UNIT 2: MONEY SUPPLY

Contents
2.0 Aims and Objectives
2.1 Introduction
2.2 Types of Financial Institutions
2.3 The Role, Advantage and Supervision of Financial Institutions
2.4 Theory of Money Supply
2.5 Methods of Monetary Control
2.6 Summary
2.7 Answers to Check Your Progress
2.8 References

2.0 AIMS AND OBJECTIVES

The objective of this unit is to communicate the students the sources of money supply and
how money supply in the economy is determined. It also examines the functions of various
tools used to manage the money supply process. After completing this unit students will,
among other things

 identify the various types of financial intermediaries and examine their role and
advantage in the economy.
 understand components of monetary base and the role of money multiplier in the
money supply process
 understand the methods used by monetary authorities to control the level of money
supply in the economy

2.1 INTRODUCTION

This unit discusses the technique and the way money is created in a given economy. In a
primitive economy in which every one knows each other well, there is no need for banks and
other financial institutions to help channel funds from lenders (savers) to borrowers. In a
highly developed economy, however, linking up savers with borrowers is not so easy. Thus

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banks play an important role in ensuring that the economy runs smoothly and efficiently. But
banks need to be supervised since they are transferring savers money to borrowers. Although
banks may be the financial institution we deal with most often in this unit, they are not the
only financial institutions we come in contact with. Non bank financial institutions play an
important in channeling funds from lenders (savers) to borrowers. Accordingly a brief
discussion is made as to how the major non bank financial institutions operate. At last this
unit develops a theory of money supply process by explaining depositor and bank behavior.

2.2 TYPES OF FINANCIAL INSTITUTION

In this section we discuss the various financial institutions. We start with the central bank

Central Bank
It has the monopoly power of issuing notes promote is acceptability among the members of
the public. It enables the government to issue public debt. The central bank carries out
transactions in foreign receipts and payments on behalf of the government. It also acts as a
financial and economic adviser to the government.

The central bank accepts deposits from the commercial banks and lends to them at times of
need. Note however, that central bank is not a profit making institution. That is, it is
established not for making profit but primarily to facilitate the well being of the financial
sector of a given economy. It is obligatory for the commercial banks to maintain a certain
proportion of their demand and time liabilities as cash balances. The central bank can regulate
the credit supply to the economy by altering the cash reserve ratios.

Commercial Banks
Commercial banks are financial intermediaries that accept deposits and make loans, offering
risk-sharing, liquidity, and information services that benefit savers and borrowers.
borrowers. It is the
largest category of depository institutions. Savers obtain risk-sharing benefits from banks'
diversified portfolios of loans; borrowers can obtain needed funds to finance the purchase of
cars, inventories, or plants and equipment. Banks also provide liquidity services through
checking accounts, in which savers' deposits are available on demand.

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Banks have stiff competition from other financial institutions in the provision
provision of risk-sharing
and liquidity services. Today, savers can deposit their cash in a money market fund that
invests, say, in Treasury bills, a transaction that was limited to large savers in the past. Savers
can also purchase a diversified portfolio by buying shares in a mutual fund. However, many
borrowers can't raise funds easily through bond or stock markets or other non-bank financial
institutions.
institutions. Commercial banks thus serve a special function in providing credit to particular
types of borrowers by reducing the transactions and information costs of lending.

Pension Funds
In performing the financial intermediation function funds provide the public with another kind
of protection payments on retirement. Employers, unions, or private individuals can set up
pension plans, which acquire funds through contributions paid in by the participants.
Although the purpose of all pension plans is the same, they can differ in a number of
attributes.

Typically, firms require that an employee work year-s for the company before he or she is
vested and can receive pension benefits; if the employee leaves the firm before the required
period all rights to benefits may be lost. Note that the advantage of pension funds is their role
in channeling this large sum of money into investment activities.

Finance Companies
Finance companies acquire funds by issuing commercial paper or stocks and bonds and use
the proceeds to make loans (often for small amounts) that are particularly suited to consumer
and business needs. The financial intermediation process of finance companies can be
described by saying that they borrow in large amounts but often lend in small amounts—a
process quite different from that of commercial banks, which issue deposits in small amounts
and then often make large loans.

Mutual Funds
Mutual funds are financial intermediaries that pool the resources of many 'small investor's by
selling them shares and use the proceeds to buy securities.
securities. Through the asset-transformation
process of issuing shares in small denominations and buying large blocks of securities, mutual
funds can take advantage of volume discounts on brokerage commissions and purchase
purchase

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diversified holdings (portfolios) of securities. This allows the small investor to obtain the
benefits of lower transactions costs in purchasing securities, as well as the reduction of risk by
diversifying the portfolio of securities held.

Credit Unions
Credit unions have grown rapidly in recent years. They are cooperative organizations often
sponsored by employers, who provide free office space and arrange for payroll deduction
savings plans. Credit unions usually provide consumer loans and mortgage loans to members.
members.

Savings and Loan Associations

Savings and loan associations originated as self-help organizations. A group of people who
wanted to finance their own houses agreed to pool their savings in order to build homes and
other requirements. Savings and loan associations now operate in much the same way as
savings banks.

We can notice from the forgoing discussion is that some of the institution do not exist at all in
Ethiopia and the others are not well developed. (This will be discussed in unit six)

Check Your Progress Exercise 1

1. State and discuss the various types of financial institutions.
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2. What is the difference between central bank and commercial banks?
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2.3 THE ROLE ADVANTAGE AND SUPERVISION OF FINANCIAL INSTITUTIONS

A) Role of Financial Institution

Financial institutions do not produce goods as manufacturing firms do. They do not transport
and distribute goods. So one may ask why we have them? It is because they serve other
important functions. Some institutions make payments for other participants in the economy
and thus facilitate the division of labor. For example, a bank clears checks and provides its
customers with important bookkeeping services when it sends out monthly statements. Others,
such as stockbrokers, bring potential buyers and sellers together.

An important segment of the financial industry is the financial intermediaries,

intermediaries, for example,
savings and loans that while they may clear payments,
payments, do something else too. Some financial
institutions intermediate by obtaining the funds of savers and then, in turn, make loans to
others.

Essentially, financial intermediaries buy and sell the right to future payments.
payments. For example,
someone opening an account at a savings and loan association gives it a sum of money in
exchange for the right to receive a larger sum back in the future. And the savings and loan
then turns around and uses the deposit to make a loan, that is, to make a current payment to
someone else, in return for that person's promise to make payments to it in the future.
This activity of trading in current payments and promises for a future payment is
extraordinarily important. To see this, consider first the extreme case of an economy with no
borrowing and lending at all. In such an economy people would still want to save and invest.
Many would want to defer income from the present to the future, either because they expect
their income to dwindle as they get older, or their needs to rise, or else because they hope to
earn some yield on their savings. But some people would not be able to earn anything on their
savings at all because they lack the opportunity to buy a physical asset that produces income,
and they would not be able to lend to anyone who has this opportunity. At the same time,
those who have the opportunity
opportunity to acquire highly productive physical assets could do so only
to the extent that they cut back on their own consumption. Obviously, such an economy
would be very inefficient.
inefficient.

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Now allow savers and potential investors in physical assets to get together and to "trade."
Savers with no opportunity to invest directly are now able to earn interest on their savings by
lending them to investors. Investors are no longer limited to their own savings in undertaking
such projects. As a result the economy is much more productive. But such borrowing and
lending generate certain costs. Savers and investors face costs in making contact, such as
having to advertise. In addition, savers have to investigate the riskness of each loan, and that
takes specialized knowledge that few people have. As a result, some savers are unwilling to
lend, some potential borrowers cannot finance projects that look risky even if they are really
quite safe, and some savers suffer losses because they cannot differentiate between sound and
unsound loans. Imagine, for example, how troublesome and difficult it would be for you to
make a mortgage loan. You would have to undertake a credit investigation, draw up a loan
document, etc.

Obviously, what is missing in such an economy is the division of labor that occurs when
specialized institutions intermediate between the borrowers and lenders. This is why we have
a system of financial, intermediation.

B) Advantages of Using Financial Institutions

Let us look at the benefits provided by financial
financial intermediaries.
Minimize Cost: We have already mentioned one benefit of using a financial intermediary: it
economizes on the information and transaction costs of borrowers
borrowers and lenders. As a concrete
example, consider a corporation that wants to borrow $10 million. Suppose the corporation
borrow on average $10,000 from a thousand households. Since these households would not
know that this corporation wants to borrow from them, the corporation
corporation would have to seek
them out by extensive advertising. And then it would have to convince them that it is a sound
borrower. A financial intermediary,
intermediary, say, a savings and loan, on the other hand, is set up to
collect the funds of many small depositors. It does not have to let households know that it
wants their funds every time a borrower approaches it for a loan. The public already knows
that it would like its funds. Moreover, since its deposits are insured, the public does not have
to investigate its credit standing. To be sure, the financial intermediary itself has to investigate
the credit standing of the borrower, but a single investigation by an expert is much less costly
than a thousand separate investigations by amateurs.

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Long-Term Loans: A second advantage of financial intermediaries is that they make it
possible for borrowers to obtain long-term loans even though the ultimate
ultimate lenders are making
only short-term loans. Much borrowing is done to acquire long-lived assets, such as houses or
factories. Someone who borrows to buy such assets does not want to finance them with a
short-term loan.

Here is where the financial intermediary comes in. Despite the fact that it has used depositors'
funds to make long-term loans, a bank or a savings and loan association can promise its
depositors that they can withdraw their deposits at any time. If it has many individually small
depositors whose decisions
decisions whether or not to withdraw their deposits are independent of each
other, then it can predict quite well the probability distribution of deposit withdrawals on any
given day and hold small but sufficient reserves to meet such withdrawals. Under normal
conditions, the decision whether or not to withdraw a deposit depends largely on the particular
circumstances of each depositor, for example, his decision to make a large purchase. Hence,
one can, under normal conditions, assume that the decisions of various depositors are
independent of each other, so that the law of large numbers applies. However,
However, this fortunate
state of affairs does not always hold. Suppose, for example
example that the public becomes afraid that
banks or other financial institutions will fail. It will then try to withdraw deposits on a massive
scale. The financial intermediaries will then not have sufficient liquid funds available to repay
these deposits.

Liquidity: Since many claims on financial intermediaries are liquid they should be
distinguished sharply from claims on other borrowers such as those in the bond market. That
is if you have a deposit in a commercial bank, you can get your money back at any time.

Risk Pooling: Financial intermediaries also pool risks. Suppose there are 100 loans made, and
that it is reasonable to expect that 99 of them will be repaid. Every lender is then afraid that he
or she will be the unlucky one. But if the lenders pool their funds, then each lender will lose 1
percent of his or her loan and not more, thus avoiding the small risk of a large loss in
exchange for accepting a more probable small loss. Thus, by pooling the funds of depositors,
depositors,
financial intermediaries reduce the riskiness of lending.

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Do these advantages mean that all finance takes place through financial intermediaries? Of
course not, since they charge a fee for their services, it is sometimes worthwhile for borrowers
and lenders to deal directly with one another. Beyond this, people who want to invest
sometimes do not borrow at all, but reduce their own consumption to avoid either the charges
of a financial
financial intermediary, or the costs of finding a willing lender. This is likely to occur if
the investment project is very risky, so that the potential borrower would have to pay a high
rate of interest to compensate the lender for the risk the lender sees in the project.

C) Government Supervision of Financial Institutions

Financial intermediaries are very heavily regulated by state governments. For example, one
cannot just start a bank the way one can start another business. Instead, a prospective bank
organizer must obtain special
special permission. Moreover, various government agencies supervise
banks and financial intermediaries
intermediaries by inspecting the assets they hold and requiring them to get
rid of risky ones.

What are the reasons for government supervision of banks? The first reason is consumer
ignorance. For competition to work effectively the buyer must be able to evaluate the quality
of the product with some degree of efficiency.
efficiency. Otherwise, various producers could succeed by
offering a defective product at a low price. Consumers can evaluate most products in either, or
both, of two ways. One is through experience. They buy, say, a bar of soap advertised. If they
don't like it not much is lost. The other way is by evaluating the product before purchase.

Unfortunately, neither method works well for deciding whether to buy the deposit services of
a financial intermediary. The foremost characteristic most households look for in a financial
intermediary is that it be safe and not fail. But experience provides little help here. Once a
bank has failed, depositors
depositors know that they should not have entrusted their funds to it, but by
then it is too late.

The other method of evaluating a product, inspecting whether, it is good or not, does not work
for financial intermediaries. Extensive effort and technical knowledge are required to evaluate
the soundness of a bank or other financial intermediary. Just looking at the balance sheet
won't do. Depositors cannot tell whether the item listed as "loans" consists of loans to sound
or risky borrowers.

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Some mechanism is obviously needed to prevent financial intermediaries from taking too
much risk. One possibility would be extensive consumer information. Thus, in principle,
depositors could subscribe to reports, written by accountants and financial analysts that
evaluate banks and other financial intermediaries.

Another way to protect the depositor is to insure deposits. One possibility

possibility would be to have
banks or the other financial intermediaries insured by private insurance companies, but there
would be the danger that if many large institutions fail, so would the insurance company. But
the government can prohibit them from buying certain risky assets.

A more important, reason for government supervision of depository institutions is that they
create the major pan of our money supply. Thus a wave of bank failures could wipe out a
significant proportion of the money stock. Suppose that massive bank failures did reduce the
supply of money. With the money supply now being smaller it would no longer suffice to buy
all the goods and services offered on the market. Production would be curtailed and
unemployment would rise, perhaps substantially so.

In addition to this even sound, well-run banks would be in danger of failing when some other
banks that took too much risk go under. The public cannot distinguish very well between
sound and risky banks. The cost of being caught in a bank failure greatly exceeds the cost of
withdrawing a deposit. Hence, in the absence of government supervision and insurance, when
the public sees some banks fail it is likely to withdraw deposits from other banks too. Such
runs may destroy well-run and safe banks.

Check Your Progress Exercise 2

1. Discuss some of the roles of financial institutions
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2. Mention and explain three roles of financial institutions
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3. What is the rationale of supervising commercial banks by the central bank
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2.4 THEORY OF MONEY SUPPLY

It is generally believed that the supply of money is created, regulated and con trolled by the
monetary authority of the country. But this is not correct. Money supply, in any country, is
determined by all the players of the game. These are the central bank, the commercial banks,
the government and the public. The recent trend is also, to include financial intermediaries,
other than commercial banks, as a source of money supply. Changes in the money supply,
therefore, are brought about by the actions of all these players—the central bank creating the
legal tender money or currency and commercial banks and other financial intermediaries
intermediaries
creating demand deposits.

Legal tender money comprising of paper notes and coins, is the most important constitutes of
the total money supply. The authority to issue paper notes and coins generally rests with the
central bank. The monetary authority has, therefore, completed control over the supply of
legal tender money. Paper money is issued by the monetary authority according to the
requirements of business and trade. The expansion or contraction of paper currency, therefore,
largely depends upon the actual needs of the economy, i.e. the financial needs of the
government, business community, households and the general business outlook.

In advanced industrialized economies, owing to the developed banking habits of the people, a
major portion of the total supply of money is in the form of deposit money, i.e. demand
deposits in banks. Demand deposits can be either primary or derived. Deposits created out of
cash deposited by individuals in their bank accounts are primary deposits, while those created
by the banks through the advance of loans investments, etc are derived deposits. An increase
in the demand deposits does not increase the total money supply because the cash available
with the people is merely transferred to the bank in the form of deposits. The primary deposits
can certainly form a basis for the expansion of credit by banks, i.e. for the creation of derived
deposits. In this way, the derived deposits certainly lead to increase in the money supply. For

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example let commercial bank X lends 100 birr (which was deposited by an individual) to a
certain borrower. Suppose that this borrower used the money to purchase goods and services.
If the firm that sold the goods make a deposit in a bank where the bank will lend it to some
other firm/or individual and so on; the banks are creating derived deposits that increase the
money supply.

In discussing the theory of money supply, one of the important concept is the Monetary Base.
The monetary base is comprised of the monetary gold stock, other types of money issued by
the government and the amount of the central bank credit outstanding. The monetary base (B)
is generally considered as the high-powered money (H), which is the total of the quantity of
paper currency and coins in the hands of the people (C) plus the actual bank reserves (R).
Therefore,
B = C + R.

The relative amount of cash and deposits that the people wish to hold is another determinant
of the money supply in the economy. If the people want to hold a larger portion of their
wealth in the form of deposits then a larger portion of the monetary base will be passed to the
banks and they will create more deposits by giving loans and advances as discussed above.
Thus, the total money supply would increase. However, people’s choice for holding larger
cash or larger deposits will depend upon the stage of development of the banking system in
the country, banking habits among the people and the degree of monetization of the economy.
The ration between bank reserves and deposits is another determinant of the money supply in
the economy. The higher the ratio of reserves and deposits, the smaller would be the amount
of demand deposits to be supported by a given quantity of reserves.

Ordinary money (M) is the sum of total currency and coins (C) held by the community and
demand deposits banks (DD). Therefore, M = C+DD. As explained earlier high powered
money (H) is the money produced by the government/central bank and held by the
community and banks. It is, therefore, the total of (i) currency held by the community (C); and
(ii) cash reserves of banks. Note that there are two kinds of reserves. These are required
reserves (RR) and excess reserves (ER). Required reserve refers to what each commercial
bank is required to keep some percentage of their deposit in the central ban. Excess reserve on
the other hand refers to any excess amount of money that commercial banks hold.

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Thus,
H= C+R
H = C+RR+ER. ………………………. (2.1)
An understanding of the difference between M and H is of vital importance for understanding
the theory of money supply. Demand deposits are money, like currency. These are created by
banks. For creating these deposits banks have to maintain reserves which are a portion of H
and provide H the power of forming the basis for the creation of demand deposits. That is
why, H is also known as “base money” We have seen that currency (C) is common to both M
and H, the only difference being that whereas demand deposits are a component of M,
reserves are a component of H. Since demand deposits are a certain multiplier of reserves,
which are the component of H, many multiplier ratio is the ratio of M to H. The relation ship
between M and H can be explained symbolically as follows

…………………… (2.2)

Banks demand for reserves depends largely upon the volume of their deposits. It is affected
by the same factors which affect the demand for currency.
If in the above equation we divide each denominator and numerator by D then

……………………..(2.3)

Since the demand for reserves and demand for currency are both affected to a very great
extent by the same factors, such as the level of income and the rate of interest, besides other
factors, it can be safely assumed that the two demands are highly co-related. The demand for
H can thus, be expressed as a function of D and two behavior ratios namely ratio of demand
for currency to deposits (C/D or simply Cr) and the ratio of reserves to deposits of banks (R/D
= RR/D + ER/D or more simply RRr + Err).

Substituting Cr for C/D, Rr for RR/D, Err for ER/D, the above equation can be as follows:

………………………… (2.4)

On the basis of the above equation we can now express M as follows:

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 ………………………….. (2.5)

It is therefore clear that the money supply is determined by H, Cr, RRr and ERr. If the volume
of Cr, RRr and ERr is low, the volume of money supply would be higher and if it is high then
the volume of money supply would be lower. A high volume of H will mean a higher volume
of M. So, the value of the money multiplier
multiplier (m) can be derived at

……………………………. (2.6)

The excess reserve ratio, Err that banks want to hold depends, on the one hand, on the interest
rate that banks could earn by investing these excess reserves, and, on the other hand, on the
benefits that banks expect to obtain from holding them.

The public's desired currency to deposit ratio Cr depends on the opportunity cost of holding
currency, as well as on the interest rate paid on securities. If interest rate rises the public will
switch to securities. But people are much more likely to treat their additional security holdings
as a substitute for deposit holdings than as a substitute
substitute for currency holdings. Hence, as they
buy securities they reduce their deposits. This raises the ratio of currency to deposits rises.
The currency to deposit ratio also depends on income or wealth, because these variables
measure the extent to) which people can afford to forgo earning interest on deposits or
securities to obtain the convenience of holding currency, and on retail sales, which is
performed by currency. Some economists believe that the currency to deposit ratio (Cr) also
varies with tax rates because in transactions where taxes are evaded it is safer to use currency
than checks, which leave records. Another factor influencing the currency ratio is the rise in
the illegal transactions in which payment is made by currency and not by check.

Thus, income, wealth, and interest rates are factors determining Err Cr and hence the money
multiplier. As income rises and interest rates increase, one would expect Err to decline
somewhat. But since it is already small to start with, this does not make much difference. At
the same time, with income and retail sales as well as interest rates on securities all rising, Cr
rise too.

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Hence, the deposit multiplier is partly endogenous, that is, affected by income, so that, even if
the Fed keeps bank reserves constant, the stock of money tends to rise as income increases,
and fall as income falls—in other words, to behave pro-cyclically.

Variations in the Money Supply

The changes in the money supply can obviously be made by those who create and also by
those who use it. We can, therefore, analyze the factors affecting the money supply under two
heads, the government or the government sector and the community,
community, the foreign sector or the
private sector.

The government influences the money supply through its budget. In the case of deficit budget,
the government can borrow from the central bank or sell securities to the banking system.
These transactions would lead to an increase in the financial
financial assets of the banking system and
cause an increase in the money supply. The government can also meet the deficit by drawing
its balances from the central bank. This will also increase the money supply. The government
can also draw upon the balances in the treasuries but this will also have the same effect as
drawing
drawing the balances from the central bank. The government can also meet the deficit by
printing more notes or by resorting to deficit financing. It also leads to an expansion of
currency which will increase the deposits in the bank and lead to further expansion of money
supply. A surplus budget of the government will affect the money supply in the reverse
direction.

The government sector's transactions with the foreign sector can also affect the money supply.
If the government has a deficit in its external transactions then some of the measures adopted
for meeting this deficit will have no effect on the money supply but some others may produce
some effect. If the government makes use of the account it has draws upon its balances with
the central bank for purchasing foreign exchange the total money supply will not be affected.
If the deficit in external payments occurs on private account the government will sell foreign
exchange to the private importers, which will reduce, the amount of currency held by the
people and the total money supply will be reduced.

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The private sector can influence the supply of money in three ways: (i) through purchase/sale
of shares and securities from/to the banks; (ii) through variations in loans and advances from
banks; and (iii) through variations in the net non-monetary liabilities of banks (through
purchasing/selling government securities). If the private sector takes more loans and advances
from the banks or sells shares and securities to the bank then the total money supply would
increase. The opposite will happen in the reverse situation. In addition to this the central bank
can influence the money supply by changing the reserve requirements of the commercial
banks and by using various credit control methods. But the central bank can succeed only
when the money market is well-developed and well-organized and all the financial institutions
are under its control.

It is thus clear that the transactions of the banking system with the government -
sector, or the domestic sector and the foreign sector can create changes in the total
money supply in the economy.

Check Your Progress Exercise 3

1. What is monetary base (high powered money)?
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2. Write notes on (a) money multiplier (b) cash reserve ratio.
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3. Differentiate between required reserve and excess reserve.
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4. The supply of money is determined by many factors as stated under equation 2.5.
Explain the impact of each variables on the money supply.
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5. The government influences the money supply through its budget. Discuss
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2.5 METHODS OF MONETARY CONTROL

So far we have examined the sources of money supply. This sub section discusses the
methods (tools) used by the central bank to control (or adjust) the money supply in the
economy. Manipulating any of the following is part and parcel of monetary policy tools of
the central bank (or the government)

A) Open market operations

Open-market operations are the prime tool of monetary policy for several reasons. First, the
central bank can buy or sell government securities to set the size of reserves. This tool is
always strong enough to do the job in developed economies where the financial sector is well
developed. Second, open-market operations occur at the initiative of the central bank, unlike
bank borrowing where the central bank can only encourage borrowing but has no precise
control over the volume involved. Third, open-market operations can be carried out in small
steps, very small ones if need be. This allows the central bank to make exact adjustments in
reserves. Fourth, open-market operations enable the central bank to adjust reserves on a
continuous basis. Finally, open-market operations are easily reversed.

B) The Discount Rate

The discount mechanism is a device by which institutions that are required to keep reserves
with the central bank can borrow from it. It serves several functions. One is to fulfill the
central bank function of last resort. If many depository institutions are short of liquidity, then

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the discount mechanism has to be supplemented by extensive open-market purchases, but
even then the discount mechanism is useful in channeling funds to those institutions that are
particularly vulnerable. Second, the discount mechanism provides a way for the central bank
to provide temporary liquidity to a particular institution that is in difficulty. Third, by
changing the discount rate the central bank can encourage or discourage borrowing, and this is
one way it can change the volume of reserves.

Note that commercial banks are not supposed to borrow for the sake of reinvesting the funds
at a profit, but only in case of need. The central bank tries to enforce this provision by
scrutinizing the activities of borrowing institutions. But the prohibition against borrowing for
profit is vague, and hence hard to enforce. For example, suppose a bank buys securities to
increase its interest earnings, even though it knows that it may soon experience a deposit
outflow. Then, when this deposit outflow does occur, and the bank is short of reserves, it
borrows from the central bank. Is it borrowing for “need” or for “profit”? What the central
bank can enforce is checks over how frequently and for how long a bank borrows. Hence the
Fed has set out specific limitations on the quantity and frequency of borrowing by individual
banks.

When banks do borrow they are under pressure to repay. The central bank believes that when
a borrowing bank obtains additional funds its first priority should be to repay these loans, and
not to buy securities or make loans. Whether banks actually behave this way is a disputed
issue. It may depend on how much-and for how long-they borrowed.

The central bank varies the interest rate it charges borrowing institutions. Thus it can induce
banks and other financial institutions to increase or to reduce their borrowing, and can change
reserves in this way. But the volume of reserves involved is usually small compared to the
change that results from open-market operations.

C) Reserve-Requirement Changes
This was first introduced by the Federal Reserve Bank (the central bank of USA commonly
known as the 'Fed') in 1935 when the 'Fed' was empowered to prescribe the minimum reserve
requirements for commercial banks to counteract the impact of a large inflow of gold and
foreign exchange within the economy. Given the amount of excess liquidity, the Fed regarded

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the manipulation of discount rate policy and OMO as inadequate and a new policy had to be
invented to mop up the express liquidity.

Raising the reserve requirement affects the money stock in two ways. First, previously excess
reserves of banks are now transformed into required reserves. Second, recall that the reserve
ratio is one of the components of the denominator in the money multiplier. Hence, a rise in the
reserve ratio lowers the money multiplier, and thus lowers the deposit expansion that banks
can undertake on the basis of their remaining excess reserves. Given the wide range within
which the Fed can change reserve requirements it has a potentially powerful tool here. But,
despite its strength, the Fed uses the reserve-requirement tool infrequently.

D) Selective Controls
The tools discussed so far operate on aggregate demand by changing reserves,' and interest
rates, and thus affect the whole economy. By contrast, "selective controls" have their initial
impact on specific markets that some economists think are relatively insulated from the
effects of overall monetary policy. These controls are also designed to focus on trouble spots
where demand may be excessive.

E) Moral suasion
Another tool is moral suasion. This simply means that the central bank uses its power of
Persuasion to get banks, or the financial community in general, to behave differently. Since
the interests of the central bank frequently coincide with the long-run self-interest
self-interest of financial
institutions, this form of control may in certain cases be more effective than appears at first.
For example, during an inflationary expansion, the central bank may urge lenders to be more
cautious in their loan policies, and lenders may treat this as sound business advice from
someone who can forecast business conditions better than they can. To be sure, sometimes
banks and other institutions may feel that the stress is more on the “suasion” than on the
“moral

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Check Your Progress Exercise 4
1. State and explain the various methods of monetary control.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
2. What is the difference between selective control method of monetary control from the other
methods explained in question number 1.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

2.7 SUMMARY

In this unit we have discussed issues related to the money supply process. In this regard we
have examined the various types of financial intermediaries that are important in affecting the
money supply in a given economy. Financial intermediaries give benefits to the economy at
large. That is, they minimize cost of fund transferring and provide long term loans. Moreover,
financial intermediaries pool risks. Financial intermediaries are very heavily regulated by
governments. This is due to many factors like consumers ignorance. Besides to this
supervision is needed since depository institutions create the major pan of our money supply
and well-run banks would be in danger of failing when some other banks that took too much
risk go under.

When it comes to the money supply theory we pointed out that money supply, in any country,
is determined by the central bank, the commercial banks, the government and the public. The
monetary base is generally considered as the high-powered money, which is the total of the
quantity of paper currency and coins in the hands of the people plus the actual bank reserves.
On the other hand ordinary money is the sum of total currency and coins held by the
community and demand deposits banks. Moreover, we have seen how the change in this
variable affects the money supply process.

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2.8 ANSWERS TO CHECK YOUR PROGRESS

Answer to check your progress 1

 The answer for each questions is well discussed in the text

Answer to check your progress 2

 Refer section 2.2 for a detailed discussion to the questions

Answer to check your progress 3

 The answer is discussed in the text

Answer to check your progress 4

 The answer is discussed in detail in the text

2.8 REFERENCES

 Laidler, D (1990), Taking Money Seriously and Other Essays, Phillip Allan, New
York

 Bain, Andrew (1992), Economics of Financial System, Oxford

 Mishkin, F.S. (1986) The economics of Money, Banking and Financial Markets, Little
Brown and Company, Boston

 Stiglitz, Joseph (1997), Principles of Macroeconomics, W. W Norton & Company,

New York

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