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LECTURE NOTES 4
CHAPTER FOUR
MONEY AND BANKING THEORY
Origins of Money
The earliest method of exchange was barter in which goods were exchanged directly
for other goods. Problems arose when either someone did not want what was being
offered in exchange for the other good, or if no agreement could be reached over how
much one good was worth in terms of the other. Exchange could only take place when
there was a coincidence of wants. Money is something which people generally accept
in exchange for a good or a service. Various forms of money were used eg. beads,
cowries and cigarettes’ and later on bank notes and coins.
Only the Reserve Bank of Zimbabwe can issue banknotes in Zimbabwe. However,
notes are not usually used to buy expensive items such as cars. The buyer is more
likely to write out a cheque, which instructs his bank to transfer money from his
account into the account of the seller. Hence bank deposits act as money.
Functions of Money
Money performs four main functions:

a medium of exchange for buying goods and services;

a unit of account for placing a value on goods and services;

a store of value when saving;

a standard for deferred payment when calculating loans.
Properties or Characteristics of Money
Any item which is going to serve as money must be:

acceptable to people as payment;

scarce and in controlled supply

stable and able to keep its value

divisible without any loss of value

portable and not too heavy to carry.
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Definitions of money
1.
M
0
 B  Monetary base = currency and reserves. It is also called high
powered money.
2. M1  currency (notes and coin) plus Demand deposits with the banking system.
Demand deposits are deposits (of money) that can be withdrawn immediately by
means of a cheque. Cash in the bank vaults and in the hands of other institutions
cannot be used in the money-goods flow and is consequently excluded. M1 therefore
includes notes and coins in circulation with public (in circulation outside banking
sector). It is sometimes referred to as ‘narrow money’. It is defined solely on the
basis of its function as a medium of exchange. as well as all demand deposits of the
domestic private sector with banks, building societies and POSBank. The definition
can be expressed symbolically as follows M=C+D where M is money supply, C is
cash and D is demand deposits.
3. M 2  M1  short term (< 30 days ) time deposits of the domestic private sector
with banking institutions, building societies and POSB. These short-term deposits are
not immediately available as a medium of exchange. and can only be withdrawn at
considerable cost in the interim. M2 is broader definition of money than M1.
4. M 3  M 2  all time deposits (> 30 day deposits) of the domestic private sector
with banking institutions, building societies and POSB. This is broad money.
MONEY SUPPLY
Definition
The money supply is the total amount of assets in circulation, which are acceptable in
exchange for goods. In modern economies people accept either notes and coins or an
increase in their current account as payment. Hence the money supply is made up of
cash and bank deposits. M1=M = Ms=Money supply (see appendix 4A)
Factors that can influence money supply
(i)
Market participants
(a) Central bank which determines the conditions and level of the cash
reserves to be held by the commercial banks against their demand
deposits.
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(b) Commercial
Banks-
they decide
on
the
basis
of
business
considerations, on the quantity of excess reserves to be held. If they
hold high excess reserves, an increase in legal reserve requirement in
order to bring about a change in the money supply may be a total
failure.
(c) Public- the greater the need for cash, the smaller the commercial
banks’ credit creation capacity becomes.
(ii)
Foreign transactions
If a local exporter earns foreign currency (in payment for exports) and exchanges
it at his bank for a demand deposit, the money supply will be directly increased.
The commercial bank which deposits the foreign currency with Reserve Bank at
the same time increases its own reserves which can be used to create further
demand deposits. Local importers have a negative effect on the quantity of money.
That is a country’s money supply generally increases when its gold and foreign
currency reserves increase and falls when the gold and foreign currency reserves
decrease.
(iii)
Government transactions
Financing of government expenditures from sources other than taxes exerts a
particularly strong influence on the money supply. See Appendix 4A to this chapter
for a detailed derivation of the supply of money.
Credit Creation
The most important services rendered by commercial banks are (1) acceptance of
deposits (demand as well as time deposits) and (2) the transfer of payments, usually
by means of cheque facilities and (3) the granting of credit, inter alia in the form of
overdraft facilities. The most important characteristic of demand deposits is the fact
that the bank is obliged to pay out the deposit in cash (bank notes) or to transfer it to
another bank or account holder in full or partially, immediately or on demand.
Some customers leave money in the bank earning interest. A bank can use these idle
deposits to make loans to people who then buy goods. Shopkeepers receive extra
money, which they redeposit with the bank. Some of this re-deposited money is left to
earn interest and can be re-lent. The bank has therefore created money. If all
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customers were to try to cash their deposits at once, there would not be sufficient
cash. The amount of money the bank can create therefore depends on the ratio of cash
to liabilities that they hold. The higher this cash ratio the less money the bank can relend or create.
How banks create money

Assume a single bank, Barclays bank

Mr. Moyo deposits $20000 cash in the bank.

By depositing $20000 in the bank, money changes its form from cash to
deposit.The change in M is expressed as follows:
M  C  D  0  $20000  $20000 (see M=C+D in 2 above )

Mrs. Maphosa wants to borrow money for her small business.

Banks know that the demand deposits held by them are not all withdrawn
immediately or simultaneously, hence they get into the habit of lending some
of these funds to deficit units in the form of overdraft facilities.Barclays Bank
can lend money to borrowers because it knows depositors will not withdraw
all at once. Provided that the bank can be convinced of Mrs. Maphosa’s credit
worthiness, a demand deposit can therefore be created in her favour without
any cash deposit. But it knows it must keep some cash as a reserve say 10%
therefore Barclays lends $18000 to Mrs. Maphosa. (NB.Deposits that banks
have received but have not loaned out are called reserves). Barclays Bank in
this case has created credit and also money supply in the country has been
increased. Mrs Maphosa can make out a cheque for $18000 to Mrs. Ndlovu
who in turn deposits the cheque in a Standard Bank account. This becomes a
deposit in the bank. M  C  D  0  $18000  $18000 . By lending
money to Mrs. Maphosa, the bank(s) increased money supply to $38000 ($20
000+$18 000) from just $20000. The banks are able to create money because
people have confidence that the cheques signed by the banks are honoured. In
the next stage of money creation, of the $18000 deposited by Mrs Maphosa,
only $16200 can be lent out by the Standard Bank B with the 10% ($1800)
being retained as reserves. The process goes on until it works itself out. The
total increase in demand deposits or change in demand deposits D is given
by
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D 
1
1
 change in cash reserves or deposits ( R)   $20000
reserve ratio
r
where r is the cash reserve ratio. D 
1
 $20000  $200000 . Therefore
0.1
total increase in demand deposits ( D ) is equal to $200000. From this
calculation changes in deposits can be as high as $200000 from an initial
deposit of $20000. If the reserve ratio increases, it limits the change in
deposits because most of the deposits are kept as reserves and not lent.
Therefore D 
1
 R where R = increase in cash reserves or deposit and r
r
= cash reserve ratio.
1
is called the credit money multiplier (m). It is clear that
r
the individual banks credit creation possibilities are restricted to only a part of
the deposits (or cash reserves) received. What in fact happens is that the
system as a whole, via the credit multiplier, can convert the amount received
in the form of a deposit (R) by a multiple thereof into demand deposits.
Just as a change in the credit multiplier can lead to a change in the level of demand
deposits, a change in the reserves (R) available to commercial banks can also lead to
changes in the Demand deposits. In other words the reserves form the basis on which
credit creation is possible. Any change in this monetary base can therefore give rise to
a much greater change in demand deposits. It must be noted that if banks hold all
deposits in reserve, banks do not influence the supply of money.
Limits to banks to create money will depend on:

Amount of reserves (liquid) assets

Reserve asset ratio

Willingness of people to borrow

Desire of people to hold cash.

What is regarded as reserve asset must be defined by law. The following assets
can however be regarded as reserve assets:
Cash balance with central bank
Foreign exchange
Treasury bills
Gold etc.
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Reserves and Monetary Policy
Although banks normally endeavour to keep only the minimum cash reserves (which
are required by law) with the Central Bank, it can sometimes happen that banks prefer
to keep more than this minimum amount in their current account with the central
bank. (In other words the reserve ratio r can be separated into required reserve ratio rr
and excess (or surplus) reserve ratio rs , that is r  rr  rs ). Excess reserves are bank
deposits with Central Bank (eg. RBZ) over and above statutory reserves
Business conditions may be of such a nature that banks prefer to consolidate their
position rather than to participate in further credit extension. In such circumstances a
lowering of the cash reserve ratio (r) by the authorities (in order to increase M) would
not have the desired effect since banks would prefer to allow excess reserves to
accumulate with the central bank rather than creating demand deposits D. the business
climate reigning in the economy is probably of decisive importance in this case.
- Banks hold excess reserve ratio because
1. Most banks are prudent (prudential banks) and sensible to see whether lending
is profitable.
2. Limited liability of banks to create
M
1
since people may not be willing to
borrow due to high interest rates.
DEMAND FOR MONEY
-
M
-
D
refers to the amount of money held by the general public in an economy.
The main reasons for holding money are:
1. Transactional reason/ motive
2. Speculative motive
3. Precautionary motive.
MONETARY POLICY
What is Monetary Policy?
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It is the use of money or its cost, the interest rate to fine tune some economic variables
such as :

Inflation

Economic growth

Investment

Balance of payments
Objective of monetary policy
In general monetary policy has two major objectives:
1. To reduce inflation (stability objective)
2. To boost economic growth (growth objective)
Instruments / Measures/tools of monetary policy
Monetary policy measures or instruments are used to increase or decrease the amount
of money, depending on the situation prevailing. Each instrument can be used in one
of 2 ways, either to increase or decrease the amount of money in circulation. These
instruments can be classified into the general or quantitative instruments and the
selective or qualitative instruments.
The following are some of common instruments:

Bank rate

Open market operations (general or quantitative)

Rediscount rate (general or quantitative)

Selective credit controls

Moral Suasion (selective or qualitative)

Reserve requirements (general or quantitative)
(general or quantitative)
(selective or qualitative)
General or quantitative instruments
These include open market operations, changes in the minimum legal cash reserve
ratio and changes in the bank or discount rate. These instruments influence the credit
creating capacity of the commercial banks in the economy by operating directly or
indirectly on their excess cash reserves.
Selective or qualitative instruments
The instruments affect the types of credit extended by the banks. They affect the
composition rather than the size of the loan portfolios of the commercial banks. The
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immediate object of imposing the selective credit controls is to regulate both the
amount and the terms on which credit is extended by the banks for selected purposes.
The selective credit control instruments enable the central bank to restrict unhealthy
expansion of credit for specific purposes; without at the same time airing credit
expansion in general.
Use of the Instruments/ Measures /Tools
The instruments are contractionary or expansionary, depending on the liquidity
situation. When there is too much money, monetary tools are used in a contractionary
way. When there is less money, monetary tools are used in an expansionary way.
Bank Rate/ Rediscount Rate
When banks borrow from the Central Bank directly, they are charged a bank rate. An
increase in the bank rate increases lending rates and reduces the amount of money. A
decrease in the bank rate reduces lending rates and increases the amount of money.
When they borrow indirectly through the discount houses, they are charged a
rediscount rate. This is the rate at which the central bank discounts first class bills. It
is a benchmark for commercial bank lending rates.
Open market operations
This is buying and selling of government securities e.g. bonds (TBs). When there is
too much money, the government sells securities to mop up excess liquidity. The
government takes the money and the public holds securities. To reduce money supply,
the government sells bonds to the public which pays with currency (notes + coins in
circulation). This reduces money available for spending. The success of the
instrument depends on whether the public wants to buy bonds or not. To persuade
people to buy bonds, the government raises interest.
When there is inadequate money, the government buys securities. The government
takes the securities and the public holds money. Money is injected into the economy.
Selective credit controls
When there are liquidity problems, the central bank and even banks have preferential
treatment of clients. Credit is allocated to some selected sectors. For example, credit
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can be allocated to export or productive sectors. Sometimes the Central Bank can
ration credit- this involves imposing a ceiling upon its discounts for any one bank or
rejecting a proportion of each discount application whenever total demand for loans
exceeds the amount the central bank is prepared to discount on any one day.
Regulation of consumer credit
The regulation of consumer credit is employed to regulate the terms and conditions
under which bank credit repayable in installments could be extended for purchasing or
carrying the consumer durable goods. The regulation of consumer credit combats
inflation by restricting the aggregate consumer demand for those goods which are in
short supply in industrially developed countries where consumer credit is largely used
to finance domestic purchases. In countries where there is no consumer credit and the
banks do not participate in financing the purchase of consumer durables to any
significant degree, the method cannot be effective in curbing the inflationary
pressures in the economy.
Moral Suasion
It involves direct solicit with the Central Bank. The central bank persuades financial
institutions to be supportive of the prevailing monetary policy stance. When there is
too much liquidity, institutions are persuaded to tighten their credit allocation
systems. When there is a shortage of liquidity, institutions are persuaded to loosen
their credit allocation systems. This measure is not mandatory but persuasive and as a
result it is difficult to influence the currency ratio
c
[c is currency (notes + coins in
D
circulation and D is deposits)] and consequently money supply.
The instrument would succeed only if the commercial banks follow scrupulously the
leadership of the central bank. This will however depend on the strength of the central
bank and the prestige enjoyed by it among the member banks. In countries with
highly liquid monetary conditions and where the central bank cannot undertake open
market operations on a massive scale to counteract the high bank liquidity, it is
advisable for the central bank to use moral suasion.
Reserve Requirements
The reserve requirements are regulations on the minimum amount of reserves that
banks must hold against deposits. When there is too much money, the reserve ratio is
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increased to reduce credit creation. When there is a shortage the reserve ratio is
reduced to increase credit creation so as to increase money supply. The government
can regulate the required reserve ratio
r . r
r
r
 m   M
s
(m is money
multiplier)
Increasing required reserve ratio reduces the lending base. The instrument is not
without its limitations:
(1) If their cash reserves are swollen, commercial banks will not care at all for
the increase in the minimum legal cash reserves ratio requirement unless
the increase is very high.
(2) They might also conduct their operations with a lower cash reserves ratio
if they are optimistic about the future.
(3) A fall in the minimum legal reserves ratio may fail to induce them to lend
in depression because they feel the consumers may not have the capacity
to repay.
A counteracting force may arise from a change in the banking practices. If
percentages of minimum legal cash reserves required to be kept with reserve banks
differ for different kinds of deposits held by banks e.g. with a minimum legal cash
reserves ratio of 10% against the demand deposits and of 3% against the time
deposits, a transfer of bank funds from the former to the latter would enable the banks
to expand credit and to that extent would induce them to disregard the credit
restriction policy enforced by the central bank.
Publicity
Central banks may employ the instrument of publicity in order to publicise the
economic facts in the weekly statements of their assets and liabilities, monthly
bulletins containing review of credit and business condition, and detailed annual
reports stating their operations and activities, the state of affairs of the money market
and banking system and general review of the trade, industry, agriculture, etc. in the
country. By resorting to publicity, the central bank enlists public opinion in favour of
its monetary policy and thereby combats opposition to its policies among political,
financial and business interests. However the method of publicity has the scope of
useful application in industrially advanced countries where public opinion is
enlightened. In the developing countries where people are mostly less educated and
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even those who are educated are not acquainted with the technique of banking the
method of publicity is of little use in controlling credit.
The equation of exchange
This is stated as: MV=PY where M = quantity of money, V= velocity of circulation of
money, P = average (or general) price level and Y= physical quantity of goods and
services produced. The equation says quantity of goods and services (Y) produced
during a year, multiplied by their prices (P), is equal to the money supply (M),
multiplied by the velocity of circulation of money (V). NB. Quantity of money in
circulation is not the same as the income (or GDP) generated in the economy.
According to the equation of exchange, the monetary value of the GDP (PY) is
greater than the value of the quantity of money (M). It is greater than the quantity of
money because the money is used more than once during the year to accommodate the
transactions represented by the GDP. V is therefore an indication of the number of
times the average dollar (either in the form of cash or in that of demand deposits)
changes hands (or circulates) during a given period. The value of V can be derived
from the equation of exchange: MV =PY and  V 
PY
.
M
For example if the money supply (M) is equal to $1000 and Y = 2000 units of
physical products and services and also that the average price of each unit (P) is $25,
 V 
2000  $25 $50000

 50 . This means that each dollar had to be used in
$1000
$1000
transactions approximately fifty times in order to accommodate a GDP of $50000. To
put it into more realistic perspective for Zimbabwe during 1998 provide the following
information
V 
with
regard
to
velocity
of
circulation
of
the
Z$
Nomin al GDP
$148351m

 6.01
Money Supply ( M 1 ) $24669.4m
The equation of exchange formulated above is no more than an identity. By definition
the equation of exchange is an identity and is always true. Value of PY must
necessarily be equal to MV.
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Quantity theory of Money
The equation of exchange was converted by the monetarists into a theory by assuming
that the velocity of circulation of money (V) was relatively constant being
determined by the nature of the banking system, the frequency with which economic
units receive and make payments, the regularity of these receipts and payments and
the payments which are on a money or barter basis. If V is assumed constant, the
supply of money M determines the total money value of purchases made by the
people during any given time period. The Quantity Theory also assumes that money
has no utility of its own apart from the utilities of commodities which money
purchases. People want it only because it acts as the medium of exchange in the
economy (a zero asset or speculative demand for money is a necessary part of the
rigid quantity theory of money). So long as money performs only the medium of
exchange function in the economy, changes in the money supply MV, assuming no
change in the aggregate output, would cause proportionate changes in the level of
prices.
It is accepted that if V is a constant the equation of exchange is converted from an
identity or a definition into a theory because we are then able to forecast or explain
the effect on the nominal value of GDP if the quantity of money changes. This
quantity theory of money says that if the quantity of money changes by a certain
percentage, the monetary value of the GDP (or PY) will change by approximately the
same percentage. In the example given above where V=50 ( V 
$50000
, an increase
$1000
in the money supply from $1000 to $1500 (a 50% increase) would lead to an increase
in PY from 50000 to 75000 provided the velocity of circulation remains constant.
According to classical economists a change in the money supply ( M ) would lead to
a proportional change in the general price level ( P ). On the other hand the
monetarists maintain that M will lead to a proportional change in the nominal value
of income ( PY ). Exactly how P and Y will react individually cannot be
determined with any degree of accuracy. It is nevertheless accepted that in the long
run changes in the money supply are solely responsible for price changes.
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The monetarists therefore argue that an increase in the supply of money in the short
term will mean an excess supply of money. This excess money will increase the
aggregate demand as well as the monetary value of the GDP. By the same token, a
sudden drop in the money supply will lead to an excess demand for money, which can
only be satisfied by curbing expenditure on goods and services. This will cause
aggregate demand to decline and the monetary value of the GDP to be reduced.
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APPENDIX 4A
Determining Money Supply
A. Reserve ratio r 
Re serve Assets
R
=
………………………………………..
D Demand Deposits
(a)
B. Currency ratio c 
C currency (notes and coins in circulatio n)
=
…………….. (b)
D
Demand deposits
In countries like Zimbabwe, the currency ratio is very high because many people keep
notes and coins at home. This is because the banking system can at times be
inconvenient.
C. Money supply Ms=M1………………………………………………………….. (1)
M s  C  D  M 1  M …………………………………………………………… (2)
From (b) M s  cD  D  (1  c) D ……………………………………………….… (3)
D. Monetary base, B= currency notes and coin+Reserve Assets, i.e. B  C  R ….. (4)
from (2) and (3) and (a) B  cD  rD  D(c  r ) …………………………………..(5)
From (5) and making D the subject  D 
B
…………………………………. (6)
cr
But M s  (1  c) D ………………………………………………………………….(3)
Substituting for D from (6) into this equation,
 M s  (1  c) D 
(1  c) B
……………………………………………………...…..(7)
(c  r )
E. If we take
1 c
 m ,……………………………………………………………....(8)
cr
then equation (7) becomes Ms=mB …………………………………….(9)
and m is the money multiplier which is greater than 1 (m>1).
[Remember that the reserve ratio r can be separated into required reserve ratio rr and
excess (or surplus) reserve ratio rs , that is r  rr  rs
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