BENSON MWATHI MUNGAI

EN 251-0420/2014

JOMO KENYATTA UNIVERSITY OF

AGRICULTURE AND TECHNOLOGY
NAME
REGISTRATION NUMBER

: MUNGAI BENSON MWATHI.

: EN251-0420/2014.

UNIT NAME

: GENERAL ECONOMICS.

UNIT CODE

: HRD 2103.

COURSE
PERIOD
ONE.
TASK

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: BSc. CIVIL ENGINEERING.

: SECOND YEAR SEMESTER
: ASSIGNMENT.

BENSON MWATHI MUNGAI

EN 251-0420/2014

ASSIGNMENT.
Question: Explain how monetary systems contribute in stabilization of the economy.
Solution.
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.
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BENSON MWATHI MUNGAI

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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 Reserve 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 Deposits

= Cash Deposits

Reserves Assets Deposits

= Cash Ratio + Reserve Assets Ratio

If the liquidity ratio is 12.5, then:
Cash
Deposits

Reserved Assets
Deposits

=1
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
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BENSON MWATHI MUNGAI

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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

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