SCHOOL OF BUSINESS

ECO 1302: INTRODUCTION TO MACROECONOMICS

TOPIC: MONEY AND BANKING

A. MONEY
Prepared by lecturer Milkah
DEFINITION OF MONEY
The following are three possible definitions of money:
(1) According to Crowther, money is anything, which is generally
accepted as a medium of exchange and in settlement of debts.
(2) According to Walker, money is what money does.
(3) According to modern economists, money is a medium of exchange.

a. Near Money-These are highly liquid assets which are not cash but can
easily be converted into cash, mpesa account ,such as bank deposits and
Treasury Bills. They are also referred to as cash equivalents.

b. Money Substitutes- These are those items that are not inform of cash but
they can be acceptable as a medium of exchange e.g. Cheques, mpesa
account

The nature and function of money

Money was developed to overcome the shortcomings and frustrations of the
barter system. This is a system where goods and services are exchanged for
other goods and services.

Shortcomings of Barter Trade

1 Double coincidence problem. One could spend a lot of time trying to find
someone with a commodity which he or she wanted considering that the
other person was also looking for and willing to accept the commodity he
or she had to offer.
2 The problem of storage. Most goods were perishable and could not be
stored for long.
3 Determination of value. A good deal of time could be wasted agreeing on

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 the correct value.
4 The divisibility problem.
5 Lack of standard of differed payment.

CHARACTERISTICS OF MONEY
Characteristics of money are also known as properties of money and they
are:

(1) Acceptability: The basis of any monetary system is that it should be

acceptable by everyone, i.e. money must be accepted by everybody as a
medium of exchange.

(2) Convertibility: Money must be converted from one currency to another,

e.g. from Kenya shilling to US dollar, dollar to sterling pound, etc.

(3) Divisibility: Money used must be divided into smaller units so that minor
debts and exact amount can be settled easily.

(4) Durability: Money should be durable that is, it should not deteriorate over
a period of time, and therefore coins are better form of money than paper
notes.

(5) Stability: Money shouldn't lose its value. It should maintain its stability
year after year so that people are willing to accept it in settlement of debts
and as a medium of exchange. In periods of rapid inflation when money
loses its value rapidly, people will want to hold their wealth in assets than
in money form.

(6) Portability: Money should not be bulky. It should be convenient to carry

from one place to another. Thus, paper money is more portable in this
regard.

(7) Scarcity: Money should be scarce. If it is not scarce, its supply will be too
much and hence losing its value leading to inflation where too much
money is chasing too few goods. That was why gold was used as a medium
of exchange because it was scarce before the invention of coin and paper
money.

(8) Homogeneity/Uniformity: Different units of money materials should have

the same value and likeness in appearance.

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(9) Cognisability: It must be possible to recognise whether it is pure money or
not.

EVOLUTION OF MONETARY SYSTEM

Money has undergone through many systems, including:
(1) Monometalism: This refers to a situation where only one specific item i.e.
metal was used as a medium of exchange. For example, around 15 th
century, it was only gold which was used as a medium of exchange.

(2) Bimetalism: "Bi" means two - which means two metals were used
simultaneously as a medium of exchange and these were mostly silver and
gold especially between 15th - 18th Century.

(3) Paper Money System: At the moment, all the countries of the world are
using paper money system, which include plastic money, coins, and notes.

FUNCTIONS OF MONEY
(1) Money is used as a medium of exchange in terms of buying and selling
goods and services. It replaced barter system and thus it is used to make
transaction. Every producer sells his surplus in exchange for money and then
he uses the money obtained to purchase his requirements. On the other hand,
when households receive money income from firms as rent, salary, wages,
etc., they use it to purchase goods and services. In this way, money is used as
a medium of exchange.

(2) Store of Value: The value of goods and business assets can only be in
form of money. By converting assets in terms of money or any other good that
cannot last for long in this respect, money stores the value of goods and
services.

(3) Measuring units of account: The use of money with its unit of
measurement (shilling and cents in Kenya) enables the prices of all goods to
be quoted in these units. This facilitates the quick comparison of the respective
values of different goods that is, money shows how much goods and services
are worth. In addition, money is the unit used in the financial accounts of all
businesses and, for example, in expressing the value of a country's national
income and balance of payments.

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(4) Can be used to move immobile properties from one place to another e.g.
buildings.

(5) Money can be used as standard of deferred payment. Many transactions

are conducted on the basis credit. Thus, payments for the work carried out
now might be made several months later and it is convenient for the debt to
be expressed and for the payment to be made in money terms rather than in
terms of some commodities. For example, a sub-contractor on a building site
may agree to do some work for the developer in return for a certain sum of
money to be paid when the work is finished. Both parties to the agreement
know how much money will change hands at the agreed date in the future.

DEMERITS OF BARTER TRADE

Before the invention of money as a medium of exchange, transaction used to
be carried out by exchange of goods by goods, a system of trade known as
barter trade. However, this system had various shortcomings such as: -
 Lack of double coincidence;
 Indivisibility;
 Commodities might not be portable;
 It is difficult to be used for deferred payments;
 It is difficult to be used as a measure of unit of account, and
 It is sometimes difficult to store the value of one commodity in terms
of one commodity.

1. DEMAND FOR MONEY

The three major theories of money demand are:

(1) The quantity theory of money

Monetary School of Thought developed the quantity theory of money. They
pointed out that the value of money is determined by the supply of money in
circulation and by the general price level. This theory can be summarised by
Irving Fisher’s equation as expressed below:

MV = PT

Where: M = Quantity of money in circulation [Money Supply

(MS)]

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 V = Velocity of money in circulation (that is number of
times money changes hands)
P = General Price level.
T = Number of transactions which take place.

From the above equation MV must be equal to PT, that is, MV=PT. MV
represents monetary payments made to the firms in the purchase of the final
output by households while PT represents firm receipts from the sale of goods
and services. What firms receive is equivalent to the expenditure of
households on purchase of goods and services. This therefore means that
money payments must be equal to money receipts. If we assume that V and T
are constant, P will vary directly with increase or decrease of the amount of
money supplied that is it changes where there is a change in money supply
circulating in the economy.

Money supply causes the price change and not change in price that causes
money supply to change. This means the money supply is the driver to price
changes meaning that price changes depend on money supply. T is assumed
to be constant because the economy in question is assumed to be at full
employment. Full employment means a situation whereby even though more
investment is injected into the economy, the level of national income or output
remains constant. In other words it explains a phenomenon where the
economy is saturated. If we express P in terms of MV and T the following
will be the result.

P = MV/T

The above equation shows that price level is determined by 3 factors:

(i) Supply of money (M)
(ii) Money Velocity in circulation (V)
(iii) Number of transactions, which take place in the whole economy
(T)

From the above we can observe that:

if V is more or less constant, then any increase in money supply will cause
inflation. If output in the economy is expanding, and V is constant, then
money supply growth is necessary or desirable to avoid deflation. This means
Government monetary policy should allow some money supply growth or

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increase if the economy is growing but should not let money supply gets out
of hand.

In summary, the value of money, like that of any other commodity, changes
according to the supply. If money supply increases when there is no increase
in the supply of goods and services for sale, money buys less and prices goes
up. This situation is called inflation. On the other hand, if the amount of
money in circulation decreases, while there is no increase in the amount of
goods and services for sale, the money buys more and prices go down. This
situation is referred to as deflation.

The quantity theory of money is based on the following basic assumptions.

 Goods sold under barter remain constant.
 Velocity of money in circulation also remains constant.
 Number of transactions also remain constant
 Demand for money also remains constant.
 No government interference with the money market and therefore
the rate of interest is assumed to remain constant.

(2) Keynesian Monetary approach John Kyenes

According to Keynes, the quantity of money or value of money is not only

determined by money supply but also by demand for money. Keynes used
the concept of the liquidity preference, which actually refers to the demand
for money, and hence his approach is also referred to as liquidity preference
theory.

Liquidity refers to the degree to which an asset can quickly and cheaply be
turned into money or cash for example a current account bank deposit is a
liquid asset since it can be withdrawn immediately compared to how long one
will realise cash after the sale of a fixed property such as a plot.

Keynes identified three motives or reasons why people hold money in its
liquid form. These motives are: -

(1) Transaction Motive: In this case, households need money to pay for their
day to day purchases, for example to buy goods and services especially
the basic needs. The level of transaction demand for money depends
basically on the individual’s level of income and on the institutional

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 arrangements such as how often an individual is paid and how often he/she
engages into monetary transaction. However money demand for
transaction motive is independent in the rate of interest meaning that
interest rate has no effect at all on this motive.
Demand for money under transactionary motive is perfectly interest
inelastic

(2) Precautionary Motive: This is the demand for money in its liquid form
for emergencies and unforeseen motive or purposes. This means to hold
money in its liquid form in order to finance unplanned rather than planned
transactions such as sickness, funerals, accidents, fires, burglary, breakage
etc. Precautionary demand for money is also likely to depend on
individual’s level of income. The higher the level of income, the more
money will be needed to safeguard against unexpected transactions.
Precautionary demand for money is also not affected by the rate of
interest. Since both Precautionary and transaction demand for money
depends on the level of income and they are not affected by the rate of
interest, they are referred to as transaction demand for money.
Demand for money under precautionary motive is perfectly interest
inelastic

(3) Speculative Motive: According to Keynes, people may choose to keep

ready money to take advantage of profitable opportunities that may arise
within the financial market such as investments in bonds. A bond is an asset
that earns a fixed sum of money for its owner each year. There is always an
inverse or an indirect relationship between a bond’s price and the rate of
interest, which implies that if interest rate goes up bond's price will fall, and
on the other hand if interest rate falls the price of bond's price will increase.
Individuals will hold money instead of investing in bonds if they expect the
interest rates to rise in the near future.

Given that a fall in the interest rate implies a capital gain for the holders of
the bonds, the Keynes theory of liquidity preference predicts that if interest
rates are high, there will be a large demand for bonds since there prices will
have fallen and hence a small demand for speculative money balance. On the
other hand if the individuals expect that in future the interest rate will be low,
they will hold more money in order to satisfy their speculative motive and as
a result the demand for bonds will be low.

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Demand for money under speculative motive is interest elastic

Keynes therefore derived an inverse or indirect relationship between the

interest rates and the speculative demand for money, a concept illustrated in
the following simple diagram.

r1
Interest rates

r2
r3 Liquidity trap

0 Q1 Q2 Q3

SDdDemand for money ( demand for

the loanable funds)

From the above diagram as the rate of interest falls from r1 to r2 the
speculative demand for money increases from Q1 to Q2. However, at a low
interest rate r3 the bonds become so unattractive because the prices are very
high and they are expected to fall. In this phenomenon, speculative demand
for money becomes perfectly elastic meaning that people hold all their money
in liquid form for speculative purpose. From the above diagram it can be
observed that the part of demand curve which is perfectly elastic is referred to
as liquidity tap whereby people expect the interest rate to rise to a particular
point or level otherwise they will hold all their money in liquid form.

In conclusion therefore according to Keynes given demand for money for the
three motives we have discussed, the value for money is determined where

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money demand is equals to money supply, that is, MS = MD. But since MD
= MDT + MDS, it therefore follows that MS = MDT +MDS, where
MDT = Money demand for transaction (and precautionary) and MDS money
demand for speculative.
Interest Rates According to Keynes
According to Keynes, interest rates are determined where money supply is
equal to money demand. Since the government through central bank
authorities fixes money supply, the rise of money supply is perfectly inelastic
with respect to changes in interest rates. Keynes argued that the level of
interest rates in an economy would then be reached by interaction of money
supply and money demand as illustrated below:

Mss (Fixed)
Interest rates

r0 Liquidity preference (M0)

Minimum
demand for
money

0 Q2 Money demand & supply

From the above diagram, the level of interest rate r0 is determined by

interaction of money supply and money demand (or liquidity preference). In
other words, interest rates in the economy are determined where Ms = MD and
that is the time the money market is said to be at equilibrium. What will be
the effect of increasing money supply in the economy? When money supply
is increased, there will be a fall in interest rates as illustrated below:

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 MS0 MS1
Interest rates

r0 Liquidity preference (M0)

r1

0 Q2 Money demand & supply

From the above diagram as money supply is increased or expanded from MS0
to MS1 the rate of interest falls from r0 to r1.

Interest Rates According to Loanable Funds Theory

This theory is also referred to as the new classical theory. It was popularised
by a 19th century classical Swedish economist Robertson. The Loanable
funds theory states that because the rate of interest is the price of capital, it is
determined by the amount savers are willing to lend to the market and the
amount investors want to borrow (demand for loanable funds). In other
words, forces of demand and supply of loanable funds determine rate of
interest.

Income levels, that is, high income, more loanable funds and low income, less
loanable funds, determine supply of loanable funds. It is also determined by
availability of financial institutions and capital markets since if they are well
established, they encourage mobilisation of savings. Conversely, if financial
institutions are not well developed, there will be poor mobilisation of loanable
funds (i.e. keeping the money under mattresses, under a tree, or in biscuits
tins). In such a situation, there will be low supply of loanable funds and hence
interest rates will go up. Supply of loanable funds will also be affected by
inflation as high inflation discourages saving.

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Demand for loanable funds comes from firms, government and individuals.
Firms borrow in order to buy capital assets.

From the above diagram, more loanable funds will be supplied at higher
interest rates and fewer at lower interest rates. As interest rates fall, firms will
demand more loanable funds. At higher interest rates, demand will fall. Rate
of interest determined at OR where supply of loanable funds is equal to
demand at OQ.

NB: In the Keynesian theory of demand for money, the transaction and
precautionary motives are usually combined as active balances since their
demand is perfectly interest inelastic. Usually abbreviated as MDT

The demand for money under speculative motive is usually abbreviated as

MDS or MSP. Because demand is interest elastic.

Thus is this theory under money market,

Money demand (MD) = MDT + MDS

3. Friedman Quantity Theory of Money

This theory is also referred to as new monetary quantity theory of money or
the Chicago Theory. According to Milton Friedman, value of money is not
only determined by demand and supply of money but will also depend on the
format in which people prefer to old their wealth. He further pointed out that
money is just one of the methods or ways in which people hold wealth.

The Chicago Equation is usually represented as follows: -

MD/P = f (W, r, dt/dy, U…)

Where: -
MD/P = Quantity of money
Total Wealth: The demand for money will directly be related to total
wealth, which is the sum of human and non-human wealth. Thus, as total
wealth increases, the desire to hold money will also increase.

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(2) Expected Rate of Return on Wealth: Since the rates of return on bonds
and equities represent the opportunity cost of holding money, there is an
inverse (i.e. negative) relationship between those expected rates of return and
demand for money.

(3) The Ratio of Human Wealth to Non-Human Wealth: Since human

wealth is so illiquid, as it cannot be sold, individuals have only a limited ability
to transfer non-human wealth into human wealth. In our above equation
therefore, the higher the dt/dy ratio the greater will be the demand for money
in order to compensate for limited marketability of human wealth.

(4) Taste and Preferences: Friedman argues that the demand for money also
depends on a number of factors that are likely to influence wealth holders'
taste and preference of money.

In summary, according to Friedman ways in which we can hold our wealth

include: -
 Money: It is considered to be the best way in which we can hold our wealth
because it is more liquid (flexible) than other methods as a medium of
exchange.
 Human wealth: Some people prefer to invest in human wealth by
developing human resource.
 Physical assets (non-human wealth): Some people prefer to invest their
wealth by buildings, vehicles, animals, etc.
 Securities and bonds: Some people prefer to invest their wealth by buying
securities and bonds so that during the time of maturity, they will gain.

Weakness:
The main problem with Friedman's demand for money function is that of
finding a suitable method of measuring total wealth. Whereas it might be
possible to measure non-human wealth, it is quite difficult to measure human
wealth.

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2. MONEY SUPPLY

Money supply refers to the currency in form of notes and coins with the public
plus all deposits held by the deposits taking institutions that is the commercial
banks and non-banking financial institutions (NBFI).

The concepts of money supply

In Kenya, the Central Bank of Kenya (CBK) distinguishes between six
concepts of money on the basis of their liquidity as follows: -
1. M0 – This is the narrowest concept of money and comprises currency held
by non-bank public. This is the money that is held by the members of the
public and it is not in the bank.
2. M1 – This includes M0 and demand deposits I commercial banks. Mostly
in current accounts.
3. M2 – This includes M1 and time and saving deposits held in commercial
banks.
4. M3 – Includes M2 and time and savings deposits held with non-banking
financial institutions (NBFIs).
5. M3X – This includes M3 and the residents’ foreign currency denominated
deposits held with commercial bank.
6. MX3T – This comprises M3X and holdings of Government securities by
non-bank public.

Determinants of money supply

These are quite obvious though the conditions necessitating increase or
decrease of money supply might be quite complex:

1. Printing of more money by the central bank. Governments that are

poor in budgeting and planning may print more money to finance deficits
(financial accommodation). Incumbent governments that are unpopular
may also print more money to fund elections. Finding of wars may also
be done this way.
2. The level of deposits, the more deposits commercial banks get the more
they can loan out. This in turn leads to the process of credit creation and
thus in money supply.
3. Government expenditure, sometimes this may exceed the government’s
budget thus running a deficit and thus government may compel the
central bank to print more money.

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4. Involvement of the central bank in open market operation. The central
bank may decide to buy back securities it has sold to the public obviously
at a higher price thus increasing money supply.
5. Foreign capital inflows, this may be in two fold. Foreigners investing in
the county and grants from donors for project to be implemented by the
citizen. This foreign currency that is pumped into the country increases
money supply.
6. Balance of payment surpluses, this occurs when exports exceed imports.
It is a rare occurrence in developing countries but this has the potential of
increasing money supply. The excess/surplus is ploughed back into the
economy.

NB: In the money market; the equilibrium level of interest rate and
national income in the country will be given by;

Demand for money =Supply of money

MD = MS
MDT + MDS = MS

Other factors.
The determinants of money supply are also referred to as sources of money
and are as follows:

 Open market operation (OMO)

 Interest rates
 Changing the cash reserve ratio
 Special deposits
 Government expenditure financed by borrowing from central bank.
 Government borrowing from bank system
 A change in public desired cash holding
 Balance of payments surplus

(1) Open Market Operation (OMO): OMO refers to buying and selling of
the government securities on the open market by the central bank. A
reduction in money supply will occur if the government sell securities

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 through its brokers since buyers will pay for these securities with
cheques drawn on the account with commercial bank. On the other
hand, there will be an expansion of money supply if the securities are
bought on the open market by the central bank. Government securities
include treasury bills and treasury bonds.

(2) Interest Rates: Since the liberalisation of interest rates in 1991, Central
Bank Kenya influences the general level of interest rate through changes in
the 90 days treasury bills rate of interest. To a great extend, this affects rate of
interest charged by commercial banks in the loans they advance to borrowers,
thus influencing the amount of money circulating in the economy.

Since commercial banks constitute an important buyer of government

financial securities, an increase in interest rates tends to reduce money supply
and their ability to create credit. Commercial banks peg their rate of interest
on the prevailing treasury bills interest rate. Therefore the higher the treasury
bills interest rate, the higher the interest rate charged by commercial banks
and hence the low the money supply. On the other hand, the lower the interest
rates charged by banks on credit, the higher the money supply in the economy.

(3) Changing the Cash Reserve Ratio: Cash reserve ratio is the amount of
cash, which must be deposited by commercial bank with the central bank. An
increase in cash reserve ratio reduces credit creation among commercial,
which will tend to lower money supply circulating into the economy. On the
other hand, a reduction in cash reserve ratio increases the ability of
commercial banks to create credit leading to an increase in money supply.

(4) Special Deposits: The central bank has the power to require the
commercial banks to lodge special deposits with it, which earns them an
interest rate. Since special deposits are compulsory they ensure a reduction of
commercial banks’ liquid assets and their ability to create credit, which will
consequently reduce money supply.

(5) Government Expenditure Financed by Borrowing from Central Bank:

If currency is issued to a government facing a budgetary deficit to finance its
expenditure, money supply will definitely increase. On the other hand, a
reduction of government borrowing from the central bank will reduce the rate
of growth of money supply. Government borrowing from the central bank
implies printing of paper money, an action which could result to an inflation
type referred to as credit inflation.

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(6) Government Borrowing from Bank System: If the public sector is running
a deficit, it may borrow some funds from the banking system, which will lead
to further expansion of money supply. Government borrows from the banking
sector through open market operation.

(7) A Change in Public Desired Cash Holding: A decision by the public to

hold more cash and maintain small bank deposit will reduce money supply as
the commercial banks' ability to create credit will be affected. On the other
hand, if public decides to hold less cash and maintain bigger bank deposits
money supply will be increased. The desire of public not to put money in the
banking institutions could be due to low interest rates paid on their deposits
and also lack of well-established financial institutions.

(8) Balance of Payment Surplus: When there is a balance of payment surplus

it implies a high inflow of foreign currency into the economy which could be
converted into domestic currency and thus increasing money supply. On the
other hand if there is a balance of payment deficit the inflow of foreign
currency is low and this could reduce the money supply.
Tools of Monetary Policy
Tools of monetary policy are also referred to as instruments of monetary
policy. The Central Bank has several instruments on monetary policy, which
it employs in various occasions depending on what macro-economic problem
it wants to address or the specific objective it wants to achieve. These tools or
instruments are outlined below:

(1) Minimum Liquidity Asset Ratio: Liquidity asset ratio can be defined as
the proportion of total assets of a bank, which are held in form of cash,
and liquid assets. When the Central Bank adjusts this ratio, bank lending
or bank credit creation ability is affected. The advantages of this
instrument are:

 All banks are affected equally,

 It is a direct way of controlling credit creation.
 It is immediate and therefore fast.

(2) Cash Ratio: This is whereby the Central Bank instructs Commercial
Banks to keep a higher or a lower percentage of deposits they receive from
the customers in cash form. The Central Bank may require the Commercial
banks to maintain minimum cash balances out of the total deposits of the
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liabilities they have. The main purpose of this instrument is to reduce banks'
free cash-base and hence their capability to give loans and advances.

(3) Open Market Operation: Open market operation refers to the sale and
purchase of marketable government securities (treasury bills and treasury
bonds) conducted in the open market by central bank as an instrument of
control of monetary policy. Open market operation mostly targets commercial
banks and non-bank financial institutions (NBFIs). Central bank sells its
holdings of government securities to commercial banks and NBFIs in order to
mop up excess reserves in them. On the other hand, if the central bank wants
to increase money supply in circulation, it injects additional liquidity by
purchasing from the existing bank stock of government securities.

(4) Selective Credit Control: Through this method, the central bank
encourages commercial banks to give credit to those sectors of the economy
considered essential and discourage those of which of lower priority. For
example, it may advice Commercial Banks and other financial institutions to
approve loans for industrial development and limit lending for speculative
purpose.

(5) Interest Rates: Low interest rates should be encouraged to promote

investment and protect small borrowers. Stability of interest rates is also
regarded as an important factor of promotion growth and development of the
economy. To ensure that the interest rates remain low, many economies have
liberalized interest rate regime where the market forces of demand and supply
determine the rate of interest banks charged to borrowers. The central bank
however influences the rate of interest rate by setting the rate of interest of
treasury bills which is then used by the commercial banks as a benchmark of
setting their base lending rate. This means that commercial banks peg their
interest rates on the prevailing treasury bills' rate of interest.

Ineffectiveness or Limitations of Monetary Policy in Developing

Countries
(1) Markets and financial institutions in many developing countries are highly
disorganised. This explains why there are many incidences of bank failure.
In such a situation the use of instruments like open market operation is
severely limited.

(2) Commercial banks in developing countries are less sensitive to changes

cash rate partly because many banks find themselves in excess liquidity due

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to lack of borrowers in their economy. This limits the effectiveness of open
market operation and cash ratio as instruments of monetary control in the
developing countries.

(3) Most Commercial Banks in developing countries are mere overseas

branches of major privately owned banking institutions in developed
countries thus such foreign Commercial Banks can turn to their parent
organisation for liquid funds in event of having their base squeezed by central
bank.

(4) The ability of developing Government to regulate their national economy

money supply is constrained by the openness of their national economies,
which give more priority to accumulation of foreign currency at the expense
of domestic financial reserves.

(5) Many people in developing countries do not deposit their money in

commercial banks or NBFIs and this makes it difficult for the central bank to
use monetary policy as an instrument to control money supply.

(6) Lack of knowledge of monetary policy instruments like open market

operation and selective credit control makes it difficult for the application of
monetary policy in developing countries.

(7) There is a lot of corruption in many developing countries and this makes
it difficult to apply an instrument like selective credit control.

(8) Monetary policy instruments are sometimes used wrongly to tackle a

certain macro-economic problem effectively. In general, monetary policy is
considered to be more appropriate in tackling and addressing external
problems such as balance of payment deficits. On the other hand, fiscal policy
is more suitable in tackling problems, which are internal in nature such as
unemployment or economic depression. However, both policies are important
for checking inflation. Therefore, there is a need for policy mix since macro-
economic problem prevailing at any given time may require fiscal rather than
monetary policy.

(9) A lot of time taken in planning and formulating monetary policy and its
implementation also takes time. It may therefore take a very long time for the
benefits of monetary policy are realised. The reality of the fact is that

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formulation and implementation of the monetary policy is not a one-time
event but a process.

(10) Lack of autonomy of Central bank may impact negatively the

implementation and execution of the monetary policy.

B. BANKING

THE CENTRAL BANKING SYSTEM

In most countries, there is a single bank that exercises control over the entire
monetary and banking system. Generally, the central bank is operated as a
public corporation so that it's subject to government control. In Kenya, the
central bank was established in 1966. The first central bank in the world was
the Bank of England, which was established in 1694.Then, Central Bank of
France was established in 1803 while the central banking system of U.S.A. is
the Federal Reserve System, which consists of twelve Federal Reserve Banks
and were established in 1913.

Functions of Central Bank

The following are the main functions of a central bank in an economy:-

(1) Banker to the Government: One of the most important aspects of the work
of central bank is to operate the government's bank accounts of which there
are two types. The first is commonly known as the exchequer account, a form
of a current account into which receipts from taxation are posted and out of
which current expenditure is paid. The second is the development account, a
form of capital account which receives all borrowing by the government and
out of which all capital expenditure is met.

(2) Banker to Commercial Banks: All commercial banks deposit money with
the central bank and their deposits fall into two categories: -
 There are those deposits, which can be readily withdrawn, and the
purpose of keeping them at the central bank is to facilitate the
settlement of inter-bank debts. When one commercial bank wants to
settle a debt with another, it does so through its account at central bank.
 The other type of account cannot be freely withdrawn by the
commercial banks. These ''special deposits'' also called reserve

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 requirements have been placed there on instructions of the central
bank as a means of reducing money supply.

(3) Management of Public Debt: Government borrows money to finance

development projects and cover balance of payments deficits. Thus, the
central bank keeps all the records regarding public debt on behalf of the
government.

(4) Holding Foreign Exchange Reserves: The central bank, on behalf of the
government, operates external monetary affairs. It keeps foreign exchange
reserves on behalf of the government. The central bank is also responsible for
maintenance of exchange rates against other currencies and also for dealings
with the IMF. The central bank also formulates and implements a country’s
foreign exchange policies.

(5) Implementation of Monetary Policy: This is probably the most important

function of any central bank. Monetary policy is mainly concerned with
controlling money supply in the economy with a view to influencing interest
rates and exchange rate and therefore controls the level of domestic inflation.
When money supply exceeds beyond acceptable level, this may cause
inflation and it is the responsibility of the central bank to control money
supply in the economy to avoid inflationary tendencies. This is executed
through the following tools (instruments): -
 Bank Rate Policy
 Special Deposits
 Open Market Operations
 Directives
 Moral Persuasions.

(6) Lender to the Last Resort: Sometimes, some commercial banks may find
themselves short of cash, which is potentially a dangerous situation, as
customers' confidence would be lost if they cannot withdraw their deposits.
The central bank is always willing to act as a lender of last resort if commercial
banks cannot raise the necessary cash elsewhere.

(7) Issuing of Coins and Notes: The central bank has the sole role of issuing
notes and coins in a country. It issues new notes and coins and also replaces
defaced currencies.

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Role of the Central Bank in a Liberalised Money Market
In the recent past, the Government of Kenya has undertaken several reforms
in the financial sector. First, the liberalisation of determination of interest rates
by market forces and secondly, the freeing of the foreign exchange i.e. the rate
of exchange of local currency (i.e., shilling) against hard currencies (dollar,
sterling pound, etc) is decontrolled and determined by the prevailing macro-
economic environment in the country.

Following this, the Central Bank of Kenya Act was amended in 1996 to reflect
the above changes. As per the amended Act, the objectives of central bank
include: -
 To formulate and implement monetary policy.
 To foster liquidity solvency and proper functioning of a stable
market based financial system.
 Formulate and implement foreign exchange policy.
 Hold and manage its foreign exchange reserves.
 Promote the smooth operations of payments, clearing and settlement
systems.
 Acts as a banker and adviser to and as a fiscal agent of the
Government, and
 Issue currency notes and coins.

As a result of the removal of exchange controls and deregulation of financial

service, the Central Bank of Kenya has acquired a new role as a supervisor
and regulator of the banking system. In this role, the Central Bank has
become an important source of guidance and advice to individual commercial
banks. It has developed an elaborate system of rules and regulations under the
Banking Act for solvency of banks and for the protection of their depositors.
If a bank was unable to meet its obligations, and so became insolvent, this
could have a major effect on public confidence in the entire financial system.
In its supervisory role, The Central Bank seeks to maintain public confidence
in the stability of banks and other financial institutions.

Commercial banks make profits from taking risks. The Central Bank of Kenya
lays down liquidity requirements with which individual banks must comply.
A bank needs liquidity to meet its customers' demand for cash withdrawals.
The Central Bank of Kenya ensures that banks: -
 Have sufficiently strong capital bases to withstand losses from bad
debts and falling asset values;

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  Maintain prudent mixture of assets to meet the current and future
needs of customers;
 Do not take excessive risks by concentrating their lending to too few
customers and on too few sectors.

Under the Banking Act, the Central Bank of Kenya has the statutory right to
information about a bank at any time. The Central Bank also has the power to
carry out regular investigations of a bank's business. It is a criminal offence
for the directors of a bank to withhold information to which the Central Bank
is entitled as a supervisor.

COMMERCIAL BANKS
Commercial banks are profit-earning institutions and they could either be
privately or government owned. Their main source of income is interest
charged on loans advanced to borrowers.

Functions of Commercial Banks

The commercial banks perform the following functions: -

(1) Accepting Deposits: Before the emergence of banking system, people

used to leave their monies in save keeping. But today, banks accept or receive
deposits from individuals, businessmen and companies. Individuals can open
the following accounts in commercial banks: -

 Current Account: business people mostly operate it and in a current

account, the customer can withdraw money anytime without notice.
Customers are also issued with cheques to make payments with them.
Most banks do not pay interest on current accounts.
 Fixed Account: This type of an account attracts a huge interest. But
most banks ask for a minimum amount to open such an account. Money
deposited in a fixed account cannot be withdrawn without giving a
specified notice.
 Savings Accounts: These are accounts, which attract interest i.e.
interest is paid on money deposited but not as huge as fixed accounts.
However, one must not withdraw money 7 days since the last
withdrawal.

By accepting deposits from individuals and organisations, commercial banks

act as financial intermediaries. What are financial intermediaries? They

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are institutions within the financial markets which facilitates financial
transactions.

Moreover, by accepting deposits, commercial banks provide storage of

wealth in form of current and deposit accounts. Also commercial banks
compete to attract deposit from firms, individuals and other organisations.

(2) Advancing Loans: Commercial banks advance loans in three ways: -

 Over-drafts to businessmen with current account and paid in a short
period. A businessman is allowed to withdraw and extra amount is paid
with interest.
 Bill of exchange, which matures after 90 days. The holder of bill of
exchange can ask a bank to discount it, as it is a form of advancing loan.
 Direct Loans: This is a loan given to a company or an individual by a
bank. The borrower must give a security (e.g. title deed as collateral) to
the bank. Banks charge interest on such a loan and it is paid in
instalments the moment it is approved and given out.

(3) Agents of Stock Exchange Market: Commercial banks buy shares and
debentures of different limited companies on behalf of their clients. They can
also buy shares in a company and become ordinary or preference shareholders.
Moreover, a commercial bank might become an underwriter, which is where
the bank agrees with issuing company that it buy the remaining shares which
the public has not been able to purchase after an offer.

(4) Transferring Money: Commercial banks facilitate transfer of money from

one place to another place. This enables the individuals to export and import
goods, as money would be transferred from one bank to another. This way,
commercial banks provide a payment mechanism through which individuals
and firms can make payments to each other. Modern banks utilise the payment
systems, which make payment by cheques. In addition, commercial banks
constitute a source through which individuals and firms can obtain notes and
coins.

(5) Provide advice to Investors: Commercial banks provide their clients with
expert advice on a broad range of issues such as those relating to investments,
take-over bids, sharing registration, leasing, underwriting, etc.

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(6) Act as foreign exchange dealers: Commercial banks act as foreign
exchange dealers as they provide a means of obtaining and selling foreign
currencies.

Role of Commercial Banks in helping the country to achieve economic

growth hence Economic Development

Generally, commercial banks play the following major roles in economic

development:
 They promote development of commerce and industry and this is
mostly through loans (i.e. overdraft) extended to businessmen, firms,
etc.
 Increase capital accumulation as individuals and firms gets loans,
which they invest on capital assets.
 They encourage savings and high saving leads to more investments
hence leading to rapid economic growth and development.

CREDIT CREATION
Definition: Credit creation is defied as the process by which banks are able to
lend out amount of money of greater magnitude than the amount of money
they originally received from the depositors. In other words, it is the process
through which commercial banks advance loans many times greater as
compared to legal money at their disposal.

How commercial banks create credit is illustrated in the following example of

multiplier create creation:

Illustration of multiplier credit creation:

Let's assume there are several commercial banks in an economy (e.g. Bank A,
Bank B, Bank C and Bank D. If a loan of Kshs.1, 000,000/- is issued by A, it
will lead in to advance loans many times greater than this amount as shown in
the table below:-

Bank A Bank B Bank C Bank D

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In the above example, an individual goes to Bank A and the bank advances to
him/her a loan of Kshs. 1,000,000. This individual will not invest or spend
this loan immediately. Suppose he deposits this amount of money to Bank B,
where he has an account. Bank B, where he is a regular customer knows that
this customer will withdraw only 10% of the deposited amount next period
and thus Bank B will retain 10% of the deposited amount and will advance a
loan of Kshs 900,000/- to another person. In this respect, another loan of Kshs
900,000 on the basis of the same amount. The process will continue until the
original advanced by Bank A will disappear.

The loans advanced by different commercial banks can be expressed as: -

1,000,000 + 900,000 + 810,000 + 729,000… = KShs.10, 000, 000

Thus, credit creation can be computed as: -

Credit creation = Excess Reserve

Reserve Ratio

In the above illustration:

Excess Reserve = 1,000,000

Reserve Ratio = 10%

Credit creation = 1,000,000

10% or 0.1

=1,000,000 - 10
100

= 1,000,000 x 100
10
= KShs. 10,000,000

Limitations of Credit Creation

The major limitations of credit creation are:
(1) The Liquidity Ratio: Liquidity ratio (also refereed as cash ratio) at which
the commercial banks keep reserves to meet the demand for the depositors. If

25
the liquidity ratio is low, the bank will be placed in a better position to create
credit. Thus, the size of the cash ratio determines the ability of a commercial
bank to create credit. Conversely, if the cash ratio is high, the bank might not
create credit much.

(2) Policy of Central Bank: All banks are authorised by the central bank to
deposit a certain amount of the money they have collected as deposits from
customers. This denies bank loanable funds. Moreover, commercial banks
cannot credit certain beyond the limit set by central bank.

(3) Securities: Banks advances loans to individuals against certain securities

which act as collateral. In most cases, borrowers may not have the requisite
securities and hence cannot get a loan from a bank.

(4) Saving Levels: If most people in an economy have low income, they may
have little to save. Thus, the banks will not accumulate enough deposits to
extend credit to borrowers, resulting to credit rationing.

(6) Interest Rate: If the interest rate is too high, individuals will not borrow
from banks as cost of capital in exorbitant.

(7) Government's Domestic Borrowing: When faced with a budgetary deficit,

the government may borrow internally. Thus, commercial banks will buy
treasury bills and treasury bonds depending on the interest they are fetching.
This way, the private investors will be crowded out hence banks cannot
extend credit to them.

NON-BANKING FINANCIAL INSTITUTIONS (NBFIs)

Definition: A non-banking financial institution is an organization, which taps

public savings in form of deposits, and uses them to lend to members of public
for investments on long-term basis. It is different from a banking institution
in that it does not offer conventional or traditional banking services such as
operating a current or a savings account.

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Examples of NBFIs
 Merchant Banks: They receive large deposits and then lend these on
large scale on long-term basis. Some merchant banks are also referred
as wholesale banks. An example in Kenya is the Diamond Trust.
 Insurance Companies: They receive money in form of premium
contributions from the public or organisations to insure against fires,
losses, accidents, life etc.
 Hire Purchase Companies acquire fixed assets and sell them on a hire
purchase basis to business people. Examples are Credit Finance
Corporation (CFC), National Industrial Credit, ART, etc.
 The Mortgage Companies: They help individuals to own homes for
example EABS, I & M, HFCK, NHC, Savings & loan (a subsidiary of
KCB).
 Collection of savings: They encourage savings and advance the loan
on the basis of members share contributions for example Savings and
credit cooperative societies (SACCOs).

Roles of the NBFIs in the Economy

NBFIs play the following roles:
 NBFIs stimulate competition with commercial banks over deposits and
credit markets, which lead to efficiency in terms of service delivery to
customers.
 NBFIs enhance the development of financial market through the
introduction of a great varieties of financial instruments for example
investments deposits accounts, savings and credit, members contribution
etc.
 NBFIs lend money on long-term basis unlike commercial banks, which
only offer money for short-term basis.
 NBFIs provide financial services which commercial banks don't provide
such as chatted mortgage loans and purchase finance.
 NBFIs encourage savings and hence investment.
 NBFIs assist the government in execution of monetary policy by buying
Government securities through the open market operation (OMO).

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