LECTURE TWO

MONEY SUPPLY
Lecture Outline
2.1 Introduction
2.2 Objectives
2.3 Money Creation by Commercial Banks
2.4 Constraints on the Banks’ Ability to Create Money
2.5 Changes in the Monetary Base
2.6 Determinants of Money Supply
2.7 Distortions in the Money Supply Process
2.8 Summary
2.9 References

2.1 Introduction
In Lecture One we noted the problems encountered in the definition of money. We also
noted that in most monetary economies, money supply, or money stock, has two types of
definitions, the narrow and the broad definition. In this lecture you will learn that the
quantity of money in a country is determined both by the actions of the non-bank public
(consumers and businesses), and by the decisions and actions of the commercial banks,
the central bank and the government.

2.2 Objectives
1. Understand and interpret the causes and effects of changes in the
money supply.
2. Examine the process of credit creation and the constraints on the
growth of bank deposits.
3. Understand the concept of money base control
4. Identify the key factors which cause the money supply to increase
5. Identify distortions in the money supply
6. Understand the techniques used for control of the money supply

1
2.3 Money Creation by Commercial Banks
One key characteristic that distinguishes commercial banks from other financial
institutions is their ability to create money. Commercial banks create money out the
customer deposits the mobilize. Demand deposits with commercial banks form a major
part of the real or spending money in a country with a developed banking system. Cash,
which forms a very small part of the total spending money, is provided by the central
bank. If the commercial banks could increase the volume of demand deposits, without
causing a reduction in the amount of cash in circulation, they would therefore increase
the quantity of spending money in the country.

The banks are in fact able to do this, for two main reasons.

1. Demand deposit holders have full confidence in the ability of banks to pay cash
on demand. Therefore the public accepts payments by cheques, and other means
provided by banks because it is both more convenient and safer than receiving
payments in cash.

2. Whenever a bank makes a loan to a customer, somewhere in the banking system a

deposit of equal value is created. When the banks increase the supply of loans
(their assets), their deposits (their liabilities) are also increased by an equal
amount.

Illustration
Suppose there is only one bank in a community, and the public with absolute confidence,
deposit their surplus cash in that bank. Suppose customer A deposits Ksh100 cash, which
is surplus to his immediate spending needs with the banks, which credits A’s account.
The bank’s liabilities (A’s deposit) and assets (Ksh. 100 in the till) have increased by the
same amount. Let us assume that the bank, as a matter of policy, keeps 10 per cent of all
deposits in cash or near cash assets to meet customers’ withdrawals of cash. The banks
can on-lend Ksh. 90 from A’s Ksh. 100 deposit to say, customer B. The bank then
credits B’s current account and debits B’s loan account with Ksh. 90; once again banks
liabilities and assets have increased by the same amount. Most probably, B has borrowed
Ksh. 90 to repay a debt for purchasing goods or services, say, from C. C accepts B’s
cheque for Ksh. 90 with confidence, and deposits it in his account at the bank. The

2
liabilities and assets are not affected by this transaction, because the credit of Ksh. 90 is
now in C’s account and the debt of Ksh. 90 is still in B’s loan account. The bank is now
able to advance Ksh. 81 (Ksh.90 less 10 percent liquidity cushion) to say customer D.

The process of receiving deposits, on lending them (less 10 percent) and creating more
deposits can continue until the total amount of deposits, or spending money, created by
the bank on the basis of A’s Ksh.100 cash deposit reaches Ksh.1000. The bank has
increased the narrow money supply by a multiplier of 10. The credit-creation multiplier
measures the amount of new deposits created from the original deposit. It can be
summarized by the following formula:

D
M 
r
(2.1)

Where D is the value of customer deposits and r is the central bank required reserve ratio.

2.4 Constraints on the Banks’ Ability to Create Money

The above example might give the wrong impression that banks, if they chose, could
create money indefinitely. This is not true. Below we discuss some of the constraints on
the banks’ ability to create money.

1. Cash Leakages
There are two types of cash leakages: internal and external cash leakages. Internal
cash leakages occur when money leaves the banking system but not the country
altogether. External cash leakages occur when cash leaves both the banking
system and the country. The outflow of funds either from the banking system or
the economy reduces the effect of the deposit multiplier process.

2. Customer Demand for Loans

If the economy has been suffering a long period of recession, then the level of
business profits will be low and the level unemployment high. Consequently, the

3
demand for loans by the private and personal sector would be low. Banks are
seriously hampered in credit-creation if the non banks public do not want to
borrow. The banks could lower interest rates charged to borrowers and attempt to
attract demand for loans. Other things being equal, a decrease in interest rates
extends the demand for loans by the non bank public, especially by business
firms, because lower borrowing cost increase their profitability. Conversely, an
increase in interest rates contracts demand for loans by firms and households; they
will defer such purchases as can be deferred until borrowing costs come down.

However, it is important to note that lowering interest rates will not automatically
lead to increased demand for loans. There must be good economic prospects as
well such that borrowers are able to service the loans.

3. Self-imposed Constraints
Banks will not knowingly risk their depositors’ funds or their own surplus
resources if there is a likelihood that the loan they give may become a bad debt.
Banks may not lend, especially in times of economic recession, to firms which are
on the verge of bankruptcy. Therefore credit-creation may not take place to the
extent that the demand for loans, at the prevailing interest rate would allow.

4. Liquidity cushion
To maintain the confidence of the non-bank public in the banks’ ability to cash
checks on demand, and to avoid a `run’ on themselves prudent banks keep a cash-
reserve-to-deposit ratio in cash and near-cash assets. The higher this liquidity
ratio is, the smaller the credit-creation multiplier. In addition to a self-applied
prudential liquidity ratio, the central bank may impose on the commercial banks’
liquidity its own prudential requirements, e.g. they may be obliged to maintain a
specific reserve-to-deposit ratio in liquid or near-liquid form. Such official
constraints on the banks’ liquidity would curb their ability to create credit.

4
5. Government Policy
Monetary policy in developed economies is ultimately under the control of
monetary authorities. If the authorities fear that the banks are exceeding the
desirable level of credit-creation, they may in the interest of the national economy
ask the central bank to restrict the ability of the commercial banks to lend. This
may be done by asking for some form of deposit at the central bank that will
reduce commercial banks’ ability and indeed desire, to lend, or it may be done by
direct instruction.

6. Profitability versus Safety

Commercial banks are business organizations. They market financial services to
make a profit, from which to meet their running and capital costs and to distribute
dividends to their shareholders. Like most of other commercial enterprises, they
usually aim to maximize profits. In theory, maximizing profits requires that they
should on-lend all the deposits they take at the highest rate possible. This might
mean lending to the riskiest borrower for the longest period of time. However, in
practice, banks cannot neglect the safety of their deposits. Sound banking
demands a fine balance, which both maximizes safety for their depositors’ funds
and maximizes dividends for their shareholders.

Banks solve the dilemma of safety versus profitability by maintaining a prudent

liquidity cushion in the form of cash in tills, operational balances with the central
bank, loans to money market on a call or short notice basis, first-class commercial
bills, government short-dated bills and certificates of deposit issued by other
banks. After the liquidity cushion portfolio is satisfactorily constructed, banks
make advances. Making advances is traditionally a bank’s major activity and the
interest on them is its main source of profit. Banks may also buy long-term,
fixed-interest government securities, partly for security and partly because they
produce a higher income than near money assets.

5
2.5 Changes in the Monetary Base
The monetary base is the amount of funds available to be used as reserves by the
financial institutions. The quantity actually available is determined by the central bank
while the public determine the fraction of the base actually held as reserves. The
monetary base is also equal to the amount of currency in circulation if everyone withdrew
the money from their deposits in currency. It can be algebraically expressed as:

B = CP + R
(2.2)

Where;

B = the monetary base

CP = the currency held by the non-bank public

R = the reserves held by the depository institutions

Reserves are held for three reasons:

(i) Transaction accounts

(ii) Excess reserves

(iii) Required reserves for non-personals time deposits.

R  rD DT  eDT  rT TNP
(2.3)

Where:

R = the total amount of reserves held by depository institutions

rD = the required reserve ratio for transaction accounts

DT = the total amount of transaction deposits held in depository institutions

e = excess reserves ratio of depository institutions expressed as a proportion of

transaction accounts

rT = the required reserve ratio for non-personal time deposits

6
TNP = the total amount of non-personal time deposits held in the depository institutions.

Thus the monetary base can be expressed as follows:

B = CP + rDDT + eDT + rT TNP

(2.4)
From the four components above it becomes apparent how the portfolio decisions of the
public and of the depository institutions contribute to monetary growth.

If the public decides to change the way in which it holds its wealth, it can change the
amount of the money supply by causing changes to be shifted from one part of the
monetary base to another. For example, an increase in currency held by the public will
increase CP and decrease either or e. If cash is transferred from the former, the
transaction account will have to be reduced by more than CP is increased. This will
reduce M1, otherwise transaction accounts will not change.

Transaction Accounts
Transaction accounts consist of all checking accounts in the system:
1. Demand deposits in commercial banks

2. Demand deposits in non-bank financial intermediaries

3. Checking accounts: Now and Automatic Transfer (ATS) accounts in commercial
banks.
4. Checking accounts: Now, Non-interest bearing NOW and share draft accounts in
NBFL.
In order to calculate the total transaction accounts in the system and relate them to the
monetary base, we must know the portfolio choices of the public. The public can hold
wealth in the form of currency transaction accounts, and other deposits.

1. We calculate the ratio of currency in the hands of the non-bank public to

transactions account(s)

Cp
c
DT

7
 2. We define the ratio of non-personal time deposits to transaction accounts t as:

TNP
t
DT
(2.5)

3. From (1) and (2) we obtain

C p  cD

TNP  tDT

4. We can now compute the monetary base as:

If B = CP + rD DT + e DT + rT TNP

Then,

B = cD T + r D DT + eD T + rT t DT
(2.6)

Factorizing the above equation we obtain:

B = (c + r D + e + r T t) DT

Therefore,

 1 
DT   B
 c  rD  e  rT t 
(2.7)

The above equation indicates that there are six determinants of the total amount of
transaction accounts in the depository institutions: the monetary base and five ratios. The
monetary authority determines B, rD and rT; the public determines c and t; while
commercial banks, e. The ratio [1/c+rD + e + rTt] is called the money multiplier. Market
forces do not affect those ratios that are set by authorities: rD and rT.

8
2.6 Determinants of Money Supply
The following factors influence the volume of money in the economy:

1. Bank deposits constitute a very large proportion of money supply. Consequently,

anything which affects bank deposits affects money supply.

2. An increase in PSBR financed by borrowing from the banks creates new bank
deposits in the banking system. Therefore money supply increases.

3. The local currency lending by the banking sector to the domestic non-bank sector
will considerably increase money supply. Since every loan creates a deposit
somewhere in the banking system, all local currency lending by banks will
increase money supply in its own right. Simultaneously, it will also enable the
banks through the credit creation multiplier to increase money supply even more.

4. The official financing of the balance of payments deficit or surplus will affect
money supply in the economy. Financing a deficit causes money to flow out of
the country. This causes a reduction in money supply.

5. If the branches of foreign banks offer better terms to depositors than those offered
by the local banks they will attract more deposits. This will reduce the deposits of
the local banks. Since there are no exchange controls in Kenya, some of the
deposits lost by the local banking industry may be invested overseas in search of
better returns. This may cause a semi-permanent reduction in money supply until
the interest rates offered locally become competitive compared to rates abroad.

6. Monetary policy also affects the banks’ capability to lend and to create deposits.
If the monetary policy is contractionary it will reduce money supply in the
economy. However, banks are able to get reserve funds from uncontrolled
sources and are able to find ways of lending without contravening the regulatory
requirements.

7. A rise in the banks’ non-deposit liabilities reduce the funds for lending and,
thereby, reduce money supply.

9
2.7 Distortions in the Money Supply Process
Certain factors cause distortions in the money supply aggregates. However, there is
nothing that monetary authorities can do about it. Such distortions make monetary
aggregates unreliable as indicators of monetary conditions in the economy. Examples of
these factors are:

1. Disintermediation
Disintermediation is a process which occurs when the monetary authorities place
direct quantitative controls on bank lending. This causes a large proportion of lending
business to be carried out in informal institutions and markets. It may also result in
the market developing new instruments that are not covered by direct controls, by
other restrictions or by the monetary aggregates. To overcome direct controls such as
lending ceilings and reserve ratios, banks begin to lend and borrow from institutions
and markets which are free from direct controls. This causes disintermediation.

2. Re-intermediation
The removal of quantitative controls triggers the re-intermediation effect on money
supply. This process reverses the effects of the disintermediation process. However,
there is no increase in money supply or increase in money demand in the economy.

3. Competition between Commercial Banks and Non-Bank Financial

Institutions
Banks compete with other non-bank financial institutions (NBFIs) for customer
deposits. If banks succeed in taking away from NBFIs some of their customers,
money supply increases.

4. Taxation
When public authorities increase taxes to reduce money supply or partly to finance
the PSBR, bank customers may borrow from banks to pay the increased tax liability.
This will increase money demand and when granted, increase money supply in the
economy.

10
Activity 2.1

Question 1 (20 Marks)

Below is an extract of information from the balance sheet of a commercial
bank.
ASSETS LIABILITIES
Reserves 250 Deposits 1750
Loans 1500

The required reserve ratio is 20 percent.

(a) How much is the bank required to hold as reserves? (5 Marks)
(b) Calculate the bank’s excess reserves. (5 Marks)
(c) By how much can the bank increase its loans? (5 Marks)
(d) Suppose a depositor comes to the bank and withdraws Ksh. 100 in
cash.
i. Show the bank’s new balance sheet, assuming the bank obtains the
cash by drawing down its reserves. (3 Marks)
ii. Does the bank now hold excess reserves? (1 Mark)
iii. Is the bank meeting the required reserve ratio? (1 Mark)

3. Discuss five factors that distort the money supply process in Kenya.

4. Explain the main determinants of the monetary base in the

economy.

5. Discuss five factors that influence money supply in Kenya.

2.8 Summary
In this second lecture you have learnt the following important points:
 The capacity of commercial banks to create money depends on
the volume of customer deposits they can mobilize.

11
  The ability of commercial banks to create money is limited by
customer demands for loans, self-imposed constraints, liquidity
cushion, central bank reserve requirements and the need to
meet safety and prudential standards.
 The monetary base determines the level of money supply in the
economy. The main determinants of the monetary base are the
transaction deposits, the required reserve ratio, the excess
reserve ratio, the non-personal time deposit ratio, and the ratio
of non-personal time deposits to transaction deposits.
 The volume of money in the economy is influenced by amount
of customer bank deposits, government expenditure,
government financing of the budget deficit, competition
between the formal commercial banking system and informal
finance, the stance of monetary policy, and an increase in the
banks’ non-deposit liabilities.
 The main factors causing distortion in the money supply
process are dis-intermediation, re-intermediation, competition
between commercial banks and other financial institutions for
customers, and the payment of tax liabilities which increases
the demand for loans.

2.9 References
1. Colin D. Campbell, Rosemary G. Campbell and Edwin C. Dolan,
Money, Banking and Monetary Policy, Dryden Press, 1988.
2. Strutter, O.N. and Speith, H., Money Institutions: Theory and Practice,
Longrnan, 1986.
3. B. Julian Beecham, Monetary Economics, Longman, 1986.

12