Monetary innovations PDF

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Determination of money supply...

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LECTURE THREE DETERMINANTS OF MONEY SUPPLY Measures of Money Supply In Kenya the CBK distinguishes between six concepts of money on the basis of liquidity  Mo: The narrowest concept of money & comprise of money held by the non banking public  MI: Includes Mo and deposit in comm. Bank (demand deposits, dd)  M2: Includes M1 and time deposits held in the comm.. banks  M3: Includes M2 and time deposits held in NBFI  M3x: Includes M3 and residents foreign currency denominations deposited in commercial Banks  M3xt: Includes M3x and holdings of government securities by the non-banking public Determinants of Money Supply 1. Money multiplier theory Complex Money Multiplier  Recall our definition of M1 as currency in circulation plus demand deposits – i.e. M1 = CC+DD  Recall our definition of Monetary base (MB) or high powered money (H) is currency in circulation plus reserves – i.e. H=MB = CC+RR  The monetary base or High powered money (H) The government is the producer of high powered money while commercial banks are the producer of demand deposits (DD)

 In order to produce demand deposits or credits banks have to keep maintain reserves which serves as the basis for multiple creation of demand deposits. It provides “high poweredness” to the currency issued by the government through the multipler effect. I.e. It is against these reserves that banks create a multiple expansions of credit which creates Money supply in an economy MB=H= Cp + R

(1)

Ms =Cp +Dp

(2)

We link H (or MB) and M1 together through the money multiplier – M1 = m*H

(3)

– For every KES1 increase in the H, the money supply (M1) increases by m*KES1 NB: m is almost always greater than 1

he multiplier is:

M m=H

From (3), t

From équation (1) and (2)

Cp + Dp m = Cp + R  Banks are required by the Central bank to hold a minimum fraction in reserve defined as the reserve requirement ratio (rr)  Banks may choose to hold excess reserves (i.e. a fraction of deposits held in reserve above and beyond the minimum required by the fed). Therefore, Reserves R has two components: R = Required Reserve (RR) + Excess Reserves (ER)

Cp + Dp m = Cp + RR + ER The behavior of the public, the banks, and the central bank in the money supply process is represented by three variables: the currency – deposit ratio (C/D), the reserve ratio (R/D) and the stock of high – powered (H) Divide everything by Dp

m=

Cp +1 Dp Cp RR ER + + Dp Dp Dp

Cp RR ER Say Dp = c, Dp = r, Dp = e

m=

c+1 c+ r+ e

(4)

Therefore based on (4) money supply is dependent upon currency to deposit ratio (c) , required reserve (r) and excess reserve (e)  (c) Captures the households banking behaviour and is affected by seasonality e.g. during Christmas holiday C/D increases as people hold more cash than deposits. C/D is also affected by cost of transactions, convenience of obtaining cash etc. The lower the currency to deposit ratio, the higher the money multiplier  (r) the lower the required reserve the more commercial banks can create credit therefore the higher the money multiplier  (e) Lower the excess reserve mean that commercial banks have incentive to create loans thus money multiplier increases

Player

Variable

Money Money

Public/Depositors Depositors+Comm

CC DD

:- CC/DD

response m

:- CC/DD

multiplier/ Rationale supply Decrease in credit

m

creation Increase

in

credit

banks Central Bank

RR

m

creation Decrease in credit

Central banks

Non borrowed MB

m

creation MB expands which

Central banks

Borrowed MB

m

in turn expands MS Excess reserves decrease which

CB, Comm. banks + interest rate

m

Public

in

turn expands MS Excess reserves decrease which

in

turn expands MS

Other determinants of Money supply 2. Deposit multiplier  If the public hold zero currency and banks hold no excess reserves, then the money multiplier is simply the inverse reserve ratio

1 rr

which is also referred to as the deposit

multiplier – A 10% rr will produce a multiplier of 10 – A 20% rr will produce a multiplier of 5  The change in credit created as a result of  change in reserve is called the deposit multiplier which depends upon cash of the cash reserve ratio.

3. Bank rate policy  It is the maximum rate at which the Central Bank of a country provides loans to the commercial Banks in an economy, also called the discount rate. Through changes in the bank rate the Central Bank influences the amount of credit creation.  When Central Bank raises the bank rate, the cost of borrowing by commercial banks from Central Bank increases discouraging borrowing. Banks also raises their lending rates, eventually firms and households are discouraged from borrowing from commercial banks which in turn leads to reduction of money supply through decrease in credit creation. The opposite is true when Central banks aims at pursuing expansionary policy (during recession) Limitations of bank rate policy  For this policy instrument to work all other market interest rates should flow the direction of bank rate if it is changed. This may not be the case if Commercial Banks maintain (or source) reserves of their own independent of the Central Bank.  For the changes in the bank rate to cause changes in all other rates, a well organized money market is needed, this is not so in developing countries like Kenya and the changes in the bank rate is not reflected in other rates.  For the successful contracting of the credit policy the real economy must be responsive to changes in the rising rate of interest however empirical studies have shown that rate of interest does not exercise a strong influence on borrowing for investment and other purposes. It true that where there is need to achieve desired effect, Demand for credit by businessmen also depends on the economic situation. Open market Operation {OMO}  It is the purchase and sale of government securities by Central Bank of a country. The sales of securities leads to a contraction of credit and purchases lead to expansion of credit thereof. 

OMO is used to complement bank rate policy. if Commercial banks fail to respond to bank rate changes, the Central bank can withdraw such surplus by buy or sell of securities and thus compel member banks to raise/lower the rates.

Limitations of OMO OMO may not be effective if commercial banks have excess reserves if:  The purchase of securities is accompanied by a withdrawal notes from currency required for holding in cases the cash reserves remain unaffected  Even if the reserve of member’s banks is increased the bank may not expand credit. The percentage of cash credit is rigidly fixed and cash vary within wide limits  The banks will contract and expand credit owing to the prevailing economic and political circumstances  Owing to political and economic uncertainty money may not attract borrowers and thus when trade is good and prospects of profit is high entrepreneurs borrow even at high rates.  The circulation of bank money should have a constant velocity but the velocity of bank deposits is never constant. It increases in times of high production decrease times of depression. Thus policy of contracting credit is neutralized by increased velocity of circulation. Deficit financing When government expenditure exceeds revenue and there is a deficit in government budget then there results to borrowing from the Central Bank which creates new currency notes for the purpose. The creation of new currency to finance the government budget is known as monetization of deficit. The government also borrows from ordinary commercial banks. When banks lend money to the government they create credit. The creation of deposit by the banks when they create credit leads to increases in money supply.

Selective Credit control They are meant to regulate the flow of credit for specific purposes. It has positive and negative side: Positive aspects arise from the fact that credit maybe channelled to some

specific activities which may be beneficial from the social point of view but on the other hand, this may be detrimental or in direct conflict with monetary policy objectives Measures to achieve this include:  The minimum margin for lending by banks against stocks of specific goods/against other types of securities 

Fixing a maximum limit/ceiling on advances within the borrower against the stock of particular sensitive commodities

 Fixing minimum discriminatory rates of interest on credit of particular commodities  In developed countries selective credit control are used to prevent exercise speculation in the share market.  In the share market buyers purchase large sums of shares by making a small amount of payment and remaining value of shares are paid by brokers using borrowing from the banks against share purchased. When Central Bank raises the margin, buyers have to pay a larger sum of money for shares purchases and as result credit contracts and speculative activities in the share market are discouraged....