1.0 Background of the Study
Prior to the introduction of money as a medium of exchange, the barter system was responsible for exchange between demanders of commodities and suppliers of these commodities. Despite the problems of the barter system, it worked sufficiently with both demand and supply forces until the introduction of money. Because money is also like any commodity, the demand for money and supply of money are real forces that help promote efficiency in any system that uses the price mechanism, since most prices are quoted in monetary units.
Nelson (2011) describes the demand for money not as the amount one wishes to have but as the amount of one’s wealth that is preferable in the form of currency or demand deposits. Because the demand for money is the demand for wealth held in the liquid form of money, Keynes (1936) identified three motives for holding money; the transactionary, the precautionary and the speculative motives. To encompass all these motives, Pomeyie (2001) identifies the demand for money as a function of income, interest rates on wealth bearing assets and the price level.
An institution that is designed to oversee the banking system and regulate the quantity of money in the economy is known as a Central Bank (Mankiw, 2001). In Ghana, the central bank is the Bank of Ghana (BOG) and its major functions include the maintenance of monetary stability of the economy (BOG, 2011). Policies are instruments used by the central bank to veer the economy into the direction it may believe is best. That policy which is used by the central bank to regulate money supply is known as Monetary policy (Pomeyie, 2001). BOG’s policy regarding money is to set an interest rate considering a target of inflation with a broad objective of growth (BOG, 2011). Stable money demand functions inform the central bank’s use of monetary policy in order to ensure that there is monetary stability in the economy. Monetary stability would refer to controlled interest rates and reserves in order to manipulate the liquidity in the economy. In the event of an unstable money demand function, monetary targets and the behavior of interest rates are not well met even with economic development (Treichel, 1997).
Every country chooses to employ a particular strategy for its monetary targets. In Africa, Tunisia’s central bank uses a three step approach in achieving its monetary targets. According to Treichel, (1997), the first step is to set the growth of money supply at 2% below that of current output, then calculate the base money supply in line with the money supply growth. After, noting the levels of net international reserves and the credit requirements of the agricultural sector, the central bank determines the quantities of liquidity for financial institutions for the benefit of other sectors of the economy.
Also, the West African Economic and Monetary Unit (WAEMU) is an organization of eight West African states that share the common currency of the CFA Franc (Rother, 1998). These countries are Benin, Burkina Faso, Ivory Coast, Guinea-Bissau, Mali, Niger, Senegal and Togo. Rother (1998), states carefully that the CBWS (the Central Bank of the West African States) considers two factors in the employment of monetary policy in the WAEMU. Their common currency, the CFA franc and the pegging of the currency to a fixed exchange rate. This means that the conduct of monetary policy is dependent on the international reserves, foreign assets as well as domestic assets, noting that changes in either of these may be affected by the exchange rate system. Ghana’s monetary policy implementation has grown through periods of monetary targeting of money supply to the current policy stance of controlling money demand by the use of inflation targeting (Amoah and Mumuni, 2008). Ghana’s adoption of inflation targeting came in order to restore macroeconomic stability especially after the severe economic crisis in...