MKU 1201 Introduction to Macroeconomics

MONEY AND BANKING

Definition of money
Money can be defined as follows:
According to David Collender (most recent definition) money is a highly liquid financial asset that is
generally accepted in exchange for other goods and is used as a reference in valuing other goods.

Money can be distinguished from income and wealth in that, wealth is the total resource owned by the
individual or business. It includes money and other assets such as bonds, car, land, house etc while income is
a flow of earning per unit of time i.e. Day, week, month etc

IMPORTANCE OF MONEY
• It enables individuals to maximize their satisfaction out of the limited resources (utility).
• Its circulation ensures the economy of a country to survive.
• A producer can acquire the services of factors of production through the money payment and after
producing different goods and sell them he can earn profit inform of money.
 A consumer can acquire utility by spending money on the purchase of different commodities and make
their marginal utility from all commodities be equal.
 Government needs money to complete different development programmes.
 Money is also needed by different entrepreneurs to complete industrial and agricultural projects.

NEAR MONEY OR NON - MONETARY LIQUID ASSETS

Near money cannot be directly used for making payments i.e. stocks, treasury bills, government securities,
saving bonds. For them to be used in transactions, they are first to be converted into proper money. The
increase or decrease in the holding of near money affects the rate of communities’ savings ad spending. The
greater the amount of wealth in the form of near monies, the greater is the tendency of the community to
consume out of this income. Secondly, as the near monies can be easily converted into cash, it directly affects
the money supply.

Characteristics of monetary economy and its advantages

• There must exist suppliers or producers and consumers or buyers
• In a monetary economy, credit market its possible
• In a monetary economy makes it possible for a price system to operate and it ensures a market for the
factors of production.

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Disadvantages of monetary economy

• The supply of money may decrease or increase excessively leading to inflation.
• Money can be hoarded or destroyed.
• The monetary authority can manipulate the money supply to suits its purpose when the economic
conditions do not warrant it.

KINDS OF MONEY IN SUMMARY

Metallic money - consists of different metals like gold, silver, lead etc
Standard money - this is when the face value and the metallic value of a coin is the same. (were in circulation
st
up to the 1 world war)
Token money - this is when the face value is greater than metallic value. (this type of money is in circulation
currently)

Paper money - these are in the form of paper notes

Convertible paper money - this is the money which can be converted into gold. This was before 1914 and
from 1925-1931

Inconvertible paper money- this is the money which cannot be converted into gold. (the paper money which is
in circulation currently)

Legal money or legal tender - these are currency notes and coins issued in any country. All legal tender is
money but not all money is legal tender e.g. cheques and credit cards (plastics) are not legal tender
Limited legal money-examples are coins of small denominations which are used to make small transactions.
Unlimited legal money- good examples are currency notes which can be used to make payments up to any
limit.

Credit money - is that medium of exchange which is accepted on confidence basis only e.g. the use of
cheques. A cheque is not money itself but just a transfer order enabling transfer of money. So this case bank
deposit is considered as money since cheque is used to transfer that bank deposit from one’s person banking
account to another. The excessive use of cheques has made bank deposits the most important kind of money.

Deposit money – it consists of deposits at banks and the financial institutions which are subject withdrawal
by cheques. In developed countries of the world 95% of transactions are carried on with cheques. Cheques are
a safe way of transferring the ownership of deposits in financial institutions. They are normally acceptable as
a medium.

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FUNCTIONS OF MONEY

PRIMARY FUNCTIONS
1. Medium of exchange - Money makes it possible to approximate the value, quality of goods to be
exchanged.
2. Money as a unit of account - money is used in affective business, especially in calculations like
accounting and auditing
3. Measure of value - it is a standard value which is used to assess the value of the various goods and
services, the prices if different goods are indicated in terms of money.
4. Store of value - money is used to store wealth, one can keep wealth in the form of land, building or
money
5. Standard or deferred payments - money is used to make future transactions.

SECONDARY FUNCTIONS OF MONEY

1. Aid to specialization, production and trade. - The market mechanism, production of commodities,
specialization, expansion and diversion of trade etc have all been facilitated by the use of money
2. Influence on income and consumption - The use of money has a direct impact on the levels of income
and consumptions in the country. All production takes place for the market and the factor payments (rent,
wages, interest and profits) are made in money.
3. Money is an instrument of making loans - People save money and deposits in banks, the banks advances
these savings to businessmen and industrialists.
4. Money as a tool of monetary management – if the money is effectively used, it helps in increasing output
and employment.
5. Instrument of economic policy - money is the most powerful factor used by the government in order to
achieve growth, reduce unemployment and maintain regular expansion of economic activity

CONTINGENT FUNCTIONS
1. Distribution of national income – money facilitates the distribution of national income among the various
factors of production.
2. Basis of credit system – banks create credit on the basis of their cash reserves.
3. Measure of marginal productivity - the marginal productivity of each factor of production is measured
with the help of money.
4. Liquidity of property- money gives a liquid form of wealth. A property can be converted into liquid form
with use of money.

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PROPERTIES OR CHARACTERISTICS OF GOOD MONEY MATERIAL.

1. General acceptability - money should be acceptable to everybody so that it can be useful for the
purposes of trade.
2. Stability of value - money should have a stable value for a long period of time.
3. Transportability - money should be easily transportable without any depreciation. It should have a large
value in small quantity. Money should be convenient to carry; it should neither be too heavy nor too bulky.
4. Durability- if the commodity chosen as money it must last for a long, should not perish, withers away,
Die or be easily defaced.
5. Divisibility- money should be divided in such a way that it is easy to pay even for the cheapest items
6. Without getting problems of change.
7. Homogeneity- money which is used in a particular country should actually look the same; should be of a
Uniform quality and capable of standardization.
8. Cognizability money should be easily recognizable by the eye, ear or touch.
9. Malleability - a commodity to serve as money should be capable of being molded and stamped.
10. Should be difficult to copy - - Money which is difficult to copy reduces chances of forged money
being Introduced in the economy.

THE SUPPLY OF MONEY

Money supply refers to quantity of money which is in circulation in a particular country, at a particular time; it
comes in the form of currency or bank deposits where currency refers to coins and notes which are used as a
medium of exchange for today transactions.

THE VARIOUS AGREGATES OF MONEY SUPPLY IN KENYA

In Kenya the central bank distinguishes between six concepts of money on the basis of their liquidity
1. M0 – This is the narrowest concept of money and comprises currency held by the non – bank public
2. M1 – this includes M0 and demand deposits with commercial banks
3. M2 – this includes M1 and time and saving deposits held with commercial banks
4. M3 – this includes M2 and time and saving deposits held with non – bank financial institutions
5. M3x – this includes M3 and residents foreign currency denominated deposits held with commercial
banks
6. M3XT – this comprises M3x and holdings of Government by non – bank public

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THE VARIOUS DETERMINANTS OF MONEY SUPPLY ARE:-

1. OPEN MARKET OPERATIONS - This refers to the selling and buying of government securities on
the open market by the central bank. A reduction in the supply will occur if the government sells
securities through its broker and vice versa
2. INTEREST RATE POLICY – an increase in the rate of interest tends to reduce money supply and
credit creation
3. CHANGING THE CASH RESERVES RATIO – increase in the cash reserves ratio reduces the credit
multiplier and hence reduces the money supply. While a reduction in the cash reserves ratio is likely to
increase the credit multiplier and hence increase money supply
4. SPECIAL DEPOSIT – since special deposits are compulsory, they ensure a reduction in commercial
banks liquid assets and reduce the bank’s ability to increase credit and hence money supply
5. GOVERNMENT EXPENDITURE FINANCED BY BORROWING FROM CENTRAL BANK
If the currency is issued to the government to finance its expenditure. Money supply will increase and
conversely a reduction in government borrowing from central bank will reduce the rate of growth of
money supply
6. GOVERNMENT BORROWING FROM THE BANKING SYSTEM – IF the public sector is running
a deficit it may want to borrow some funds from the banking system which may lead to a further
expansion of money supply
7. A CHANGE IN THE PUBLICS DESIRED CASH HOLDINGS: a decision by the public to hold more
cash and small bank deposits will reduce money through its effect on credit creation. If the public decides
to hold less cash and bigger bank deposits. money supply would be increased through a higher degree of
credit creation

MONETARY SYSTEMS

Monetary system is that system under which money is issued and controlled in a country. Various monetary
systems which have been prevailing in different countries of the world are;
1) Monometallism - under this system, coins of a specified metal are used as money. (E.g. If gold is used,
gold standard or silver standard)
2) Bimetallism- is that system under which coins of two metals are used simultaneously. (In U.k 19 century
used)
3) Paper managed system - under this system, paper notes are issued by the central bank of a country. The
supply of these papers is controlled by the central bank according to the requirements of a country.
4) Gold standard- is that system under which currency is based on gold.

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The various forms of gold standard are:-

1. Gold currency standard - it is also known as full bodied gold standard. Gold serves not only as a
standard of value but also gold coins are used to make transactions. This system prevailed in U.K, U.S.A,
Germany, France and other countries before 1914.
2. Gold Bullion Standard - under this system, the value of the currency is fixed in terms of gold by making
such currency (paper notes) convertible into gold (bullion - gold bars not gold) and vice versa. This
system prevailed in U.K from 1925 to 1931.
3. Gold exchange standard - it is a gold standard for making foreign payment only, also when the home
country’s nationals receive payments from abroad in terms of currencies convertible into gold, the
currency authority ( i.e. the central bank of the home country converts it into home currency)
4. Gold parity standard - under this system, paper notes circulate in the country but the value of the
domestic currency is fixed in terms of gold. This system is under the supervision of international monetary
funds after Second World War. This is the type of gold standard which the member countries of the I.M.F
are supposed to have.

VALUE OF MONEY

Value of money means purchasing of money or the quantity of any commodity which can be exchanged for
one unit of money. It depends upon the price level. If the price level is higher, value of money will be smaller
and vice versa. There are several forces that determine the value of money and the general price level:-
• The volume of trade
• The quantities of currency
• The velocity (or rapid circulation of currency)

These three factors change independently as well as in relation to each other.

The determination of value of money has been explained by the economists in different ways. The
following theories are of great importance:-

QUANTITY THEORY OF MONEY - The quantity theory of money states

1. Other things being equal, changes in the value of money are directly proportioned to changes in the
quantity of money in circulation.
2. Other things being equal, changes in the value of money depend upon changes in the quantity of money
in circulation.
3. In other words, if other things remaining equal, if the quantity of money is doubled the price level would
be twice but the value of money will be reduced by half. Also, if other things remaining equal or the same

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if the quantity of money is halved, the price level will become half but the value of money will be double
i.e. its purchasing capacity will be higher.

Professor Irving Fisher expressed the quantity theory using the following equation or identity.

PT = MV = (P = MV/T)
Where M = quantity of money, V = velocity of money (it means the number of times one unit of money is
used to make transactions), T = number of transactions
V and T are assumed to be constant in the short run. If M increases, P will also increase e.g. if we assume M =
200, V = 10 and T= 100 then with the formula P = MV/T, 200*10/100 = 20 if we hold V and T constant as
should be the case but double M, P = MV/T = 400*10/100 = 40 Therefore we can see the quantity of money
resulting from changes in the money supply directly affects the price.

ASSUMPTIONS OF THE QUANTITY THEORY OF MONEY

This theory applies when the following factors remain constant
1. Velocity of money – if velocity of money decreases proportionately to increase in supply of money
then the price level will remain the same and vice versa, so it should remain constant.
2. Number of transactions – if the number of transactions increases with increase in quantity of money,
in that case, the price level will also remain the same. In short, there must be no changes in the number
of transactions with the changes in quantity of money.
3. Barter transactions – barter transactions must not change with the change in quantity of money of
money because if the goods which were previously exchanged for good are now exchanged for money
then quantity theory will not apply.
4. Hoardings – if the increased quantity of money is hoarded then the price level will not rise and vice
versa, so there must be no change in the hoardings.
5. Quantity and velocity of credit money – credit money or bank money and its velocity should remain
constant otherwise quantity theory of money will not apply.

CRITICISMS OF THE QUANTITY THEORY OF MONEY

1. The theory is based on weak assumptions. It’s obvious that when M increases or decreases, V and T
will also either increase or decrease since the variables are not independent of one another.
2. In its original format is too mechanistic i.e. it implies that an increase in the quantity of money
produces a proportionate increase in prices. This is not essential since the prices of commodities are
not changing the same way.
3. It ignores the important psychological factor that expectation of future changes influence peoples
actions

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4. It takes no account of the effect of hoarding money.

5. It approaches the problem from the side of supply and ignores the effect of demand.
6. In its original form, it takes no account of the influence of changes in the velocity of circulation.
7. The quantity theory cannot explain a rise in the prices of commodities due to a rise in costs of
production. When output rises, employment expands and supply of money may remain constant
depending on the development of technology.
8. It is not a theory at all but simply the way of showing the variables, namely MVT and P are related to
one another
9. There is nothing like general price level. It is more realistic to talk about a series of section price levels
like those which are used to calculate consumer price indices.
10. The theory takes no account of interest rate, the quantity theory of money cannot be complete without
reference to the rate of interest

KEYNESIAN THEORY OF MONEY (DEMAND FOR MONEY)

According to Lord Keynes, demand for money refers to a desire to hold wealth in the form of money instead
of investing it. This preference for money over other kinds of assets is known as liquidity preference. Lord
Keynes gave three main reasons why people prefer money. These are
1. The transaction motive - this is intended to meet our day to day requirement because our daily wants
are obtained for some act of exchange for food, clothes, and transport e.t.c.
2. Precautionary motive - money can be kept to meet certain requirements which cannot be foreseen e.g.
health problems, loss of jobs.
3. The speculative motive - an investor has to assess the future prospects in both capital and money
markets. The speculative motive depends upon the rate of interest or the price of the stock.

CASH BALANCE EQUATION OR CAMBRIDGE EQUATION

This equation is also known as demand and supply theory of money. This theory was represented by the
economists of Cambridge school of thought. According to this theory, value of money is determined at that
level where demand for money and supply of money are equal to each other. The demand for money is
defined as the quantity of money which is kept in cash form which as we said is also known as liquidity
preference. The demand for money depends upon the following three motives as we have mentioned already
1. The transaction motive
2. The precautionary motive
3. The speculative motive.

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The supply of money according to Cambridge school is determined by the central bank and the state. The
supply of money consists of 1.) Currency notes II.) Coins III) Bank deposits

Cash balance of Cambridge equation is as follows:

P = M/K.R where
M = total supply of money in circulation
P = general level of prices of consumer goods
R = volume of production or real income of the community for a period
K = the proportion of the national income that people prefer to hold in form of money. It represents
demand for money

From this equation we come to the conclusion that value of money depends on quantity of money, size of
nation income and demand for money. This theory is more realistic as compared to fisher’s equation.

MONETARISM VERSION OF QUANTITY THEORY

Milton Friedman presented his version for quantity theory of money in 1956. A group of economists who
support this theory are known as monetarists. They have given the following equation:
M.V =P.Y where M = Total stock of money, V = velocity of income, P = general level of prices and Y = flow
of real income.
This equation states that money value of gross national product must be equal to product of average of money
time’s velocity. Monetarists recognize that velocity of money is not constant but is fairly predictable. The y are
of the opinion that the above equation is the best way to study economic activity. A careful study of M and V
can be used to predict the behavior of nominal gross national product. They say that money is a form of
holding one’s wealth as an alternative of holding it in any other form like bonds, physical goods and so on.
They believe that close control of supply of money can maintain the value of money at a specific level.

EFFECTS OF CHANGES IN THE VALUE OF MONEY

Effects of production - rising prices stimulate production though a depression usually follows falling prices
check production and increase unemployment. When prices are falling, profits tend to be lower than was
anticipated.
Effects on distribution - changes in the value of money have different effect upon different groups of people.
1. Those with fixed incomes in terms of money find that the value of their incomes increases when the
price is falling, but if prices are rising the value of their income declines.
2. Those whose income depends upon profits find that their real income increases when prices are rising,
for profits increase more rapidly than prices.

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3. Wage earners find that there is a time - lag between a rise in prices and a rise in wages.

MEASUREMENT OF THE CHNAGES IN THE VALUE OF MONEY OR PRICE INDEX NUMBER

In order to measure the changes in the value of money, change in price level are measured. If price level goes
up, value of money falls and vice versa. The changes in price level can be measured through price index
numbers.
 Price index numbers is a number which indicates the price level of commodity in the current period in
comparison with the price level of the same commodity in the base period.
 In order to construct price index numbers, the following steps are taken
st
 The 1 step is to choose the base year that is the year with reference to which the price changes in other
years are sought to be studied. It should be a normal year, neither too prosperous nor year of depression.
 The next is to select the commodities and services purchased by an average family.
 After commodities and services have been selected, their prices have to be ascertained. Retail prices are
the best because they are the prices at which commodities are purchased for consumption.
 The next step is to represent the price of each commodity for the base year as 100 and the price for the
frequent year as a percentage of the price of the base year.
 Finally, we take the average of both the base year and the current year figures in order to find out change.

Price relative method (as we have explained above) - this method attempts to show the differences in price
of a commodity from one period to another. The index received of non-base year is the price relative which
relates the two prices for the two years. So the index of the base year is always 100, but the index of the
current year can be calculated as under
 Index of the current year = P1/P0 * 100
 Where P1 = price of current year, P0 = price of base year
 There are two methods to measure consumer price index
 Weighting methods - not all the commodities are of equal importance, it is therefore necessary to
multiply the indices of those goods by the figure of their importance. The figure of the importance is
always determined by the frequency with which the commodity is exchanged.

Price index for 2014 = P1W* 100 ,

POW
= 9985 * 100
5280
= 189.1 = 189

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It means the purchasing power of sh.189 in 2014 is equal to sh. 100 in 2005. The value of money has fallen at
this rate.

PROBLEMS ENCOUNTERED WITH MEASURING PRICE INDICES

The following problems are usually encountered when constructing the price index:
1. Relevance of index - patterns of expenditure for various income groups are different and keep
changing over time. Secondly, price index should relate to specific groups of people in specific
locations with specific range of incomes.
2. Choice of weights
 Not all the items purchased are included in the index, only a representative section of items is
considered.
 There is a special problem in Africa where consumption of home produced food is relatively
important.
 Calculating a weight for the cost of housing for those living in their own houses or in rented houses
raises difficulties e.g. two wage earners with the same cash income may experience different housing
costs.
3. Changing patterns of expenditure – the price index does not allow changes in pattern of expenditure
over time. The base year remains the same and therefore loses its relevance over time.
4. Collection of price data
 Collection of information regarding prices is expensive and laborious.
 Resources may even be wasted if the results are not used by the government to establish policies on
prices for commodities whose prices tend to be sorted out according to grade or quality) this makes it
difficult to assess the deficiency in the quality of the produce.
 Prices are often fixed after a process of bargaining. There may be discounts causing variations in
prices paid for the same article. ( some agricultural products are cheaper during harvesting and
expensive later)

5. Technical difficulties - there are technical difficulties in selecting a base year, for it may turn out to be an
abnormal year in some countries, the compilation of price indices is handled seriously by experts who
organize continuous family - expenditure surveys and collects information from a variety of relevant sources.

MONETARY POLICY

It is a public interventionist measures aimed at influencing the level and pattern of economic activity so as to
achieve certain desired goals. Monetary policy covers all actions by the central and availability of money and

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credit in the economy. It works specifically on two principal economic variables, the aggregate supply of
money in circulation and the level of interest rates.

OBJECTIVES OF THE MONETARY POLICY

1. The attainment of full employment; a policy that lowers the rate of interest constitutes expansionary
monetary policy and is likely to lead to increased investment and hence more job opportunities.
2. The achievement of price stability; price stability can be maintained by regulating money supply though
the tools of the central bank such as discount rate, minimum reserve requirements and open market
operations.
3. To attain economic growth which can be defined as a process whereby the real GNP per capita increases
over a period of time. Monetary policy can contribute to this end by providing investment funds through
cheaper credit and by mobilizing savings which can then be used for investment.
4. To maintain equilibrium in the balance of payments, that is monetary policy can be used in such a way
that credit is selectively directed to the export sector and away from the import sector.
5. The creation of sound banking and financial institutions to mobilize savings for capital formation.

INSTRUMENTS OF MONETARY POLICY

1. THE MINIMUN LIQUIDITY ASSETS RATIO - This is the proportion of the total assets of a bank
which are held in form of cash, and liquid assets. A related instrument has been the cash ratio whereby the
central bank may instruct commercial banks to keep a higher or lower percentage of deposits received by
them in cash form.
2. OPEN MARKET OPERATIONS - It refers to the sales or purchases of marketable securities conducted
in the open market by the central bank as an instrument of control over the monetary system.
3. SELECTIVE CREDITT CONTROL - This is a qualitative measure of credit control used to encourage
those sectors of economy activity considered essential and to discourage those which are of lower priority
4. INTEREST RATE POLICY - It has been official policy in Kenya to follow a low interest rate policy for
the purpose of encouraging investment and protecting the small borrower. Stability of interest rates has
also been emphasized since it is regarded as an important factor in promoting development.

LIMITATIONS OF MONETARY POLICIES IN DEVELOPING COUNTRIES

1. Monetary policy, however, plays a more limited role in developing countries for a number of reasons,
2. Markets and financial institutions in many developing countries are highly disorganized with many
developing countries operating under a dual monetary policy system with a small organized money
market catering for the financial requirements of middle and upper class individuals, and a large

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disorganized and uncontrolled money market to which most low income individuals are forced to turn in
times of financial needs.
3. Commercial banks in developing countries are less sensitive to changes in their cash base partly because
many banks find themselves with excess liquidity because of the scarcity of viable projects and credit
worthy borrowers.
4. Many commercial banks in developing countries are merely overseas branches of major private banking
institutions in developed countries. Thus foreign commercial banks can turn to parent organizations for
liquid funds for liquid funds in the event of having their base squeezed by local monetary authorities.
5. In developing countries there is no direct linkage between lower interest rates, higher investment and
expanded output. This is because investment decisions are rarely sensitive to interest rate movement
with business expectations being a much more important variable determining investment.
6. The ability of developing country governments to regulate national money supply is constrained by the
openness of their economies and by the fact that the accumulation of foreign currency earnings is
significant but highly variable sources of their domestic financial resources.
7. Many people in developing countries do not deposit their money with commercial bank; it therefore
much more difficult for the central bank to use the traditional instrument is of monetary policy to control
the money supply.
8. Lack of knowledge about the operation of monetary policy instruments like open market operations and
selective credit controls makes them less effective in developing countries.
9. There is corruption in many developing countries which make instruments like selective credit control
ineffective.
10. Monetary instruments are sometimes used inappropriately and do not address the problem that
effectively. The policy mix is very important since the problem at hand may require fiscal rather than
monetary.

CREDIT CREATION BY COMMERCIAL BANKS AND IT’S LIMITATIONS

A central bank is the primary source of money supply in an economy through circulation of currency.

It ensures the availability of currency for meeting the transaction needs of an economy and facilitating various
economic activities, such as production, distribution, and consumption.

However, for this purpose, the central bank needs to depend upon the reserves of commercial banks. These
reserves of commercial banks are the secondary source of money supply in an economy. The most important
function of a commercial bank is the creation of credit.

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Therefore, money supplied by commercial banks is called credit money. Commercial banks create credit by
advancing loans and purchasing securities. They lend money to individuals and businesses out of deposits
accepted from the public. However, commercial banks cannot use the entire amount of public deposits for
lending purposes. They are required to keep a certain amount as reserve with the central bank for serving the
cash requirements of depositors. After keeping the required amount of reserves, commercial banks can lend
the remaining portion of public deposits.

According to Benham’s, “a bank may receive interest simply by permitting customers to overdraw their
accounts or by purchasing securities and paying for them with its own cheques, thus increasing the total bank
deposits.”

Let us learn the process of credit creation by commercial banks with the help of an example.

Suppose you deposit Ksh 10,000 in a bank A, which is the primary deposit of the bank. The cash reserve
requirement of the central bank is 10%. In such a case, bank A would keep Ksh. 1000 as reserve with the
central bank and would use remaining Ksh. 9000 for lending purposes.

The bank lends Ksh. 9000 to Mr. X by opening an account in his name, known as demand deposit account.
However, this is not actually paid out to Mr. X. The bank has issued a check-book to Mr. X to withdraw
money. Now, Mr. X writes a check of Ksh. 9000 in favor of Mr. Y to settle his earlier debts.

The check is now deposited by Mr. Y in bank B. Suppose the cash reserve requirement of the central bank for
bank B is 5%. Thus, Ksh. 450 (5% of 9000) will be kept as reserve and the remaining balance, which is Ksh.
8550, would be used for lending purposes by bank B.

Thus, this process of deposits and credit creation continues till the reserves with commercial banks reduce to
zero.

This process is shown in the Table-1: - Credit creation process

Bank New deposit/primary deposit Demand deposit Derivative deposit/loan

Bank A 10,000 1,000 9,000
Bank B 9,000 450 8,550
Bank C 8,550 855 7,695
Bank N - - -
Total 50,000 10,000 40,000

From Table-1, it can be seen that deposit of Ksh. 10,000 leads to a creation of total deposit of Ksh. 50,000
without the involvement of cash

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The process of credit creation can also be learned with the help of following formulae:

Total Credit Creation = Original Deposit * Credit Multiplier Coefficient

Credit multiplier coefficient= 1 / r where r = cash reserve requirement also called as Cash Reserve Ratio
(CRR)

Credit multiplier co-efficient = 1/10% = 1/ (10/100) = 10

Total credit created = 10,000 *10 = 100,000

If CRR changes to 5%,

Credit multiplier co-efficient = 1/5% = 1/ (5/100) = 20

Total credit creation = 10,000 * 20 = 200,000

Thus, it can be inferred that lower the CRR, the higher will be the credit creation, whereas higher the CRR,
lesser will be the credit creation. With the help of credit creation process, money multiplies in an economy.
However, the credit creation process of commercial banks is not free from limitations.

Some of the limitations of credit creation by commercial banks are shown in Figure-3:

The limitations of credit creation process (as shown in Figure-3) are explained as follows:

(a) Amount of Cash:

Affects the creation of credit by commercial banks. Higher the cash of commercial banks in the form of public
deposits, more will be the credit creation. However, the amount of cash to be held by commercial banks is
controlled by the central bank.

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The central bank may expand or contract cash in commercial banks by purchasing or selling government
securities. Moreover, the credit creation capacity depends on the rate of increase or decrease in CRR by the
central bank.

(b) CRR:

Refers to reserve ratio of cash that need to be kept with the central bank by commercial banks. The main
purpose of keeping this reserve is to fulfill the transactions needs of depositors and to ensure safety and
liquidity of commercial banks. In case the ratio falls, the credit creation would be more and vice versa.

(c) Leakages:

Imply the outflow of cash. The credit creation process may suffer from leakages of cash.

The different types of leakages are discussed as follows:

(i) Excess Reserves:

Takes place generally when the economy is moving towards recession. In such a case, banks may decide to
maintain reserves instead of utilizing funds for lending. Therefore, in such situations, credit created by
commercial banks would be small as a large amount of cash is resented.

(ii) Currency Drains:

Imply that the public does not deposit all the cash with it. The customers may hold the cash with them which
affects the credit creation by banks. Thus, the capacity of banks to create credit reduces.

(d) Availability of Borrowers:

Affects the credit creation by banks. The credit is created by lending money in form of loans to the borrowers.
There will be no credit creation if there are no borrowers.

(e) Availability of Securities:

Refers to securities against which banks grant loan. Thus, availability of securities is necessary for granting
loan otherwise credit creation will not occur. According to Crowther, “the bank does not create money out of
thin air; it transmutes other forms of wealth into money.”

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(f) Business Conditions:

Imply that credit creation is influenced by cyclical nature of an economy. For example, credit creation would
be small when the economy enters into the depression phase. This is because in depression phase,
businessmen do not prefer to invest in new projects. In the other hand, in prosperity phase, businessmen
approach banks for loans, which lead to credit creation.

In spite of its limitations, we can conclude that credit creation by commercial banks is a significant source for
generating income.

The essential conditions for creation of credit are as follows:

a. Accepting the fresh deposits from public

b. Willingness of banks to lend money

c. Willingness of borrowers to borrow

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