The objectives of commercial banks

Commercial banks have three main objectives: profitability, liquidity and security.

Commercial banks aim to achieve high profits for their shareholders mainly by lending. This
objective conflicts with its two other objectives and a balance has to be achieved between the three
objectives. Commercial banks have to achieve a certain level of liquidity and security. They need to
have enough liquid assets, such as cash and short-term securities that will soon be turned into cash,
to meet the expected request by their customers to withdraw their money in cash. These liquid
assets are, however, not very profitable. Indeed, no money is earned on holding cash.

Commercial banks also aim for security. They do not want to go out of business and they have to
convince their customers that they are financially sound. To achieve this aim they try to ensure they
have sufficient financial capital to cover their risker loans. A commercial bank will keep some assets
that are liquid but not very profitable and some that are profitable but not very liquid. It may also
keep some of its profits in case some of its borrowers do not repay their loans or some of the firms it
buys shares in go out of business.

Causes of changes in the money supply

There are five main causes of an increase in the money supply in an open economy:
1 an increase in commercial bank lending
2 an increase in government spending financed by borrowing from commercial banks
3 an increase in government spending financed by borrowing from the central bank
4 the sale of government bonds to private sector financial institutions (quantitative easing)
5 more money entering than leaving the country.

Commercial banks and credit creation

When commercial banks lend, they create money. This is because when a bank gives a loan (also
called an advance by bankers), the borrower’s account is credited with the amount borrowed. Banks
are in a powerful position to create money because they can create more deposits than they have
cash and other liquid assets (items that can be quickly converted into cash). From experience, banks
have found that only a small proportion of deposits are cashed. When people make payments, they
tend to make use of credit cards, debit cards and online transfers. These means of payment involve a
transfer of money using entries in the records that banks keep of their customers’ deposits rather
than by paying out cash. So, banks can create more deposits than they have liquid assets.
Nevertheless, they have to be careful when calculating what liquidity ratios (the proportion of liquid
assets to total liabilities) to keep. This ratio can be set by a central bank when it is called a reserve
ratio. The lower the proportion of liquid assets commercial banks keep, the more they can lend .
However, they have to be able to meet their customers’ demands for cash. If they miscalculate and
keep too low a ratio, or if people suddenly start to cash more of their deposits, there is a risk of a run
on se the banking system.

The bank credit multiplier

By estimating what reserve ratio to keep, a bank will be able to calculate its bank credit multiplier.
When calculating its bank credit multiplier, a commercial bank will take into account its reserve ratio

Bank credit multiplier (after loans have been made)

Value of new assets created / Value of change in liquid assets
 For example, if total deposits rise by $600 million as a result of a new cash deposit of $100 million,
the bank credit multiplier is $600m/$100m = 6.
It is also possible to calculate the bank credit multiplier, in advance.
Bank credit multiplier (in advance) = 100/ liquidity ratio

Reserve ratio
If a bank keeps a reserve ratio of 5%, the bank credit multiplier will be 100 / 5 = 20. With this
knowledge, a bank can then calculate how much it can lend. The bank first works out the possible
increase in its total liabilities. This is found by multiplying the change in liquid assets by the bank
credit multiplier. So, if the bank credit multiplier is 20 and liquid assets rise by $40 million, total
deposits can rise by $40 million × 20 = $800 million. To work out the change in loans (advances), the
change in liquid assets is deducted from the change in liabilities. This is because the change in
liabilities will include deposits given to those putting in the liquid assets. In the example, the change
in loans can be $800 million − $40 million = $760 million.
However, in practice a bank may not lend as much as the bank credit multiplier implies it can. This is
because there may be a lack of households and firms wanting to borrow or a lack of credit-worthy
borrowers.

A central bank may seek to influence commercial banks’ ability to lend. For example, the bank may
engage in open market operations. These involve the central bank buying or selling government
securities to change bank lending. If the central bank wants to reduce bank loans, it will sell
government securities. The purchasers will pay by drawing on their deposits in commercial banks
and so cause the commercial banks’ liquid assets to fall.

The capital ratio

The capital ratio is a commercial bank’s available financial capital expressed as a percentage of its
riskier assets. The available financial capital includes its retained profits and newly issued shares.
While government securities are normally assumed to carry no risk, some loans may be considered
risky if the economy got into difficulties. For example, if a commercial bank had a capital ratio of 8%,
this would mean that 8% of its risker assets are covered by readily available financial capital. The
higher the capital ratio a commercial bank has, the more unexpected losses it can experience
without going out of business. The capital ratio is designed to protect the bank’s customers in the
event of a financial crisis and to promote the stability of the banking sector by discouraging excessive
risk taking.

The role of a central bank

The central bank of a country carries out a range of functions. It issues bank notes and authorizes the
minting of coins. It is the bank of the commercial banks. Commercial banks keep deposits in the
central bank. This enables the commercial banks to make and receive payments from other
commercial banks and to withdraw money when needed. Their deposits at the central bank are
considered to be liquid assets. The central bank will also usually lend to commercial banks if they get
int financial difficulty.
Two of the other key functions of a central bank are to act as the banker to the government and to
implement the government’s monetary policy.

Government deficit financing

If the government spends more than it raises in taxation, it will have to borrow. This is organized by
the central bank. If the central bank borrows, on behalf of the government, by selling government
securities, including National Savings certificates, to the non-bank private sector (non-bank firms and
the general public), it will be using existing money. The purchasers will be likely to draw money out of
their bank deposits. So, the rise in liquid assets resulting from increased government spending will be
matched by an equal fall in liquid assets as money is withdrawn.
However, if a budget deficit is financed by borrowing from commercial banks or the central bank
itself, the money supply will increase. When a government borrows from the central bank, it spends
money drawn out of its account kept at the central bank. This spending will increase deposits in
commercial banks and so increases their liquid assets. With more liquid assets, they will be able to
lend more.
Commercial banks will also be able to lend more if the government borrows from them by selling
them short-term government securities. This is because these securities count as liquid assets and so
can be used as the basis for loans.

Quantitative easing
When the rate of interest is very low, a central bank may decide to try to increase aggregate demand
by in the use of quantitative easing. This involves a central bank buying both government and private
securities, of different maturities, from financial institutions, including commercial banks. In return
for the securities, the central bank credits the accounts of the commercial banks. With more liquid
assets, it is hoped that the commercial banks will lend more. This should increase the money supply
and reduce the short-term and long-term interest rate. These changes may, in turn, increase
investment and consumer expenditure and so aggregate demand and economic activity.

Changes in the balance of payments

The total currency flow refers to the total net outflow or inflow of money resulting from
international transactions, as recorded in the different sections of the balance of payments. If, for
example, export revenue exceeds import expenditure, money will flow into the country on the trade
balance. Exporters will deposit the money into the country’s commercial banks, which will lead to a
multiple increase in the money supply.

The effectiveness of policies to reduce inflation.

Contractionary monetary and/or contractionary fiscal policy can be used to reduce inflation. Supply-
side policy can also be used in the case of cost-push inflation. For example, increased spending on
training can raise labour productivity and so reduce labour costs or at least reduce the upward
pressure on labour costs. Lower corporate tax may encourage firms to buy more efficient capital
equipment, which can also put downward pressure on price rises.

How effective policies are in reducing inflation depends on a number of factors:

Demand for Money

Introduction
Households and firms hold their wealth in a variety of different assets. Two main types of assets can
be distinguished:

 Financial assets – either monetary assets, such as cash and deposits in current accounts at
banks, or non- money assets such as stocks and shares.
 Physical assets – such as houses, buildings, cars, furniture, machinery, computers and
inventories.
When economists talk about the demand for money, they do not refer to how much money people
would like to have, but rather how much H and F choose to hold in the form of money as opposed to
holding either non-money financial assets or physical assets.

There is therefore an opportunity cost to a household if it holds $300 in cash. It could instead buy
shares , and receive dividends and possibly capital gains. Or even it could buy a new television and
enjoy the services it provides. Hence the price of holding money is the benefits foregone from
holding another type of asset.

The demand for money is determined by two main factors:

 Income
The higher the income level, the greater the demand for money. This is because the higher
the level of income, the greater will be spending in the economy. The more households
spend, the more money they spend to use to complete transactions.

 Rate of interest.
One of the alternative uses of money is to buy financial assets which yield interest . A
household can buy government bonds on which interest is payable. The higher the rate of
interest, the greater the opportunity cost of holding money. Money demand will fall
For example, if interest rates on government bonds is 5%, the opportunity cost of holding
$100 for one year in money is $5 foregone in terms of interest.
If the rate of interest is 20%, the opportunity cost is $20.

The diagram below shows the relationship between the demand for money, and interest rates and
income.
The higher the rate of interest, the lower will be the demand for money. A rise in income would shift
the demand for money curve to the right, from Md to Md1. This is because a rise in income raises
the demand for money at any given rate of interest. The opposite is also true when income falls the
demand for money curve will shift to the left.

Keynesian Theory of the demand for money.

Keynesian Theory identifies three reasons or motives why H and F hold money rather than other
types of assets . These are:

1. Transitionary motive
 People do not receive money incomes as often as they make payments. Thus, it is inevitable
that they should hold a certain stock of money all the time to enable them to carry out their
transactions or to meet day-to-day expenses.

2. Precautionary motive
Apart from day-to-day expenditures and purchases, money is held to cover events of an
uncertain nature (unforeseen events); for example, illness, unemployment and emergencies,
etc. In other words, money is kept for precautionary purposes.

The amount of money held for the first two motives is known as active balances. Two factors
influence the demand for money for transitionary and precautionary motives:

a) The level of current income – the higher the income level, the higher will be the demand
for the first two motives. The demand for active balances thus varies directly with the
level of income.
b) The length of interval (in receiving incomes) – the longer the interval, the greater the
demand for money.

Thus, the demand for active balances is rather insensitive to changes in the rate of interest. It
does not depend on the rate of interest and hence, the demand curve for money for these
two motives is perfectly inelastic.

3. Speculative Motive
Any sum left after the household or firm has held enough money for the first two motives is
known as ‘idle balance’ and it is used for speculative motive.

Keynes defines the speculative motive for liquidity preference as the “object of securing
profit from knowing better than the market what future will bring forth”.

A speculator is someone who hopes to make a profit or to avoid a loss on the basis of what
he expects future price to be. In this theory the speculator will speculate a government
bond. These are securities issued by the government in order to raise medium term and
long-term loans.

The speculator buys bonds for two reasons:

 o To earn interest on the bond
o To make a capital gain by selling the bond at a higher price.

If the interest rate is high, this will reduce the desire to hold money. money for idle balances
will fall therefore speculative demand for money will fall.
On the other hand, if interest rate is low, there will be less of an incentive to switch out of
money into other assets. People will hold more idle balances, therefore speculative demand
for money will rise.

2nd alternative of explanation:

According to Keynes, there is an inverse relationship between price of the bond and the
interest rate. The analysis of speculative demand for money can be explained as follows:

If the actual rate of interest is thought to be low, individuals will expect the rate to rise in the
near future and so will expect the price of bonds to fall implying capital losses for bond
holders. Thus, speculators will sell bonds and more idle balances, that is, speculative demand
for money will rise.
In this way, Keynes derive an inverse relationship between rate of interest and speculative
demand for money as illustrated below:

Liquidity Preference Schedule/ curve

The demand for money curve is called the Liquidity Preference Schedule. It shows the relationship
between the demand for money and the rate of interest. The diagram below combines the three
motives for holding money.
OA of money is demanded whatever the rate of interest. This is the amount demanded for
transactions and precautionary purposes.
At an interest rate r1 , OC of money is demanded, where OA is demanded for precautionary and
transactions purposes and AC is demanded for speculative purposes.
When interest rates rise to r2, the demand for money falls. The transactions and precautionary
demands for money remain the same at OA and the speculative demand for money falls to AB.

The transactions and precautionary demands for money will increase if real income in the economy
rises or if there is inflation. This, shown in the figure below, has the effects of pushing the LPC to the
right. If the transactions and precautionary demands increase from OA to OB, then the LPC will shift
from LP1 to LP2.
Interest rate determination

Economic theory suggests that, just as the price of a good is determined by the forces of demand
and supply, so is the price of money. So what is the price of money? It is how much needs to be paid
if money is borrowed – it is the rate of interest.

The diagram below shows the demand and supply curves of money. The demand curve is usually
called the LPC. It is downward sloping because the higher the rate of interest, the more H and F will
wish to hold non-money assets such as bonds or shares.
The money supply is drawn as a vertical line,showing that the supply of money remains constant
whatever the rate of interest. The money supply is said to be exogenous. (independent )

The equilibrium rate of interest re occurs when the demand for money equals the supply of money .

Economic theory suggests that if the rate of interest is above or below this level then it will tend
towards its equilibrium value.

Assume that the rate of interest is r1 ( that is there is an excess demand for money).
H and F want to hold more money than they are currently holding. They will react by selling some of
their non-money assets and converting them into money.

If they sell bonds, the price of bonds will fall. If bond prices fall, interest rates automatically increase.
(According to Keynes, there is an inverse relationship between price of bonds and rate of interest),

So excess demand for money will push up interest rates, leading to a movement back along the LPC.
This will continue until H and F are in equilibrium where the demand for money equals the supply of
money.

Now assume the reverse- that there is excess supply of money such as would exist at a rate of
interest r2. H and F hold more money than they wish, so they will attempt it into buying bonds. An
increase in demand for bonds will develop leading to a rise in their prices. Consequently this will lead
to a fall in interest rates back towards the equilibrium interest re.

Shifts in LPC and Money supply curves.

Recall:
LP shifts to the right if:
i. Increase in real income
ii. Inflation
iii. Greater length of interval in receiving income.

Money supply curve shifts to the right if:

i. People buys bonds
ii. Minting of new funds
iii. Increase the lending capacity of commercial banks
iv. Commercial banks keep a lower cash reserve ratio.

Liquidity Trap
If the supply of money decreases the rate of interest will rise and if the supply of money increases,
the rate of interest will fall. However, it is not possible to reduce the rate of interest below a certain
level. At a certain level of interest, the demand for money becomes perfectly elastic.
The liquidity trap is located on the LPC where the slope of the curve becomes horizontal.
Keynes described a situation where it would not be possible to drive down the rate of interest by
increasing the money supply. He described this situation as the liquidity trap. He thought it could
occur when the rate of interest is very low and the price of bonds is very high. In this case, he
thought that speculators would expect the price of bonds to fall in the future, so if the money supply
was to be increased they would hold all the extra money. They would not buy bonds for fear of
making a capital loss, and because the return from holding such securities would be low. The above
figure shows that at a rate of interest R, demand for money becomes perfectly elastic and the
increase in the money supply has no effect on the rate of interest.

Loanable Funds Theory

According to this theory, the rate of interest is the price that equates the demand for and supply of
loans or loanable funds.

Demand for loans

Loans are demanded by firms for investment purposes. Firms carry out investment because they
expect a return from such an investment. The amount of loans they will demand, that is, the amount
of investment to be paid depends on the relationship between the cost of loans and the yield from
these fund when invested.

Since firms are assumed to be profit maximizer, they will go on demanding loans until the yield from
the last unit of the loan is equal to the cost of the loan. The cost of the loan is the rate of interest
payable on it. The yield from the last unit of loan invested is known as the MEI/MEC.

It can be said that the rate of interest and the demand for loans are inversely related. Thus the
demand curve for loans is downward sloping as follows:
Supply of loans
Whether loans are supplied by households individually or by the community as a whole, they involve
sacrifice of present consumption and loss of liquidity.

As illustrated below, using more resources to produce capital goods means giving up some quantity
of consumer goods in the present period, thus capital accumulation or investment necessitates
refraining from some current consumption.

In this theory, savings are seen as providing the supply of loans and releasing resoufrom the
production of current consumer goods into the production of capital goods. Interest is requireby the
supplier of loans as a compensation for the sacrifice and the loss involved. The opportunity cost of
saving is the present consumption foregone.
The higher the rate of interest, the more willing households and individuals will be to save and so
sacrifice some present consumption for future consumption. Thus the supply of loans varies directly
with the ROI and the supply curve is upward sloping as follows:

The equilibrium rate of interest or the equilibrium price of capital is determined at the point where
the demand and supply curves intersect.

The demand for loans is equal to the supply of loans at point E and the equilibrium rate of interest is
OR. Any change in the conditions of demand and supply will cause changes in the equilibrium rate of
interest.

Criticisms
1. The theory ignores the possibility that savers may be given a purpose for which they are
saving for example to buy a new car or to pay for a holiday.
2. A substantial amount of saving in modern industrialized societies is done as a matter of habit
independently of interest rate levels.
3. Even though the rate of interest falls, the demand for loans may not increase if MEI is lower
that the ROI. So investment sometimes is interest-independent.
4. It is difficult to measure the capital stock in a country and thus it is difficult to identify and
measure the reward of capital.
5. The theory provides only a short run explanation of the determination of the rate of interest.
6. The theory concludes that a falling ROI will induce greater investment to take place and so
cause a shift from less K intensive to more K intensive methods of production. But
economists at the University of Cambridge ( Jones Robinson and Lord Kaldor) have pointed
out that this conclusion may not hold due to the phenomenon of ‘reswitching’.

At first, as the ROI falls from R to R1, methods of production do become more K intensive
(that is the demand for loans increase from L to L1.) But any further falls in the ROI to R2 will
cause a ‘reswitch’ to occur and methods of production become less K intensive. The demand
for loans falls to L2. This is a possibility in labour abundant and capital- scarce countries like
India.

The monetary transmission mechanism.

This is the process by which a change in monetary policy works through the economy via a
change in AD to the price level and the real GDP. There are a number of links in this process:
An increase in the supply of money:
o Money market (diagram 1)
Assume there is an increase in the money supply. At the old level of interest rates
there is now excess liquidity, that is, too much money. Households try to shed this
liquidity by moving out of money into bonds and other assets. This bids up the price
of bonds and so reduces their return- the interest rate). This process continues until
bonds prices are so high ( interest rates so low) that there is no further incentive to
move out of money. Both the money and the bond markets are back in equilibrium.
o The capital goods market (diagram 2)
The lower interest rates will increase the amount of investment- because the cost of
borrowing has fallen, there are more investment projects which as now profitable.
The extent of the increase in investment is in relation to changes in the interest rate,
ie the interest rate elasticity of investment.
o The goods market (diagram 3&4)
With an increase in investment, there is an increase in AD. If the economy is below
full employment, this will lead to an increase in output and employment (diagram 3).
If the economy is at full employment, this will lead to an inflationary gap and upward
pressure on prices. (Diagram 4)

If prices do increase, this will increase the money value of National Income, which will
increase the transactions demand for money. This will shift the demand for money curve
outwards which in turn increases interest rates and brings AD down again, that is, a one-off
increase in the money supply will create forces that reduce any inflationary gap and so the
inflation. This assumes that the money supply is held constant and not increased again.