TOPIC: MONEY AND BANKING

A. MONEY
DEFINITION OF MONEY
The following are three possible definitions of money:
(1) According to Crowther, money is anything, which is generally
accepted as a medium of exchange and in settlement of debts.
(2) According to Walker, money is what money does.
(3) According to modern economists, money is a medium of
exchange.
CHARACTERISTICS OF MONEY
Characteristics of money are also known as properties of money and
they are:
(1) Acceptability: The basis of any monetary system is that it should be
acceptable by everyone, i.e. money must be accepted by everybody as
a medium of exchange.
(2) Convertibility: Money must be converted from one currency to
another, e.g. from Kenya shilling to US dollar, dollar to sterling pound,
etc.
(3) Divisibility: Money used must be divided into smaller units so that
minor debts and exact amount can be settled easily.
(4) Durability: Money should be durable that is, it should not deteriorate
over a period of time, and therefore coins are better form of money
than paper notes.
(5) Stability: Money shouldn't lose its value. It should maintain its
stability year after year so that people are willing to accept it in
settlement of debts and as a medium of exchange. In periods of rapid
inflation when money loses its value rapidly, people will want to hold
their wealth in assets than in money form.
(6) Portability: Money should not be bulky. It should be convenient to
carry from one place to another. Thus, paper money is more portable
in this regard.
(7) Scarcity: Money should be scarce. If it is not scarce, its supply will
be too much and hence losing its value leading to inflation where too

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 much money is chasing too few goods. That was why gold was used as
a medium of exchange because it was scarce before the invention of
coin and paper money.
(8) Homogeneity/Uniformity: Different units of money materials should
have the same value and likeness in appearance.
(9) Cognisability: It must be possible to recognise whether it is pure
money or not.

EVOLUTION OF MONETARY SYSTEM

Money has undergone through many systems, including:
(1) Monometalism: This refers to a situation where only one specific item
i.e. metal was used as a medium of exchange. For example, around
15th century, it was only gold which was used as a medium of
exchange.
(2) Bimetalism: "Bi" means two - which means two metals were used
simultaneously as a medium of exchange and these were mostly silver
and gold especially between 15th - 18th Century.
(3)Paper Money System: At the moment, all the countries of the world
are using paper money system, which include plastic money, coins,
and notes.
4. Digital currency-crypto currencies

FUNCTIONS OF MONEY
(1) Money is used as a medium of exchange in terms of buying and
selling goods and services. It replaced barter system and thus it is used
to make transaction. Every producer sells his surplus in exchange for
money and then he uses the money obtained to purchase his
requirements. On the other hand, when households receive money
income from firms as rent, salary, wages, etc., they use it to purchase
goods and services. In this way, money is used as a medium of exchange.
(2) Store of Value: The value of goods and business assets can only be
in form of money. By converting assets in terms of money or any other
good that cannot last for long in this respect, money stores the value of
goods and services.
(3) Measuring units of account: The use of money with its unit of
measurement (shilling and cents in Kenya) enables the prices of all goods
to be quoted in these units. This facilitates the quick comparison of the

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respective values of different goods that is, money shows how much
goods and services are worth. In addition, money is the unit used in the
financial accounts of all businesses and, for example, in expressing the
value of a country's national income and balance of payments.
(4) Can be used to move immobile properties. from one place to
another e.g. buildings.
(5) Money can be used as standard of deferred payment. Many
transactions are conducted on the basis credit. Thus, payments for the
work carried out now might be made several months later and it is
convenient for the debt to be expressed and for the payment to be made
in money terms rather than in terms of some commodities. For example,
a sub-contractor on a building site may agree to do some work for the
developer in return for a certain sum of money to be paid when the work
is finished. Both parties to the agreement know how much money will
change hands at the agreed date in the future.

DEMERITS OF BARTER TRADE

Before the invention of money as a medium of exchange, transaction
used to be carried out by exchange of goods by goods, a system of trade
known as barter trade. However, this system had various shortcomings
such as: -
● Lack of double coincidence;
● Indivisibility;
● Commodities might not be portable;
● It is difficult to be used for deferred payments;
● It is difficult to be used as a measure of unit of account, and
● It is sometimes difficult to store the value of one commodity in
terms of one commodity.
DEMAND FOR MONEY
The three major theories of money demand are:
(1) The quantity theory of money
Monetary School of Thought developed the quantity theory of money.
They pointed out that the value of money is determined by the supply of
money in circulation and by the general price level. This theory can be
summarised by Irving Fisher’s equation as expressed below:
MV = PT
Where: M = Quantity of money in circulation [Money Supply

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 (MS)]
V = Velocity of money in circulation (that is number of
times money changes hands)
P = General Price level.
T = Number of transactions which take place.
From the above equation MV must be equal to PT, that is, MV=PT. MV
represents monetary payments made to the firms in the purchase of the
final output by households while PT represents firm receipts from the
sale of goods and services. What firms receive is equivalent to the
expenditure of households on purchase of goods and services. This
therefore means that money payments must be equal to money receipts.
If we assume that V and T are constant, P will vary directly with increase
or decrease of the amount of money supplied that is it changes where
there is a change in money supply circulating in the economy.
Money supply causes the price change and not change in price that
causes money supply to change. This means the money supply is the
driver to price changes meaning that price changes depend on money
supply. T is assumed to be constant because the economy in question is
assumed to be at full employment. Full employment means a situation
whereby even though more investment is injected into the economy, the
level of national income or output remains constant. In other words it
explains a phenomenon where the economy is saturated. If we express P
in terms of MV and T the following will be the result.
P = MV/T
The above equation shows that price level is determined by 3 factors:
(i) Supply of money (M)
(ii) Money Velocity in circulation (V)
(iii) Number of transactions, which take place in the whole economy
(T)

From the above we can observe that:

if V is more or less constant, then any increase in money supply will
cause inflation. If output in the economy is expanding, and V is
constant, then money supply growth is necessary or desirable to avoid
deflation. This means Government monetary policy should allow some
money supply growth or increase if the economy is growing but should
not let money supply gets out of hand.
In summary, the value of money, like that of any other commodity,
changes according to the supply. If money supply increases when there
is no increase in the supply of goods and services for sale, money buys

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less and prices goes up. This situation is called inflation. On the other
hand, if the amount of money in circulation decreases, while there is no
increase in the amount of goods and services for sale, the money buys
more and prices go down. This situation is referred to as deflation.
The quantity theory of money is based on the following basic
assumptions.
● Goods sold under barter remain constant.
● Velocity of money in circulation also remains constant.
● Number of transactions also remain constant
● Demand for money also remains constant.
● No government interference with the money market and
therefore the rate of interest is assumed to remain constant.

(2) Keynesian Monetary approach

According to Keynes, the quantity of money or value of money is not only
determined by money supply but also by demand for money. Keynes
used the concept of the liquidity preference, which actually refers to
the demand for money, and hence his approach is also referred to as
liquidity preference theory.
Liquidity refers to the degree to which an asset can quickly and cheaply
be turned into money or cash for example a current account bank
deposit is a liquid asset since it can be withdrawn immediately compared
to how long one will realise cash after the sale of a fixed property such as
a plot.
Keynes identified three motives or reasons why people hold money in its
liquid form. These motives are: -
(1) Transaction Motive: In this case, households need money to pay for
their day to day purchases, for example to buy goods and services
especially the basic needs. The level of transaction demand for money
depends basically on the individual’s level of income and on the
institutional arrangements such as how often an individual is paid and
how often he/she engages into monetary transaction. However money
demand for transaction motive is independent in the rate of interest
meaning that interest rate has no effect at all on this motive.
(2) Precautionary Motive: This is the demand for money in its liquid
form for emergencies and unforeseen motive or purposes. This means to
hold money in its liquid form in order to finance unplanned rather than
planned transactions such as sickness, funerals, accidents, fires,

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burglary, breakage etc. Precautionary demand for money is also likely to
depend on individual’s level of income. The higher the level of income,
the more money will be needed to safeguard against unexpected
transactions. Precautionary demand for money is also not affected by the
rate of interest. Since both Precautionary and transaction demand for
money depends on the level of income and they are not affected by the
rate of interest, they are referred to as transaction demand for money.
(3) Speculative Motive:
According to Keynes, people may choose to keep ready money to take
advantage of profitable opportunities that may arise within the financial
market such as investments in bonds. A bond is an asset that earns a
fixed sum of money for its owner each year. There is always an inverse or
an indirect relationship between a bond’s price and the rate of interest,
which implies that if interest rate goes up bond's price will fall, and on
the other hand if interest rate falls the price of bond's price will increase.
Individuals will hold money instead of investing in bonds if they expect
the interest rates to rise in the near future.
Given that a fall in the interest rate implies a capital gain for the holders
of the bonds, the Keynes theory of liquidity preference predicts that if
interest rates are high, there will be a large demand for bonds since there
prices will have fallen and hence a small demand for speculative money
balance. On the other hand if the individuals expect that in future the
interest rate will be low, they will hold more money in order to satisfy
their speculative motive and as a result the demand for bonds will be
low.
Keynes therefore derived an inverse or indirect relationship between the
interest rates and the speculative demand for money, a concept
illustrated in the following simple diagram.

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 Spspeculative demand

From the above diagram as the rate of interest falls from r1 to r2 the
speculative demand for money increases from Q1 to Q2. However, at a low
interest rate r3 the bonds become so unattractive because the prices are
very high and they are expected to fall. In this phenomenon, speculative
demand for money becomes perfectly elastic meaning that people hold all
their money in liquid form for speculative purpose. From the above
diagram it can be observed that the part of demand curve which is
perfectly elastic is referred to as liquidity tap whereby people expect the
interest rate to rise to a particular point or level otherwise they will hold
all their money in liquid form.
In conclusion therefore according to Keynes given demand for money for
the three motives we have discussed, the value for money is determined
where money demand is equals to money supply, that is, MS = MD. But
since MD = MDT + MDS, it therefore follows that MS = MDT +MDS, where
MDT = Money demand for transaction (and precautionary) and MDS
money demand for speculative.

Interest Rates According to Keynes

According to Keynes, interest rates are determined where money supply
is equal to money demand. Since the government through central bank
authorities fixes money supply, the rise of money supply is perfectly
inelastic with respect to changes in interest rates. Keynes argued that
the level of interest rates in an economy would then be reached by
interaction of money supply and money demand as illustrated below:

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From the above diagram, the level of interest rate r0 is determined by
interaction of money supply and money demand (or liquidity preference).
In other words, interest rates in the economy are determined where Ms =
MD and that is the time the money market is said to be at equilibrium.
What will be the effect of increasing money supply in the economy?
When money supply is increased, there will be a fall in interest rates as
illustrated below:

From the above diagram as money supply is increased or expanded from

MS0 to MS1 the rate of interest falls from r0 to r1.
Interest Rates According to Loanable Funds Theory
This theory is also referred to as the new classical theory. It was
popularised by a 19th century classical Swedish economist Robertson.
The Loanable funds theory states that because the rate of interest is the
price of capital, it is determined by the amount savers are willing to lend
to the market and the amount investors want to borrow (demand for
loanable funds). In other words, forces of demand and supply of
loanable funds determine rate of interest.

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Income levels, that is, high income, more loanable funds and low income,
less loanable funds, determine supply of loanable funds. It is also
determined by availability of financial institutions and capital markets
since if they are well established, they encourage mobilisation of savings.
Conversely, if financial institutions are not well developed, there will be
poor mobilisation of loanable funds (i.e. keeping the money under
mattresses, under a tree, or in biscuits tins). In such a situation, there
will be low supply of loanable funds and hence interest rates will go up.
Supply of loanable funds will also be affected by inflation as high
inflation discourages saving.
Demand for loanable funds comes from firms, government and
individuals. Firms borrow in order to buy capital assets. Therefore,
according to this theory, rate of interest is determined as illustrated
below: -
Illustration:

From the above diagram, more loanable funds will be supplied at higher
interest rates and fewer at lower interest rates. As interest rates fall,
firms will demand more loanable funds. At higher interest rates,
demand will fall. Rate of interest determined at OR where supply of
loanable funds is equal to demand at OQ.

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3. Friedman Quantity Theory of Money
This theory is also referred to as new monetary quantity theory of
money or the Chicago Theory. According to Milton Friedman, value of
money is not only determined by demand and supply of money but will
also depend on the format in which people prefer to old their wealth. He
further pointed out that money is just one of the methods or ways in
which people hold wealth.
The Chicago Equation is usually represented as follows: -
MD/P = f (W, r, dt/dy, U…)
Where: -
MD/P = Quantity of money
W = total wealth, i.e., the sum of human and non-human wealth
R = the expected rates of return to on various forms of wealth
dt/dy = the ratio of human wealth to non-human wealth
U = change in tastes and preferences
Let's explain each of the independent variables in turn.
(1) Total Wealth: The demand for money will directly be related to total
wealth, which is the sum of human and non-human wealth. Thus, as
total wealth increases, the desire to hold money will also increase.
(2) Expected Rate of Return on Wealth: Since the rates of return on
bonds and equities represent the opportunity cost of holding money,
there is an inverse (i.e. negative) relationship between those expected
rates of return and demand for money.
(3) The Ratio of Human Wealth to Non-Human Wealth: Since human
wealth is so illiquid, as it cannot be sold, individuals have only a limited
ability to transfer non-human wealth into human wealth. In our above
equation therefore, the higher the dt/dy ratio the greater will be the
demand for money in order to compensate for limited marketability of
human wealth.
(4) Taste and Preferences: Friedman argues that the demand for money
also depends on a number of factors that are likely to influence wealth
holders' taste and preference of money.
In summary, according to Friedman ways in which we can hold our
wealth include: -

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● Money: It is considered to be the best way in which we can hold our
wealth because it is more liquid (flexible) than other methods as a
medium of exchange.
● Human wealth: Some people prefer to invest in human wealth by
developing human resource.
● Physical assets (non-human wealth): Some people prefer to invest
their wealth by buildings, vehicles, animals, etc.
● Securities and bonds: Some people prefer to invest their wealth by
buying securities and bonds so that during the time of maturity, they
will gain.
Weakness:
The main problem with Friedman's demand for money function is that of
finding a suitable method of measuring total wealth. Whereas it might be
possible to measure non-human wealth, it is quite difficult to measure
human wealth.

MONEY SUPPLY
Money supply refers to the currency in form of notes and coins with the
public plus all deposits held by the deposits taking institutions that is
the commercial banks and non-banking financial institutions (NBFI).
The concepts of money supply
In Kenya, the Central Bank of Kenya (CBK) distinguishes between six concepts of
money on the basis of their liquidity as follows: -
1. M0 – This is the narrowest concept of money and comprises currency
held by non-bank public. This is the money that is held by the
members of the public and it is not in the bank.
2. M1 – This includes M0 and demand deposits I commercial banks.
Mostly in current accounts.
3. M2 – This includes M1 and time and saving deposits held in
commercial banks.
4. M3 – Includes M2 and time and savings deposits held with
non-banking financial institutions (NBFIs).
5. M3X – This includes M3 and the residents’ foreign currency
denominated deposits held with commercial bank.

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6. MX3T – This comprises M3X and holdings of Government securities by
non-bank public.
DETERMINANTS OF MONEY SUPPLY
The determinants of money supply are also referred to as sources of
money and are as follows:
● Open market operation (OMO)
● Interest rates
● Changing the cash reserve ratio
● Special deposits
● Government expenditure financed by borrowing from central
bank.
● Government borrowing from bank system
● A change in public desired cash holding
● Balance of payments surplus
(1) Open Market Operation (OMO): OMO refers to buying and selling
of the government securities on the open market by the central
bank. A reduction in money supply will occur if the government
sell securities through its brokers since buyers will pay for these
securities with cheques drawn on the account with commercial
bank. On the other hand, there will be an expansion of money
supply if the securities are bought on the open market by the
central bank. Government securities include treasury bills and
treasury bonds.

(2) Interest Rates: Since the liberalisation of interest rates in 1991,

Central Bank Kenya influences the general level of interest rate through
changes in the 90 days treasury bills rate of interest. To a great extend,
this affects rate of interest charged by commercial banks in the loans
they advance to borrowers, thus influencing the amount of money
circulating in the economy.
Since commercial banks constitute an important buyer of government
financial securities, an increase in interest rates tends to reduce money
supply and their ability to create credit. Commercial banks peg their rate
of interest on the prevailing treasury bills interest rate. Therefore the
higher the treasury bills interest rate, the higher the interest rate
charged by commercial banks and hence the low the money supply. On
the other hand, the lower the interest rates charged by banks on credit,
the higher the money supply in the economy.
(3) Changing the Cash Reserve Ratio: Cash reserve ratio is the amount
of cash, which must be deposited by commercial bank with the central

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bank. An increase in cash reserve ratio reduces credit creation among
commercial, which will tend to lower money supply circulating into the
economy. On the other hand, a reduction in cash reserve ratio increases
the ability of commercial banks to create credit leading to an increase in
money supply.
(4) Special Deposits: The central bank has the power to require the
commercial banks to lodge special deposits with it, which earns them an
interest rate. Since special deposits are compulsory they ensure a
reduction of commercial banks’ liquid assets and their ability to create
credit, which will consequently reduce money supply.
(5) Government Expenditure Financed by Borrowing from Central
Bank: If currency is issued to a government facing a budgetary deficit to
finance its expenditure, money supply will definitely increase. On the
other hand, a reduction of government borrowing from the central bank
will reduce the rate of growth of money supply. Government borrowing
from the central bank implies printing of paper money, an action which
could result to an inflation type referred to as credit inflation.
(6) Government Borrowing from Bank System: If the public sector is
running a deficit, it may borrow some funds from the banking system,
which will lead to further expansion of money supply. Government
borrows from the banking sector through open market operation.
(7) A Change in Public Desired Cash Holding: A decision by the public
to hold more cash and maintain small bank deposit will reduce money
supply as the commercial banks' ability to create credit will be affected.
On the other hand, if public decides to hold less cash and maintain
bigger bank deposits money supply will be increased. The desire of public
not to put money in the banking institutions could be due to low interest
rates paid on their deposits and also lack of well-established financial
institutions.
(8) Balance of Payment Surplus: When there is a balance of payment
surplus it implies a high inflow of foreign currency into the economy
which could be converted into domestic currency and thus increasing
money supply. On the other hand if there is a balance of payment deficit
the inflow of foreign currency is low and this could reduce the money
supply.
THE MONETARY POLICY
Definition: Monetary Policy may be defined as one of the public
interventionist measures aimed at influencing the level and pattern of
economic activities so as to achieve certain desired macro-economic goals

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such as price stability. In other words monetary policy is the policy
which seeks to influence the economic activities using tools available to
the Central Bank such as money supply and interest rates. The Central
Bank carries out the technical work of formulation and executing the
monetary policy.

Objectives of the Monetary Policy

The major objectives of monetary policy are to:
(1) Attainment of full employment: Monetary policy can be used to
achieve this objective where the Government through central bank will
encourage commercial banks to extend credit to labour intensive sectors,
such as agriculture, construction and light industries such as Jua Kali.
In addition the government may use the monetary policy to influence
lowering of interest rates which will encourage investment and hence
more jobs creation.
(2) Achievement of price stability: In order to achieve this objective,
monetary policy is used to control inflation by regulating amount of
money circulating in the economy.
(3) Attainment of economic growth: This can be achieved by providing
investments funds through cheaper credit to potential investors while
mobilising saving, which will further stimulate investments. Also
monetary policy can be used to lower interest rates on credit, which will
encourage investments and thus higher levels of economic growth.
(4) Bringing equilibrium in the balance of payment: Credit may
selectively be directed to export sectors and away from imports sectors.
Furthermore, capital inflow can be encouraged and capital outflow
discouraged through monetary policy by controlling the exchange rate.
(4) Creating sound banking and financial institutions:
This is important because financial institutions play a vital role in
mobilising funds for investments such as branch banking in both rural
and urban areas.
Tools of Monetary Policy
Tools of monetary policy are also referred to as instruments of monetary
policy. The Central Bank has several instruments on monetary policy,
which it employs in various occasions depending on what
macro-economic problem it wants to address or the specific objective it
wants to achieve. These tools or instruments are outlined below:

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(1) Minimum Liquidity Asset Ratio: Liquidity asset ratio can be defined
as the proportion of total assets of a bank, which are held in form of
cash, and liquid assets. When the Central Bank adjusts this ratio,
bank lending or bank credit creation ability is affected. The
advantages of this instrument are:
● All banks are affected equally,
● It is a direct way of controlling credit creation.
● It is immediate and therefore fast.
(2) Cash Ratio: This is whereby the Central Bank instructs Commercial
Banks to keep a higher or a lower percentage of deposits they receive
from the customers in cash form. The Central Bank may require the
Commercial banks to maintain minimum cash balances out of the total
deposits of the liabilities they have. The main purpose of this instrument
is to reduce banks' free cash-base and hence their capability to give
loans and advances.
(3) Open Market Operation: Open market operation refers to the sale
and purchase of marketable government securities (treasury bills and
treasury bonds) conducted in the open market by central bank as an
instrument of control of monetary policy. Open market operation mostly
targets commercial banks and non-bank financial institutions (NBFIs).
Central bank sells its holdings of government securities to commercial
banks and NBFIs in order to mop up excess reserves in them. On the
other hand, if the central bank wants to increase money supply in
circulation, it injects additional liquidity by purchasing from the existing
bank stock of government securities.
(4) Selective Credit Control: Through this method, the central bank
encourages commercial banks to give credit to those sectors of the
economy considered essential and discourage those of which of lower
priority. For example, it may advice Commercial Banks and other
financial institutions to approve loans for industrial development and
limit lending for speculative purpose.
(5) Interest Rates:
(6) Low interest rates should be encouraged to promote investment and
protect small borrowers. Stability of interest rates is also regarded as
an important factor of promotion growth and development of the
economy. To ensure that the interest rates remain low, many
economies have liberalized interest rate regime where the market
forces of demand and supply determine the rate of interest banks
charged to borrowers. The central bank however influences the rate of
interest rate by setting the rate of interest of treasury bills which is
then used by the commercial banks as a benchmark of setting their

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 base lending rate. This means that commercial banks peg their
interest rates on the prevailing treasury bills' rate of interest.
Limitations of Monetary Policy in Developing Countries
(1) Markets and financial institutions in many developing countries are
highly disorganised. This explains why there are many incidences of
bank failure. In such a situation the use of instruments like open market
operation is severely limited.
(2) Commercial banks in developing countries are less sensitive to
changes cash rate partly because many banks find themselves in excess
liquidity due to lack of borrowers in their economy. This limits the
effectiveness of open market operation and cash ratio as instruments of
monetary control in the developing countries.
(3) Most Commercial Banks in developing countries are mere overseas
branches of major privately owned banking institutions in developed
countries thus such foreign Commercial Banks can turn to their parent
organisation for liquid funds in event of having their base squeezed by
central bank.
(4) The ability of developing Government to regulate their national
economy money supply is constrained by the openness of their
national economies, which give more priority to accumulation of
foreign currency at the expense of domestic financial reserves.
(5)

(5) Many people in developing countries do not deposit their money in

commercial banks or NBFIs and this makes it difficult for the central
bank to use monetary policy as an instrument to control money supply.
(6) Lack of knowledge of monetary policy instruments like open market
operation and selective credit control makes it difficult for the application
of monetary policy in developing countries.
(7) There is a lot of corruption in many developing countries and this
makes it difficult to apply an instrument like selective credit control.
(8) Monetary policy instruments are sometimes used wrongly to tackle a
certain macro-economic problem effectively. In general, monetary policy
is considered to be more appropriate in tackling and addressing external
problems such as balance of payment deficits. On the other hand, fiscal
policy is more suitable in tackling problems, which are internal in nature
such as unemployment or economic depression. However, both policies
are important for checking inflation. Therefore, there is a need for policy

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mix since macro-economic problem prevailing at any given time may
require fiscal rather than monetary policy.
(9) A lot of time taken in planning and formulating monetary policy and
its implementation also takes time. It may therefore take a very long time
for the benefits of monetary policy are realised. The reality of the fact is
that formulation and implementation of the monetary policy is not a
one-time event but a process.
(10) Lack of autonomy of Central bank may impact negatively the
implementation and execution of the monetary policy.

B. BANKING
THE CENTRAL BANKING SYSTEM
In most countries, there is a single bank that exercises control over the
entire monetary and banking system. Generally, the central bank is
operated as a public corporation so that it's subject to government
control. In Kenya, the central bank was established in 1966. The first
central bank in the world was the Bank of England, which was
established in 1694.Then, Central Bank of France was established in
1803 while the central banking system of U.S.A. is the Federal Reserve
System, which consists of twelve Federal Reserve Banks and were
established in 1913.
Functions of Central Bank
The following are the main functions of a central bank in an economy:-
(1) Banker to the Government: One of the most important aspects of
the work of central bank is to operate the government's bank accounts of
which there are two types. The first is commonly known as the
exchequer account, a form of a current account into which receipts from
taxation are posted and out of which current expenditure is paid. The
second is the development account, a form of capital account which
receives all borrowing by the government and out of which all capital
expenditure is met.
(2) Banker to Commercial Banks: All commercial banks deposit money
with the central bank and their deposits fall into two categories: -
● There are those deposits, which can be readily withdrawn, and the
purpose of keeping them at the central bank is to facilitate the
settlement of inter-bank debts. When one commercial bank wants

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 to settle a debt with another, it does so through its account at
central bank.
● The other type of account cannot be freely withdrawn by the
commercial banks. These ''special deposits'' also called reserve
requirements have been placed there on instructions of the
central bank as a means of reducing money supply.
(3) Management of Public Debt: Government borrows money to finance
development projects and cover balance of payments deficits. Thus, the
central bank keeps all the records regarding public debt on behalf of the
government.
(4) Holding Foreign Exchange Reserves: The central bank, on behalf of
the government, operates external monetary affairs. It keeps foreign
exchange reserves on behalf of the government. The central bank is also
responsible for maintenance of exchange rates against other currencies
and also for dealings with the IMF. The central bank also formulates and
implements a country’s foreign exchange policies.
(5) Implementation of Monetary Policy: This is probably the most
important function of any central bank. Monetary policy is mainly
concerned with controlling money supply in the economy with a view to
influencing interest rates and exchange rate and therefore controls the
level of domestic inflation. When money supply exceeds beyond
acceptable level, this may cause inflation and it is the responsibility of
the central bank to control money supply in the economy to avoid
inflationary tendencies. This is executed through the following tools
(instruments): -
● Bank Rate Policy.
● Special Deposits.
● Open Market Operations.
● Directives.
● Moral Persuasions.

(6) Lender to the Last Resort: Sometimes, some commercial banks may
find themselves short of cash, which is potentially a dangerous situation,
as customers' confidence would be lost if they cannot withdraw their
deposits. The central bank is always willing to act as a lender of last
resort if commercial banks cannot raise the necessary cash elsewhere.
(7) Issuing of Coins and Notes: The central bank has the sole role of
issuing notes and coins in a country. It issues new notes and coins and
also replaces defaced currencies.
Role of the Central Bank in a Liberalised Money Market

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In the recent past, the Government of Kenya has undertaken several
reforms in the financial sector. First, the liberalisation of determination
of interest rates by market forces and secondly, the freeing of the foreign
exchange i.e. the rate of exchange of local currency (i.e., shilling) against
hard currencies (dollar, sterling pound, etc) is decontrolled and
determined by the prevailing macro-economic environment in the
country.
Following this, the Central Bank of Kenya Act was amended in 1996 to
reflect the above changes. As per the amended Act, the objectives of
central bank include: -
● To formulate and implement monetary policy.
● To foster liquidity solvency and proper functioning of a stable
market based financial system.
● Formulate and implement foreign exchange policy.
● Hold and manage its foreign exchange reserves.
● Promote the smooth operations of payments, clearing and
settlement systems.
● Acts as a banker and adviser to and as a fiscal agent of the
Government, and
● Issue currency notes and coins.

As a result of the removal of exchange controls and deregulation of

financial service, the Central Bank of Kenya has acquired a new role as a
supervisor and regulator of the banking system. In this role, the
Central Bank has become an important source of guidance and advice to
individual commercial banks. It has developed an elaborate system of
rules and regulations under the Banking Act for solvency of banks and
for the protection of their depositors. If a bank was unable to meet its
obligations, and so became insolvent, this could have a major effect on
public confidence in the entire financial system. In its supervisory role,
The Central Bank seeks to maintain public confidence in the stability of
banks and other financial institutions.
Commercial banks make profits from taking risks. The Central Bank of
Kenya lays down liquidity requirements with which individual banks
must comply. A bank needs liquidity to meet its customers' demand for
cash withdrawals. The Central Bank of Kenya ensures that banks: -
● Have sufficiently strong capital bases to withstand losses from
bad debts and falling asset values;
● Maintain prudent mixture of assets to meet the current and
future needs of customers;
● Do not take excessive risks by concentrating their lending to too
few customers and on too few sectors.

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Under the Banking Act, the Central Bank of Kenya has the statutory
right to information about a bank at any time. The Central Bank also has
the power to carry out regular investigations of a bank's business. It is a
criminal offence for the directors of a bank to withhold information to
which the Central Bank is entitled as a supervisor.
COMMERCIAL BANKS
Commercial banks are profit-earning institutions and they could either
be privately or government owned. Their main source of income is
interest charged on loans advanced to borrowers.
Functions of Commercial Banks
The commercial banks perform the following functions: -
(1) Accepting Deposits: Before the emergence of banking system, people
used to leave their monies in save keeping. But today, banks accept or
receive deposits from individuals, businessmen and companies.
Individuals can open the following accounts in commercial banks: -
● Current Account: business people mostly operate it and in a
current account, the customer can withdraw money anytime
without notice. Customers are also issued with cheques to make
payments with them. Most banks do not pay interest on current
accounts.
● Fixed Account: This type of an account attracts a huge interest.
But most banks ask for a minimum amount to open such an
account. Money deposited in a fixed account cannot be withdrawn
without giving a specified notice.
● Savings Accounts: These are accounts, which attract interest i.e.
interest is paid on money deposited but not as huge as fixed
accounts. However, one must not withdraw money 7 days since the
last withdrawal.
By accepting deposits from individuals and organisations, commercial
banks act as financial intermediaries. What are financial
intermediaries? They are institutions within the financial markets
which facilitates financial transactions.
Moreover, by accepting deposits, commercial banks provide storage of
wealth in form of current and deposit accounts. Also commercial banks
compete to attract deposit from firms, individuals and other
organisations.
(2) Advancing Loans: Commercial banks advance loans in three ways: -

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 ● Over-drafts to businessmen with current account and paid in a
short period. A businessman is allowed to withdraw and extra
amount is paid with interest.
● Bill of exchange, which matures after 90 days. The holder of bill
of exchange can ask a bank to discount it, as it is a form of
advancing loan.
● Direct Loans: This is a loan given to a company or an individual
by a bank. The borrower must give a security (e.g. title deed as
collateral) to the bank. Banks charge interest on such a loan and it
is paid in instalments the moment it is approved and given out.
(3) Agents of Stock Exchange Market: Commercial banks buy shares
and debentures of different limited companies on behalf of their
clients. They can also buy shares in a company and become ordinary
or preference shareholders. Moreover, a commercial bank might
become an underwriter, which is where the bank agrees with issuing
company that it buy the remaining shares which the public has not
been able to purchase after an offer.
(4) Transferring Money: Commercial banks facilitate transfer of money
from one place to another place. This enables the individuals to export
and import goods, as money would be transferred from one bank to
another. This way, commercial banks provide a payment mechanism
through which individuals and firms can make payments to each other.
Modern banks utilise the payment systems, which make payment by
cheques. In addition, commercial banks constitute a source through
which individuals and firms can obtain notes and coins.
(5) Provide advice to Investors: Commercial banks provide their clients
with expert advice on a broad range of issues such as those relating to
investments, take-over bids, sharing registration, leasing, underwriting,
etc.
(6) Act as foreign exchange dealers: Commercial banks act as foreign
exchange dealers as they provide a means of obtaining and selling foreign
currencies.
Role of Commercial Banks in Economic Development
Generally, commercial banks play the following major roles in economic
development:
● They promote development of commerce and industry and this is
mostly through loans (i.e. overdraft) extended to businessmen,
firms, etc.
● Increase capital accumulation as individuals and firms gets loans,
which they invest on capital assets.
● They encourage savings and high saving leads to more investments
hence leading to rapid economic growth and development.

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CREDIT CREATION.
Definition: Credit creation is defined as the process by which banks are
able to lend out amount of money of greater magnitude than the amount
of money they originally received from the depositors. In other words, it
is the process through which commercial banks advance loans many
times greater as compared to legal money at their disposal.

How commercial banks create credit is illustrated in the following

example of multiplier create creation:
Illustration of multiplier credit creation:
Let's assume there are several commercial banks in an economy (e.g.
Bank A, Bank B, Bank C and Bank D. If a loan of Kshs.1, 000,000/- is
issued by A, it will lead in to advance loans many times greater than this
amount as shown in the table below:-

Bank A Bank B Bank C Bank D

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In the above example, an individual goes to Bank A and the bank
advances to him/her a loan of Kshs. 1,000,000. This individual will not
invest or spend this loan immediately. Suppose he deposits this amount
of money to Bank B, where he has an account. Bank B, where he is a
regular customer knows that this customer will withdraw only 10% of
the deposited amount next period and thus Bank B will retain 10% of
the deposited amount and will advance a loan of Kshs 900,000/- to
another person. In this respect, another loan of Kshs 900,000 on the
basis of the same amount. The process will continue until the original
advanced by Bank A will disappear.
The loans advanced by different commercial banks can be expressed as:
-
1,000,000 + 900,000 + 810,000 + 729,000… = KShs.10,000,000
Thus, credit creation can be computed as: -
Credit creation = Excess Reserve
Reserve Ratio
In the above illustration:
Excess Reserve = 1,000,000
Reserve Ratio = 10%
Credit creation = 1,000,000.
10% or 0.1
=1,000,000 - 10
100
= 1,000,000 x 100
10
= KShs. 10,000,000

Limitations of Credit Creation

The major limitations of credit creation are:
(1) The Liquidity Ratio: Liquidity ratio (also refereed as cash ratio) at
which the commercial banks keep reserves to meet the demand for the
depositors. If the liquidity ratio is low, the bank will be placed in a better

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position to create credit. Thus, the size of the cash ratio determines the
ability of a commercial bank to create credit. Conversely, if the cash
ratio is high, the bank might not create credit much.
(2) Policy of Central Bank: All banks are authorised by the central
bank to deposit a certain amount of the money they have collected as
deposits from customers. This denies bank loanable funds. Moreover,
commercial banks cannot credit certain beyond the limit set by central
bank.
(3) Securities: Banks advances loans to individuals against certain
securities which act as collateral. In most cases, borrowers may not have
the requisite securities and hence cannot get a loan from a bank.
(4) Saving Levels: If most people in an economy have low income, they
may have little to save. Thus, the banks will not accumulate enough
deposits to extend credit to borrowers, resulting to credit rationing.
(6) Interest Rate: If the interest rate is too high, individuals will not
borrow from banks as cost of capital in exorbitant.
(7) Government's Domestic Borrowing: When faced with a budgetary
deficit, the government may borrow internally. Thus, commercial banks
will buy treasury bills and treasury bonds depending on the interest they
are fetching. This way, the private investors will be Crowded out hence
banks cannot extend credit to them.
NON-BANKING FINANCIAL INSTITUTIONS (NBFIs)
Definition: A non-banking financial institution is an organization, which
taps public savings in form of deposits, and uses them to lend to
members of public for investments on long-term basis. It is different from
a banking institution in that it does not offer conventional or traditional
banking services such as operating a current or a savings account.
Examples of NBFIs
● Merchant Banks: They receive large deposits and then lend these
on large scale on long-term basis. Some merchant banks are also
referred as wholesale banks. An example in Kenya is the Diamond
Trust.
● Insurance Companies: They receive money in form of premium
contributions from the public or organisations to insure against
fires, losses, accidents, life etc.
● Hire Purchase Companies acquire fixed assets and sell Them on
a hire purchase basis to business people. Examples are Credit
Finance Corporation (CFC), National Industrial Credit, ART, etc.

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 ● The Mortgage Companies: They help individuals to own homes
for example EABS, I & M, HFCK, NHC, Savings & loan (a
subsidiary of KCB).
● Collection of savings: They encourage savings and advance the
loan on the basis of members share contributions for example
Savings and credit cooperative societies (SACCOs).
Roles of the NBFIs in the Economy
NBFIs play the following roles:
● NBFIs stimulate competition with commercial banks over deposits
and credit markets, which lead to efficiency in terms of service
delivery to customers.
● NBFIs enhance the development of financial market through the
introduction of a great varieties of financial instruments for example
investments deposits accounts, savings and credit, members
contribution etc.
● NBFIs lend money on long-term basis unlike commercial banks,
which only offer money for short-term basis.
● NBFIs provide financial services which commercial banks don't
provide such as chatted mortgage loans and purchase finance.
● NBFIs encourage savings and hence investment.
● NBFIs assist the government in execution of monetary policy by
buying Government securities through the open market operation
(OMO).

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