Principles of Economics CHAPTER 12

Sajjad Ahmad Malik

RISE PREMIER SCHOOL OF ACCOUNTANCY
 CHAPTER 12

Part-01: BANKS:

Central bank:
Central bank is known as the father of banking system or watch dog of monetary system of the
country. It is also concerned with meeting a number of objectives such as:

• provide banking and other financial services to commercial banks and government.
• currency stability, credit control, Economic growth, full employment, low inflation and
equilibrium in balance of payment.
• To implement policies of the state and to exercise its power of issuance currency and its
circulation in the country’.

1.1: STATE BANK OF PAKISTAN:

The "State Bank of Pakistan (SBP)" is the central bank of Pakistan that plays role in the management
of financial systems of the country. The basic features of State Bank of Pakistan are to prepare the
monetary policy of the government of Pakistan, and organization, management of the entre
economic, banking, and financial systems. Authorized Capital of SBP at the time of establishment
was PKR 30 billion.

Functions of Central Bank (SBP):

1. Sole supplier of currency:

The central bank has the responsibility of supplying the notes and coins throughout a country. It
also has greater control over it.

Two systems are usually adopted to issue currency notes:

• Fixed Fiduciary System: This system allows the note issuing authority to issue currency
notes up to a certain limit without backing reserves or precious metals etc. But any note
issued beyond this limit must be backed by 100% reserves.

• Proportional Reserve System: This is a flexible system of note issuance and is popular in
most of the countries of the world. Under this system central bank can issue currency notes
by keeping a certain percentage of reserves in form of gold, silver or foreign currencies.
(In Pakistan reserve requirement varies from 30% - 40%)

2. Banker to the government:

It offers advice upon the public debts of a country through working with a government. And also
providing funding to governments for its projects, in the same way a commercial bank would to
its customers.

3. Banker to the banks:

• By holding cash reserves from each bank for safe keeping, the central bank brings a level
of protection to the banks.
• A central bank can offer a counselling service to commercial banks if ever they find
themselves in financial difficulty, and in need of advice.

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4. Lender of last resort:

• If a commercial bank is unable to use other sources to meet its financial requirements,
then theyuse the central bank.
• This brings greater liquidity to the system, and helps protect savers’ deposits.

5. To control inflation:
• SBP uses method of open market operation techniques. such as:
➢ for controlling the currency circulation in the country,
➢ fixing rate of interest,
➢ fixing the foreign exchange rate
➢ controllingthe banking loans in the country.

6. Promotes Islamic Banking:

SBP gave the order to the commercial bank that they establish a separate counter for consumers
wishing to deposit in an Islamic mode of investment then.

7. Promotes Export and discourage Imports

SBP makes possible for exporters to get easy foreign remittance in the country and also
discouraged unnecessary import from foreign country, particularly luxury goods and services

8. Exchange rate controls:

The central bank has control over a country’s foreign currency, and gold reserves. These are used
in times to manipulate the exchange rates and to achieve objectives, such as the balance of
payments.

9. Custodian of Monetary Reserves:

Central bank serves as custodian of monetary reserves such as gold and foreign currencies.

10. Clearing agent:

As all commercial banks have accounts with the central bank, when undertaking transactions,
they can do so within the central bank, reducing the necessity of issuing and transferring cash.

11. Established Financial institutes:

To improve the performance of financial and economic matters of Pakistan. For facilitation of
government and general consumers, SBP establishes NBP (National Bank of Pakistan). it is an
agent to SBP that handles treasury transactions for the government of Pakistan

12. Establish specialised banks:

The govern men t of Pakistan established two banks under SBP for the promotion of the
agriculture sector and the industry sector, Zarai Taraqiyati Bank (ZTB) and Industrial
Development Bank of Pakistan (IDBP).
Both banks give soft loans to consumers for the development of the agriculture and industrial
sectors

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1.2: OTHER BANKS:

Bank:
• “A financial institute licensed by the government to receive deposits, which then invests these
funds in a number of securities.”
• “Bank is a financial institution which receives deposits and issues loans.”
• Bank is ‘a financial institution which is engaged in borrowing and lending of money.”

Financial intermediaries:
A financial institution through which savers can indirectly provide funds to borrowers. e.g. banks,
mutual funds and pension funds.

Types of banks:

1. Commercial bank
A commercial bank is a financial institution that accepts deposits from customers and provides loans
and other financial services.
Functions:
• Accepting deposits.
▪ Granting loans and advances.
▪ Agency functions.
▪ Discounting bills of exchange. (will be discussed later)
▪ Credit creation. (will be discussed later)
2. Investment banks:
• A bank that provides financial services for corporate and institutional customers, such as investing
and raising capital and arranging mergers and acquisitions.
• An investment bank acts as an intermediary in large and complex financial transactions.
• An investment bank is usually involved when a startup company prepares for its launch of an initial
public offering (IPO) and when a corporation merges with a competitor.
3. Retail bank:
• Retail bank provides financial services to the general public.
• Also referred to as consumer or personal banking.
• This side of the industry allows consumers to manage their money by giving them access to basic
banking services, credit, and financial advice.
4. Cooperative bank:
This is a type of financial institution that provides banking and other financial services to its
members.
A co-operative bank is a small-sized, financial entity, where its members are the owners and
customers of the Bank.

5. Specialized bank:
A bank targeted to a specific section of the economy in which firms and customers can have access
to specialized forms of banking services.

For example: the Agricultural Development Bank of Pakistan (ADBP) provides long, medium- and
short-term loans to agriculturalists, IDBP, (SME) and HBFC

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1.3: FUNCTIONS OF COMMERCIAL BANKS:

• Receiving Deposits: commercial bank is to receive deposits to earn profit (in form of interest).

• Advancing Loans:
Banks issues loan against some returns (interest) to those who need funds for their domestic or
business activities.

• Lockers Facility:
Commercial banks also offer some safety lockers to general public to keep their valuables such
as jewelry and other secret documents. Banks charge a nominal fee against this facility.

• Credit Creation:
This is a process by which commercial banks generate funds for further loans. This process will
be covered in detail in subsequent section of this chapter

• Discounting of Bills of Exchange: Bill of exchange is an instrument which is used to make a

credit transaction possible. Seller of goods receives documentary evidence, guaranteeing that
buyer will make payment within promised time. If seller needs money before its promised time,
he can get money from bank against this bill of exchange. Bank will deduct some amount as the
payment is being made before maturity. This process is called discounting of bill of exchange.

Part-02: CREDITS:

Credit or Credit money:

A contractual agreement whereby a borrower receives something of value in the present, in exchange
for payment in the future, generally with interest. E.g., IOU’s, bonds and money market accounts.

Maturity
Period of time for which a financial instrument remains outstanding

2.1: TYPES OF CREDIT

• Bank credit:
This type of credit exists when an individual or firm goes to a bank, receives an amount of money
against some security and then pays back the amount over a period of time.

• Trade credit:
This exists between a customer and a seller, usually in the commercial sector. A purchaser
can order a good, receive the good, and then pay for it after a certain period of time
i.e.,30, 60 or 90 days.

• Advances:
Amount taken in advance from any customer with promise of providing goods in future.

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2.2: ADVANTAGES & DISADVANTAGES OF CREDIT

Advantages of credit:
The credit money has the following advantages:

Spending & consumption:

Credit money allows immediate consumption of expensive goods, based on future earnings (this
includes houses, education, cars, which could otherwise not be bought).

Economic policies:
If there are inflationary trends in the economy, government increases the interest rate. This directs
people to convert their cash in credit money to gain interest. This will reduce the cash holdings and
will help to decrease inflation.

Working of banks & financial institutions:

Credit money is the basis for the functions and operations of banks and financial institutions.

International trade:
• Credit money has also greatly expanded the international trade.
• A product may b cheaper in country A and expensive in country B so traders from B can
purchase the product from A.
• Payment during import/ export process remains outstanding for months and it is also a sort
of credit.

Government:
Governments need credit money to perform all such functions as maintenance of law and order,
defense expenditure, provision of justice, pension etc.

Disadvantages of credit money:

The Inflation Problems:

Credit creation might increase money supply in the country which may cause inflation.

Creation of monopolies:
Commercial banks generally advance loans to large scale enterprises, industrialists and business due
to their strong financial position. This may lead to establish monopolies.

Economic Instability:
Excess credit creation becomes a cause of inflation and over investment which may result in
Economic Instability

Unproductive loans:
Easily available credit money turns into unproductive loans which become wasteful use of credit
money.

Income inequalities:
Only rich can meet pre-conditions for obtaining credit. They can get heavy loans and make more
money by investing them into more profitable activities.

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2.3: CREDIT CREATION PROCESS:

To understand this system, we will use hypothetical data regarding different banks engaged in the
process. Suppose banks are engaged in the process of credit creation. Bank A receives a new deposit
(initial deposit) or Rs. 1000 million. Assuming the reserve requirement of central bank is 10%, a bank
can issue a new loan of Rs. 900 million (90% of the deposited amount).

HOW MUCH MONEY CAN BE CREATED? / CREDIT MONEY MULTIPLIER:

Credit money multiplier is reciprocal of reserve ratio (in case of no leakage of cash withdrawal).
How much money, banks can create if the reserve ratio (r) is 10% and initial deposit is Rs. 1000
million
1
Money Multiplier (MM) = 1
= = 10
Reserve Ratio 10%

Total Credit Creation = Initial deposits x MM

= 1000 x 10 = 10,000

Credit Money Multiplier (With Leakage):

Total Credit Creation = Initial Deposit x 1

Reserve Ratio +Leakage

PROCESS OF CREDIT CREATION

POSITION OF BANK New Deposited New loan NEW RESERVES

(10%)
Bank A 1000 900 100
Bank B 900 810 90
Bank C 810 729 81
Sum of remainingBanks (Balancing) 7290 6561 729
Total 10,000 9,000 1,000

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Assumptions of Credit Creation:

• Unchanged reserve requirements by central bank:

Reserve requirements should remain same. Changing reserve requirements by central bank can
cause a greater fluctuation in lending ability of commercial banks.

• Amount of initial deposit:

Amount of credit is dependent on the initial size of the money supply. The larger this is, the more
credit can be created.

• No prompt cash requirements:

Cash requirements by depositors can affect the process of credit creation. Hence, it is assumed
that there are no immediate cash requirements in the economy.

• Excess reserves by commercial banks:

Some banks will choose to hold additional reserves for strategic reasons (day to day cash
requirement). The fact that they hold onto more of their reserves, means that they pass on less to
the next bank, and therefore the effectof the multiplier will decrease.

• Developed banking system:

It is further assumed that a developed banking system, along with financial innovations are
existing in the country which keeps cash requirements limited in the country.

Limitations of credit creation:

• Total amount of cash:

Amount of credit is dependent on the initial size of the money supply. The larger this is, the more
credit can be created.

• Size of reserve ratio:

The lower the ratio requirements are, the more credit can be created. In many countries, there is
a minimum level (usually 20%)

• Liquidity Preferences:
In period of high inflation, people may not wish to hold their money in banks that would mean
less money is available to banks thereby less credit would be created.

• Availability of quality securities:

If high valued collateral assets are not available, less credit would be created and vice versa.

• Central Bank policies:

The central bank may utilise a number of instruments to control how much credit is created by
banks.

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Part-03: MONETARY POLICY

Monetary policy
• “The policy which is adopted by central bank of a country to control supply of money and
credit is knows as monetary policy”.
• “Monetary policy refers to measures taken by central bank to influence macroeconomic
activity especially by controlling money supply and credit by changing rates of interest.”

3.1: TYPES OF MONETARY POLICY:

Types of Monetary Policy:

1. Expansionary Policy/Anti Deflationary Monetary Policy

2. Contractionary Policy/Anti-Inflationary Monetary Policy

Expansionary policy LRAS

An expansionary monetary policy means,

when the central bank wishes to increase SRAS
the level of aggregate demand within an
economy.
Price Level

Tools: P1
• Decreasing Interest rate
• Increasing money supply
P0
Expansionary monetary policy is used to AD1
achieve
• Economic growth
• Full employment AD0
• Equilibrium in Balance of payment Y0 Y1 Yf Real Output
Contractionary policy LRAS

A Contractionary monetary policy means,

SRAS
when the central bank wishes to decrease
the level of aggregate demand within an
Price Level

economy.
Tools: P0
• increasing Interest rate
• decreasing money supply P1

Contractionary monetary policy is used to AD0

lower the inflation.
AD1

Y1 Y0 Yf Real Output

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3.2: INSTRUMENTS OF MONETARY POLICY:

There are two types of Instruments

1. Quantitative Controls:
2. Qualitative Controls:

1. Quantitative Controls:

Open Market Operations: (OMO)

Open market operations mean buying and selling of government securities by the central bank in the
open market

If central bank wishes to reduce the level of aggregate demand in the economy:

• central bank will sell government securities to dealers and commercial banks in the market.
• In return, dealers and commercial banks pay money to the central banks.
• As cash in hand of commercial banks decrease, their ability to create money decreases.
• Consequently, the level of money supply tightens, and aggregate demand declines.
• Inflation decreases

Fall in cash
Bought by Tight Rising
Selling of reserves of Control on
commerce Money Interest Fall in AD
Securities commerci Inflation
-al banks Supply Rate
al banks

Reserve requirements:
In order to keep the reserves safe, commercial banks will have deposited some particular percentage
at the central bank.

The central banks are able to reduce the level of aggregate demand in an economy by changing the
reserve requirements:

• By increasing the level of reserves, this reduces the amount of credit available in the economy.
• Lower the availability of credit, lower the money supply in the economy.
• Consequently, interest rates rise and firms are discouraged from borrowing to invest more
money.
• The effect of tight money reduces the level of aggregate demand (AD) = (C+I+G+(X-M),
causing a drop in output, employment and inflation.

Increase in Lesser Tight Rising

Less Control on
Reserve ability to money Interest Fall in AD
Investment Inflation
Ratio loan out supply Rates

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Discount Rate (or Bank Rate) Policy:

It is also called discount rate. It is a rate at which central bank rediscount bills of exchange. By
discounting a bill of exchange actually central bank is providing loan to commercial banks. By
changing the bank rate, central bank indirectly influences the market rate of interest

Increasing Rising Lessen Tight Rising Control on

Cost of loan able Money Interest Fall in AD
Bank Rate Inflation
Borrowing funds Supply Rates

Exchange Rates:
Central bank can buy or sell foreign currencies to control exchange rate and indirectly control export
and import. For example if government buys dollars, there will be shortage of dollar and price of
dollars increase and PKR depreciates which makes export cheaper and increase export. It will
increase aggregate demand and inflation.

Credit Rationing:
Fixing the maximum limit of loan issue, by central bank to its member commercial banks is called
credit rationing. By changing this limit central bank can control money supply in the economy.

2. Qualitative Controls:

Changes in Marginal Requirements:

• Marginal Requirement refers to the difference between value of security demanded by
central bank to advance loan to commercial banks and the amount of loan actually issued.
• Central bank advances loan to commercial banks against some securities.
• In order to control money supply central bank can change this margin.
• Narrow margin, low money supply

Moral Persuasion:
Central bank can morally persuade commercial banks to take specific steps that are consistent with
the central bank’s macroeconomic objectives. This can be done through personal discussion and by
issuing non-obligatory directives (there will be no punishment in case of non-compliance of these
directives).

Direct Action:
This is a severe action that Central bank exercises only when commercial bank does not cooperate or
refuses to follow the policies of central bank. The central bank may take direct action in a number of
ways such as;
• It can impose fine and penalty to bank who is not cooperating.
• It may refuse discount facility to the bank under consideration.
• It may change the rates over the bank rate for particular bank etc.
Special Deposit:
Central Banks offers special deposits to commercial banks for short term on which it offers more
attractive rate of interest than the market. This deposit reduces money supply in market.

Prudential Control:
Central Bank can control credit by issuing some articles & regulations related to credit volume which
are known as Prudential control

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3.3: OBJECTIVES OF MONETARY POLICY:

1. Inflation: Keeping inflation low and steady for a more stable economic performance.
2. Economic growth: With appropriate economic policy, the government wishes to develop overall
per capita income within the country.
3. Exchange rate stability: Achieve stable exchange rates between countries in part through
adjusting the balance of payments.
4. Full employment: It is necessary to increase production and demand for goods, allowing
resources to be fully utilised for the economy to reach full employment.
5. Credit control: Making banks exercise control over their issuance of credit, but also ensuring
that the most vulnerable in society are receiving their fair share.
6. Correction of Current Account Deficit: One of the major objectives of monetary policy is the
correction of balance of payment or current account deficit. It can be done by variation in rate of
interest specially on bonds.

Conflict between Objectives:

It is not possible to achieve all of these objectives at once – some conflict exists between them.

1. Price stability versus full employment:

If economy want to achieve full employment, central bank will apply EMP (Expansionary policy)
to increases aggregate demand. Doing so could drive up inflation, putting more pressure on the
price stability target.

2. Economic growth vs exchange rate stability:

In order to boost economic growth, a central bank may decide to manipulate exchange rates to
increase the likelihood of exports. Doing so could cause instability in exchange rates.

3. Economic growth vs credit control:

A way to grow the economy might be through the expansion of credit, as it would spur investment
and spending. However, this comes with heightened economic risk of credit defaulting.

3.4: LIMITATIONS OF MONETARY POLICY:

1. Existence of non-monetary sector:

In developing Countries large portion of society are not using money for exchange (for example
bartering in rural areas), then monetary policy fails to implement its policies.

2. Existence of non-banking financial institutions:

These are organizations that offer credit to consumers, however do not come under the
supervision of the central bank.

3. High liquidity in financial markets:

If the central bank tries to tighten money supply, agents can counter this by creating their own
liquidity.

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4. Time lags:
The effects of a monetary policy will often take time to occur. Therefore, a central
bank must have to predict what will happen in the future, and implement policies
accordingly. Sometimeshowever there will be too much uncertainty for these policies
to be correct.

5. Lack of co-ordination between monetary and fiscal policies:

In simple terms, monetary policies are implemented by the central bank, and fiscal
policies areimplemented by the government. If the two organisations do not co-
ordinate, they cannot achieve their objectives.
Price Level

Y1 Y2 Yf Real Output (Y)

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