchange for food stuffs.

Merits of Barter trade

·         Buyers and sellers are able to get immediately those goods and services they require

·         Enables a country or person dispose off its surplus

·         Promotes harmony, peace and understanding among trading partners

·         Promotes specialization in production

·         Promotes the standard of living of those involved in trade

Limitations of Barter trade

Despite the advantages mentioned above, barter trade has a number of drawbacks as discussed below

a)      Requires double coincidence of wants

For barter trade to take place there must be double coincidence of wants. This means, that there must be somebody who has what you have and is in need of what you have for barter trade to take place. E.g. if someone has a goat and wants beans, then he has to look for someone who has beans and is in need of a goat. This situation is very difficult to come by.

b)     Lack of standard measure of value

In barter trade, it is difficult to determine how much of a commodity should be exchanged for another. For example if someone has fish and is need of a cow, it will be difficult for him to determine the number of fish to exchange for one cow.

c)      Indivisibility of some commodities

Some commodities cannot be subdivided into small quantities without loss of value. For example if you have a cow and you want one tin of maize, it will be difficult to subdivide a cow into smaller parts equivalent to one tin of maize.

d)     Perishability of commodities

Some commodities will go bad before they reach the market resulting in losses to the seller.

e)      Inconvenience in transporting some commodities

Some goods are too bulky to be carried from one place to another. This will greatly hinder trade.

f)       Lack of standard of deferred payment

It is difficult to make payment in future using goods since their value could have reduced or needs of the person to be paid could have changed

g)      Lack of unit of account

It is difficult to calculate the value of goods and keep a record for future reference

h)     Hinders specialization

Lack of double coincidence of wants makes people produce as many products as possible in order to satisfy market demand

MONEY SYSTEM

Because of the many drawbacks, barter trade is no longer used; instead it has been replaced by money system of trade

Development of money

a)      The earliest form of money was commodity money which consisted of various commodities such as ivory, salt, beads, hides and skins. Commodity money had several limitations which include the following:

·         Some commodities were perishable

·         Some commodities were not portable

·         Some commodities could be obtained easily without effort

·         Some commodities were indivisible

b)      Because of the above limitations, commodity money was replaced with metallic money which was in the form of copper, silver and gold. Metallic however had the following limitations:

·         They were insecure to keep and carry around due to their high value

·         They were heavy to carry around

·         There were not easy to divide

c)      The above limitations led to the metallic money being replaced with paper money (paper notes) which was issued by goldsmiths and silversmiths who provided safe custody of precious metals. Paper money had the following limitations:

·         Fake notes came into existence

·         Paper money lacking a legal force (backing by the law)

·         Lack of credibility of the issuing authority

d)     Paper money was followed by the development of legal tender currency notes and coins which had the backing of the law. Legal tender currency were issued in the form of bank notes and coins

e)      The need for convenience has given rise to representative and plastic money. Representative money are in form of cheques, money orders, bills of exchange etc. whereas plastic money is in the form of credit cards

Forms of money

·         Commodity money

·         Metallic money

·         Paper notes

·         Bank notes

·         Coin money

·         Bank deposits (money held in current accounts)

·         Quasi money e.g. cheques, bill of exchange, credit cards, money orders, postal orders etc.

Characteristics of money

For any commodity to be accepted as money, it must have the following characteristics

a)      Acceptability

Money must be generally accepted by everyone as a medium of exchange for goods and services

b)     Divisibility

Money should be easy to subdivide into smaller units (Denominations) without losing its value. This will enable people carry out transactions with ease.

c)      Portability

Money should be light and not bulky in order to be carried around without difficulties.

d)     Durability

Money should be able to stay for long without getting torn, defaced or losing its shape and texture. The material used to make money should therefore be able to withstand tear and wear.

e)      Stability

Money should be able to last for a long time without fluctuating in value.

f)       Homogeneity

Money of the same denomination should be uniform in quality and therefore identical. This makes it more recognizable and hence acceptable

g)      Cognisability

Money should be ease to recognize such that it is easy to differentiate between fake and genuine money.

h)     Scarcity

Money should be relatively scarce in supply inoder to retain its value. This is because if money is abundant in supply, it will lose its value greatly.

i)        Malleability

The material used to make money especially coins should be ease to cast into different shapes

j)       Not easy to forge

The material used to make money shouldn’t be easily available. The technique used in making money should also be highly secretive in order to avoid forging

Functions of money

The following are the roles played by money in the economy

a)      Medium of exchange

Money enables trade to take place as it is exchanged for various goods and services

b)     Measure of value

Money provides a common denominator in which the value of various goods and services are expressed. For example 1kg of sugar is valued at Ksh 140.

c)      Unit of account

Money provides a method through which the value of various commodities is calculated and a record kept. For example, land can be measured and its value recorded in terms of money.

d)     Store of value

Money can be used as a means of storing wealth. This is done by saving money which can be used in the future to buy different commodities.

e)      Standard of deferred payment

Money can be used to settle debts at any time because it is generally accepted as a medium of exchange for goods and services.

f)       Transfer of immovable assets

Immovable assets can be sold and the money realized used to buy similar assets elsewhere.

Demand for money (liquidity preference)

Demand for money refers to the desire of people to hold on money without intending to spend it. This desire is influenced by three motives (reasons):

·         The transaction motive

·         Precautionary motive

·         Speculative motive

a)      The transaction motive

Refers to holding money in order to meet daily expenses such as buying food, paying for transport etc. one therefore has to ensure that he has money at all times to meet these daily expenses. Such moneys are held for transaction motives.

The amount of money held for transaction motive will depend on the following factors:

·         Individual level of income: A person who earns more will have more money at his disposal hence he will hold more money to meet daily transactions as compared to someone with a low income

·         Interval between pay days: When the interval between paydays is far apart, more money will be held unlike when the interval is short. For example, a person who is paid after a month need to hold more money to meet daily expenses for the whole month unlike a person who is paid daily.

·         Spending habits: High spenders will hold more money as compared to low spenders. This is because they need more money to satisfy their spending habits

·         Prices of commodities: When prices are high, people will require more money in order to meet their daily expenses unlike when prices are low

·         Availability of credit: When people are not allowed to buy on credit, they will need more money to meet their daily expenses unlike when credit facilities are allowed

The transaction motive can further be subdivided into income motive and business motive. Income motive refers to holding money to spend on personal or family needs. Business motive refers to where money is held to meet business recurring needs such as paying wages.

b)     The precautionary motive

This is where people tend to hold money to meet expenses that may occur unexpectedly. Such expenses may relate to sickness, accidents etc.

The amount of money held for precautionary purposes may depend on factors such as:

·         Level of income: people with high levels of income tend to keep more money to cater against emergencies than people with low income levels

·         Family status: high class individuals with high incomes tend to hold more money as a precautionary measure against emergencies as compared to low class individuals

·         Age: older people are prone to health complications as compared to younger, they therefore need to keep more money to guard against emergencies

·         Number of dependants: with more dependants, emergencies will be more hence more money has to be held to guard against these emergencies

·         Individual temperaments: this has to do with how a person perceives life. An optimistic person will assume that nothing will go wrong in the future, such person will therefore keep little money to guard against emergencies as compared to a pessimistic person who assumes that many things will happen in the future

·         Interval between incomes: when the interval between incomes is long, more money will be held to cater against as compared to when the interval between incomes is short

c)      The speculative motive

This refers to holding money to spend in the future when economic conditions become favorable. For example an individual will keep his money inorder to spend it in the future when prices are low

Amount of money held for speculative motive will depend on the following factors:

·         Levels of income: the higher the income level, the higher the amount of money held

·         Individual temperaments: an optimistic person who doesn’t care the future happens will keep less money for speculative purposes as compared to a pessimistic person who is very conscious about the future.

Supply of money

Supply of money refers to the stock of monetary items in circulation at a given time. These monetary items may consist of

·         Total currency in form of notes and account

·         Total monetary deposits in commercial banks

Factors influencing the supply of money in the economy

a)      Central bank’s monetary policy

b)       Ability of commercial banks to lend money to the public

c)      Ability of central bank to control the lending ability of commercial banks

d)     The rate of interest in the economy i.e. higher interest rates limits lending by commercial banks resulting in lower supply of money and vice versa

e)      The national budget i.e. the higher the national budget, the higher the supply of money and vice versa

BANKING

Banking refers to all the activities carried out by banks and other financial institutions involving money.

Development of banking

Banking developed from the services offered by goldsmiths and silversmiths. These services included:

·         Accepting deposits of precious metals from the public

·         Providing safe custody of the precious metals received

·         Providing loans to traders from the deposits of precious metals held and charging interest on those loans

·         Issued paper notes to the depositors which facilitated change of ownership of the precious metals deposited without having to withdraw the deposits

Many goldsmiths and silversmiths emerged to provide these services prompting governments to start controlling their activities. This led to the rise of banks and the need to control these banks led to the emergence of the central bank.

Banking system in Kenya consists of;

·         The central bank

·         Commercial banks

·         Non-banking financial institutions

a)      Commercial banks

These are banks which are formed with the main aim of making profit through financial intermediation. Their profits are made through:

·         Interests earned on loans and overdrafts extended to customers

·         Investments in the economy

·         Income from daily operations e.g. ledger fees charged on customers’ deposits

Examples of commercial banks in Kenya may include:

·         Kenya commercial bank

·         Family bank

·         National bank of Kenya

·         Standard chartered bank

·         Co-operative bank of Kenya etc.

Services offered by commercial banks

a)      Accepting deposits

Deposits constitute money kept in commercial banks by customers. By accepting deposits help people save their money. These deposits are accepted in three main accounts depending on the customers' desire namely

·         Current account

·         Savings account

·         Time(fixed) deposit accounts

b)     Lending money

Lending money refers to giving out money in form of loans. Commercial bank gives loans to individuals, businesses and government agencies. Such loans attract interest at given rates. These loans encourage investments in the economy leading to economic growth.

c)      Safekeeping of valuable items

Commercial banks do accept some valuable items from their customers for safekeeping. Such valuable items may include title deeds, jewelry, wills etc. a fee is charged for safekeeping of these items.

d)     Facilitating transfer of money

Commercial banks provide methods through which money can be transferred from one person to another. This is made effective using methods such as; cheques, standing orders, credit transfers etc.

e)      Provision of foreign exchange

Commercial bank facilitates the exchange of different currencies. This is done to facilitate foreign trade. To offer foreign exchange services, commercial banks charge a fee.

f)       Offering advisory services

Through their customer care services, commercial banks advise their customers on the available investment opportunities and on the best ways to manage their funds.

g)      Provision of trustee services

Commercial banks can undertake to manage a deceased customer’s property on behalf of the inheritors if requested by the customer. This is mostly done if by the time of death of the customer, inheritors were minors. The property is passed over to the inheritors when they attain maturity. To do this, the bank charges a fee.

h)     Acting as guarantor or referee

Commercial banks may act guarantors to their customers who want to acquire goods on credit or borrow money from other financial institutions

i)        Linking savers and borrowers

By accepting deposits and lending money in for of loans, commercial banks provide a forum through which savers and borrowers can interact

Money transfer services

a)       Standing order

This is an instruction to the bank from the account holder to be paying a given amount of money to a named person at given intervals for as specific period of time.

b)      Credit transfer

This is method where one cheque is used to pay a given number of people whose account numbers and names are written on the cheques

c)      Telegraphic transfer

This is a method of transferring money from one account holder to another. The sender fills an application form containing the details of the payee

d)      Electronic funds transfer

This is a method of transferring money from one account holder to another via computers within the same bank or between different banks

e)       Cheque

This is a written order by the account holder (drawer) to his bank to pay on demand a specified amount of money to the person named on its face (payee) or to the bearer.

f)       Credit cards

These are cards which allows the customer to obtain goods and services from specified sellers without paying for them in cash. The value of the goods is deducted directly from the buyer’s bank account and the money remitted to the seller

g)      Travelers cheques

These are cheques which are issued to travelers in and out of the country to settle their debts in the country’s they are visiting

Commercial bank accounts

Commercial banks accept deposits from their customers into three accounts;

·         Current accounts

·         Savings accounts

·         Fixed(time) deposit accounts

a)      Current accounts

This is an account where money can be deposited and be withdrawn at any time provided there is sufficient funds in the account

This account is suitable for business people who need money regularly

Its features

·         Money is withdrawn at any time

·         No minimum balance is required to be maintained in the account

·         Account holders are allowed to use cheques to facilitate payments

·         Money deposited in the account do not earn interest

·         Customers can withdraw in excess of what is in their account. This excess withdrawal is known as an overdraft

·         Deposits can be made at any time

·         The bank charges ledger fees for maintaining the account

·         The account holder is given periodical bank statements to show a summary of the transactions between him/her and the bank for a given period of time

Advantages of a current account

·         They allow overdrafts

·         Cheques can be used to effect withdrawals and make payments

·         No minimum balance is to be maintained

·         Regular bank statements are issued to the account holder

·         Money can be deposited at any time

·         Money can be withdrawn at any time

Disadvantages of current accounts

·         No interest earned on deposits

·         Ledger fees is charged to operate the account

·         Withdrawals at any time discourages savings

b)     Savings account

This is an account where money deposited is only withdrawn after a given period of time. Suitable for those who are interested in saving.

Its features

·         Money deposited beyond a certain minimum earns interest

·         Cheques are not used by the account holder to facilitate payment

·         Overdrafts are not allowed

·         A minimum balance has to be maintained in the account

·         A notice must be served when withdrawing large amount of money exceeding a given limit

·         Money is only withdrawn by the account holder himself

·         Money can be deposited in the account at any time

·         An initial deposit is required when opening the account

Advantages of a savings account

·         Earns interest

·         Low initial deposit

·         Deposits can be made at any time

·         Restrictions on withdrawals encourages savings

·         Deposits can be made at anytime

Disadvantages of savings accounts

·         A minimum balance is required to be maintained at all time

·         A fee is charged when withdrawing

·         Ledger fee is charged to operate the account

·         Overdrafts are not allowed

c)      Fixed(time) deposit account

This is an account where money deposited cannot be withdrawn until after the expiry of an agreed upon period. The period can be 3 months, 6 months, 1 year or 5 years. During this period no further deposits can be made.

This account suitable for people who have money that is not intended for immediate use.

Its features

·         Earns interest at an agreed rate depending on the amount of money deposited and the duration

·         There is a minimum amount of money that can be deposited in this account

·         A  deposit certificate is issued to the account holder to act as evidence of the contract

·         If money is withdrawn before the expiry of the agreed period, no interest is earned

·         At the expiry of the agreed upon period, all the money can be withdrawn together with the interest earned

·         Involves large amounts of deposits

·         Money is deposited in the account once

·         The rate of interest is usually higher than in savings accounts

·         There is a minimum amount of money that can be deposited in the account

Advantages of fixed deposit accounts

·         Allow the account holder time to plan on how to spend the money deposited

·         Deposited money can be used as a collateral security for a loan

·         High interest is earned

·         No ledger fees

·         Encourages savings

Disadvantages of fixed deposit account

·         A notice is given when terminating the account

·         No interest if money is withdrawn before the expiry of the contract period

·         Money deposited cannot be accessed before maturity of the period

·         No regular deposits

·         Minimum balance is high

Differences between fixed deposit accounts and savings accounts

Fixed deposit accounts	Savings accounts
Money is not withdrawn until the contract is over	Money is withdrawn after an agreed interval
Can be used as a security for a bank loan	Can be used as a security for a bank overdraft
The account remains in force for a specific period of time	The account is in force as long as the minimum balance is maintained
A large amount of money is required to open the account	A small amount of money is required to open the account
A separate account is required for each deposit	All deposits can be made in the same account
A certificate of deposit is issued once money is deposited in the account	A passbook or a bank card is issued when deposits are made into the account
Interest earned is high	Interest earned is low

 

Differences between savings accounts and current accounts

Savings accounts	Current accounts
Withdrawals are made after a specific period of time	Withdrawals are made at any time
A minimum balance must always be maintained in the account	No minimum balance is required to be maintained in the account
Cheques cannot be used to make payment	Cheques are used to make payment
Overdrafts are not allowed	Overdrafts are allowed
Interest is earned on the money deposited	No interest is earned on the money deposited
Large withdrawals require a notice to be given to the bank	Any amount of money can be withdrawn from the bank without a notice to the bank
Money remittance services are not permitted	Money remittance services are permitted

 

Reasons why majority of Kenyans do not operate bank accounts

·         Most Kenyans earn low incomes which is entirely consumed hence no savings to keep in bank accounts

·         Requirements to open bank accounts are not favourable to most Kenyans

·         Instability in the banking sector discourages most Kenyans from operating bank accounts

·         Ignorance of the existence of banking facilities by most Kenyans

·         Banking facilities are located far away from some people

Ways in which commercial banks advance money to their customers

·         Bank overdraft facilities

·         Discounting bills of exchange and promissory notes

·         Giving out personal loans

Disadvantages of a bank overdraft

·         It may be expense as interest charged is high

·         Frequent use of overdraft by the business may be seen as a sign of mismanagement by financiers

·         Banks may recall the overdraft at any time

·         Overdrafts are not easily available unless one is well known or has a good reputation

·         Overdrafts are only given to current account holders

·         Overdrafts offer a limited amount of financing hence not suitable for long term financing

·         Overdrafts require short repayment period which may affect the cash flow of the business

Reasons why commercial bank loans are not popular in Kenya

·         High rate of interest is charged on the loans

·         Individuals and firms may have cheaper sources of loans

·         Not so many people have accounts with commercial banks

·         Acquiring commercial bank loans involves a lengthy procedure

·         Many people fear the consequences of failing to repay the loans

·         Many people do not have recognized property to attach as collateral security

b)     The central bank

This is a financial institution which is established by the government of the country to manage and control the supply of and demand for money

Functions of the central bank

a)      Issue of currency

The responsibility of issuing new currency lies with the central bank. The central bank will ensure adequate amount of money is in circulation. This is because excess money leads to inflation while too little money may suppress economic activities

b)     Acts as a banker to commercial banks

The central bank offers banking services to the commercial banks. These banking services include:

·         Maintains current accounts for commercial banks

·         Receiving money deposits from commercial banks and providing safe custody of such deposits

·         Facilitates the settlement of inter-bank debts

·         Lends money to commercial banks

·         Advices commercial banks on financial matters

c)      Acts as a banker to the government

The central bank provides banking services to the government. These banking services include:

·         Maintains current accounts for all government ministries and departments

·         Receiving money deposits from the government and providing safe custody of such deposits

·         Making payments on cheques drawn by the government

·         Advising the government on financial matters

·         Providing safe custody of funds received from abroad on behalf of the government

d)     Controlling commercial banks

The central bank regulates the operations of commercial banks by giving them instructions on lending procedures and proper banking practices. This is done to prevent these commercial from exploiting their clients. Some of the methods used by central bank to regulate commercial banks include the following:

·         Licensing commercial banks

·         Inspecting commercial banks

·         Approving the establishment of branches of commercial banks

·         Ensuring the protection of depositors funds

·         Punishing and closing down errant commercial banks

·         Interpreting and implementing government monetary policies to all commercial banks

e)      Links the country to external financial institutions

The central bank links the country with external financial institutions such as World Bank and the IMF. This facilitates healthy financial relationships enabling the country access financial assistance from such institutions

f)       Maintaining stability in exchange rates

The central bank monitors the rates of exchange between the local currency and other currencies. It therefore comes up with methods of ensuring that stability in exchange rates is maintained at all time. This is done through the following methods:

·         Devaluation of the local currency

·         Ensuring that no commercial bank is allowed to effect payments abroad without seeking permission from the central bank

·         Ensuring that no commercial bank is allowed to buy or sell foreign currency without seeking permission from the central bank

·         Requiring commercial banks to submit periodic reports to the central bank showing their foreign exchange deals

g)      Lender of last resort

The central bank can give loans to commercial banks. Commercial banks can therefore obtain loans from the central bank to meet their daily financial obligations when need arises

h)     Facilitates clearing of cheques

Through the clearing house, the central bank facilitates the clearing of cheques between different commercial banks

i)        Administering public debt

Public debt refers to all outstanding government borrowings both internal and external. The central bank is responsible for ensuring that such a debt is paid. The central bank therefore does the following:

·         Sales government securities such as treasury bills and bonds to the public

·         Discounts government securities

·         Redeeming government securities on maturity

·         Maintains a register of all government securities

·         Paying accrued interest on government securities

j)       Controlling monetary system

The central bank controls the supply of money in the economy. It does by using certain methods known as the instruments of monetary policy which will be discussed later.

The monetary policy

Monetary policy refers to the deliberate move by the government through the central bank to manipulate the supply, availability and cost of money in order to achieve the desired economic levels

Reasons for monetary policies

·         To facilitate rapid and steady economic growth

·         Create employment

·         Stabilize prices of goods

·         Ensure balanced economic development

·         Ensure equilibrium in the balance of payments

Tools of monetary policy

These are methods the central bank uses to control the supply of money in the economy. These tools are discussed below

a)      Bank rate policy

The central bank as lender of last resort gives loans to commercial banks at an interest rate. This interest rate determines the lending rates of commercial banks to individual borrowers. To reduce the supply of money in the economy therefore, the central bank will increase its lending rate forcing commercial banks to increase rate of interest on their loans. This makes loans expensive therefore discouraging borrowers. On the other hand to increase the supply of money in the economy, the central bank will lower its lending rate making loans cheaper hence encouraging borrowing

Factors limiting the effectiveness of bank rate policy

·         Availability of excess reserves in commercial banks enabling them to lend money to the public without having to approach the central bank for more money.

·         Few monetary transactions especially in under-developed countries

·         Existence of other lending institutions such as SACCOs from where loans can be accessed by the public

·         Reduction in the number of potential borrowers to the extent that changes in bank rates have no effect on borrowing

·         Savings and investments are done purely for safety reasons but not to earn interest

b)     Open market operations(OMO)

The central bank can regulate the supply of money in the economy by selling or buying government securities in the open market. Government securities include treasury bills and government bonds.

To reduce the supply of money in the economy, the central bank sells these government securities to the public, this will help in withdrawing money from the economy as people pay for these securities through commercial banks

On the hand the central bank can increase the supply of money by buying bank the government securities earlier sold. This will have an effect of releasing more money to the economy thereby increasing the supply of money

c)      Cash/liquidity ratio requirement

The central bank requires commercial banks to hold a certain proportion of their total deposits in form of cash in order to assist in meeting their day to day operations. This proportion is known as the cash ratio.

Cash ratio = cash held / total deposit

At other times, the central bank may require commercial banks to hold part of their total deposits in the form of liquid assets. This proportion is known as the liquidity ratio

To reduce the money supply in the economy, the government will reduce the amount of money always available in the cash. This will reduce the amount of money available for lending. On the other hand reducing the amount of money always available in commercial banks reduces their ability to lend.

d)     Compulsory deposit requirements

The central bank may require commercial banks to deposit a specific amount of money in the accounts they hold with it. These deposits will affect the amount of money available for lending by commercial banks. To reduce money supply therefore, the central bank will increase the amount of the compulsory deposits. On the other hand, to increase the supply of money, the central bank will reduce the amount of compulsory deposits.

e)      Selective credit control

The central bank may give instructions to commercial banks to only lend money to specific sectors of the economy. This will reduce the supply of money. On the other hand, to increase the supply of money, the government will reduce all forms of restrictions

f)       Directives and requests

The central bank may give directives to the commercial banks on the rate of interest to charge on their loans. To increase the supply of money, directives to lower interest rates will be issued. On the other directives to increase interest rates will be issued if the objective is to reduce the supply of money.

The central bank may also request commercial banks to adjust their interest rates as required. This is known as moral persuasion

Limitations of monetary policies

a)      Bank rates may not be effective where central banks lacks the power to enforce its rules

b)      Treasury bills lack a wider market hence hindering the effectiveness of open market operations

c)      Central bank may have limited control over commercial banks especially in developing countries

d)     Limited use of cheques and other banking services renders monetary policies ineffective

c)      Non-banking financial institutions

These are institutions which address financial needs of specific sectors of the economy which commercial banks cannot address. These institutions include;

a)      Development financial institutions

These are institutions which offer financial services to the manufacturing sector. Examples may include:

·         Kenya industrial estate

·         Industrial development bank etc.

b)     Housing finance companies

These are institutions whose major responsibilities to finance housing activities. They do this by either putting up houses which they sell to interested people or by giving mortgages to people to buy houses. Examples may include:

·         Housing finance company of Kenya

·         East African building society

c)      Savings and credit co-operative societies(SACCOs)

These are financial institutions which are formed to enable members save and access loans more conveniently. They are formed by people engaged in similar activities or are under a similar employer. Examples include:

·         Mwalimu Sacco

·         wakulima Sacco

·         Stima Sacco etc.

d)     Insurance companies

These are financial institutions which guard against risks. They also encourage savings. Examples may include:

·         Madison insurance company

·         Blue shield insurance company

·         British American insurance company etc.

e)      Micro finance companies

These are institutions which offer financial services to small scale and medium sized enterprises. Examples may include:

·         Faulu Kenya

·         Kenya women finance trust etc.

f)       Agricultural finance houses

These are institutions which offer financial services specifically to the agricultural sector e.g. the agricultural finance corporation.

Functions of Non-banking financial institutions

·         Giving loans

·         They offer training services

·         Advisory services that equip people with knowledge on how to set up and run businesses

·         They may extend guarantee/trustee services to members

·         They offer savings services to their clients

·         They generate revenue to the government through tax and dividends

·         They supplement the government’s effort of developing the economy

·         They create employment opportunities

Advantages of borrowing money from non-banking financial institutions

a)      They give long-term loans

b)      They provide finances for specific projects

c)      They give loans at relatively lower interest rates compared to commercial banks

d)     They accept lower collateral value

e)      They give longer grace period for loan repayment

Differences between commercial banks and Non-banking financial institutions

Commercial banks	Non-banking financial institutions
They provide current accounts	They don’t provide current accounts
They provide short term and medium term loans	They only provide long term loans
They are under the direct control of the central bank	They are not directly controlled by the central bank
They offer finances to all sectors of the economy	They only offer finances to specific sectors of the economy
They provide foreign exchange services	They do not provide foreign exchange services
They participate in the central bank clearing house	They do not participate in the central bank clearing house
They safe keep valuable items	They do not safe keep valuable items
They finance working capital	They finance capital for development
Offers bank overdrafts for current account holders	They do not offer bank overdraft facilities

 

Similarities between commercial banks and non-banking financial institutions

a)      Both accept deposits from the public

b)      Both lend money to the public

c)      Both are registered under the banking act except building societies

d)     Both pay interest on money deposited with them

e)      They both provide investment advice to their clients

f)       They both charge interest on loans advanced to their clients

NOTE: Due to the current changes in the banking industry, some non-banking financial institutions are now carrying out banking activities

Trends in banking

a)      Introduction of automated teller machines(A.T.Ms)

Advantages of ATMs

·         They are conveniently located

·         They offer 24hr services

·         Transactions are secured through pin

·         They provide additional information about the account

·         They save time

·         ATM cards can be used as credit cards to buy goods

·         They are cheaper

·         ATM cards are highly portable

·         Withdrawals can be done on behalf of somebody

Disadvantages of ATMs

·         They may not be used by the illiterate

·         They contribute to unemployment

·         They encourage cases of theft

·         ATM machines are not always available

 

b)      Introduction of computer usage which have facilitated networking of branches

c)      Restructuring of accounts

d)     Soft conditions on loan access

e)      Improved customer care services

f)       Introduction of mobile banking through M-pesa and airtel money which enables users

·         Send money

·         Withdraw money

·         Buy airtime

·         Access account balance

·         Buy goods and services from registered sellers

·         Withdraw money from A.T.Ms

g)      Introduction of pesa point money services where money can be withdrawn at any time

h)      Introduction of mobile banks.

TOPIC 4: PUBLIC FINANCE

CONTENTS

·         Introduction

·         Sources of public finance

·         Government borrowing

·         Government expenditure

·         Taxation

·         Budget

INTRODUCTION

Public finance refers to all activities carried out by the government in relation with raising of finances and the spending of the finances raised

SOURCES OF PUBLIC FINANCE

·         Fines imposed by courts on offenders

·         Rent and rates paid for using government property

·         License fees paid by those who want to operate businesses

·         Dividends and profits earned from government direct investments

·         Interests earned on loans advanced by the government to firms

·         Proceeds from sale of government property

·         Taxes

·         Government borrowing

NOTE: The main sources of public finance are taxes and government borrowings

GOVERNMENT BORROWING

The government may borrow from internal or external sources. Internally the government may borrow from commercial bank while externally it can borrow for the World Bank

The government can only borrow when finances raised from the sources listed above are inadequate.

Outstanding government borrowing is referred to as public debt or national debt

Types of government borrowing

a)      Internal borrowing

These are the borrowings by the government from firms and individuals within the country. This is done through O.M.O.

b)     External borrowings

These are the borrowings by the government from outside the country

The government may borrow externally from another country (bilateral) or from international financial institutions (multilateral)

The sum of internal and external borrowing is referred to as national debt. National debt can further be classified into two:

Reproductive debt: refers to money borrowed by the government that is used to finance activities that generate additional income e.g. debts used to finance irrigation projects

Dead weight debt: refers to money borrowed by the government that is used to finance activities which generate no income e.g. debts used to finance salaries for civil servants

Factors influencing government borrowing

·         Cost of borrowing

·         Borrowing conditions

·         Whether borrowing will deprive funds hence leaving little for private sectors to borrow from.

GOVERNMENT (PUBLIC) EXPENDITURE

Refers to spending by the government

Categories of government expenditure

a)      Recurrent expenditure

Refers to spending by the government that takes place on a regular basis e.g. payment of salaries to civil servants, providing free drugs to public hospitals etc.

b)     Development expenditure

Refers to spending by the government aimed at financing development projects e.g. construction of roads, construction of schools etc.

c)      Transfer payments

Refers to the amount of money paid by the government to people who do not contribute to national income generation e.g. money paid as bursaries to needy students.

d)     Capital expenditure

Refers to the amount of money spent by the government to buy fixed assets such as vehicles

Principles of government expenditure

Principles refer to rules and conditions governing spending by the government. These principles include:

a)      Sanctions

According to this principle, any government expenditure must be approved by relevant authorities before it is executed. The approving authority in most cases is parliament.

b)     Maximum social benefit

According to this principle, Government expenditure, must aim at benefitting majority of the country’s citizens

c)      Flexibility

According to this principle, public expenditure should be flexible enough to allow adjustments in order to meet prevailing economic situations e.g. diverting public expenditure to avert hunger during times of drought

d)     Economy

According to this principle, public expenditure should avoid wastage that may result in unnecessary losses.

e)      Proper financial management

According to this principle, public funds should be well managed. This is done by keeping proper accounting records which are audited regularly.

Functions of public finance

Functions of public finance refer to the reasons explaining why the government engages itself in activities concerned with raising and spending of finances. These reasons include:

a)      Provision of essential services

The government raises money in order to provide essential services such as health care to its citizens at a cheaper cost

b)     Raising revenue

Revenue refers to all moneys collected by the government. The government engages in public finance in order to generate revenue which is to be used in financing its activities

c)      Controlling the consumption of certain products

The government uses public finance to control the consumption of harmful products such as alcohol and cigarettes by increasing taxes levied on them

d)     Encouraging the consumption of certain products

Through public finance, the government may encourage the consumption of certain products such as fertilizers. This is done through introducing subsidies or lowering taxes on such products

e)      Promoting balanced regional development

Through public finance, the government can promote equitable regional development by initiating development projects in areas that are lagging behind in development. This can also be done by giving subsidies and tax holidays to those willing to set up businesses in underdeveloped areas

f)       Redistribution of wealth

The government can redistribute wealth by taxing the rich more and using the money obtained to provide essential services to the poor.

g)      Promotion of economic stability

Economic stability can achieve by initiating development projects which create employment opportunities using the money raised through public finance.

h)     Creation of a conducive business environment

The government can use the money raised through participation in public finance to improve infrastructure which help in encouraging investments

TAXATION

Tax: a tax is a compulsory payment by individuals and organizations to the government. These payments are not made in exchange for anything

Taxation: taxation is the process through which the government raises its revenue by collecting taxes

Reasons for taxation

a)      Raising revenue  

Taxes help generate revenue for the government which is used to provide essential services

b)     Discourage the consumption of harmful products

Increasing taxes on harmful products such as alcohol and cigarettes will discourage their consumption

c)      Discouraging the importation of certain products

Importation of certain products can be discouraged by increasing taxes charged on them. This is done in order to protect home industries from unfair competition from foreign industries which may lead to their collapse.

d)     Reducing inequalities in income distribution.

This is done by taxing the rich more and using the money raised to provide essential services to the poor

e)      Controlling inflation

Taxes reduce the supply of money in the economy therefore lowering general demand leading to decrease in prices

f)       Influencing the location of industries

The government may influence the location of business by lowering taxes on profits made by firms located in certain regions

g)      Correcting balance of payments

High taxes on imports may discourage importation hence contributing to a favourable balance of payments

NOTE: The major reason for taxation is to raise revenue

Factors determining the amount of tax to be collected

a)      Distribution of incomes

The government will collect more tax when incomes are evenly distributed unlike when incomes are unevenly distributed. This is because almost everybody is brought into the tax bracket

b)     Social and political factors

When a country is politically stable, the amount of tax collected is more than when there is political instability

c)      Honesty and efficiency of tax authorities

Transparency among the officials charged with tax collection will enable the government raise more revenue through taxation since they will guard against corruption

d)     Level of incomes

When citizens earn more, they pay more tax than when they earn less

e)      Economic structure of the country

Refers to the relative sizes of commercial and subsistence sectors. When the commercial sector is larger than the subsistence sector, more tax is collected from the incomes created.

Principles of taxation

Refers to the characteristics that a good tax system must have. They are also known as the cannons of taxation. They include the following:

a)      Equitable

A good tax system should ensure fairness in payment in that the tax burden is distributed equally

b)     Certainty

Tax to be paid should be clear in terms of amount, time and manner in which it should be paid

c)      Convenience

Tax should be charged at a time and manner convenient to the tax payer e.g. at the end of the month through a check-off system

d)     Economical

The cost of collecting and administering tax should be lower than the revenue collected

e)      Flexibility

A good tax system should be able to adapt to changes in national income in the sense that when national income rises, more tax is collected and vice versa

f)       Elastic

A good tax system should allow the adjustment of tax rates at any time in order to enable the government increase revenue when need arises

g)      Ability

The amount of money to be charged as tax should be reasonable to enable the taxpayer pay without straining

h)     Diversification

A variety of taxes should be levied in order to bring as many citizens as possible within the tax bracket so as to ensure maximum revenue collection

i)        Simplicity

The mechanism of calculating tax should be simple in order to be understood by each tax payer

Impact and incidence of a tax

Impact: refers to the tax burden on the initial person the tax is imposed

Incidence: the final resting place of the tax

Classification of taxes

1)      According to structure

Taxes are classified according to the relationship between the amount paid as tax and the income of the tax payers. These include:

·         Progressive taxes

·         Proportional taxes

·         Regressive taxes

 

a)      Progressive taxes

This is a tax system where the amount of tax paid increases proportionately with increase in income e.g. income tax

Some of the disadvantages of a progressive tax are:

·         Discourages vertical mobility of labour

·         Reduces output

·         Discourages people from working more

·         Discourages investors

b)     Proportional taxes

This is a tax system where a fixed percentage is used to calculate tax to be paid e.g. value added tax

c)      Regressive taxes

In this tax system, low income earners pay more tax than high income earners i.e. the tax rate decreases with an increase in income

2)      Classification according to impact on the tax payer

Based on the impact, the tax has on the tax payer; a tax may be classified either as direct or indirect.

DIRECT TAXES

These are taxes where the incidence and the impact of the tax is on the same person

Types of direct taxes

·         Personal income tax e.g. P.A.Y.E

·         Corporation tax: tax on companies’ profits

·         Stamp duty: tax paid on conveyance of land to another person

·         Estate(death)duty: tax charged on property transferred after death the owner

·         Wealth tax: tax charged on personal wealth that goes beyond a certain limit

·         Capital gains tax: tax charged when a fixed asset  is sold at a higher price than the book value

·         Capital transfer tax: tax imposed on the value of property transfered from one person to another

·         Specific duty: this is a tax that is based on the quantity of goods irrespective of their value

·         Ad valorem: this is a tax that is based on the value of goods

Merits of direct tax

a)      Economical in collection

Most direct taxes are collected at source therefore reducing the cost of collection greatly

b)     Tax revenue is certain

The government is assured of the revenue expected from direct taxes. This is because based on incomes which in most cases must be earned

c)      Equitable

Direct taxes ensure that there is fairness in payment of tax such that high income earners pay more tax than low income earners

d)     Does not affect the price of goods and services

Direct taxes do not lead to inflation. This is because they are levied on consumer incomes.

e)      Ensures equitable distribution of wealth

Direct taxes ensure equity in income distribution. This is because high income earners are taxed more than low income earners and the incomes obtained are used to provide essential services for the poor

f)       Makes taxpayers conscious

Tax payers are aware that they pay tax; therefore they become keen on how their money is spent. This makes the government spend this money efficiently.

g)      Simple to understand

Direct tax is simple to understand by both the contributor and the collector

h)     Highly desirable

The tax is desirable since it affects only a few people in the economy

i)        Elastic and flexible

The rates of direct taxes can be adjusted at any time in order to raise the required revenue.

Benefits of direct taxes to the government

a)      Enhances distribution of wealth

b)      The society is aware of direct taxes hence they monitor the usage of revenue collected from these taxes

c)      It is simple to administer

d)     It has a wide tax base hence more revenue is collected

e)      It is simple to understand

f)       It is economical to collect

g)      It is elastic i.e. the tax rates can be lowered or increased according to the needs

h)      It does not affect the prices of goods and services

Demerits of direct taxes

a)      Easy to evade

Contributors can easily evade paying tax by provide false information about their incomes

b)     Reduces savings

Direct taxes reduce the ability of tax payers to save since it reduces their incomes. This negatively affects investments.

c)      Discourages people from working

High rate of direct tax may discourage people from working since any extra income they earn is taxed

d)     Discourages investments

Heavy taxes on profits discourages investments since taxes will reduce this profits

e)      Inconvenience

Direct taxes may highly inconvenience the tax payer as he will be required to adjust his personal budget in order to pay this tax.

f)       Not imposed on all citizens

Low incomes earners whose level of income does not fall within the tax bracket do not pay direct tax. This reduces the amount of revenue collected by the government.

INDIRECT TAXES

These are those taxes where the tax burden can be shifted to another person. These are in most cases imposed on goods and services consumed. These taxes include:

·         Sales tax: sales imposed on sales made by the seller

·         Value added tax: tax imposed on the value the business adds to its final product

·         Export duty: tax levied on exports. The aim is to raise revenue and discourage exportation of specific products

·         Import duty: tax charged on imports. The aim is to raise revenue, reduce dumping and discourage importation of specific products.

·         Excise duty: tax imposed on goods manufactured and sold locally. The aim is to raise revenue and discourage the consumption of harmful products.

Merits of indirect taxes

a)      Can be used selectively

Indirect taxes can be used selectively to achieve certain objectives e.g. the government may raise tax on alcohol to discourage their consumption

b)      Tax payment is voluntary

Taxpayer may choose whether to pay or not to pay tax by avoiding buying the taxed product

c)      Difficult to evade

It is not easy to evade paying indirect taxes because they are attached to the price of the product

d)     Encourages people to work harder

Indirect taxes have the effect of increasing the price of goods. As a result, people are forced to work harder in order to earn more incomes to enable them afford buying products whose prices has risen.

e)      Convenience

Indirect taxes are convenient since they are paid in small amounts. The tax is also hidden in the price to the extent that the buyer may not be aware of the tax.

f)       Elastic

It is easy for the government to adjust the tax rates inorder to suit different economic conditions.

g)      Raises more revenue

Compared to direct taxes, indirect taxes raise more revenue to the government since it is paid by many people.

Demerits of indirect taxes

a)      Leads to increase in prices

Since indirect taxes are imposed on products, they are likely to lead to price increase

b)     Less equitable

The burden of indirect taxes falls uniformly on all consumers irrespective of their levels of income. This is because they all buy taxed products at the same price. It is therefore more of a burden to the poor than to the rich.

c)      Easy to avoid

Indirect taxes can be avoided by those people who don’t buy the taxed product. This is likely to reduce government revenue

d)     Leads to uncertainty in revenue collection

The amount of revenue collected from indirect taxes varies with time as a result the government cannot forecast the expected amount of revenue

e)      Lack of contributor’s awareness

Since indirect taxes are hidden in the price of the product, many contributors are not aware that they pay tax. As a result they don’t monitor how revenue collected is being spent.

f)       Interferes with the production of specific products

Indirect taxes may affect negatively the quantity produced of taxed products as consumers shift their demand to non-taxed product.

g)      Expensive to collect

Collecting indirect taxes is quite expensive since inspectors have to be employed to ensure that manufactures submit the right amount of tax collected to the tax authorities.

BUDGET

A budget is a statement of estimates or proposals of the way the government plans to raise finances and how such finances are to be spent in a given year known as the financial/fiscal year.

Types of Budgets

a)      Balanced budget

This is a budget where budgeted expenditure equals budgeted revenue

b)     Deficit budget

Ways of financing a deficit budget

a)      Borrowing from central bank through overdrafts, short term loans etc.

b)      Borrowing from international financial institutions such as the world bank and IMF

c)      Borrowing from capital markets e.g. AFC.

d)     Borrowing from domestic money markets such as commercial banks, the public through the sale of treasury bills and bonds

e)      Borrowing from other countries

f)       Getting grants or donations from mother countries, agencies and individuals

g)      Printing currencies not backed by production of goods and services

h)      Imposing additional or new taxes on selected goods

i)        Sale or lease of government assets

j)        Putting in place cost-cutting measures to reduce government expenditure

This is a budget where the budgeted revenue is less than budgeted expenditure

c)      Surplus budget

This is a budget where budgeted revenue is more than budgeted expenditure

 

Importance (uses) of a budget

a)      It identifies the sources of government revenue

b)      Aids in allocating the available revenue properly

c)      It shows the impact of various monetary and fiscal policies in the economy e.g. the impact of price or wage levels

d)     Aids in establishing policies which are meant for the redistribution of national wealth equitably

e)      Helps in the formulation of policies meant to spur economic growth

f)       It helps in controlling unplanned expenditure by the government

It helps in the formulation of measures to curb inflation