1.

Money

A. The nature and function of money

The development of money was necessitated by specialization and exchange. Money was needed to overcome
the shortcomings and frustrations of the barter system which is system where goods and services are exchanged
for other goods and services.

Disadvantages of Barter Trade

• It is impossible to barter unless A has what B wants, and A wants what B has. This is called double
coincidence of wants and is difficult to fulfill in practice.

• Even when each party wants what the other has, it does not follow they can agree on a fair exchange. A
good deal of time can be wasted sorting out equations of value.

• The indivisibility of large items is another problem. For instance if a cow is worth two sacks of wheat,
what is one sack of wheat worth? Once again we may need to carry over part of the transaction to a later
period of time.

• It is possible to confuse the use value and exchange value of goods and services in a barter economy.
Such a confusion precludes a rational allocation of resources and promotion of economic efficiency.

• When exchange takes place over time in an economy, it is necessary to store goods for future exchange.
If such goods are perishable by nature, then the system will break down.

• The development of industrial economies usually depends on a division of labour, specialization and
allocation of resources on the basis of choices and preferences. Economic efficiency is achieved by
economizing on the use of the most scarce resources. Without a common medium of exchange and a
common unit of account which is acceptable to both consumers and producers, it is very difficult to
achieve an efficient allocation of resources to satisfy consumer preferences.

For these reasons the barter system is discarded by societies which develop beyond autarky to more specialized
methods of production. For such peoples a money system is essential.

Money may be defined as anything generally acceptable in the settlement of debts.

The Historical development of money

For the early forms of money, the intrinsic value of the commodities provided the basis for general
acceptability: For instance, corn, salt, tobacco, or cloth were widely used because they had obvious value
themselves. These could be regarded as commodity money.

Commodity money had uses other than as a medium of exchange (e.g. salt could be used to preserve meat, as
well as in exchange). But money commodities were not particularly convenient to use as money. Some were
difficult to transport, some deteriorated overtime, some could not be easily divided and some were
valued differently by different cultures.

As the trade developed between different cultures, many chose precious metal’s mainly gold or silver as their
commodity money. These had the advantage of being easily recognizable, portable, indestructible and
scarce (which meant it preserved its value over time).
The value of the metal was in terms of weight. Thus each time a transaction was made, the metal was weighed
and payment made. Due to the inconvenience of weighing each time a transaction was made, this led to the
development of coin money. The state took over the minting of coins by stamping each as being a particular
weight and purity (e.g. one pound of silver). They were later given a rough edge so that people could guard
against being cheated by an unscrupulous trade filling the edge down.

It became readily apparent, however, that what was important was public confidence in the “currency” of
money, it’s ability to run from hand to hand and circulate freely, rather than its intrinsic value. As a result there
was deliberately reduced below the face value of the coinage.

Any person receiving such a coin could afford not to mind, so long as he was confident that anyone to whom
he passed on the coin would also “not mind”. Debasement represents an early form of fiduciary issue, i.e.
issuing of money dependent on the “faith of the public” and was resorted to because it permitted the extension
of the supply of money beyond the availability of gold and silver.

Paper Money

Due to the risk of theft, members of the public who owned such metal money would deposit them for safe
keeping with goldsmiths and other reliable merchants who would issue a receipt to the depositor. The metal
could not be withdrawn without production of the receipt signed by the depositor. Each time a transaction
was made, the required amount of the metal would be withdrawn and payment made.

It was later discovered that as long as the person being paid was convinced the person paying had gold and the
reputation of the goldsmith was sufficient to ensure acceptability of his promise to pay, it became convenient
for the depositor to pass on the goldsmith’s receipt and the person being paid will withdraw the gold himself.
Initially, the gold would be withdrawn immediately after the transaction was made. But eventually it was
discovered that so long as each time a transaction was made the person being paid was convinced that there
was gold, the signed receipt could change hands more than once. Eventually, the receipts were made payable
to the bearer (rather than the depositor) and started to circulate as a means of payment themselves, without the
coins having to leave the vaults. This led to the development of paper money, which had the added advantage
of lightness.

Initially, paper money was backed by precious metal and convertible into precious metal on demand. However,
the goldsmiths or early bankers discovered that not all the gold they held was claimed at the same time and that
more gold kept on coming in (gold later became the only accepted form of money). Consequently they started
to issue more bank notes than they had gold to back them, and the extra money created was lent out as loans
on which interest was charged. This became lucrative business, so much so that in the 18th and 19th centuries
there was a bank crisis in England when the banks failed to honour their obligations to their depositors, i.e.
there were more demands than there was gold to meet them. This caused the government to intervene into
the baking system so as to restore confidence. Initially each bank was allowed to issue its own currency and to
issue more currency than it had gold to back it. This is called fractional backing, but the Bank of England
put restrictions on how much money could be issued.

Eventually, the role of issuing currency was completely taken over by the Central Bank for effective control.
Initially, the money issued by the Central Bank was backed by gold (fractionally), i.e. the holder had the right
to claim gold from the Central Bank. However, since money is essentially needed for purchase of goods and
services, present day money is not backed by gold, but it is based on the level of production, the higher the
output, the higher is the money supply. Thus, present day money is called TOKEN MONEY i.e. money
backed by the level of output.
Over time, therefore, it became clear that for an item to act as money it must possess the following
characteristics.

• Acceptability

If money is to be used as medium of exchange for goods and services, then it must be generally accepted as
having value in exchange. This was true of metallic money in the past because it was in high and stable demand
for its ornamental value. It is true of paper money, due to the good name of the note-issuing authority.

• Portability

If an item is to be used as money, it must be easily portable, so that it is a convenient means of exchange.

• Scarcity

If money is to be used in exchange for scarce goods and services, then it is important that money is in scarce
supply. For an item to be acceptable as money, it must be scarce.

• Divisibility

It is essential that any asset which is used as money is divisible into small units, so that it can be used in exchange
for items of low value.

• Durability

Money has to pass through many different hands during its working life. Precious metals became popular
because they do not deteriorate rapidly in use. Any asset which is to be used as money must be durable. It
must not depreciate over time so that it can be used as a store of wealth.

• Homogeneity

It is desirable that money should be as uniform as possible.

Functions of money

a. Medium of exchange: Money facilitates the exchange of goods and services in the economy. Workers
accept money for their wages because they know that money can be exchanged for all the different things
they will need. Use of money as an intermediary in transactions therefore, removes the requirement for
double coincidence of wants between transactions. Without money, the world’s complicated economic
systems which are based on specialization and the division of labour, would be impossible. The use of
money enables a person who receives payment for services in money to obtain an exchange for it, the
assortment of goods and services from the particular amount of expenditure which will give maximum
satisfaction.

b. Unit of account: Money is a means by which the prices of goods and services are quoted and accounts
kept. The use of money for accounting purposes makes possible the operation of the price system and
automatically provides the basis for keeping accounts, calculating profit and loss, costing etc. It facilitates
the evaluation of performance and forward planning. It also allows for the comparison of the relative
values of goods and services even without an intention of actually spending (money) on them e.g. “window
shopping”.
c. Store of Wealth/value: The use of money makes it possible to separate the act of sale from the act of
purchase. Money is the most convenient way of keeping any form of property which is surplus to
immediate use; thus in particular, money is a store of value of which all assets/property can be converted.
By refraining from spending a portion of one’s current income for some time, it becomes possible to set
up a large sum of money to spend later (of course subject to the time value of money). Less durable or
otherwise perishable goods tend to depreciate considerably over time, and owners of such goods avoid
loss by converting them into money.

d. Standard of deferred payment: Many transactions involve future payment, e.g. hire purchase,
mortgages, long term construction works and bank credit facilities. Money thus provides the unit in
which, given the stability in its value, loans are advanced/made and future contracts fixed. Borrowers
never want money for its own sake, but only for the command it gives over real resources. The use of
money again allows a firm to borrow for the payment of wages, purchase of raw materials or generally to
offset outstanding debt obligations; with money borrowing and lending become much easier, convenient
and satisfying. It’s about making commerce and industry more viable.

Only money, of all possible assets, can be converted into other goods immediately and without cost.

B. The Determination of the Value Money

Since money is primarily a medium of exchange, the value of money means what money will buy. If at one
time a certain amount of money buys fewer things than at a previous time, it can be said that the value of money
has fallen. Since money itself is used as unit of account and a means of measuring the “value” of other things,
its own value can be seen only through the prices of other things. Changes in the value of money, therefore,
are shown through changes in prices.

The quantity theory of money

In the 17th Century it was noticed that there was a connection between the quantity of money and the general
level of prices, and this led to the formulation of the Quantity Theory of Money. In its crudest form is stated
that an increase in the quantity of money would bring about an appropriate rise in prices. If the quantity of
money was doubled, prices would double and so on. Algebraically, this could be stated as:

P=aM
Where a is constant, P the price level, and M the supply of money. If the supply of money doubled, to 2M, the
new price level P will equal

a(2m) = 2(aM) = 2P

that is, double the old price level.

After being long discarded, the theory was revived in the 1920s by Professor Irving Fisher, who took into
account the volume of transactions, that is to say, the amount of “work” that the money supply had to do as a
medium of exchange. That is the velocity
of circulation. Money circulated from hand to hand. If one unit of money is made to serve four transactions,
this is equivalent to four units of money, each being used in only one transaction.

As modified by Irving Fisher, the quantity theory came to be expressed by the equation
of exchange.

MV = PT
 The symbol M represents the total amount of money in existence – bank notes etc, and bank deposits.

The symbol V represents the velocity of circulation, i.e. the number of times during the period each unit of
money passes from hand to hand in order to affect a transaction. Thus if the amount of money in the hands
of the public during the year was an average $1,000,000 and each dollar on average was used five times, the
total value of
transactions carried out during the year must have been $5,000,000.

MV therefore represents the amount of money used in a period.

On another side of the equation, P stands for the general price level, a sort of average of the price or all kinds
of commodities-producers’ goods as well s consumer’s goods and services. The symbol T is the total of all
transactions that have taken place for money during the year.

The equation of exchange shows us that the price level, and, therefore, the value of money, can be influenced
not only by the quality of money but also by:

i. the rate at which money circulates, and

ii. the output of goods and services.

Thus prices may rise without any change taking place in the quantity of money if a rise occurred in the velocity
of circulation. On the other hand, prices might remain stable in spite of an increase in the quantity of money
if there was corresponding increase in the output of goods and services.

Even in its revised form, however, the Quantity Theory has been subjected to the following criticisms:

a. It is not a theory at all, but simply a convenient method of showing that there is certain relationship
between four variable quantities – M, V, P and T. it shows that only the total quantity of money, as
determined by the actual amount of money in existence the velocity of circulation, is equal to the value of
total trade transactions multiplied by their average price. As such it is obviously a truism, since the amount
of money spent on purchases is obviously a truism, since the amount of money spent on purchases is
obviously equal to the amount received from sales. Not only must MV be equal to PT, but MV is PT,
since they are only two different ways of looking at the same thing.

b. Even if the equation of exchange is only a truism, it would not be quite correct to say that it
demonstrates nothing. For example, it shows that it is possible for there to be an increase in the quantity
o f money without a general rise in prices. It informs us, too, that if there is to be a change in one or
more of the variables of the equation, there must be a change in one or more of the other variables.
Cleary, it would be wrong to read into it more than this.

c. The four variables, M, V, P and T, are not independent of one another as the equation of exchange
implies. For example, a change in M is likely of itself to bring a change in V or T or both. It is probable
that a rise in pries will follow an increase in the quantity of money, but this will most likely be brought
about because the increase in the quantity of money stimulates demand and production.

d. A serious defect is to allow the symbol P to represent the general price level. Price changes do not keep
in step with one another. In its original form the equation was criticized because it implied that an
increase in the quantity would automatically bring about a proportionate increase in all prices. A study
of price changes shows that some prices increased by many times while others by fewer times. Clearly,
then, there is no general price level, but instead, as the index of Retail Price shows, a number of sectional
price levels, one for food, another for clothing, another for fuel and light, and so on.
 e. The Quantity Theory only attempts to explain changes in the value of money, and does not show how
the value of money is in the first place determined.

f. The Quantity Theory approaches the question of the value of money entirely from the supply perspective.

C. The demand for and supply of money

i. Demand for money

The demand for money is a more difficult concept than the demand for goods and services. It refers to the
desire to hold one’s assets as money rather than as income-earning assets (or stocks).

Holding money therefore involves a loss of the interest it might otherwise have earned. There are two schools
of thought to explain the demand for money, namely the Keynesian Theory and the Monetarist Theory. (See
pp 18 – 26)

The demand for money and saving

The demand for money and saving are quite different things. Saving is simply that part of income which is not
spent. It adds to a person’s wealth. Liquidity preference is concerned with the form in which that wealth is
held. The motives for liquidity preference explain why there is desire to hold some wealth in the form of cash
rather than in goods affording utility or in securities. (See pp 18 – 26)

ii. The supply of money

Refers to the total amount of money in the economy.

Most countries of the world have two measures of the money stock – broad money supply and narrow
money supply. Narrow money supply consists of all the purchasing power that is immediately available for
spending. Two narrow measures are recognized by many countries. The first, M0 (or monetary base), consists
of notes and coins in circulation and the commercial banks’ deposits of cash with the central banks.

The other measure is M2 which consists of notes and coins in circulation and the NIB (non-interest-bearing)
bank deposits – particularly current accounts. Also in the M2 definition are the other interest-bearing retail
deposits of building societies. Retail deposits are the deposits of the private sector which can be withdrawn
easily. Since all this money is readily available for spending it is sometimes referred to as the “transaction
balance”.

Any bank deposit which can be withdrawn without incurring (a loss of) interest penalty is referred to as a “sight
deposit”.

The broad measure of the money supply includes most of bank deposits (both sight and time), most building
society deposits and some money-market deposits such as CDs (certificates of deposit).

Legal Tender

Legal tender is anything which must be by law accepted in settlement of a debt.

Determinants of the money supply

Two extreme situations are imaginable. In the first situation, the money supply can be determined at exactly
the amount decided on by the Central Bank. In such a case, economists say that the money supply is exogenous
and speak of an exogenous money supply.

In the other extreme situation, the money supply is completely determined by things that are happening in the
economy such as the level of business activity and rates of interest and is wholly out of the control of the
Central Bank. In such a case economists would say that there was an Endogenous money supply, which means
that the size of the money supply is not imposed from outside by the decisions of the Central Bank, but is
determined by what is happening within the economy.

In practice, the money supply is partly endogenous, because commercial banks are able to change it in response
to economic incentives, and partly exogenous, because the Central Bank is able to set limits beyond which the
commercial banks are unable to increase the money supply.

Measurement of changes in the value of money

Goods and services are valued in terms of money. Their prices indicate their relative value. When prices go
up, the amount which can be bought with a given sum of money goes down; when prices fall, the value of
money rises; and when prices rise, the value of money falls. The economist is interested in measuring these
changes in the value of money.

The usual method adopted to measure changes in the value of money is by means of an
index number of prices i.e. a statistical device used to express price changes as percentage of prices in
a base year or at a base date.

Preparation of Index Numbers

A group of commodities is selected, their prices noted in some particular year which becomes the base year
for the index number and to which the number 100 is given. If the prices of these commodities rise by 1 per
cent during the ensuing twelve months the index number next year will be 101. Examples of Index Number
are Cost-of Living-Index, Retail Price Index, Wholesale Price Index, Export Prices Index, etc.

Problems of Index Numbers

The construction of Index Numbers presents some very serious problems and, as they cannot be ideally solved,
the index numbers by themselves are limited in their value and reliability as a measurement of changes in the
level of prices. The problems are:

a) The problems of weighting

The greatest difficulty facing the compiler of index number is to decide on how much of each commodity to
select. This is the problem of weighting. Different “weights” will yield different results, as the following
example illustrates. Assume that there are only three commodities, A, B, C and the prices of which are
Kshs.50/=, Kshs.20/= and Kshs.10/=, respectively. By taking one unit of each that is, without any weighting
– the index number for the base year constructed as follows:-

Base Year

Commodity Price Weight Index

Kshs.
 A 50 1 100
B 20 1 100
C 10 1 100
3 300

Assume that one year later the price of A is Kshs.45/=, B Kshs.25/= and C Kshs. 15/=.

Base Year

Commodity Price Weight Index

Kshs.
A 45 1 90
B 25 1 125
C 15 1 150
3 365

index for all items = 121.6

The index number in the second year is 121.6, showing an increase in price of 21.6 per cent over the base year.
If the commodities A, B, C are all differently weighted a different result will be obtained. For example, suppose
that one will then be compiled as follows:-

Base Year

Commodity Price Weight Index

Kshs.
A 50 1 100
B 20 4 400
C 10 20 2,000
25 2,500
Index for all items = 100

Second Year

Commodity Price Weight Index

Kshs.
A 50 1 90
B 20 4 500
C 10 20 3,000
25 3,590

Index for all items 143

By weighting C heavily this index shows a rise in prices of 43.6 per cent, although individual prices show only
the same change as before. By weighting commodity A more heavily, an index number can actually be compiled
from the same date to show a fall in prices.

b) The next problem is to decide what grades and quantities to take into account. By including more than one
grade an attempt is made to make a representative selection. An even greater difficulty occurs when the
prices of a commodity remain unchanged, although the quantity has declined.
c) The choice of the base year. This would preferably be a year when prices are reasonably steady, and so
years during periods either of severe inflation or deflation are to be avoided.

d) Index numbers are of limited value for comparisons over long periods of time because:

• New commodities come on the market.

• Changes in taste or fashion reduce the demand for some commodities and increase the demand for
others.
• The composition of the community is likely to change.
• Changes may occur in the distribution of the population among the various age groups.
• The rise in the Standard of living.

e) Changes in the taxation of goods and services affect the index.

2. THE BANKING SYSTEM

Consists of all those institutions which determine the supply of money. The main element of the Banking
System is the Commercial Bank (in Kenya). The second main element of Banking System is the Central Bank
and finally most Banking Systems also have a variety of other specialized institutions often called Financial
Intermediaries.

The Central Bank

These are usually owned and operated by governments and their functions are:

i. Government’s banker: Government’s need to hold their funds in an account into which they can make
deposits and against which they can draw cheques. Such accounts are usually held by the Central Bank

ii Banker’s Bank: Commercial banks need a place to deposit their funds; they need to be able to transfer
their funds among themselves; and they need to be able to borrow money when they are short of cash.
The Central Bank accepts deposits from the commercial banks and will on order transfer these deposits
among the commercial banks. Consider any two banks A and B. On any given day, there will be cheques
drawn on A for B and on B for A. If the person paying and the person being paid bank with the same
bank, there will be a transfer of money from the account or deposit of the payee. If the two people do
not bank with the same bank, such cheques end up in the central bank. In such cases, they cancel each
other out. But if there is an outstanding balance, say in favour of A, then A’s deposit with the central
bank will go up, and B’s deposit will go down. Thus the central bank acts as the Clearing House of
commercial banks.

iii. Issue of notes and coins: In most countries the central bank has the sole power to issue and control
notes and coins. This is a function it took over from the commercial banks for effective control and to
ensure maintenance of confidence in the banking system.

iv. Lender of last resort: Commercial banks often have sudden needs for cash and one way of getting it is
to borrow from the central bank. If all other sources failed, the central bank would lend money to
commercial banks with good investments but in temporary need of cash. To discourage banks from over-
lending, the central bank will normally lend to the commercial banks at a high rate of interest which the
 commercial bank passes on to the borrowers at an even higher rate. For this reason, commercial banks
borrow from the central bank as the lender of the last resort.

v. Managing national debt: It is responsible for the sale of Government Securities or Treasury Bills, the
payment of interests on them and their redeeming when they mature.

vi. Banking supervision: In liberalized economy, central banks usually have a major role to play in policing
the economy.

vii Operating monetary policy: Monetary policy is the regulation of the economy through the control of
the quantity of money available and through the price of money i.e. the rate of interest borrowers will have
to pay. Expanding the quantity of money and lowering the rate of interest should stimulate spending in
the economy and is thus expansionary, or inflationary. Conversely, restricting the quantity of money and
raising the rate of interest should have a restraining, or deflationary effect upon the economy.

a) Open Market Operations: The Central Bank holds government securities. It can sell some of these, or
buy more, on the open market, buying or selling through a stock exchange or money market. When the
bank sells securities to be bought by members of the public, the buyers will pay by writing cheques on
their accounts with commercial banks. This means a cash drain for these banks to the central bank,
represented by a fall in the item “bankers” deposits’ at the central bank, which forms part of the
commercial banks’ reserve assets. Since the banks maintain a fixed liquidity (or cash) ratio, the loss of
these reserves will bring about multiple contraction of bank loans and deposits.

By going into the market as a buyer of securities, the central bank can reverse the process, increasing the
liquidity of commercial banks, causing them to expand bank credit, always assuming a ready supply of
credit-worthy borrowers.

Conversely, if the central bank wanted to pursue an expansionary monetary policy by making more credit
available to the public, it would buy bonds from the public. It would pay sellers by cheques drawn on
itself, the sellers would then deposit these with commercial banks, who would deposit them again with the
central bank. This increase in cash and reserve assets would permit them to carry out a multiple expansion
of bank deposits, increasing advances and the money supply together.

b) Discount Rate (Bank Rate) This is the rate on central bank advances and is also called official discount
rate or “minimum lending rate”. When commercial banks find themselves short of cash they may, instead
of contracting bank deposits, go to the central bank, which can make additional cash available in its
capacity as “lender of last resort”, to help the banks out of their difficulties. The Central Bank can make
cash available on a short-term basis in either of two ways; by lending cash directly, charging a rate of
interest which is referred to as the official “discount rate”, or by buying approved short-term securities
from the commercial banks. The central bank exercises regulatory powers as a lender of last resort by
making this help both more expensive to get and more difficult to get. It can do the former by charging
a very high “penal” rate of interest, well above other short-term rates ruling in the money market. Similarly,
when it makes cash available by buying approved short-term securities, it can charge a high effective rate
of interest by buying them at low prices. The effective rate of interest charged when central bank buys
securities (supplying cash) is in fact a re-discount rate, since the bank is buying securities which are already
on the market but at a discount.

The significance of this rate of interest charged by the central bank in one way or the other to commercial
banks, as a lender of last resort, is that if this rate goes up the commercial banks, who find that their costs
of borrowing have increased, are likely to raise the rates of interest on their lending to businessman and
other borrowers. Other interest rates such as those charged by building societies on house mortgages, are
then also likely to be pulled up.
c) Variable Reserve Requirement
(Cash and Liquidity Ratios)

The Central Bank controls the creation of credit by commercial banks by dictating cash and liquidity ratios.
The cash ratio is:

Cash Reserves
Deposits

The Central Bank might require the commercial banks to maintain a certain ratio, say 1/10. Hence:

Cash Reserves = 1
Deposits 10

Deposits = 10 x Cash Reserves

This means that the banks can create deposits exceeding 8 times the value of its liquid assets. The liquidity
ratio can be rewritten as:

Cash + Reserves Assets = Cash + Reserves Assets

Deposits Deposits Deposits

= Cash Ratio + Reserve Assets Ratio

If the liquidity ratio is 12.5, then:

Cash + Reserved Assets = 1

Deposits Deposits 8

Deposits = 10 x cash + 2.5 x Reserve Assets.

In most countries the Central Bank requires that commercial banks maintain a certain level of Liquidity
Ratio i.e. Cash reserves (in their own vaults and on deposit with the Central Bank) well in excess of what
normal prudence would dictate. This level shall be varied by the Central Bank depending on whether they
want to increase money supply or decrease it.

This is potentially the most effective instrument of monetary control in less developed countries because the
method is direct rather than via sales of securities or holding bank loans and advances. The effects are
immediate. This method moreover does not require the existence of a capital market and a variety of financial
assets. However, increased liquidity requirements may still be offset in part if the banks have access to credit
from their parent companies. A further problem is that a variable reserve asset ratio is likely to be much more
useful in restricting the expansion of credit and of the money supply than in expanding it: if there is a chronic
shortage of credit-worthy borrowers, the desirable investment projects, reducing the required liquidity. Ratio
of the banks may simply leave them with surplus liquidity and not cause them to expand credit. Finally, if the
banks have substantial cash reserves the change in the legal ratio required may have to be very large:

d) Supplementary Reserve, Requirements/Special Deposit

If the Central Bank feels that there is too much money in circulation, it can in addition require commercial
banks to maintain over and above cash or liquid assets some additional reserves in the form of Special
 Deposits. The commercial banks are asked to maintain additional deposits in their accounts at the central
bank, deposits which cease to count among their reserve assets as cover for their liabilities.

e) Direct control and Moral Suasion

Without actually using the above weapons, the central bank can attempt simply to use “moral suasion” to
persuade the commercial banks to restrict credit when they wish to limit monetary expansion. Its
effectiveness depends on the co-operation of the commercial banks.

f) General and Selective Credit Control

These are imposed with the full apparatus of the law or informally using specific instructions to banks and
other institutions. For instance, the central bank can dictate a ceiling value to the amount of deposits the
bank can create. This is more effective in controlling bank lending than the cash and liquidity ratio. It
can also encourage banks to lend more to a certain sector of the economy (e.g. agriculture) than in another
(estate building). Selective controls are especially useful in less developed investment away from less
important sectors such as the construction of buildings, the commercial sector, or speculative purchase of
land, towards more important areas.

(For more on Monetary Policy, see Lesson 7)

B. Commercial Banks

A Commercial Bank is a financial institution which undertakes all kinds of ordinary banking business like
accepting deposits, advancing loans and is a member of the clearing house i.e. operates or has a current account
with the Central Bank. They are sometimes known as Joint Stock Banks.

Functions of Commercial Banks

In modern economy, commercial banks have the following functions:

i. They provide a safe deposit for money and other valuables.

ii. They lend money to borrowers partly because they charge interest on the loans, which is a source of
income for them, and partly because they usually lend to commercial enterprises and help in bringing
about development.

iii. They provide safe and non-inflationary means for debt settlements through the use of cheques, in that no
cash is actually handled. This is particularly important where large amounts of money are involved.

iv. They act as agents of the central banks in dealings involving foreign exchange on behalf of the central
bank and issue travellers’ cheques on instructions from the central bank.

v. They offer management advisory services especially to enterprises which borrow from them to ensure that
their loans are properly utilized.

Some commercial banks offer insurance services to their customers eg. The Standard Bank (Kenya) which
offers insurance services to those who hold savings accounts with it.
Some commercial banks issue local travellers’ cheques, e.g. the Barclays Bank (Kenya). This is useful in that it
guards against loss and theft for if the cheques are lost or stolen, the lost or stolen numbers can be cancelled,
which cannot easily be done with cash. This also safe if large amounts of money is involved.

Bank Deposit

Bank notes and coins together constitute the currency in circulation. But they form only a part of the total
money supply. The larger part of the money supply in circulation today consists of bank deposits. Bank
deposits can either be a current account or deposit account. These are created by commercial banks and the
process is called credit creation.

Credit Creation

The ability of banks to create deposit money depends on the fact that bank deposits need to be only fractionally
backed by notes and coins. Because the bank does not need to keep 100 per cent reserves, it can use some of
the money deposited to purchase income-yielding investments.

Illustration

i. A Single Monopoly Bank

Consider first a country with only one bank (with as many physical branches as is necessary) and assume that
the bank has found from experience that it needs only to hold 10% of cash s a proportion of total deposits –
proportion of transactions that customers prefer to settle by means of cash, rather than cheque. Now imagine
the balance sheet of the bank look like this:

Initial Position of single bank

Liabilities £1,000 Assets £1,000

Deposits 1,000 Cash 100

Loans 900

Total 1,000 Total 1,000

Deposits are shown as liabilities, since the bank can be called up to repay in cash any amounts credited to
customers in this way. Assets consist of cash held by the bank, plus loans, which represents the obligations of
borrowers towards the bank. The cash ratio is the ratio of cash held (£100,000) to its liabilities ((£1,000,000),
and is 10 per cent in this case.

Suppose now a customer deposits (liabilities) in this initial position will be:

120 x 100 = 11.8%

1,020

This is unnecessarily high, nearly 12 per cent compared to the conventional ratio of 10 per cent. The bank can
therefore safely make additional interest-bearing loans. If it lends an extra £180,000, according deposits will
rise from £1,020,000 to £1,200,000, so that the 10 per cent ratio of cash to deposit is restored. The final
position is as shown below, and indicates that bank deposits have been created to the extent of ten times the
new cash deposit.
Addition of cash deposit raises cash reserves and cash ratio

Liabilities £1,000 Assets £1,000

Deposits 1,020 Cash 120

Loans 900

Total 1,020 Total 1,020

This is a stable position. Borrowers will make out cheques to other people in payment for goods and services
supplied. But these others must be customers of the same bank, since there is only one bank. There will follow
no more than a book transaction within one bank, the bank deposits being transferred from one customer to
another. Total deposits, total cash, and the cash ratio will not be affected.

Comparing the initial position in the first table with the final position in the table below, we can see that the
increase in bank deposits, which we can call ΔD is 200 and the increase in cash held by the banks, which we
can write as ΔC, is 20. Thus ΔD is ten times ΔC, obviously because 1/r, where r is the cash ratio used, is 10.

Thus ΔD = ΔC
r

Restoration of Conventional cash ratio by creation of additional bank deposits

Liabilities £1,000 Assets £1,000

Deposits 1,200 Cash 120

Loans 1,080

Total 1,200 Total 1,200

ii. Many Banks

A single bank with a “monopoly” of credit creation is rarely found in real world. What is usually found is
where the bank receiving the new deposit is one of several independent banks. In that case the bank will not
seek immediately to expand deposits to the number of times the cash ratio, by extending loans. It will know
that the borrowers will use the credit granted to them to pay for goods and services, or to repay debts; and that
therefore they will be making cheques out to other individuals who by now have accounts in other banks. The
bank can thus expect to lose cash to other banks. Either the borrowers will withdraw cash directly, with which
to pay individuals who then deposit this cash with other banks, or if they pay by cheque these cheques will be
deposited with other banks, and the other banks themselves will present them for cash at the first bank.

Suppose in our example above, (illustration 1), the bank made the extreme assumption that none of the
borrowers’ cheques would be paid to its own customers. It will create only a relatively small amount of extra
deposits, just sufficient to restore its cash ratio. It will, in fact, make £18,000 worth of additional loans and
retain cash of £2,000. That will restore its cash ratio as shown below.

Initial round of credit creation by first bank

Liabilities (£1,000) Assets (£1,000) Cash ratio

Deposits Cash Loans %

Original position 1,000 100 900 10.0
Add cash deposit +20 +20 - --
Second position 1,020 120 900 11.8
Increase loans +18 - +18 --
Cash drain by cheques -18 -18 - --
Final position 1,020 102 918 10.0
Net change +20 +2 +18 --

However, the £18,000 lost in cash through cheques drawn by borrowers will be received by other banks who
in turn will find themselves with excess cash reserves, and in turn create additional loans. There will thus be
second generation of bank deposit creation, each bank again retaining only 10 per cent of the new cash received,
and creating loans in the ratio of nine to one. This new drain of cash will generate more deposits, and so on,
each new round being nine-tenths of the value of the previous one as follows (£’000s).

20 +18+ 16.20 + 14.85 + 13.12 + …

which can be written as

{1 + 9/10 + (9/10) 3 + (9/10) 4 +……..}

Each successive round of deposit creation is smaller than the previous one, so that the series converges.
Mathematically, the series will eventually add up to converge to 200. This is because for any value of between
0 and 1 the series tends to the value 1/1-z.

In an example z = 9/10, which is between 0 and 1, so on the formula applies. Hence

20{1 + 9/10) 2 + (9/10) 3 + ….} = { 1 } = 200

1 – 9/10

if we use ΔD to refer to the final increase or increment in bank deposits, ΔC too the initial increase in cash
received, and “r” to the cash ratio, then ΔD = 200, ΔC = 20,
r = 1/10.

Since 1 – r = 1 – 1/10 = 9/10, we have

ΔD = ΔC {1 + (1 – r) + (1 – r) 2 + (1 + r) 3 + …..}

ΔD = ΔC = ΔC
1 – (1 – r) r

Given the increase in cash received, the additional deposits created will depend on the fraction of cash retained
as backing. The ration ΔD/ΔC of deposits created to increase in cash is referred to as the bank deposit
multiplier.

Limits on the process of bank deposit creation

On the demand side, there may be a lack of demand for loans, or at least of borrowers who are sufficiently
credit worthy. On the supply side, the volume of bank deposits will not in general rise and fall as a result of
changes in the amount of cash held or deposited by the public, since the public’s currency requirements
tends to be fairly stable, and roughly proportional to the volume of transactions.

3. MONEY MARKETS
The expression “money markets” is used to refer to the set of institutions and individuals who are engaged
in the borrowing and lending of large sums of money for short periods of time (overnight to three months).
The money market is not located in a place – it is rather a network of brokers, buyers and sellers.

Most money market transactions are concerned with the sale and purchase of near money assets such as bills
of exchange and certificates of deposit.

Function of Money Markets

The money markets are the place where money is “wholesaled”. As such the supply of money and interest rate
which are of significance to the whole economy is determined there.

It is also used by the central bank to make its monetary policy effective.

CAPITAL MARKETS

Markets in which financial resources (money, bonds, stocks) are traded i.e. the provision of longer term finance
– anything from bank loans to investment in permanent capital in the form of the purchase of shares. The
capital market is very widespread.

It can also be defined as the institution through which, together with financial intermediaries, savings in the
economy are transferred to investor.

Interest and the Keynesian Liquidity Preference Theory

Interest is a factor income in that it is considered to be payment to or return on capital in the sense that it is
payment to those who provide loanable funds, which are used for the purchase of capital assets. The payment
of interest to the providers of loanable funds may be justified on the following grounds:

• The lender postpones present consumption and enjoyment and interest is paid as persuasion for him/her
to make this sacrifice.

• There is risk of default in that the borrower may fail to pay back and interest is paid as persuasion for the
lender to undertake this risk.

• There is loss of purchasing power due to increases in prices over time, and interest is paid as compensation
for this loss.

• The borrower earns income from the investment, and the tender can justifiably claim a share in that
income.

THEORIES OF INTEREST RATES DETERMINATION

Interest rates, refers to payment, normally expressed as a percentage of the sum lent which is paid over a year,
for the loan of money. There are many rates of interest depending on the degree or risk involved, the term
of the loan, and the costs of administration, namely, real, nominal and pure rate of interest.

Pure rate of interest is one from which factors like risk involved, the term of the loan and the cost of
administration has been removed. All rates of interest are related to each other and if one rate changes so
will others.
There are two theories as to how the rate of interest is determined – the loanable funds and the liquidity
preference theories.

a. The Loanable Funds Theory

Also called the classical theory of interest, was developed at the time of classical economists like Adam Smith,
David Ricardo and Thomas Malthus, who held the view that economic activities were guided by some kind of
invisible hand i.e. through the self interest motive and the price mechanism, and that Government interference
was unnecessary and should be kept at minimum.

Interest SSss S
Rate %

Loanable Funds

They therefore explained the rate of interest in terms of the demand for money and supply of loanable funds.
The demand comes from firms wishing to invest. The lower the rate of interest the larger the number of
projects which will be profitable. Thus, the demand curve for funds will slope downwards from left to right.

The supply of loanable funds comes from savings. If people are to save they will require a reward-interest – to
compensate them for forgoing present consumption. If the interest rate is high, people will be encouraged to
save and lend. If the interest rate is low, people will be discouraged from saving and lending. Hence, the supply
curve of loanable funds slopes upwards.

Interest
Rate % S

Loanable Funds
The market rate of interest is therefore determined where the demand for and supply of loanable funds are
equal. Geometrically this corresponds to the point of intersection between the supply curve and the demand
curve for loanable funds.

D
S

Interest Rate%

D
S

L Loanable Funds

i is the equilibrium market rate of interest and L the equilibrium level of loanable funds. Above i, there is
excess of supply over demand, and interest rates will be forced downwards. Below i there is excess of demand
over supply and interest rates will be forced upwards.

Changes in demand or supply will cause shifts in the relevant curves and changes in the equilibrium rate of
interest.

Although this theory has a certain amount of validity, it has been criticized on the following grounds:

i. It assumes that money is borrowed entirely for the purchase of capital assets. This is not true because
money can be borrowed for the purchase of consumer goods (e.g. cars or houses)

ii. It assumes that the decision to borrow and invest depends entirely on interest. This is not the case, for
business expectations play more important role in the decision to invest. Thus if business expectations
are high, investors will borrow and invest, even if the rate of interest is high and if business expectations
are low investors will not borrow and invest even if the rate of interest is low.

iii. It assumes that the decision to save depends entirely on the rate of interest. This is not true for people
can save for purposes other than earning interest, e.g. as precaution against expected future events like
illness or in order to meet a certain target (this is called target savings) or simply out of habit.

b. The Keynesian Theory

Also called the Monetary Theory of Interest, was put forward by the Lord John Maynard Keynes in
1936. In the theory, he stated that the rate of interest is determined by the supply of money and the desire
 to hold money. He thus viewed money as a liquid asset, interest being the payment for the loss of that
liquidity.

Keynes formulated derived from three motives for holding money, namely:

• Transactions;
• Precautionary; and
• Speculative.

Thus Keynes contended that an individual’s aggregate demand for money in any given period will be the result
of a single decision that would be a composite of those three motives.

a. Transactions demand for money

Keynes argued that holding money is a cost and the cost is equal to the interest rate foregone. People holding
money as assets could also buy Government bonds to earn interest. But money’s most important function is
as medium of exchange. Consumers need money to purchase goods and services and firms need money to
purchase raw materials and hire factor services. People therefore hold money because income and expenditure
do not perfectly synchronize in time. People receive income either on monthly, weekly, or yearly basis but
spend daily, therefore money is needed to bridge the time interval between receipt of income and its
disbursement over time.

The amount of money that consumers need for transactions will depend on their spending habits, time
interval after which income is received and Income. Therefore holding habit and Interval Constant, the
higher the income level the more the money you hold for transactions. Keynes thus concluded that transactions
demand for money is Interest Inelastic.

Interest
Rate %

Liquidity
Preference
b. Precautionary Demand for Money

Individuals and businessmen require money for unseen contingencies, Keynes hypothesized that individuals’
demand and institutional factors in society to be considered in the short run.

Money demanded for these two motives is called active balances, because it is demanded to be put to specific
purposes. The demand for active balances is independent of the rate of interest. Hence the demand curve for
active balances is perfectly inelastic.

Interest
Rate %

Liquidity
Reference

c. Speculative Demand for Money

Finally, money is demanded for speculative motives. This looks at money as a store of value i.e. money is held
as an asset in preference to an income yielding asset such s government bond.

Keynes thus explained the Speculative motive in terms of the buying and selling of Government Securities or
Treasury Bills on which the government pays a fixed rate of interest.

According to Keynes, securities can be bought and sold on the free market before the government redeems
them, and the price at which they are sold does not have to be equal to their face value. It can be higher or
lower than the face value depending on the level of demand for securities. He defined the market rate of
interest as

Market rate of fixed government rate of interest on securities

Interest = Market price of securities
It follows therefore, that when the market price of securities is high the market interest rate will be low. Also
if the market price of securities ( high holders of securities) will sell them now and hold money. Hence the
demand for money is high when the interest rate is low. On the other hand when the market price of securities
is low, the market rate of interest will be high. Also if the market price of securities is low, it can be expected
to rise. Hence people will buy securities at a low price, hoping to sell them at higher prices. In buying securities,
people part with money. Hence the demand for money is low when interest rate is high. It follows, therefore,
that the demand curve for money for the speculative motive slopes downwards as shown on the next page.

Interest
Rate % LI

Liquidity
Preference

It flattens out at the lower end because there must be a minimum rate of interest payable to the people to
persuade them to part with money. This perfectly elastic part is called LIQUIDITY TRAP.

The total demand for money at any given interest rte is the sum of the demands for the active balances and the
speculative motive. Thus, the total demand curve for money is obtained by the horizontal summation of the
two demand curves.

Interest Interest Interest

Rate % Rate % Rate %

La
L1 L
Active speculative Total
 Balance Motive Demand
i1 i1 i1

i2 i2 i2

1 2 3 4 5
i3 i3 i3

Li1 L31
Liquidity Liquidity Liquidity
Preference Preference Preference

1+2=4

Note that the demand for money for active balances is constant at La at all rates of interest. At interest rate i1,
the demand for speculative motive is Li1. Hence total demand is (La + Li1)

At the interest rate i2 and the total demand is (La + L31) and so on. This gives rise to the total demand curve
LL.

Interest
Rate %
M

Liquidity Preference

At any given time, the supply of the money is fixed, as determined by the monetary authorities. Hence the
supply of money is independent of the rate of interest and the supply curve of money is perfectly inelastic as
shown above.

The equilibrium rate of interest is determined by the interaction of demand and supply forces, and this
corresponds to the point of intersection between the demand curve and the supply curve.

Interest L
 rate % M

i
L

i is the equilibrium rate of interest. Above it there is excess supply over demand and the interest rates will be
forced downwards. Below it there will be excess demand over supply and interest rates will be forced upwards.
An increase in the supply of money will cause interest rates to fall down because people will need less persuasion
to part with money. An increase in supply is indicated by a shift to the right of the supply curve.

Interest L2
Rate % L1
M

i1

i2 L

Liquidity

When supply increases from M1 to M2, interest rates falls from i1 to i2. Conversely, fall in the supply of money
(indicated by a shift to the left of the supply curve) causes interest rates to rise because people will need more
persuasion to part with the money. Thus when supply falls from M2 to M1, interest rate will rise from i2 to i1.

An increase in the demand for money (indicated by an upward swing of the demand curve will cause interest
rate to rise.

Interest L
Rate % M1 M2
 i1

i2

Liquidity

An increase in demand from L1 to L2 causes interest rate to rise from i2 to i1. This is because at the initial rate
of interest the increase in demand creates excess of demand
over supply which causes interest rates to rise.

Conversely, when demand falls (indicated by downward swing of the demand curve) interest rate falls as at the
initial rate of interest there will be excess of supply over demand. Thus, when demand falls from L2 to L1,
interest rate falls form i1 to i2.

THE IS – LM MODEL

IS – LM analysis aims to find the level of income and rate of interest at which both the commodity market and
money market will be in equilibrium.

There IS curve is locus of points representing all the different combinations of interest rates and income levels
consistent with equilibrium in the goods or commodity market.

The IS curve is shown in the diagram below:

Interest
Rate
(i)

IS curve

0 National Income (Y)

Figure: The IS curve

The IS curve is a linear function in the two variables Yand I.

The LM curve is a locus of points representing all the different combinations of interest rates and income levels
consistent with equilibrium in the money market. The LM curve is shown in the following diagram.

Interest
rate LM curve
 (i)

0 National Income (Y)

Figure: The LM Curve

The LM curve is also a function which is linear in the two variables I and Y.

IS – LM analysis aims at obtaining simultaneous equilibrium in both the commodity and the money markets.
Graphically, this situation can be represented as follows:

Interest
Rate IS – curve LM - curve
(i)
_
i

_
Y National income (Y)

Figure: Equilibrium in both the commodity and money markets.

The equilibrium in the two markets is represented graphically by the intersection of the IS and LM curves.

The commodity market for a simple two – sector economy is in equilibrium when
Y = C + I. The money market, on the other hand, is in equilibrium when the supply of money (Ms) equals the
demand for money (Md). The demand for money is in turn made up of the transaction – precautionary demand
(MDT) and speculative demand for money (MDS).

Numerical example.

Assume that:

C = 178 + 0.6 Y

I = 240 – 300 i

MS = 550
 MDT = 0.2 Y

MDS = 480 – 500i

Commodity market equilibrium (IS) exists where;

Y=C+I

= 178 + 0.6Y + 240 – 300i

Y – 0.6Y = 418 – 300 i

0.4Y + 300 i – 418 = 0

Monetary equilibrium (LM) exists where

MS = MDT + MDS

550 = 0.2y + 480 – 500 i

0.2Y – 500 i – 70 = 0

Simultaneous equilibrium in both markets requires that :

0.4Y + 300 i – 418 = 0 …………… (i)

0.2Y + 500i – 70 = 0 …………… (ii)

Multiply (i) by 5 and (ii) by 3 in order to eliminate i.

2 Y + 1500 i – 2,090 = 0
0.6Y + 1500 i - 210 = 0
2.6Y _= 2,300
Y =2,300

= 885

_
substitute Y = 885 into (i) or (ii)

0.4 (885) + 300i – 418 = 0

354 + 300i – 418 = 0

300 i = 64

i = 0.21