BFM 412 Monetary Theory and Policy (2) - 1

DEPARTMENT OF ACCOUNTING & FINANCE
COURSE CODE: BFM 412
COURSE TITLE: Monetary Theory and Policy
BY: Mr. MBURU PETER
Cell phone No.:0723135375
Email address:mbgipe@yahoo.com
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COURSE DESCRIPTION
BFM 412: MONETARY THEORY AND POLICY
Contact hours: 42
Pre-requisites: BFM 311
Purpose: To Introduce the learner to both governments‟ monetary and fiscal policies and
implication on economic performance.
Expected learning outcomes of the course

By the end of the course unit the learners should be able to:-
I. Describe the role of money in the economy
II. Describe financial markets, financial instruments, and financial institutions
III. Explain the determinants of money supply
IV. Describe the Keynesian theory and its application
V. Explain expectation theories and rational expectation relate to market efficiency.
Course content
Introduction: the role of money in the macro-economy; Central Banking and conduct of
monetary policy; Tools of monetary policy; Bank reserves and money supply; Determinants of
the money supply; Monetary theory; The demand for money; the Keynesian framework; The
AS-AD model; Money and inflation; rational expectations: theory and implications.
Teaching / learning Methodologies: lectures and tutorials; group discussion; demonstration;
individual assignment; case studies.
Instructional materials and equipment: projector; test books; design catalogues; computer
laboratory; design software; simulators
Course Assessment
Examination -70%
Continuous Assessment Test (CAT) -20%
Assignments -10%
Total 100%
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Reference
Baye M. R. and Dennis W. J (1995) Money, Banking & Financial Markets; An Economic
Approach. Houghton Mifflin Company. USA
Carl E. Walsh, (1998), Monetary Theory and Policy, The MIT press
Culthbertson k. (2005), The Supply and Demand for Money, Basil Blackwell
Harris L (2004), Monetary Theory, McGraw Hill
Mankiw N. G. and Mark P. T. (2006) Economics, Thomson Learning, UK.
Shekhar K. C. &Lekshmy S. (2007) Banking Theory and Practice, 20TH edition, New Delhi,
India
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Contents
COURSE DESCRIPTION.................................................................................................................................... i
Course content........................................................................................................................................... i
Reference .................................................................................................................................................. ii
CHAPTER ONE (WEEK ONE) .......................................................................................................................... 1
MONEY AND BANKS ...................................................................................................................................... 1
INTRODUCTION ......................................................................................................................................... 1
1.1 Money ............................................................................................................................................. 1
1.2 Functions of money......................................................................................................................... 2
1.3 Physical properties of money.......................................................................................................... 5
1.4 Review questions ................................................................................................................................ 6
Reference: ................................................................................................................................................. 6
CHAPTER TWO (WEEK 2&3) .......................................................................................................................... 7
FINANCIAL MARKETS, FINANCIAL INSTITUTIONS AND FINANCIAL INSTRUMENTS ...................................... 7
2.1 Financial markets ................................................................................................................................ 7
Classification of financial markets ........................................................................................................ 7
2.2 Financial instruments........................................................................................................................ 10
Money market instruments ................................................................................................................ 10
2.2.2 Capital market instruments ....................................................................................................... 15
Review questions .................................................................................................................................... 17
Reference: ............................................................................................................................................... 17
CHAPTER THREE (WEEK 4&5)...................................................................................................................... 18
MONEY DEMAND AND MONEY SUPPLY ..................................................................................................... 18
3.1 Money demand ................................................................................................................................. 18
3.1.2 The classical view of money demand......................................................................................... 18
3.1.2 Keynes’s view of money demand .............................................................................................. 21
3.2 Money supply.................................................................................................................................... 22
100-percent reserve banking .............................................................................................................. 23
3.2.2 Fractional-reserve banking ........................................................................................................ 24
3.2.3 A model of the money supply ........................................................................................................ 27
Reference: ............................................................................................................................................... 30
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CHAPTER FOUR (WEEK 6)............................................................................................................................ 31
MONEY AND INFLATION ............................................................................................................................. 31
4.1 Difference between inflation and economic growth ........................................................................ 31
4.2 The price level and real output ......................................................................................................... 31
4.2.1 Measuring the price level ...................................................................................................... 31
4.2.2 Measuring nominal and real output .......................................................................................... 32
4.3 Inflation and economic growth......................................................................................................... 32
Inflation ............................................................................................................................................... 33
4.3.2 Economic growth ....................................................................................................................... 33
The relationship between inflation and economic growth .................................................................... 33
4.5 Causes of inflation............................................................................................................................. 34
4.5.1 Growth in the money stock........................................................................................................ 34
4.5.2 Velocity and economic growth .................................................................................................. 34
Reference: ............................................................................................................................................... 36
CHAPTER FIVE (WEEK 7&8) ......................................................................................................................... 38
CENTRAL BANKING...................................................................................................................................... 38
5.0 Introduction ...................................................................................................................................... 38
5.1 What are the main functions of a central bank? .............................................................................. 38
5.2 Major macro-economy policies ........................................................................................................ 40
5.3 Monetary policy ................................................................................................................................ 41
5.4 Monetary policy functions of a central bank .................................................................................... 42
5.4.1 Monetary policy objectives ........................................................................................................ 42
5.4.2 Instruments of monetary policy................................................................................................. 45
5.5 Why do banks need a central bank? ................................................................................................. 50
5.6 Should central banks be independent? ............................................................................................ 51
5.7 REVIEW QUESTIONS.......................................................................................................................... 52
Reference: ............................................................................................................................................... 52
CHAPTER SIX (WEEK 9 &10) ........................................................................................................................ 53
AGGREGATE DEMAND (AD) AND AGGREGATE SUPPLY (AS) ...................................................................... 53
6.1 The model of aggregate supply and aggregate demand .................................................................. 53
6.1.1 Aggregate demand (AD)............................................................................................................. 54
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Why the aggregate demand curve slopes downward? ...................................................................... 55
Why the aggregate demand curve might shift? ................................................................................. 56
6.1.2 Aggregate supply ........................................................................................................................... 58
The Aggregate supply curve................................................................................................................ 58
Why the aggregate supply curve is vertical in the long-run? ............................................................. 59
Why the long-run aggregate supply curve might shift?...................................................................... 59
Why the aggregate supply curve slopes upward in the short-run...................................................... 61
6.2 REVIEW QUESTIONS.......................................................................................................................... 62
Reference: ............................................................................................................................................... 62
CHAPTER SEVEN (WEEK 11 &12)................................................................................................................. 63
ANALYSIS OF SHIFTS IN AGGREGATE DEMAND AND/OR AGGREGATE SUPPLY...................................... 63
7.1 THE EFFECTS OF A SHIFT INAGGREGATE DEMAND........................................................................... 63
What should policymakers do when faced with such recession? ...................................................... 64
7.2 THE EFFECTS OF A SHIFT IN AGGREGATE SUPPLY............................................................................. 64
What should policymakers do when faced with stagflation? ............................................................. 65
7.3 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND ............................ 66
7.3.1 How monetary policy influences aggregate demand. ............................................................... 67
The theory of liquidity preference ...................................................................................................... 67
7.3.2 Equilibrium in the money market .................................................................................................. 69
7.4 THE DOWNWARD SLOPE OF THE AGGREGATE DEMAND CURVE ..................................................... 69
Reference: ............................................................................................................................................... 71
CHAPTER EIGHT (WEEK 13) ......................................................................................................................... 72
THE IS-LM MODEL AND AGGREGATE DEMAND.......................................................................................... 72
8.0 Introduction ...................................................................................................................................... 72
8.1 The IS-curve....................................................................................................................................... 72
Factors that shifts the IS-curve ........................................................................................................... 73
8.2 The LM-curve .................................................................................................................................... 74
Factors that shift LM-curve: ................................................................................................................ 75
8.3. General equilibrium ......................................................................................................................... 75
8.4 IS-LM model and aggregate demand ................................................................................................ 75
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Reference: ............................................................................................................................................... 76
CHAPTER NINE (WEEK 14)........................................................................................................................... 78
FORMATION OF FUTURE EXPECTATION ..................................................................................................... 78
9.0 Introduction ...................................................................................................................................... 78
8.1 Three theories of expectation formation ......................................................................................... 78
MARKOV EXPECTATIONS .................................................................................................................... 79
ADAPTIVE EXPECTATIONS ................................................................................................................... 79
RATIONAL EXPECTATIONS................................................................................................................... 80
8.2 Rational Expectation and the Efficient Market Hypothesis .............................................................. 81
Reference: ............................................................................................................................................... 81
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CHAPTER ONE (WEEK ONE)
MONEY AND BANKS

OBJECTIVES
At the end of this chapter a student should be able to:
 Define money and differentiate money from income and wealth

 Clearly explain the functions of money
 Clearly discuss physical properties of a commodity used as money.
INTRODUCTION
Money and banking are two subjects closely intertwined with our daily lives and with the very
day functioning of our economy. On atypical day, you encounter money and banks in many
firms like from the obvious contact made when you use shillings to buy lunch or go to the bank
to withdraw funds to the almost invisible contact via the investment of your school‟s
endowment.
Money and banks, and the financial system as a whole, play a vital role in the national economy.
The total quantity of money in the economy and the rate at which the quantity grows over time
has important implications for interest rates, inflation rates, and the economy’s overall
functioning.
1.1 Money
Money is anything generally accepted as a medium of exchange. A medium ofexchange is
virtually anything used to pay for goods and services or settle debts. Thus, the distinguishing
feature of money is that society widely accepts it to settle transactions. Throughout the history of
humankind, numerous things have served as money, including shells, stones, and beads, sacks of
grain, gold, cigarettes, paper bills and checks. Money is not synonymous with wealth or income.
An individual’s wealth refers to the stock of assets the individual owns, less his or her debts. For
example, your wealth includes the total value of your holdings of real estate, stocks and bonds,
cash on hand, money deposited in banks or other financial institutions, cars and even textbooks,
minus the amount you owe to others. In contrast income refers to a flow of earnings over some
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given time interval, say, a week, month or year. Your wealth is like an “inventory” of everything
you own minus debts owed to others while your income represent the “change” in the inventory
that occurs during a given time period.
1.2 Functions of money

Having an overview of what money is and recognizing the distinctions among money, income,
and wealth. We now examine four roles of money in an economy. Money serves as:
i. A medium of exchange
ii. A unit of account
iii. A store of value
iv. A standard of deferred payment
i. Medium of exchange
The primary function of money in an economy is to serve as a medium of exchange. This simply
means that when you buy goods, serves or financial instruments (such as stocks and bonds), you
pay with money.
It is hard to envision/imagine life without money as the medium of exchange. Imagine a barter
economy i.e. an economy that has no money in which goods are traded directly for other goods.
If a baker wants shoes, it is not enough to find a shoemaker but the baker must find a shoemaker
willing to trade shoes for bread. Barter transaction requires a double coincidence of wants i.e.
each individual must have something the other desires. If this happens, exchange will take place.
The shoemaker will get bread and the baker will get shoes. But if the baker does not want shoes,
or vice versa, no exchange will take place. In this case, the two parties will have to continue to
search for someone who wants what they have for trade.
Thus, we see that barter is highly inefficient, since the baker would have to spend considerable
time searching for someone willing to accept breads as payment for some other good. This
search time is a transaction cost. i.e. cost borne in making an exchange.
When money is used as the medium of exchange, the baker can use money to buy shoes from the
shoemaker even if the shoemaker does not want bread the shoemaker, in turn can use the money
received to buy whatever he or she desires from the third party.
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In monetary economy all individuals find money useful because money satisfies the double
coincidence of wants. Therefore, one main advantage of a monetary economy (an economy that
uses money as a medium of exchange) is that it eliminates the problem of finding a double
coincidence of wants, that is, it reduces the transaction costs of exchange.
ii. Unit of account
Money serves as a unit of account i.e. the values of goods and services are stated in units of
money, just as time is measured in minutes and distance in fact. Accountants record the revenue
and costs of companies in terms of money. Similarly, individuals budget their expenditure and
income flows in terms of money.
In a monetary economy, the medium of exchange nearly always also serves as the unit of
account. Because the medium of exchange is common to virtually all transaction, it is convenient
to state the price of goods and services in terms of the medium of exchange. In Kenya the unit
account is the Kenya shilling, which is also the medium of exchange.
The use of money as the unit of account reduces the amount of information individuals need to
make purchase decisions. In monetary economy prices are quoted in terms of the unit of account
(is it dollars, shillings or yen). If there are 1,000 goods for sale, there are 1,000 prices one for
each good. Each price specifies how many units of money must be given up to receive one units
of each good.
In the absence of a common unit of account, there would be more price than goods in the
economy. To see this imagine you live in a simple barter economy with only four goods; apples,
oranges, shoes and bread. Apple sellers would have to quote three different prices. One price tag
would indicate how many oranges it takes to buy an apple, a second price tag would state how
many pairs of shoes it takes to buy an apple and third price tag would reveal how many oranges
it takes to buy apple. Similarly other sellers will have to quote third prices.
If millions of goods were available, as in our economy, there would be millions of price tags to
put on each item. It would be costly to figure out whether you could afford to buy an item when
each item had millions price tags
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In a monetary economy we use money as unit of account and each good has a single price tag.
The presence of money as a unit of account reduces the amount of price information you need to
buy goods in the market place, and this too reduces the transaction cost associated with
exchange.
iii. Store of value
Money serves as a store of value, that is, it is a means of storing today‟s purchasing power
to purchase, say, a house or a car tomorrow. In the absence of money or other assets as a store of
value, individuals and companies would have to maintain stocks of goods to use to trade in the
future. This approach would be inefficient for two reasons:
1. Some commodities, like fruit and milk are perishable and would be of little or no
value if stored for future use.
2. Even when a commodity is not perishable, a car for instance, it can be very costly to
use it to store value over time. General motors‟ would find it very costly to maintain
inventory of extra cars to pay their workers. General motor workers, in turn, would
find it useless to be paid with engine parts or transmissions, for they would have a
difficult time finding someone willing to accept an engine part or a transmission as
payment for food or housing.
Money is not the only store of value. Indeed, other assets such as savings accounts, stocks and
bonds are often better stores of value than money. These assets pay interest or dividends,
whereas currency and many checkable deposits do not. Thus, while money provide a convenient
store of purchasing power, it is not wise to use money as a store of value over long periods of
time. However, money is unmatched by others assets in its liquidly which gives it an advantage
over other assets as a temporary store of value.
Liquidity is a term economist use to describe how cheaply and easily an asset may be converted
into a medium of exchange.
iv. Standard of deferred payment
Money serves as a standard of deferred payment; that is, a payment that is differed to the future
is usually stated as a sum of money. For example, if you owe money to a friend and plan to pay it
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back in a week, you usually state the amount you owe in money terms. In the absence of money,
you would have to plan on making payment in term of some other good. Having a common
standard for deferred payments, which is the same as the medium of exchange and unit of
account makes it relatively easy to determine exactly how much a deferred of payment will be.
There are efficiencies in thinking of payments today and payment tomorrow or next year in
terms of a common item, money. However, money is a standard of deferred payment, but not
necessarily the best standard for all purposes.
1.3 Physical properties of money

The following are properties which make a commodity a good choice to serve as money:
i. Money should be portable

ii. Money should be divisible
iii. Money should be durable
iv. Money should be of recognizable value
i. Portability
For ease of use in transactions, money should be portable. The easier it is to carry around, the
more effective it is as a medium of exchange. Thus, commodity money should generally be a
substance that is valuable in small quantities. This explains why early humankind quickly turns
to gold and silver and no lead as form of money.
ii. Divisibility
To permit transaction of various sizes, money should be made of a commodity that is divisible
into smaller units to facilitate making “change”. Gold and silver also serve well in the respect,
since small coins can be minted to facilitate small transactions.
iii. Durability
Money should be durable, i.e. it should not wear out in use and should not depreciate quickly
when not in use. Gold and silver also meet this criterion.
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iv. Recognizable value/ It must be widely accepted
Money should have easily recognizable value, i.e. it should be easy for people engaged in
exchange to agree to the value of the good used as money. Part of the motivation for coining
gold was to provide this property. In the days of gold coins were stamped with a face value equal
to the value in weight of the gold they contained. In addition, each coin was stamped with the
seal of the government or the face of the king as a guarantee of the coin‟s authenticity and
weight. This practice made it difficult for unscrupulous individuals to snip/slice off portions of
gold or manufacture “counterfeit” money. It also reduced the uncertainly regarding whether a
particular coin was indeed worth the value stated by the individual wishing to exchange it, thus
increasing the acceptability of gold coins as payment.
1.4 Review questions

i. What is money?
ii. Explain the functions of money in the economy.
iii. Describe the properties of a commodity that can be used as money.
Iv Money is used as a store of value but this function is inefficient.Discuss
V Why would any economist not take money to mean wealth or income
Reference:
Baye M. R, and Dennis W. J (1995) Money, Banking & Financial Markets; An Economic
India
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CHAPTER TWO (WEEK 2&3)
FINANCIAL MARKETS, FINANCIAL INSTITUTIONS AND FINANCIAL

INSTRUMENTS
OBJECTIVES
At the end of the chapter, a student should be able to:
 Define financial market

 Discuss various methods of classifying financial market
 Distinguish between money market instruments and capital market instruments
 Calculate yield on financial instruments
2.1 Financial markets

Financial market are institutions or arrangements that facilitate the exchange of financial assets,
including deposits and loans, corporate stocks and bonds, government bonds, and more exotic
instruments such as options and futures contracts. They are mechanism in our society for
converting public savings into investments such as buildings, machinery, infrastructure and
inventories of goods and raw materials. This enables the economy to grow; new jobs are created
and living standards to rise. Financial markets therefore perform the essential economic function
of channeling funds from economic units which have surplus funds (net savers) to economic
units with a net deficit of funds (investors).
Classification of financial markets

There are several methods of classifying financial markets. Some are as follows:
i. Classification of the markets based on the type of instrument or service as follows:

(a) Debt markets
This is the most familiar type of market. In debt markets, the lenders provide funds to borrowers
for some specified period of time. In return for the funds, the borrower agrees to pay the lender
the principal loan plus some specified amount of interest.
Debt markets are used by:

 Individuals to finance purchases such as houses, cars home appliances e.t.c.
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 Corporate borrowers to finance working capital and new equipment
 The central and local governments to finance various public expenditures
Debt instruments include bonds, mortgages and the various types of bank loans. These are
contractual agreements by the borrower to pay the holder of the instrument fixed amounts of
money at regular intervals until the maturity date, when the final payment is made. The regular
payments contain elements of both principal and interest payments.
(b) Equity markets
This is the market for raising funds by issuing equities such as common stock. Equities are
claims to share in the net income and the assets of a business. Equities usually make periodic
payments in form of dividends to their holders. Holders are residual claimants in that the
corporate must pay all its debt holders before its equity holders. Equities usually have no
maturity dates.
(c) Financial service markets
These are markets where individuals and corporate can purchase services that enhance the
working of the debt and equity markets.
Bank for example; provide depositors many services in addition to paying them interest on their
deposits. These include money transmission services, safe deposit facilities, payment
servicese.t.c. Thus, in addition to participating in the debt market, by issuing loans banks also
provide financial services that provide „convenience‟ to consumers in various ways.
Another financial service is brokerage services. Brokers are intermediaries who compete for the
right to help people buy or sell something of value. Stockbrokers help individuals to buy or sell
assets such as stocks and bonds. As intermediaries, brokers receive a fee for performing the
services of matching buyers and sellers of assets. Dealers on the other hand, buy and sell
securities on their portfolio, not just matching buyers and sellers.
Finally, financial service markets provide consumers, businesses, and governments with
financial risk management services, that is, protection against life, health, property and income
risks through sale of various insurance policies.
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ii. A broad classification that distinguishes between primary and secondary market
(a) Primary market
The primary market is used for trading of new securities that have never before been issued. Its
primary function is raising capital to support new investments or corporate expansions. The best
example of a primary market is the market for corporate initial public offers (IPOs) which are
used to sell company shares to the public for the first time.
(b) Secondary markets
These are markets that deal in securities which were issued previously. The chief function of a
secondary market is to provide liquidity to investors, that is, provide an avenue for converting
financial instruments into ready cash. Examples of secondary markets are markets for stocks and
shares and that of long-term bonds.
iii. A classification of markets based on the term to maturity and liquidity of the
instrument.
This method categories financial market into:-
 Money market
 Capital markets
(a) Money markets
Money markets are financial markets that are used for trading of short-term debt instruments,
generally those with original maturity of less than one year. The money market is the place
where individuals and institutions with temporary surpluses of funds meet the needs of
borrowers who have temporary fund shortages. Thus, the money markets enable economic units
to manage their liquidity positions. A security with a maturity of period of less than one year is
considered a money market instrument.
One principal function of the money market is to finance the working capital needs of
corporations and to provide governments with short-term funds as they wait to collect tax. The
money market also supplies funds for speculative buying of securities and commodities.
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(b) Capital markets
The capital market is designed to finance long-term investmentsby businesses, governments and
households. Capital market instruments are mainly longer term securities (those with original
maturities of more than one year) and equities. Examples include bonds and shares traded on the
stock exchange.
2.2 Financial instruments

The following are some of the most common instruments in use today
Money market instruments

They are short-term dated securities. Because of their short terms to maturity, they undergo the
least price fluctuations and are therefore the least risky instruments. These include treasury bills,
negotiable bank certificate of deposit, commercial paper, repurchase agreements e.t.c.
(a) Treasury bills

i. These are short-term debt instruments issued by the government.
ii. They are issued in 3, 6 and 12 month maturities to finance government activities.
iii. They pay a set amount at maturity and have no interest payments.
iv. Interest is covered by the fact that they are initially sold at a discount, that is, an
amount lower than the amount they are redeemed at on maturity.
v. They are the most liquid of all money market securities because they are the most
actively traded.
vi. Interest rates on treasury bills are usually the anchor/benchmark for all money market
interest rates.
vii. They are also the safest among the money market instruments because the chance of
default are minimal (the government can always increase taxes or issue currency to
pay off its debts)
viii. Thus, T-bills are popular due to their zero default risk, ready marketability and high
liquidity.
Types of treasury bills
There are several types of bills that are issued by governments:
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(a) Regular-series bills
i. These are issued routinely every week or month in competitive auctions
ii. They have original maturities of three months, six months and one year.
iii. New three and six month bills are auctioned weekly; one year bills are normally sold
once each month.
(b) Irregular-series bills
i. These are issued only when the treasury has a special cash need.
ii. They can be strip bills or cash management bills.
 Strip bills comprise of a package offering of bills requiring investors to bid
for an entire series of different bill maturities. Investors who did successively
must accept bills at their bid price each week for several weeks running.
 Cash management bills consist simply of reopened issues of bills that were
sold in prior weeks. The reopening of a bill issue normally occurs when there
is an unusual or unexpected treasury need for cash.
Calculating the yield on bills
i. Treasury bills do not carry a promised interest rate but instead are sold at a discount
from par.
ii. Their yield is therefore based on their appreciation in price between time of issue and
the time they mature or are sold by the investor.
iii. Bills yields are determined by the bank discount method which ignores compounding
of interest rates and uses a 360-day year for simplicity.
iv. The bank discount rate (DR) on bills is given by the following formula:-
DR=( x )100
For example, a 180 days bill with a par value of Kshs. 100 and auctioned at Kshs.97
Would have a discount rate of:
DR=( X )100=6%
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Because the rate of return on treasury bills is figured in a different way than the rate of return on
most debt instruments, the investor must compare investment yield to make realistic comparisons
with other securities.
The investment yield or rate (IR) for treasury bills can be obtained by the following formula
IR= x )100
For the above bill,
IR= X = 6.27%
This IR formula explicitly recognizes that each bill is purchased at a discounted price, which
should be used instead of par value as the basis for determining the bills true return. The
investment rate (IR) is always higher than discount rate (DR) because of the compounding of
interest and the use of a 365 day year. In leap year, 366 is used instead of 365.
(c) Commercial paper

i. A commercial paper is a short-term debt instrument issued by large banks and well
known corporations.
ii. It promises to pay back higher specified amount at a designated/specified time in the
immediate future, say, 30 days.
iii. Issuers of commercial paper sell the instrument directly to other institutions as a way
of raising funds for their immediate needs instead of borrowing from banks.
iv. Issuance of commercial paper is a cheaper way of raising funds for a firm than
borrowing from a bank.
v. A firm must be large and creditworthy enough for lenders to accept its commercial
paper.
vi. Funds raised from paper issue are mainly used for current transactions e.g. to
purchase inventories, pay taxes, meet pay rolls e.t.c. rather than capital transactions
(long term investments)
vii. Commercial papers are traded in primary market.
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viii. Opportunities for resale in the secondary market are limited, although some dealers
redeem the notes they sell in advance of maturity and others trade paper issued by
large finance companies and holding companies.
ix. Because of the limited resale possibilities, investors are usually careful to purchase
those paper issues whose maturity matches their planned holding periods.
Types of commercial paper
There are two types of commercial paper:
i. Direct paper – issued directly to the investor, sold by large finance companies and
bank holding companies that deal directly with the investor rather than using a
securities dealer as an intermediary.
Directly placed paper must be sold in large volume to cover the substantial cost of
distribution and marketing.
ii. Dealer paper (industrial paper dealer) – usually issued by security dealers on behalf of
their corporate customers. It is mainly issued by non financial companies who borrow
less frequently than firms issuing direct paper. The issuing company may sell the
paper directly to dealer, who buys less discount and commissions and then attempts to
resell it at the highest possible price in the market. Alternatively, the issuing company
may carry all the risk, with dealer only agreeing to sell the issue at the best price
available less commission, referred to as a best effort basis.
Note
Yields of commercial paper are calculated by the bank discount method. Just like with
treasury bills, most commercial papers are issued at par, where by the investor yield arise
from the price appreciation of the security between its purchase date and maturity date.
For example, if a million – shilling commercial note with a maturity of 180 days is acquired
by an investor at a discounted price of Kshs. 980,000, the discount rate of return (DR) is:
DR= X ) 100
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DR= ( x ) 100 = 4%
Advantages of commercial paper
i. It is a cheaper method of raising funds for a company because the interest rate is
generally lower than bank loans.
ii. Interest rates are usually more flexible than for bank loans.
iii. Its quicker method of raising funds either through a dealer or direct finance. Dealers
usually keep in close contact with the market and generally know where funds may be
found quickly.
iv. Generally large amounts of funds may be borrowed more conveniently than through
say, bank loans mainly because there are legal restrictions concerning the amount of
money that can lend to a single company.
v. The ability to issue commercial paper gives a company considerable leverage when
negotiating with banks.
Disadvantages of issuing commercial paper
i. Risk of a company that frequently issues commercial paper alienating itself from
banks whose loans may be required in case of an emergency.
ii. Commercial paper cannot be paid off at the issuer‟s discretion. It generally remains
outstanding until maturity unlike bank loans which permit early retirement without
penalty.
(b) Repurchase agreements
A repurchase agreement(repo) is a short-term loan where by the borrower sells marketable

securities such as treasury bonds to the lender but undertakes to buy them back at a later date at a
fixed price plus interest or at a price which is slightly higher than one they were sold to the
lender.
Thus, repos are in effect temporally extension of credit collateralized by marketable securities.
Some repos are for a specified period of time (term) while others carry no express maturity dates
but may be terminated by either party on short notice. These are known as continuing contracts.
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The main borrowers in the repos markets are dealers and banks. Lenders in the market include
large banks, corporations, state and local governments, insurance companies and foreign
financial institutions who find the market a convenient, relatively low-risk way to invest
temporary cash surpluses that may be retrieved quickly when needed.
Normally the securities that form collateral for a repo are supposed to be placed in a custodial
account in a bank. When the loan is repaid, the borrower‟s repo liability is cancelled and the
securities returned to them.
Traditional overnight lending makes up the bulk repos but there is a growing trend of repos
carrying longer maturities of between one and three months. These are known as term
agreements.
Interest income from repurchase agreements is usually determined from the formula:
RP interest income = (Amount of loan xCurrent RP rate) )
For example, interest income from an overnight loan of Ksh. 100 million of a dealer at 7 seven
percent RP rate would be
(100,000,000 x 0.07) x =ksh. 19,444.44
Under a continuing contract, the rate changes daily, so the calculation would be made for each
day the funds were loaned, with the total interest owed being paid to the lender when the contract
is ended by either party.
2.2.2 Capital market instruments

These are debt and equity instruments which have maturities greater than one year. They have far
wider price fluctuations than money market instruments and are considered to be fairly risky
investments. The most common capital market instruments in use include
1. Corporate stocks
2. Mortgages
3. Corporate bonds
4. Marketable long-term government securities
15
5. State and local government bonds
6. Bank commercial loans
7. Consumer loans
(a) stocks
These are equity claims on the net income and assets of a corporation. They confer on the holder,
a number of rights as well as risks. They are two types of corporate stocks:
i. Common stock
ii. Preferred/preference shares
i. Common stock
It is the most important form of corporate stock, it represents residual claim against the assets of
the issuing firm. It also entitles the owner to share in the net earnings of the firm when it is
profitable and to share in the net market value (after all debts are paid) of the company assets if it
is liquidated.
Stock holders risk exposure is limited to the extent of investment in the company. If a company
with outstanding shares of common stock is liquidated, the debts of the firm are paid first from
the assets available, then preferred stock holders are paid their share and whatever remains is
distributed among the common stock holders on a pro-rata basis. The volume of stock that a
corporation may issue is known as the authorized share capital and additional shares can only be
issued by amending the articles and memorandum of association with the approval of current
stock holders in a general meeting.
(b) Preferred stock
These carry a stated annual divided stated as a percentage of the par value e.g. a 8% preference
share is entitled to 8% divided on each share held provided the company declares a divided.
They occupy the middle ground between debt and equity including the advantages and
disadvantages of both instruments used in raising long-term finance. In case of liquidation, they
are paid after other creditors but before equity holders. They have no voting right.
16
Review questions
I. Define financial markets and discuss various methods of classifying financial
markets
II. Distinguish between money market instruments and capital market instruments and
in each case describe two example of instruments
III. A 90 days treasury bill with a par value of Kshs 200 and auctioned at Kshs 194. Find
the discount rate and then investment yield or rate.
IV. If 1,000 shillings commercial note with a maturity of 180 days is acquired by
investors at a discounted price of Kshs. 980. Find the discount rate and then
investment yield or rate.
V Discuss any three types of treasury bills issued by government
Reference:
Baye M. R, and Dennis W. J (1995) Money, Banking & Financial Markets; An Economic
India
17
CHAPTER THREE (WEEK 4&5)
MONEY DEMAND AND MONEY SUPPLY

OBJECTIVES
At the end of this chapter, the student should be able to;
 Define money demand

 Explain the classical view of money demand
 Explain Keynes‟s view of money demand
 Define money supply and explain what comprise money supply
 Explain 100-percent reserve banking and fractional reserve banking.
 Discuss a model of money supply
3.1 Money demand

The demand for money is the desired holding of financial assets in the form of money, that is,
cash or bank deposit. It can refer to the demand for money narrowly defined as M1 (non-interest
bearing holding) or for money in the broader sense of M2 or M3.
3.1.2 The classical view of money demand

The classical view of money demand considers income to be primary determinant of money
demand. The higher your income, the greater the amount of money you will hold.
The simple quantity theory
Irving Fisher developed the simple quantity theory of money demanded which views
transactions as the primary motive for holding money. It has roots in the equation of exchange
that links aggregate pending in an economy and the stock of money.
To illustrate the development of fisher‟s idea about money demand, we consider a simple
economy in which total spending in a year (TS) is $1,000 and the stock of money (M) is $ 200.
Why can individuals in the economy buy $1,000 worth of goods and services if the money
stock is only $200?
18
The answer is that on average each dollar is used more than once in a year. In fact, in this
example each dollar must be used on average of five times in a year for a money supply of $ 200
to support $ 1,000 of spending.
The number of times an average unit of money changes hands in a year is called velocity (V).
We can write the equation of exchange as M x V =TS
This equation state that money supply in the economy (M) multiplied by the number of times the
average unit of money changes hands in one year (V) will equal the value of annual total
spending (TS).
The equation of exchange provides a useful way to think about money and the economy. The
equation of exchange is not a theory bur an identity. To determine the velocity we simply divide
total spending by the money supply and obtain:
V=
This equation of exchange is important because it tells us that if the quantity of money increases,
either total spending will increases, velocity fall, or both.
In our example, total spending is $1,000, velocity is 5, and the quantity of money is $ 200. If the
quantity of money increases to $ 400 and velocity stays constant, total spending must increase to
$ 2000. This is because the economy now has $ 400 of money, and if everyone spends this
money at a rate that causes it to change hands five times in a year, spending will have to be:
$ 400 X 5 = $ 2000
If the money supply increases to $ 400 but total spending stays at $ 1,000. Then we know
velocity has fallen to 2.5. With $ 400 of money and spending at $ 1000, money must change
hands 2.5 times in one year, on average.
To develop a theory of money demand, Fisher reasoned that velocity would be constant since it
depends on slowly moving variables such as the frequency with which people are paid and
institutional characteristics of payment system. This line of reasoning implies the equation of
exchange can be used to write money demand as:
19
Md =
Since velocity was thought to be constant, any increase in total spending would lead to an
increase in the demand for money. The idea was that with constant velocity, an increase in
spending requires greater money holding, to satisfy the equation of exchange. Thus, money
demand was linked to the desire to make transactions. This is why we say the simple quantity
theory is based on the transactions motive for holding money.
Fisher had further insight into money demand, which he got from considering how total spending
could change. Fisher separated total spending (TS) into the quantity of goods purchased (Y) and
the price of those goods (P):
TS=P x Y
Using this formula, we can write the equation of exchange as
M x V= P x Y
Then the simple quantity theory of money demand becomes
Md =
This version of the quantity theory of money demand stresses that people will want to hold
money if either the prices of goods they want to purchase increase or the quantities they want
to purchase increase. In either case, the amount of money required to pay for the purchase of
these goods will increase.
Suppose people are purchasing 1,000 goods at a price of $1 each. From our previous example
velocity is 5, so money demand is $ 200, calculated as
What happens if the prices of the goods double to $ 2 each?
If people still want to purchase $1,000 goods they will now make purchases in the amount of $
2,000 per year. With velocity constant of 5, this increases money demand to $ 400 ( )
20
Alternatively, consider what happens if the number of goods people want to purchase rises to $
2,000, but the price of each stays at $ 1. In this case, the dollar amount of purchase is also $
2000, so with velocity at 5, money demand is again $ 400. Thus with velocity constant, increase
in the price level have the same effect on money demand as do increase in the number of goods
and services purchased.
As long as the physical amount of purchase stays constant, any increase in prices will be
matched by a proportional change in money demand. Thus, the simple quantity theory of money
demand is often called a theory of the demand for real money balances. Real money balances
are the nominal money stock divided by the price level (M/P) and are a measure of the
purchasing power of money.
For a give quantity of dollars, M, increase in the price level mean less can be purchased. Increase
in purchasing power come about from either an increase in the money stock (M), or a reduction
in the price level (P), while decrease in purchasing power result from either a decrease in the
money stock or an increase in the price level.
To write the simple quantity theory of money demand in terms of the demand for real money
balances, we simply divide both sides of equation Md= , by the price level (P), to obtain
Since the simple quantity theory of money views velocity in equation above as constant, the
demand for real money balances depends solely on real income. If real income doubles, real
money balances double as well, i.e. twice as many real balances would be needed to make
transactions.
3.1.2 Keynes’s view of money demand

The modern view of money demand owes much to the work of John Maynard Keynes in the
1930s. While classical economists tended to emphasize the use of money in making transactions,
Keynes identified three motives for holding money.
1. Transaction motive
21
People hold money because it is useful in making purchases. Naturally the transaction motive for
holding money would give rise to money demand that is positively related to income. People
with higher incomes typically make transactions and thus will hold more money. In fact, like the
classical economists, Keynes viewed money held for transaction purposes as being proportional
to income. Transaction motive of holding money is affected by factors such as level of income
,frequency of payment of an individual, individuals spending habits ,availability of credit
facilities and rate of inflation.
2. Precautionary motive.
People hold money to meet unexpected expenditure requirements, such as for emergencies or the
proverbial rainy day. This is a refinement of the store of wealth function of money. Keynes also
viewed money held for precautionary purposes as being proportional to income. Precautionary
motive is affected by other factors such as age of individual, family statures and size ,and interest
rates in the country’s financial institution.
3. Speculative motive
The most novel/new idea in Keynes’s theory of money demand was the speculative motive,
which implies money demand depends on interest rates. In this respect people may choose to
keep ready money to take advantage of profitable opportunities that may arise in financial
markets such as to invest in bonds which may arise or they may sell bonds for money when they
fear a fall in bonds market prices. Like the other two motives speculative motive is affected by
interest rates ,price of securities in the stork market and whether the individual is pessimistic or
optimistic
3.2 Money supply

The money supply/money stock is the total amount of money available in an economy at a --
particular point in time. There are several ways to define “money”, but standard measures
usually include currency in circulation and demand deposits ( depositors easily accessed assets
on the books of financial institutions).
Money supply data are recorded and published, usually by the government or the central bank of
the country. Public and private sector analysis have long monitored changes in money supply
22
because of its possible effects on the price level, inflation and business cycle.
In a simplified definition of quantity of money, money supply is the number of dollars/shillings

held by the public, and we assumed that the federal reserve/central bank controls the supply of
23
money by increasing or decreasing the number of dollars in circulation through Open-Market
Operations (OMO).
Although this explanation is a good first approximation, it is incomplete, for it omits the role of
the banking system in determining the money supply. Money supply is determined not only by
central bank‟s policy, but also by the behavior of households which hold money and of banks in
which money is held.
Money supply includes both currency in the hands of the public and deposits at banks that
household can use on demand (i.e. when they need the money) for transactions, such as checking
account. If M=money supply, C=currency in the hands of the public, and D=demand deposit,
then we can write
Money supply= currency in the hands + demand deposit
M= C+ D
To understand the money supply, we must understand the interaction between currency in the
hands and how policy influences these two components of the money supply.
100-percent reserve banking

Suppose that banks accept deposits but do not make loans. The only purpose of the bank is to
provide a safe place for depositors to keep their money.
The deposits that banks have received but have not lent out are called reserves. Some reserves
are held in the volt of local banks through the country, but most are held at central bank, such as
the Federal Reserve.
In our hypothetical economy, all deposits are held as reserves, that is, banks simply accept
deposit, place the money in reserve, and leave the money there until the depositor makes a
withdrawal or writes a check against the balance. This system is called 100-percent-reserve
banking.
24
Unlike banks in our economy, this bank is not making loans, so it will not earn profit from its
assets. The bank presumably charges depositors a small fee to cover its costs.
A dollar deposited in a bank reduces currency in the by 1 dollar and raises deposit by 1 dollar, so
the money supply remains the same. If banks hold 100 percent of deposit in reserve, the banking
system does not affect the supply of money.
3.2.2 Fractional-reserve banking

Nowimagine that banks start to use some of the deposit to make loans, for example to families
who are buying houses or to firms that are investing in new plants and equipment. The advantage
to the banks is that they can charge interest on the loans.
The banks must keep some reserves on the hand so that reserves are available whenever
depositors want to make withdrawals. But as long as the amount of new deposits approximately
equals the amount of withdrawals, a bank need not keep all its deposits in reserve. Thus, bankers
have an incentive to make loans. When they do so, we have fractional-reserve banking, a
system under which banks keep only a fraction of their deposit in reserve.Fractional –reserve
banking is related to the phenomena of multiple deposit creation.That is when cash is deposited
into the a bank ,tehbank loansout most of thatmoney and most of the money gets redeposited into
the banking system and gets mostly loaned out again and redeposited and so on.The chain of
deposits creation –Excess Reserves being loaned out and redeposited in the banking system until
the Banks have basically no more excess reserves.In conclusion deposit creation process involves
two assumptions :
(i) The banks loan out 100%of their excess reserves
(ii) All loans get redeposited into the banking system
Simple deposit multiplier =Ultimate change in deposits
Change in bank reserves
1/RRR
RRR is the Rate of Required Reserve e.g. the Rate of Required Reserve is 10% the simple multiplier
will be 1/RRR=1/0.1=10 times.The explanation is that an increase in bank reserves of 1 million
would ultimately cause both the checking deposits and bank loans (money supply) to increase ten
times that amount or 10 million.
Here is first bank‟s balance sheet after it makes a loan.

25
First bank‟s balance sheet
Assets Liabilities
Reserves $ 200 Deposit $1,000
Loans $ 800
This balance sheet assumes that the reserve-reserve ratio (the fraction of deposits kept in reserve)
is 20 percent. First bank keeps $ 200 of the $ 1,000 in deposit in reserve and lends out the
remaining $ 800.
Notice the first bank increases the supply of money by $800 when it makes loan. Before loan is
made, the money supply is $1,000, equal to the deposits in first bank. After the loan is made, the
26
money supply is $ 1,800. The depositor still has a demand deposit of $1000, but now the
borrower holds $800 in currency. Thus, in a system of factional-reserve, banking, banks create
money.
The creation of money does not stop with first bank. If the borrower deposits the $ 800 in
another bank, the process of money creation continues. Here is the balance sheet of the second
bank.
Second bank‟s balance sheet
Assets Liabilities
Reserves $ 160 Deposit $ 800
Loans $ 640
Second bank receive the $ 800 in deposits, keeps 20 percent, or $ 160, in reserve, and then loans
out $ 640. Thus second bank creates $ 640 of money.
If this $ 640 is eventually deposited in third bank, this bank keeps 20 percent, or 128, in reserve
and loans out $512, resulting in this balance sheet.
Third bank‟s balance sheet
Assets Liabilities
Reserves $ 128 Deposit $ 640
Loans $ 512
The process goes on and on. With each deposit and loan, more money is created.
25
Reserve-deposit ratio refers to the fraction of deposit in reserve. In a system of fractional-
reserve banking, banks create money.
Although this process of creation can continue forever, it does not create an infinite amount of
money. Letting rrdenote the reserve-deposit ratio, the amount of money that the original $ 1,000
creates is
Original deposit =$ 1,000
First bank lending = (1-rr) x 1000
Third bank lending = (1-rr)3x1000
Total money supply =1000+(1-rr)+(1-rr)2+(1-rr)3+…] x

1000
Money supply = ( 1/rrr ) x 1,000 (using sum of infinite geometric series)

.
In this example, r rr=0.2, M o n e y s u p p l y = 1 / 0 . 2 * 1 0 0 0 = $ 5 0 0 0
Note
 The banking system’s ability to create money is the primary difference between banks
and other financial institutions.
 Financial markets have the important function of transferring the economy’s resources
from those households that wish to save some of their income for the future to those
households and firms that wish to borrow to buy investment goods to use in their
production.
26
 Financial intermediation is the process of transferring funds from savers to borrowers.
Many institutions in the economy act as financial intermediaries; the most prominent
examples are the stock market, the bond market, and the banking system. Yet, of these
financial institutions, only banks have the legal authority to create assets that are part of
the money supply, such as checking accounts. Therefore, banks are the only financial
institutions that directly influence the money supply.
Although the system of fractional reserve banking creates money. It does not create wealth.
When a bank loans out some of it reserves, it gives borrowers the ability to make transactions
and therefore increase the supply of money. The borrowers are also under the obligation to the
bank, however, so the loan does not make them wealthier. In other words, the creation of money
by the banking system increases the economy‟s liquidity, not its wealth.
3.2.3 A model of the money supply

What determines the money supply? Here is the presentation of a model of the money supply
under fractional-reserve banking. The model has three exogenous variables
i. The monetary base (B) which is the total dollars held by the public as currency on
the hand (C) and by banks as reserves (R). This is directly controlled by the central
bank/federal reserve.
ii. The reserve-deposit ratio (rr) –this is the fraction of deposits that banks hold in
reserve. This is determined by the business policies of banks and the law regulating
banks.
iii. The currency-deposit ratio (cr) –this is the amount of currency in hands (C) people
hold as a fraction of their holdings of demand deposit (D). It reflects the preferences
of households about the form of money they wish to hold.
The model shows how the money supply depends on the monetary base, the reserve-deposit
ratio, and the currency-deposit ratio. It helps us examine how fed reserve/central bank policy
and the choices of banks and households influence the money supply.
27
Definition of the money supply and the monetary base:
M=C+D equation 1
B=C+R equation 2
Where
M = money supply is the sum of currency on the hands (C) and demand deposit (D).
B = Monetary base is the sum of currency on hands (C) and bank reserves (R).
To solve for the money supply as a function of the three exogenous variables [(the monetary
base (B), the reserve-deposit ratio (rr), and the currency-deposit ratio (cr)], we begin by
dividing the first equation by the second to obtain:
Then divide both the top and bottom of the expression on the right by D
Note
= The currency-deposit ratio cr,
The reserve-deposit ratio rr.
Making these substitutions, and bringing the B from the left to the right side of the equation, we
obtain,
M= Xb
This equation shows how the money supply depends on the three exogenous variables. We can
see that the money supply is proportional to the monetary base. The factor of proportionality,
(cr+1)/(cr+rr), is denoted by m and is called the money multiplier
28
We can write
M=m x B
Each dollar of the monetary base produces m dollar of money. Because the monetary base has a
multiplied effect on the money supply, the monetary base is sometimes called high-powered
money.
The numerical example below, approximately describes a hypothetical economy. Suppose that
the monetary base (B) is $ 500 billion, the reserve deposit ratio (rr) is 0.1, and the currency-
deposit ratio (cr) is 0.6. In this case, the money multiplier is
m= =2.3
and the money supply is
M=2.3 X $ 500 billion = $ 1,150
Each dollar of the monetary base generates 2.3 dollars of money, so the total money supply is
$1,150 billion,
Note
i. The money supply is proportional to the monetary base, thus, an increase in the
monetary base increase the money supply by the same percentage.
ii. The lower the reserve-deposit ratio, the more loans banks make, and the more
money banks create from every dollar of reserves. Thus a decrease in the reserve-
deposit ratio raises the money multiplier & the money supply.
iii. The lower the currency-deposit ratio, the fewer dollars of the monetary base the
public holds as reserves, and the more base dollars banks can create. Thus, a
decrease in the currency-deposit ratio raise the money the money multiplier and the
money supply.
Review questions
i. Differentiate between money demand and money supply
29
ii. Discuss the simple quantity theory as used in the classical view of money demand
iii. Explain three motives of holding money as explained by Keynes
iv. Discuss 100-percent-reserve banking and fractional-reserve banking
v. Explain the following terms as used in the model of money supply
(a) The monetary base (B)
(b) The reserve-deposit ratio (rr)
(c) The currency-deposit ratio (cr)
vi. State the major function of financial market
vii. Define financial intermediation
viii. What makes banks differ from other financial institutions?
ix. Suppose that the monetary base (B) is $ 1000 billion, the reserve deposit ratio (rr) is
0.2, and the currency-deposit ratio (cr) is 0.12. Find the total money supply.
Reference:
India
30
CHAPTER FOUR (WEEK 6)
MONEY AND INFLATION

OBJECTIVES
At the end of this chapter, the student should be able to:
 Differentiate between inflation and economic growth.

 Discuss price level and real output
 Explain relationship between inflation and economic growth.
 Explain how growth rate of money supply, growth rate of velocity and the growth rate of
output cause inflation
4.1 Difference between inflation and economic growth

Inflation refers to general rise in the level of prices in the economy while economic growth
refers to increase in quantity and variety of things available for consumption and is result of the
technological advances and increases in the pool of productive resources e.g. the size of the
workforce.
4.2 The price level and real output

4.2.1 Measuring the price level
The price level is a measure of the average prices of goods and services in the economy. It serves
as a gauge of the general purchasing power of money. The consumer price index (CPI) is the
measure of price level that is must familiar. Consumer price index measures the cost of the
basket of goods and service purchased by the average urban household. The items in the basket
are determined from a survey conducted in the base year. Thus the CPI reports how much more
or less expensive the fixed base year basket of goods and services would be in different years. If
the CPI is higher today than it did in base year, it costs more to buy the basket of goods and
services today than it did in base year.
31
4.2.2 Measuring nominal and real output
Nominal output refers to the current dollar/shilling value of the final goods and services
produced in the economy. Gross domestic product GDP, the most common used measure of
nominal output, is the total dollar value of all final goods and services produced in the economy
in one year. GDP measures the current dollar value of final output, i.e. it measures only the
output of goods and services sold to final consumers of the products.
Since nominal output is the current dollar value of all final sales of newly produced goods and
services in the economy, it is the summation of the quantities of final goods and services (P)
multiplied by the products prices (Y) i.e. nominal output=PxY
Notice that if the price level (P) doubled but the level of output (Y) remained the same, nominal
output would double even though no additional goods and services are available.
Real output is a measure of the physical quantity of goods and services available to the final
consumers of the items. When the price level increases, nominal output will increase even if real
output remains constant. To avoid confounding/confusing growth and inflation, we normally use
real output to measure the output of the economy. Real output is obtained by dividing nominal
output by the price level:
Real Y=
For example if the GDP of a given country was 780 Billion in 2010 and the consumer price
index (CPI) was 1.25 in the same year, the real output (real GDP is obtained by dividing GPP by
the price level (CPI))
Real GDP2011= 624 billion.
4.3 Inflation and economic growth

Now that you have a basic understanding of the price level and real output, we will show how to
use these measures to calculate the rate of inflation and the rate of economic growth.
32
Inflation
The inflation rate is the rate of change in the price level. Inflation rates are stated as a percentage
change on an annual basis. For instance, if the price level is Pt in year t and Pt-1in year t-1, the
inflation rate ( ) between year t and t-1 is defined as
Inflation rate (∏) = )100
For example, the price level as measured by the CPI was 117.8 in 2009 and increased to 120.8 in
2010. Thus, the inflation rate between 2009 and 2010 was
∏ == ) 100 = ) 100 =2.5%
Average prices in the economy increased by 2.5 percent between 2009 and 2010.
4.3.2 Economic growth

Economic growth is change in real output. The economic growth rate is usually stated as a
percentage change on an annual basis. If real output was Yt in year t and Yt-1in year t-1, the
economic growth rate between years t and t-1 is defined as
Economic growth rate (GY) == )100
For example, real output (real GPP) was $4796.7 billion in 2009 and increased to $4873.7 billion
in 2010. Thus, the economic growth rate between 2009and 2010 was
GY= )100 = = )100=1.6%
Between 2009 and 2010, the real quantity of final goods and services produced in the economy
increased by 1.6 percent.
The relationship between inflation and economic growth

We can use a very simple formula to relate the rate of economic growth, growth in nominal
output, and inflation. The growth rate of GDP equals the growth rate of real GDP plus the
growth rate of prices (the inflation rate). Thus, using G to represent growth rates, we can
calculate the growth rate of real GPP as
33
G real GDP =G nominal GPP – G price level.
Where the subscripts (like real GDP) refers to what is growing.
This formula reveals that the growth rate in real GDP (the rate of economic growth) equals the
growth rate in nominal GDP (called the nominal growth rate) minus the growth in the price level
(inflation)
For instance, if prices increases by 5 percent per year and nominal GDP increases by 7 percent
per year, real output increases by only 2 percent per year, since 7%-5%=2%
4.5 Causes of inflation

Anything that cause the growth rate of money supply to increase, the growth rate of velocity to
increase or the growth rate of output to decrease causes inflation.
4.5.1 Growth in the money stock

The increase in money stock leads to an increase in prices and nominal output but no increase in
the real amount of goods available in the economy. In this sense, increase in the money stock
leads to a higher price level.
To understand this imagine that an economy with one commodity (1 litre of soda) and one
consumer. The total money stock in the pocket of consumer is $1. Clearly, then, the maximum
price the consumer could pay for the soda is $1. Since the money in your pocket you cannot
consume it, all you can consume is the one litre of the soda.
Now suppose that by some miracle, another dollar appears to the consumer‟s pocket. The money
stock is now $ 2, but only 1 litre of soda is still available. The consumer would be willing to pay
a price of $2 for the litre of soda. Since the money stock doubled, the price of soda doubled, and
thus nominal output doubled as well. But since there is still only one litre of soda in the
economy, real output is constant and the consumer is not better off than before the extra dollar
appeared.
4.5.2 Velocity and economic growth

In an economy with many individuals and many goods and services, to explain the relationship
between the money stock and the price level, we have to take into account the velocity of money.
34
Velocity of money measures the number of times the average dollar/shilling changes hands in the
economy.
Why does velocity matter?
With many people and goods but only a single dollar in money, something remarkable happens.
People can make more than $1 in purchases. You can use the $ 1 to buy something; the person
you pay can in turn use the same $1 to buy from someone else and so on. If velocity is 2, the
average dollar bill changes hands two times. $ 1 in money leads to $2 worth of purchases. If
velocity is 10, $1 in money leads to 10 transactions, or $10 worth of purchases.
More generally, if the money stock is M and velocity is V, the total dollar value of transactions
in the economy is MV. Similarly, if P is the price level and Y is real output, the dollar value of
this output (nominal output) is PY. Since the dollar value of transactions equals the dollar value
of the goods and services in the economy, it follows that;
MV=PY
This fundamental relationship between the dollar value of exchanges (transactions) and nominal
output is known as the equation of exchange. The equation of exchange can be used to obtain a
detailed picture of the cause of inflation. In particular, it implies that
+ = +
Where
= means a change in
= the percentage change in money stock.
= the percentage change in velocity.
= the percentage change in price.
= the percentage change in real output.
35
This complicated relation is easier to visualize if we let Gm represent the growth in money stock,
G vthe growth rate in real output and ∏ the inflation rate and rewrite the above equation as
Gm + G v = ∏+ G y
This equation simply says that the growth rate in the money stock (Gm) plus the growth rate in
velocity (G v) equal the inflation rate (∏) plus the growth rate in the real output (G y). We can
rearrange this formula to obtain an expression for the inflation rate in terms of the growth rate
of money, velocity and real output.
∏= Gm + G v - G y
The inflation rate thus equals the growth rate of the money stock, plus the growth rate of
velocity, minus the growth of rate in real output. Changes in any of the three growth rates on the
right-hand side of the equation can lead to change in the inflation rate.
Review questions
i. Distinguish between the following terms
(a) Inflation and growth
(b) Inflation rate and growth rate
ii. Explain the difference between nominal output and real output
iii. The price level as measured by the CPI was 235.6 in 2009. In 2010, it changed to
241.6. Compute the inflation rate between 2009 and 2010
iv. If the price level as measured by the CPI was 150 in 2010 and the project price level
for 2011 is 120. Calculate the expected inflation rate between 2010 and 2011.
v. Discuss the relationship between inflation and economic growth
vi. Discuss how growth in the money stock/supply cause inflation
vii. Explain how change in velocity of money influence inflation
Reference:
36
Shekhar K. C. &Lekshmy S. (2007) Banking Theory and Practice, 201H edition, New Delhi,
India
Mankiw N. G. and Mark P. T. (2006)Economics, Thomson Learning, UK.
37
CHAPTER FIVE (WEEK 7&8)
CENTRAL BANKING
Objectives
At the end of this chapter, the student should be able to:-
 Define what is meant by central bank

 Explain the main functions of central bank
 Explain major macro-economic policies
 Discuss clearly about monetary policy
 Explain the monetary policy objectives and instruments which central bank can use to
achieve its objectives
 Give reason why banks need central bank
5.0 Introduction
The Central Bank of Kenya (CBK), like most other central banks around the world, is entrusted
with the responsibility of formulating and implementing monetary policy directed to achieving
and maintaining low inflation as one of its two principal objectives; the other being to maintain a
sound market-based financial system. Since its establishment in 1966, the CBK has essentially
used a monetary –targeting framework to pursue the inflation objective. The use of this monetary
policy strategy has been and continues to be based on the presumption that money matters, that
the behavior of monetary aggregates has major bearing on the performance of the economy,
particularly on inflation.
5.1 What are the main functions of a central bank?

A central bank can generally be defined as a financial institution responsible for overseeing the
monetary system for a nation, or a group of nations, with the goal of fostering economic growth
without inflation.
38
The main functions of a central bank can be listed as follows:
i. The central bank controls the issue of notes and coins (legal tender). Usually, the central
bank will have a monopoly of the issue, although this is not essential as long as the
central bank has power to restrict the amount of private issues of notes and coins.
ii. It has the power to control the amount of credit-money created by banks. In other words,
it has the power to control, by either direct or indirect means, the money supply.
iii. A central bank should also have some control over non-bank financial intermediaries that
provide credit.
iv. Encompassing both parts 2 and 3, the central bank should effectively use the relevant
tools and instruments of monetary policy in order to control:
 Credit expansion;
 Liquidity; and
 The money supply of an economy.
v. The central bank should oversee the financial sector in order to prevent crises and act as a
lender-of-last-resort in order to protect depositors, prevent widespread panic withdrawal,
and otherwise prevent the damage to the economy caused by the collapse of financial
institutions.
vi. A central bank acts as the government‟s banker. It holds the government‟s bank account
and performs certain traditional banking operations for the government, such as deposits
and lending. In its capacity as banker to the government it can manage and administer the
country‟s national debt.
vii. The central bank also acts as the official agent to the government in dealing with all its
gold and foreign exchange matters. The government‟s reserves of gold and foreign
exchange are held at the central bank. A central bank, at times, intervenes in the foreign
exchange markets at the behest of the government in order to influence the exchange
value of the domestic currency.
39
5.2 Major macro-economy policies
There are five major forms of economic policy (or, more strictly macroeconomic policy)
conducted by governments that are of relevance. These are: monetary policy; fiscal policy;
exchange rate policy; prices and incomes policy; and national debt management policy.
i. Monetary policy is concerned with the actions taken by central banks to influence the
availability and cost of money and credit by controlling some measure (or measures) of
the money supply and/or the level and structure of interest rates.
ii. Fiscal policy relates to changes in the level and structure of government spending and
taxation designed to influence the economy. As all government expenditure must be
financed, these decisions also, by definition, determine the extent of public sector
borrowing or debt repayment. An expansionary fiscal policy means higher government
spending relative to taxation. The effect of these policies would be to encourage more
spending and boost the economy. Conversely, a contractionary fiscal policy means
raising taxes and cutting spending.
iii. Exchange rate policy involves the targeting of a particular value of a country‟s currency
exchange rate thereby influencing the flows within the balance of payments. In some
countries it may be used in conjunction with other measures such as exchange controls,
import tariffs and quotas.
iv. Prices and incomes policy is intended to influence the inflation rate by means of either
statutory or voluntary restrictions upon increases in wages, dividend and/or prices.
v. National debt management policy is concerned with the manipulation of the

outstanding stock of government debt instruments held by the domestic private sector
with the objective of influencing the level and structure of interest rates and/or the
availability of reserve assets to the banking system.
40
5.3 Monetary policy
Monetary policy relates to the control of some measure (or measures) of the money supply
and/or the level and structure of interest rates. In recent years, much greater emphasis has been
placed on monetary policy within a government‟s policy package.
This is because broad consensus has emerged that suggest that price stability is an essential pre-
condition for achieving the central economic objective of high and stable levels of growth and
employment. Monetary policy is viewed as the preferred policy choice for influencing prices.
Although traditionally the choice of monetary policy over fiscal policy as the main policy tool
was viewed as a matter of ideological choice, nowadays it is seen more as a pragmatic solution.
As it is widely recognized that high and variable inflation harms long-term growth and
employment, policymakers have tended to focus on those policies that appear to be most
successful in dampening inflationary pressures.
Price stability, therefore, has become a key element of economic strategy, and monetary policy is
widely accepted as the most appropriate type of policy to influence prices and price expectations.
The preference for using monetary policy over other types of policy relates to two main factors –
the role of the monetary authorities (central banks) as sole issuers of banknotes and bank
reserves (known as the monetary base) and the long run neutrality of money.
The central bank is the monopoly supplier of the monetary base and as a consequence can
determine the conditions at which banks borrow from the central bank. The central bank can
influence liquidity in the short-term money markets and so can determine the conditions at which
banks buy and sell short-term wholesale funds. By influencing short-term money market rates,
the central bank influences the price of liquidity in the financial system and this ultimately can
impact on various economic variables such as output or prices.
41
In long run a change in the quantity of money in the economy will be reflected in a change in the
general level of prices but it will have no permanent influence on real variables such as the level
of (real) output or unemployment. This is known as the long-run neutrality of money. The
argument goes that real income or the level of unemployment are, in the long term, determined
solely by real factors, such as technology, population growth or the preferences of economic
agents. Inflation is therefore solely a monetary phenomenon.
As a consequence in the long run:
 A central bank can only contribute to raising the growth potential of the economy by
maintaining an environment of stable prices.
 Economic growth cannot be increased though monetary expansion (increased money

supply) or by keeping short-term interest rates at levels inconsistent with price stability.
In the past it has been noted that long periods of high inflation are usually related to high
monetary growth. While various other factors (such as variations in aggregate demand,
technological changes or commodity price shocks) can influence price developments over the
short period, over time these influences can be offset by a change in monetary policy.
5.4 Monetary policy functions of a central bank

The most important function of any central bank is to undertake monetary control operations.
Typically, these operations aim to administer the amount of money (money supply) in the
economy and differ according to the monetary policy objectives they intend to achieve.
5.4.1 Monetary policy objectives

Monetary policy is one of the main policy tools used to influence interest rates, inflation and
credit availability through changes in the supply of money (or liquidity) available in the
42
economy. It is important to recognize that monetary policy constitutes only one element of an
economic policy package and can be combined with a variety of other types of policy (e.g., fiscal
policy) to achieve stated economic objectives.
Historically, monetary policy has, to a certain extent, been subservient to fiscal and other policies
involved in managing the macro-economy, but nowadays it can be regarded as the main policy
tool used to achieve various stated economic policy objectives (or goals).
The main objectives of economic (and monetary) policy include:
i. High employment – often cited as a major goal of economic policy. Having a high level
of unemployment results in the economy having idle resources that result in lower levels
of production and income, lower growth and possible social unrest. However, this does
not necessarily mean that zero unemployment is a preferred policy goal. A certain level
of unemployment is often felt to be necessary for the efficient operation of a dynamic
economy. It will take people a period of time to switch between jobs, or to retrain for new
jobs, and so on – so even near full employment there maybe people switching jobs who
are temporarily out of work. This is known as frictional unemployment.
In addition, unemployment may be a consequence of mismatch in skills between workers

and what employers want – known as structural unemployment. (Typically, although
structural unemployment is undesirable monetary policy cannot alleviate this type of
unemployment). The goal of high employment, therefore, does not aim to achieve zero
unemployment but seeks to obtain a level above zero that is consistent with matching the
demand and supply of labour. This level is known as the natural rate of unemployment.
(Note, however, that there is much debate as to what is the appropriate natural level of
unemployment – usually a figure of around 4% is cited as the appropriate level)
ii. Price stability – considered an essential objective of economic policy, given the general
wish to avoid the costs associated with inflation. Price stability is viewed as desirable
because a rising price level creates uncertainty in the economy and this can adversely
43
affect economic growth. Many economists (but by no means all) argue that low inflation
is a necessary prerequisite for achieving sustainable economic growth.
iii. Stable economic growth – provides for the increases over time in the living standards of
the population. The goal of steady economic growth is closely related to that of high
employment because firms are more likely to invest when unemployment is high and
firms have idle production they are unlikely to want to invest in building more plants and
factories. The rate of economic growth should be at least comparable to the rates
experienced by similar nations.
iv. Interest rate stability – a desirable economic objective because volatility in interest rates
creates uncertainty about the future and this can adversely impact on business and
consumer investment decisions (such as the purchase of a house). Expected higher
interest levels deter investment because they reduce the present value of future cash flows
to investors and increase the cost of finance for borrowers.
v. Financial market stability – also an important objective of the monetary authorities. A

collapse of financial markets can have major adverse effects on an economy. The US
Wall Street Crash in 1929 resulted in a fall of manufacturing output by 50 percent and an
increase in unemployment to 25 to 30 percent of the US work force by 1932. (Over
11,000 banks closed over this period.)
Note that financial market stability is influenced by stability of interest rates because
increases in interest rates can lead to a decrease in the value of bonds and other
investments resulting in losses in the holders of such securities.
vi. Stability in foreign exchange markets – has become a policy goal of increasing
importance especially in the light of greater international trade in goods, services and
44
capital. A rise in the value of a currency makes exports more expensive, whereas a
decline in the value of a currency leads to domestic inflation. Extreme adverse
movements in a currency can therefore have a severe impact on exporting industries and
can also have serious inflationary consequences if the economy is open and relatively
dependent on imported goods. Ensuring the stability of foreign exchange markets is
therefore seen as an appropriate goal of economic policy.
At first glance it may appear that all these policy objectives are consistent with one another,
however conflicts do arise. The objective of price stability can conflict with the objectives of
interest rate stability and full employment (at least in the short-run) because as an economy
grows and unemployment declines, this may result in inflationary pressures forcing up interest
rates. If the monetary authorities do not let interest rates increase this could fuel inflationary
pressures, yet if they do increase rates then unemployment may occur. These sorts of conflicts
create difficulties for the authorities in conducting monetary and other macroeconomic policy.
Typically, the most important long-term monetary target of a central bank is price stability that
implies low and stable inflation levels. Such a long-term goal can only be attained by setting
short-term operational targets. Operational targets are usually necessary to achieve a particular
level of interest rates, commercial banks‟ reserves or exchange rates. Often they are
complemented by intermediate targets such as a certain level of long-term interest rates or broad
money growth (monetary aggregates). In choosing the intermediate targets, policymakers should
take into account the stability of money demand and the controllability of the money aggregate.
The chosen target should also be a good indicator of the effect of the monetary policy decision
on the price stability target.
5.4.2 Instruments of monetary policy

In the past, it was common for central banks to exercise direct controls on bank operations by
setting limits either to the quantity of deposits and credits (e.g., ceilings on the growth of bank
deposits and loans), or to their prices (by setting maximum bank lending or deposit rates). As a
result of the significant financial liberalization process aimed at achieving an efficient allocation
45
of financial resources in the economy, there has been a movement away from direct monetary
controls towards indirect ones.
Indirect instruments influence the behaviour of financial institutions by affecting initially the
central banks‟ own balance sheet. In particular the central bank will control the price or volume
of the supply of its own liabilities (reserve money) that in turn may affect interest rates more
widely and the quantity of money and credit in the whole banking system.
The two most significant assets of the Central Bank are debt securities followed by loans and
advances. On the liability side, debt securities are again the largest proportion, followed by
deposits by central banks and deposits by banks and building societies.
The indirect instruments used by central banks in monetary operations are generally classified
into the following:
 Open market operations (OMOs);

 Discount windows
 Reserve requirements.


i. Debt securities and open market operations
Debt securities are mainly represented by Treasury securities (i.e., government debt) that central
banks use in open market operations are the most important tools by which central banks can
influence the amount of money in the economy.
Although the practical features of open market operations may vary from country to country, the
principles are the same: the central bank operates in the market and purchases or sells
government debt to the non-bank private sector. In general, if the central bank sells government
debt the money supply falls (all other things being equal) because money is taken out of bank
accounts and other sources to purchase government securities. This leads to an increase in short-
term interest rates. If the government purchases (buys-back) government debt this results in an
injection of money into the system and short-term interest rates fall. As a result, the central bank
can influence the portfolio of assets held by the private sector. This will influence the level of
liquidity within the financial system and will also affect the level and structure of interest rates.
46
The main advantages of using open market authorities to influence short-term interest rates
are as follows:
i. They are initiated by the monetary authorities who have complete control over the
volume of transactions;
ii. Open market operations are flexible and precise – they can be used for major or minor
changes to the amount of liquidity in the system;
iii. They can easily be reversed;
iv. Open market operations can be undertaken quickly.
Open market operations are the most commonly used indirect instruments of monetary policy in
developed economies. One of the main reasons for the widespread use of market operations
relates to their flexibility in terms of both the frequency of use and scale (i.e., quantity) of
activity. These factors are viewed as essential if the central bank wishes to fine-tune its monetary
policy. In addition, OMOs have the advantage of not imposing a tax on the banking system.
ii. Loans to banks and the discount window
The second most important monetary policy tool of central bank is the so-called „discount
window‟ (in the United Kingdom this tool is often referred to as „standing facilities‟). It is an
instrument that allows eligible banking institutions to borrow money from the central bank,
usually to meet short-term liquidity needs. Discount loans to banks account for a relatively large
proportion of a central bank‟s total assets.
By changing the discount rate, that is, the interest rate that monetary authorities are prepared to
lend to the banking system, the central bank can control the supply of money in the system. If,
for example the central bank is increasing the discount rate, it will be more expensive for banks
to borrow from the central bank so they will borrow less thereby causing the money supply to
decline. Vice versa, if the central bank is decreasing the discount rate, it will be cheaper for
47
banks to borrow from it so they will borrow more money. Manipulation of the discount rate can
therefore influence short-term rates in the market.
Direct lending to banks can also occur through the central bank‟s lender-of-last-resort (LOLR)
function. By acting as a lender-of-last-resort the central bank provides liquidity support directly
to individual financial institution if they cannot obtain finance from other sources. Therefore it
can help to prevent financial panics.
iii. Reserve requirements
Banks need to hold a quantity of reserve assets for prudential purposes. If a bank falls to its
minimum desired level of reserve assets it will have to turn away requests for loans or else seek
to acquire additional reserve assets from which to expand its lending. The result in either case
will generally be a rise in interest rates that will serve to reduce the demand for loans.
The purpose of any officially imposed reserve requirements is effectively to duplicate this
process. If the authorities impose a reserve requirement in excess of the institutions‟ own desired
level of reserves (or else reduce the availability of reserve assets) the consequence will be that
the institutions involved will have to curtail their lending and/or acquire additional reserve assets.
This will result in higher interest rates and a reduced demand for loans that, in turn, will curb the
rate of growth of the money supply.
By changing the fraction of deposits that banks are obliged to keep as reserves, the central bank
can control the money supply. This fraction is generally expressed in percentage terms and thus
is called the required reserve ratio: the higher the required reserve ratio, the lower the amount of
funds available to the banks. Vice versa, the lower the reserve ratio required by the monetary
authorities, the higher the amount of funds available to the banks for alternative investments.
The advantage of reserve requirements as a monetary policy tool is that they affect all banks
equally and can have a strong influence on the money supply. However, the latter can also be a
disadvantage, as it is difficult for the authorities to make small changes in money supply using
this tool. Another drawback is that a call for greater reserves can cause liquidity problems for
48
banks that do not have excess reserves. If the authorities regularly make decisions about
changing reserve requirements it can cause problems for the liquidity management of banks. In
general, an increase in reserve requirements affects banks‟ ability to make loans and reduces
potential bank profits because the central bank pays no interest on reserves.
Reserve requirements are often referred to as instruments of portfolio constraint. It means that
they may be imposed by the authorities on the portfolio structure of financial institutions, with
the purpose of influencing credit creation and, possibly, the type of lending taking place.
Other instruments
i. Moral suasion
Moral suasion refers to the range of informal requests and pressure that the authorities may exert
over banking institutions. The extent to which this is a real power of the authorities relative to
direct controls is open to question, since much of the pressure that the authorities would exert
involves the institutions having to take actions that might not be in the bank‟s commercial
interests. However, the position and potential power of the authorities probably provides them
with some scope to use moral suasion, which may perhaps be utilised most effectively in the
context of establishing lending priorities rather than absolute limits to credit creation.
ii. Direct controls
Direct controls involve the authorities issuing directives in order to attain particular intermediate
targets. For example, the monetary authorities might impose controls on interest rates payable on
deposits, may limit the volume of credit creation or direct banks to prioritise lending according to
various types of customer.
Although these direct controls have the benefits of speed of implementation and precision, they
are discriminating towards the institutions involved and are likely to lead to disintermediation as
both potential borrowers and potential lenders seek to pursue their own commercial interests.
49
Their use, therefore, is perhaps best reserved for short-term requirements not least since their
effectiveness will tend to decline the longer they are applied. Such controls, however, are widely
used in many developing countries where the authorities may force banks to (say) lend a certain
percentage of loan-book to „priority sectors‟.
iii. Gentlemen’s agreements
These are voluntary agreements between the central bank and banks, aimed at improving
monetary conditions in the economy. In Tanzania such agreements have been used between the
central bank and the largest commercial bank in an effort to lower the spread on interest rates.
5.5 Why do banks need a central bank?

The banking sectors of most countries have pyramid structure where a central bank is at the apex
and the ordinary banking institutions are at the base of the pyramid. Central banks can also be
thought of as „super-banks‟, at the centre of the financial system, responsible for both „macro‟
functions, such as monetary policy decisions; and „micro‟ functions, including the lender-of-last
resort (LOLR) assistance of the banking sector. Over time the role and functions of central banks
have developed and evolved, as has the environment in which banks operate.
Liberalization, financial innovation and technology have contributed to major changes in the
operating environment.
The lender-of-last-resort (LOLR) function of the central bank
In its role as a the lender-of-last-resort (LOLR), the central bank will provide reserves to a bank
(or banks) experiencing serious financial problems due to either a sudden withdrawal of funds by
depositors or to a situation where the bank has embarked on highly risky operations and thus
cannot find liquidity anywhere else (i.e., no other institutions will lend to a bank considered near
collapse).
50
It is clear that the central bank will extend credit to an illiquid bank to prevent its failure only in
exceptional situations and in doing so it also carries out a „macro‟ function by preventing
potential financial panics. However, the central bank cannot guarantee the solvency of every
banking institution in a country. This is because it would encourage bankers to undertake undue
risk and operate imprudently, especially if banks knew that they would always be bailed out (by
taxpayers‟ money) were they to become insolvent. In other words, the security of the LOLR
function could induce or increase moral hazard in banks‟ behaviour.
5.6 Should central banks be independent?

In recent years there has been a significant trend towards central bank independence in many
countries and the issue has generated substantial debate all over the world. Theoretical studies
seem to suggest that central bank independence is important because it can help produce a better
monetary policy. For example, an extensive body of literature predicts that the more independent
a central bank, the lower the inflation rate in an economy.
Central bank independence can be defined as independence from political influence and
pressures in the conduct of its functions, in particular monetary policy. It is possible to
distinguish two types of independence: goal independence, that is, the ability of the central bank
to set its own goals for monetary policy (e.g., low inflation, high production levels); and
instrument independence, that is, the ability of the central bank to independently set the
instruments of monetary policy to achieve these goals .
It is common for a central bank to have instrument independence without goal independence;
however, it is rare to find a central bank that has goal independence without having instrument
independence. In the United Kingdom, for example, the Bank of England is currently granted
instrument independence and practices what is known as inflation targeting. This means that it is
the government that decides to target the inflation rate and the Bank is allowed to independently
choose the policies that will help to achieve that goal. Such a situation is only acceptable in a
51
democracy because the Bank is not elected and thus goals should only be set by an elected
government.
While central bank independence indicates autonomy from political influence and pressures in
the conduct of its functions (in particular monetary policy), dependence implies subordination to
the government. In the latter case, there is a risk that the government may „manipulate‟ monetary
policy for economic and political reasons. It should be noted, however, that all independent
central banks have their governors chosen by the government; this suggests that to some extent
central banks can never be entirely independent.
5.7 REVIEW QUESTIONS

i. Define Central bank and give main functions of Central Bank.
ii. State and explain five macroeconomic policies.
iii. Discuss main objectives of Central Bank when undertaking monetary policy
iv. Briefly explain tools Central Bank can use to effect monetary policies
V. Briefly explain why banks need Central Bank
Reference:
India
52
CHAPTER SIX (WEEK 9 &10)
AGGREGATE DEMAND (AD) AND AGGREGATE SUPPLY (AS)

OBJECTIVES
 Describe how aggregate demand – aggregate supply model help in determining aggregate
price level and quantity of output in an economy
 Describe aggregate demand and reasons why aggregate demand curve slopes downward
from left to right
 Give reasons why aggregate demand curve shift
 Define aggregate supply; aggregate supply curve and give reason why supply curve
aggregate is vertical in the long-run and what can cause it to shift.
 Explain why short-run aggregate supply curve slopes upward from left to right
6.1 The model of aggregate supply and aggregate demand

The amount of output depends on the economy‟s ability to supply goods and services, which in
turn depends on the supplies of capital and labour and on the available production technology.
Flexible prices are crucial because prices adjust to ensure that the quantity of output demanded
equals the quantity supplied. The economy works quite differently when prices are sticky.
Output also depends on the demand for goods and services. Demand, in turn, is influenced by
monetary policy, fiscal policy, and various other factors. Because monetary policy and fiscal
policy can influence the country‟s output over the time horizon, when price is sticky, price
stickiness provides a rationale for why these policies may be useful in stabilizing the economy in
the short run.
53
The model of aggregate supply (AS) and aggregate demand (AD) allows us to study how the
aggregate price level and the quantity of aggregate output are determined. It also provides a way
to contrast how economy behaves in ling-run and in short-run.
Price level Aggregate demand Aggregate supply
Equilibrium price
level
0 equilibrium quantity quantity of output
(Aggregate supply and aggregate demand model i.e. AD-AS model)
6.1.1 Aggregate demand (AD)

Aggregate demand is the total demand for final goods and services in the economy (Y) at a given
time and price level. It is the amount of goods and services in the economy that will be
purchased at all possible price levels.That is AD describes the relationship between price level (P)
and output (Y).
Aggregate demand curve shows the relationship between the quantities of output demanded and
the aggregate price level. In other words, the aggregate demand curve tells us the quantity of
goods and services people want to buy at any given level of prices.
The figure below illustrates the aggregate demand curve as a downward sloping curve.
Price level
P1
P2
Y1 Y2 Quantity of output
54
This means that ceteris paribus, a fall in the economy‟s overall level of prices (from P 1 to P2)
tends to raise the quantity of goods and services demanded from (Y1 to Y2).
Why the aggregate demand curve slopes downward?

Why does a fall in the price level raise the quantity of goods and services demanded? To answer
this question, recall that GDP (Y) is the sum of consumption (C), Investment (I), government
purchases/spending (G), and net exports (NX).
Y=C+I+G+NX
Each of these four components contributes to the aggregate demanded for goods and services.
Assuming the government spending is fixed by policy, the other three components of spending
(consumption, investment, and net exports) depends on economic conditions and, in particular,
on the price level.
To understand the downward sloping of the aggregate demand curve, it is crucial to examine
how the price level affects the quantity of goods and services demanded for consumption
investments and net exports.
i. The price level and consumption (the wealth effect)
Consider the money that you hold in your wallet and your bank account. The nominal value of
this money is fixed, but its real value is not. When prices fall, this money is more valuable
because then it can be used to buy more goods and services. Thus, a decrease in the price level
makes consumers wealthier, which in turn encourages them to spend more. The increase in
consumer spending means a larger quantity of goods and services demanded.
ii. The price level and investment (The interest rate effect)
The price level is one determinant of the quantity of money demanded. The lower the price level,
the less money households need to hold to buy the goods and services they want. When the price
level falls, households try to reduce their holdings of money by lending some of it out. For
instance, a household might use its excess money to buy interest bearing bonds. Or it might
deposit its excess money in an interest-bearing saving account, and the bank would use funds to
make more loans. In either case, as households try to convert some of their money into interest-
bearing assets, they drive down interest rates.
Lower interest rates, in turn, encourage borrowing by firms that want it invest in new factories
and equipment and by households who want to invest in new housing. Thus, a lower price level
reduces the interest rate, encourages greater spending on investment goods, and services
demanded.
iii. The price and net export (the exchange rate effect)
55
A lower price level lowers the interest rate. In response, some investors will seek higher returns
by investing abroad. For instance, as the interest rate of Kenya government bonds falls, an
investor might sell Kenya government bonds in order to buy other government bonds with better
interest rate say US government bonds.
As investor tries to convert his shillings into dollars in order to buy the US bonds, he increases
the supply of shillings in the market for foreign exchange. The increased supply of shilling
causes the kenya shillings to depreciate relative to other currencies.
Because each shilling buys fewer units of foreign currencies, imports become more expensive to
Kenyan residents. This change in real exchange rate ( the relative prices of domestic and foreign
goods) increases Kenyan exports of goods and services and decreases Kenyan imports of goods
and services.
Net exports, which equals export minus imports of goods and services increase. Thus, when a
fall in the Kenyan price level causes its interest rates to fall, the real value of the shillings falls
and this depreciation stimulates Kenyan net exports and thereby increases the quantity of goods
and services demanded in the Kenyan economy.
Why the aggregate demand curve might shift?

The demand slope of the aggregate demand curve shows that a fall in the price level raises the
overall quantity of goods and services demanded. Many other factors, however, affect the
quantity of goods and demanded at a given level. When one of these factors changes, the
aggregate demanded curve shifts. The following are some example of events that shifts aggregate
demand.
i. Shifts arising from consumption
Suppose people suddenly become more concerned about saving for retirement and, as a result,
reduce their current consumption. Because the quantity of goods and services demanded at any
price level is lower, the aggregate demand curve shifts to the left.
Price level
AD2 AD1
0 Quantity of output
56
Conversely, imagine that a stock market boom makes people wealthier and less concerned about
saving. The resulting increase in consumer spending means a greater quantity of goods and
services demanded at any given price level, so the aggregate demand curve shifts to the right.
Price level
0 Quantity of output
Thus, any event that changes how much people want to consume at a given price level shifts the
aggregate demand curve.
One policy variable that has this effect is the level of taxation. When government cut taxes, it
encourages people to spend more.
ii. Shifting arising from investment.
Any event that changes how much firms want to invest at a given price level also shifts the
aggregate demand curve. If firms become pessimistic about future business conditions, they may
cut back an investment spending, shifting the aggregate demand curve to left.
Tax policy can also influence aggregate demand through investment. An investment tax credit (a
tax rebate tied to a firm‟s investment spending) increases the quantity of investment goods the
firms demand at any given interest rate. It therefore shifts the aggregate demand curve to the
right.
The repeal of an investment tax credit reduces investment and shifts the aggregate demand curve
to the left.
Another policy variable that can influence investment and aggregate demand is the money
supply. An increase in money supply lowers the interest rates in the short-run. This makes
borrowing less costly, which stimulates investment spending, and thereby shifts the aggregate
demand curve to the right. Conversely, a decrease in the money supply raises the interest rate,
discourages investment spending, and thereby shifts the aggregate demand curve to the left.
iii. Shifts arising from government purchases/spending
The most direct way that policymaker shift the aggregate demand curve is through government
purchases/spending. For example, suppose the government decides to reduce purchases of new
57
weapons systems. Because the quantity of goods and services demanded at any price level is
lower, the aggregate demand curve shifts to the left.
Conversely, if the government starts building more motorways, the result is a greater quantity of
goods and services demanded at any price level, so the aggregate demand curve shifts to the
right.
iv. Shift arising from net exports.
Any event that changes net exports for a given price level also shifts aggregate demand. For
instance, when US experience a recession, it buys fewer goods from Kenya. This reduces Kenya
net exports and shifts the aggregate demand for the Kenya economy to the left. Converse it true.
Net exports sometimes change because of the movements in the exchange rate. Appreciation of
local currency depresses net exports and shifts the aggregate demand curve to the left.
Conversely depreciation of the local currency stimulates net exports and shifts the aggregate
demand curve to the right.
6.1.2 Aggregate supply

Aggregate supply is the total supply of goods and services that forms in a national economy plan
on selling during a specific time period. It is the total amount of goods and services that firms are
willing to sell at a given price level in an economy.
The Aggregate supply curve

The aggregate supply curve tells us the total quantity of goods and services that firms produce
and sell at any given price level. Unlike the aggregate demand curve, which is always downward
sloping, the aggregate supply curve shows a relationship that depends crucially on the time being
examined. In the long-run, the aggregate supply curve is vertical, whereas in the short-run the
aggregate supply curve is upward sloping.
58
Why the aggregate supply curve is vertical in the long-run?
What determines the quantity of goods and services supplied in the long-run?
In the long-run, an economy‟s production of goods and services (its real GDP) depends on its
supplies of labour, capital and natural resources and on the available technology used to turn
these factors of production into goods and services. Because the price level does not affect these
long-run determinates of real GDP, the long-run aggregate supply curve is vertical as in the
figure below
price level
P1
P2
0 natural rate of output quantity of output
In other words, in the long-run, the economy‟s labour, capital, natural resources and technology
determine the total quantity of goods and services supplied, and this quantity supplied is same
regardless of what the price level happens to be.
Why the long-run aggregate supply curve might shift?

The position of the long-run aggregate supply curve shows the quantity of goods and services
predicted by classical macroeconomic theory. This level of production is sometimes called
potential output or full-employment output. To be more accurate, we call it the natural rate
output because it shows what the economy produces when unemployment is at its natural rate.
Any change in the economy that alters the natural rate of output shifts the long-run aggregate
supply curve. Because output in the classical model depends on labour, capital, natural resources
and technological knowledge, we can categorize shifts in the long-run supply curve as arising
from these sources.
59
i. Shifts arising from labour.
The greater the number of workers the greater the quantity of goods and services supplied. As a
result of an increase in number or workers, the aggregate supply curve would shift to the right.
price level
0 output1 output 2 Quantity of output
If many workers left the economy to go abroad, the long-run aggregate supply curve would shift
to the left.
ii. Shifts arising from capital.
An increase in the economy‟s capital stock increases productivity and, thereby, the quantity of
goods and services supplied. As a results, the aggregate supply curve shifts to the right.
Conversely, a decrease in the economy‟s stock decreases productivity and the quantity of goods
and services supplied, shifting the long-run aggregate supply curve to the left.
iii. Shifts arising from natural resources
An economy‟s production depends on its natural resources, including its land, minerals and
weather. A discovery of a new mineral deposit shifts the long-run aggregate supply curve to the
right. A change in weather patterns that makes forming more difficult shifts the long-run
aggregate supply curve to the left.
iv. Shifts arising from technological knowledge.
Perhaps the most important reason that the economy today produces more than it did a
generation ago is that our technological knowledge has advanced. The invention of the computer,
for instance, has allowed as producing more goods and service from any given amount of labour,
capital and natural resources. As a result, it has shifted to long-run aggregate supply curve to the
right.
Conversely, if the government passed new regulation methods, perhaps because they are too
dangerous for workers, the result would be a leftward shift in the long-run aggregate supply
curve.
60
Why the aggregate supply curve slopes upward in the short-run.
In short-run, the aggregate supply curve is upward sloping as show in the figure below
Price level
P1
P2
That is, over a period of a year or two, an increase in the overall level of prices in the economy
tends to raise the quantity of goods and services supplied, and decrease in the level of prices
tends to reduce the quantity of goods and services supplied.
Why might the short-run aggregate supply curve shifts
1. Shift arising from labour
An increase in the quantity of labour available (perhaps due to a fall in the natural rate of
unemployment) shifts the aggregate supply curve to the right.
A decrease in the quantity of labour available (perhaps due to a rise in the natural rule of
unemployment) shifts the aggregate supply curve to the left.
2. Shifts arising from capital
An increase in physical or human capital shifts the aggregate supply curve to the right. A
decrease in physical or human capital shifts the aggregate supply curve to the left.
3. Shifts arising from natural resources
An increase in the available of natural resources shifts the aggregate supply curve to the right.
4. Shifts arising from technology
Advance in technological knowledge shifts the aggregate supply curve to the right. A decrease
in the available technology shifts the aggregate supply curve to the left.
5. Shifts arising from the expected price level
A decrease in the expected price level shifts the short-run aggregate supply curve to the right.
An increase in the expected price level shifts the short-run aggregate supply curve to the left.
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6.2 REVIEW QUESTIONS
i. Define aggregate demand and aggregate supply
ii. Give an example of events that would shift the aggregate demand curve. Which way
would these event shift the curve?
iii. Explain why the long-run aggregate supply curve is vertical
iv. Give an example of events that would shift long-run aggregate supply curve. Which way
would these event shift the curve?
V With the aid of a diagramme derive the aggregate demand curve
Reference:
India
62
CHAPTER SEVEN (WEEK 11 &12)
ANALYSIS OF SHIFTS IN AGGREGATE DEMAND AND/OR AGGREGATE SUPPLY

OBJECTIVES
 Explain the effects of shifts in aggregate demand curve and aggregate supply curve on
general price level and level of output in an economy
 Describe measures that policy makers can take when faced with stagflation
 Explain the influence of monetary and fiscal policy on the aggregate demand.
 Explain equilibrium in the money market.
7.1 THE EFFECTS OF A SHIFT INAGGREGATE DEMAND

Suppose that for some reason a wave of pessimism suddenly overtakes the economy. The cause
might be a government scandal, a crash in the stock market or the outbreak of war overseas
.because of this event; many people lose confidence in the future and alter their plans.
Household cut back on their spending and delay major purchases and firms put off buying new
equipment.
The impact of this is the reduction of the aggregate demand for goods and services. That is, for
any given price level, households and firms now want to buy a smaller quantity of goods and
services.
The figure below shows the aggregate demand curve shifts to the left from AD1 toAD2.
Price level AS1
P1 A AS2
P2 B
P3 C
AD2 AD1
In short-run, the economy moves along the initial short-run aggregate supply curve AS1, going
from point A to point B.
As the economy moves from point A to B, output falls from Y1 to Y2, and the price level falls
from P1 to P2.
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The falling level of output indicates that the economy is in recession. Firms respond to lower
sales and production by reducing employment. Thus pessimism about the future leads to falling
incomes and rising unemployment.
What should policymakers do when faced with such recession?
They can take action to increase aggregate demand. An increase in government spending or
increase in the money supply would increase the quantity of goods and services demanded at any
price and therefore, shift the aggregate demand curve to the right.
If policymakers can act with sufficient speed and precision, they can offset the initial shift in
aggregate demand; return the aggregate demand curve back to AS 1 and bring the economy back
to point A.
Even without action by policymakers, the recession will remedy itself over period of time.
Because of the reduction in aggregated demand, the price level falls. The fall in the expected
price level alters wages, price level and perceptions; it shifts the short-run aggregate supply
curve to the right from AS1 to AS2. This adjustment of expectants, allow the economy over time
to approach point C, where the new aggregate demand curve (AD2) crosses the long-run
aggregate supply curve.
In the new long-run equilibrium, point C, output is back to its natural rate. Even though the wave
of pessimism has reduced aggregate demand, the price level has fallen sufficiently (to P 3) to
offset the shift in the aggregate demand curve. Thus in the long-run, the shift in the aggregate
demand is reflected fully in the price level and not at all in the level of output.
NB/
i. In the short-run, shifts in aggregate demand cause fluctuation in the economy‟s output
of goods and services.
ii. In the long-run, shifts in aggregate demand affect the overall price level but do not
affect output.
7.2 THE EFFECTS OF A SHIFT IN AGGREGATE SUPPLY
Suppose that suddenly some firm experience an increase in their costs of production. For
example, war in the Middle East might interrupt the shipping of crude oil, driving up the cost of
producing oil products.
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The macroeconomic impact of such an increase in production costs is that for any given price
level, firms now want to supply a smaller quantity of goods and services. The figure below
shows the short-run aggregate supply curve shifts to the left from AS1 to AS2.
Price level AD AS2 AS1
P2 B
P1 A
0 Y2 Y1 Quantity of output
In the short-run, the economy moves along the existing aggregate demand curve, going from
point A to point B. the output of the economy falls from Y1 toY2, and the price level rises from
P1 to P2.
Because the economy is experience both stagnation (falling output) and inflation (rising prices)
such an event is sometimes calledstagflation.
What should policymakers do when faced with stagflation?
1. One possibility is to do nothing.
In this case, the output of goods and services remains depressed at Y2 for a while. Eventually,
however, the recession will remedy itself as wages; prices and perception adjust to the higher
production costs. A period of low output and high unemployment, for instance, puts downward
pressure on worker‟s wages. Lower wages, in turn, increase the quantity of output supplied.
Overtime, as the short-run aggregate supply curve shifts backward AS 1, the price level falls, and
the quantity of output approaches its natural rate. In long-run, the economy returns to point A,
where the aggregate demand curve crosses the long-run aggregate supply curve.
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2. Alternately, policymakers who control monetary and fiscal policy might attempt to offset
some of the effects of the shift in the short-run aggregate supply curve by shifting the
aggregate demand curve.
This possibility is as shown in the figure below.
Price level
AS2 AS1
P3
P2
P1
AD1 AD2
Natural rate of output Quantity of output
In this case, changes in policy shift the aggregate demand curve to the right from AD1 to AD2 i.e.
exactly enough to prevent the shift in aggregate supply from affecting output. The economy
moves directly from point A to point C. output remains at its natural rate, and the price level rises
from P1 to p3. In this case, policymakers are said to accommodate the shift in aggregate supply
because they allow the increase in costs to permanently affect the level of prices
NB
1. Shifts in aggregate supply can cause stagflation i.e. combination of recession (falling
output) and inflation (rising prices)
2. Policymakers who can influences aggregate demand cannot offset both of these adverse
effect simultaneously.
7.3 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE

DEMAND
Imagine that you are a member of the Central Bank of Kenya Monetary Policy Committee
(MPC), which sets Kenya monetary policy, you observe that the minister of finance has
announced in his budget speech that he is going to cut government spending. How should the
MPC respond to this change in fiscal policy?
To answer this question, you need to consider the impact of monetary and fiscal policy on the
economy. Monetary and fiscal policies can each influence aggregate demand.
Thus, a change in one of these policies can lead to short-run fluctuates in output and prices.
Policymaker will want to anticipate this effect and, perhaps, adjust the other policy in response.
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7.3.1 How monetary policy influences aggregate demand.
To understand how policies influence aggregate demand, one needs to examine the interest rate
effect in more detail. The theory of liquidity preference shows how interest rate is determined.
The theory is used to understand the downward slope of the aggregate demand curve and how
monetary policy shifts this curve.
The theory of liquidity preference

John Maynard Keynes proposed the theory of liquidity preference to explain what factors
determine the economy‟s interest rate. The theory is, in essence, just an application of supply and
demand for money.
We have two type of interest rate, the nominal interest rate which is the interest rate as usually
reported, and the real interest rate which is the interest rate corrected for the effects of inflation.
For analysis purposes, expected rate of inflation is held constant. Thus, when the nominal
interest rate rises or falls, the real interest rate that people expect to earn rise or falls as well.
Development of theory of liquidity preferences by considers the supply and demand for money
and how each depends on the interest rate.
7.3.1.1 Money supply

The first element of the theory of liquidity preference is the supply of money. The money
supply is controlled by the central bank, such as central bank of Kenya. The central bank can
alter the money supply by changing the quantity of reserves in the banking system through the
purchase and sale of government bonds in outright open-market operations.
When the central bank buys government bonds, the money it pays for the bonds is typically
deposited in banks, and this money is added to bank reserves.
When the central bank sells government bonds, the money is received for the bond is withdrawn
from the banking system and bank reserves fall. These changes in bank reserve, in turn, lead to
changes in banks‟ ability to make loans and create money.
In addition to these open-market operations, the central can alter the money supply by changing
reserves requirements (the amount of reserves banks must hold against deposit) or the
refinancing rate (the interest rate at which banks can borrow reserves from the central bank)
If we assume that the central bank controls the money supply directly, then the quantity of
money supplied in the economy is fixed at whatever level the central bank decides to set it.
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Because the quantity of money supplied is fixed by central bank policy, it does not depend on
other economic variables. In particular, it does not depend on the interest rate once the central
bank has made its policy decision; the quantity of money supplied is the same, regardless of the
prevailing interest rate. Fixed money supply is normally represented by a vertical supply curve as
shown below.
Interest rate money supply (quantity fixed by CBK)
r1
Equilibrium r
r2 money demand
Quantity of money
7.3.1.2 Money demand

The second element of the theory of liquidly preference is the demand for money. As a starting
point for understanding money demand, recall that any asset‟s liquidly refers to the ease with
which that asset is converted into the economy‟s medium of exchange.
Money is the economy‟s medium of exchange, so it is by definition the most liquid asset
available. The liquidly of the money explains the demand for it: people choose to hold money
instead of other assets that offer higher rates of return because money can be used to buy goods
and service.
Although many factors determine the quantity of money demanded, the one emphasized by the
theory of liquidly preference is the interest rate. The reason is that the interest rate is the
opportunity cost of holding money. That is, when you hold wealth as cash in your wallet, instead
of as an interest-bearing bond, you lose the interest you could have earned. An increase in the
interest rate raises the cost of holding money and, as a result, reduces the quantity of money
demanded.
A decrease in the interest rate reduces the cost of holding money and raises the quantity
demanded. Thus, as shown in the figure above money demand curve slope downward.
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7.3.2 Equilibrium in the money market
According to the theory of liquidity preference the interest rate adjusts to balance the supply and
demand for money. There is one interest rate, called equilibrium interest rate, at which the
quantity of money demanded exactly balances the quantity of money supplied. If the interest rate
is at any other level which is not equilibrium interest rate, people will try to adjust their
portfolios of assets and as a result, drive the interest rate toward the equilibrium.
For example, suppose that the interest rate is above the equilibrium level, such as r1 in figure
above. In this case, the quantity of money that people want to hold, , is less than the quantity
of money that the central bank has supplied. Those people who are holding the surplus of money
will try to get rid of it by buying interest bearing bonds or by depositing it in an interest-bearing
bank account. Because bond issuers and bank prefer to pay lower interest rates, they respond to
this surplus of money by lowering the interest rates they offer. As the interest falls, people
become more willing to hold money until at the equilibrium interest rate, people are happy to
hold exactly the amount of money the central bank has supplied. Conversely, at interest rates
below the equilibrium level, such as r2 in figure above. The quantity of money that people want
to hold, , is greater than the quantity of money that the central bank has supplied. As a result,
people try to increase their holdings of money by reducing their holdings of bonds and other
interest bearing assets.
As people cut back on their holdings of bonds, bond issuer find that they have to offer higher
interest rates to attract buyers. Thus, interest rate rises and approaches the equilibrium level.
7.4 THE DOWNWARD SLOPE OF THE AGGREGATE DEMAND CURVE

The price level is one determinant of the quantity of money demanded. At higher prices, more
money is exchanged every time a good or service is sold. As a result, people will choose to hold
a larger quantity of money. That is, a higher price level increases the quantity of money
demanded for any given interest rate. Thus, an increase in the price level from p1 to p2 shifts the
money demand curve to the right from to as shown in panel (a) of figure below.
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Interest rate price level
Money supply
r2 p2
r1 P1
0 Quantity fixed Quantity of 0 Y2 Y Quantity

by CBK money output
Figure (a) The money market Figure (b) the aggregate demand
curve (goods & service market)
Shift in money demand affects the equilibrium in the money market. For a fixed money supply,
the interest rate must rise to balance money supply and money demand. The higher price level
has increased the amount of money people want to hold and has shifted the money demand curve
to the right. Yet the quantity of money supplied is unchanged, so the interest rate must rise from
r1 to r2 to discourage the additional demand.
This increase in the interest rate has ramification not any for the money market but also for the
quantity of goods and services demanded, as shown in panel (b) of figure above. At higher
interest rate, the cost of borrowing and the return to saving are greater. Fewer households choose
to borrow to buy a new house, and these who do, buy smaller house, so the demand for
residential investment falls. Thus, when the price level rises from P1 to P2, increasing money
demand from MD1 to MD2 and raising the interest rate from R1 to R2, the quantity of goods and
services demanded falls from Y1 to Y2.
Review questions
i. With the aid of a diagram explain the effects leftward shift in aggregate demand
curve. Explain measures which policy measures can undertake counteract these
effects
ii. With the aid of a diagram explain the effects leftward shift in aggregate supply curve.
Explain measures which policy measures can undertake counteract these effects
iii. Briefly explain the influence of monetary and fiscal policy on aggregate demand
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Iv .What are effects on the equilibrium the money market when there is shift in
money demand
V .Explain equilibrium the money market
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Reference:
India
72
CHAPTER EIGHT (WEEK 13)
THE IS-LM MODEL AND AGGREGATE DEMAND

OBJECTIVES
 Explain IS-curve, what determine the slope of IS-curve, and factors that can shifts the IS-
curve
 Describe the effects of expansionary fiscal policy and contractionary fiscal policy of IS-
curve, and thus the interest rate and level of output
 Explain LM-curve and factors that can shift the LM-curve.
 Describe the effects of expansionary monetary policy and contractionary monetary policy
on the LM-curve, and thus the interest rate and level of output.
8.0 Introduction
The IS-LM model is an aggregate demand model which gives best interpretation of Keynesian
short-run macroeconomic model. The model takes price level as exogenous variable and shows
what determines national income.
IS-curve defines equilibrium in the goods market. IS stands for investment and saving, therefore
IS-curve represents what‟s going on in the market for goods and services.
LM-curve describes equilibrium in the money market. LM stands for liquidity and money and
therefore, LM curve represents what‟s happening to the supply and demand for money.
Because the interest rate influences both investments and money demand, interest is the variable
that links the two halves of the IS-LM model. The IS-LM model shows how interactions between
these markets determine the position the position and slope of the aggregate demand curve and,
therefore, the level of national income in the short run.
8.1 The IS-curve

An IS-curve shows combinations of interest rate and income/output that equilibrates the goods
market. The curve slopes downwards from left to right. Change in government spending,
taxation and investment shifts the IS-curve.
The IS-curve is derived from the Keynesian cross. Keynes, in his general theory, proposed that
an economy‟s total income was, in the short run, determined largely by the desire to spend by
households, firms and government. The more goods and services firm can sell. The more firm
can sell, the more output they will choose to produce and the more workers they will choose to
hire. Thus, the problem during recessions and depressions, according to Keynes, is as a result of
inadequate spending. The Keynesian cross is the attempt to model this insight.
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The equation for IS-curve for closed economy is a shown below;
Y=C+I+G
Interest (i)
0 output/income (Y)
The slope of IS-curve depends on:
i. Responsiveness of investment spending to changes in interest rate. This is represented

by the size of investment coefficient. If this coefficient is large, investment spending
is sensitive to interest rate i.e. the IS-curve will be relatively flat. If the coefficient is
small, IS-curve will be relatively steep.
ii. The spending multiplier – a higher multiplier means a flatter is curve and low
multiplier implies steeper IS-curve.
Thus a large investment coefficient and small multiplier gives a flatter IS-curve while a small
investment coefficient and high spending multiplier gives a steeper IS-curve.
Factors that shifts the IS-curve

i. Changes in autonomous consumption
ii. Changes in government spending
iii. Changes in taxation
iv. Changes in investment
v. Changes in net exports ( for open economy)
An expansionary fiscal policy involves either increase in government spending or a tax cut.
This shifts the IS-curve out to the right. Thus increasing both level of output and interest rate.
Interest rate (i) LM
i1
i0
IS0 IS1
0 Y0 Y1 Output (Y)
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Conversely, a contractionary fiscal policy involves either reduction in government spending or
increase in taxes. This shifts the IS-curve inward to the left, thus reducing both output and
interest rate.
Interest rate (i) LM
i0
i1
IS1 IS0
0 Y1 Y0 Output (Y)
8.2 The LM-curve

The LM-curve describes equilibrium in the money market. LM-curve shows combination of
interest rate (i) and output (Y) that equilibrates money market for a given level of income. LM-
curve slopes upwards from left to right.
interest rate (i) LM curve
Output (Y)
Expansionary monetary policy involves increase in money supply, shifts the LM-curve
outward to the right thereby increasing output and lowering interest rate.
Interest rate (i) LM0
i0 LM1
i1
IS
0 Y0 Y1
Contractionary monetary policy involves a reduction in money supply. This shifts LM-curve up
to the left causing a reduction in output and an increase in interest rate.
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Interest rate (i)
IS LM1 LM0
i1
i0
0 Y1 Y0 Output (Y)
Equation for LM curve is = f(Y,i), which means that real money supply is a function of
income/output and interest rate.
Factors that shift LM-curve:

i. Factors that affect real money supply ] such as change in money supply and
changes in prices.
ii. Factors affecting money demand such a changes in income and changes in interest
rate.
8.3. General equilibrium

General equilibrium in the economy is obtained when the IS-curve intersects LM-curve i.e. when
goods and services markets and money markets are in equilibrium. The IS-LM model is a short
run analytical model.
Interest rate (i) IS
ie
LM
Ye output (Y)
ie = market equilibrium interest rate
Ye=Equilibrium output.
8.4 IS-LM model and aggregate demand

IS-LM model is a short run model where prices are assumed fixed. In the long run, prices do
change. When prices change, the LM curve shifts, thereby affecting the level of income in the
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economy. The aggregate demand function describes the relationship between price level (P)
outputs (Y).
To determine the aggregate demand function we examine what happens to the IS-LM model
when price level changes. We derive the aggregate demand curve by assuming price increases
from P0 to P1 holding Money supply constant. An increase in price level shifts LM-curve up to
the left reducing output and raising interest rate.
Deriving aggregate demand curve from IS-LM curve
Interest rate (i) Price (p)
i1 P1
i0 P0 AD
0 Yi Y0 Output (Y) 0 Yi Y0 Output (Y)
Review questions
i. Define IS-curve and state factors that can shifts the IS-curve.
ii. With the aid of a diagram, explain the effects of increase in government spending on
the level of output and interest rate in the economy.
iii. With the aid of diagram, explain the effects of increase in tax on the level of output
and interest rate in the economy.
iv. Define LM-curve and state factors that can shift LM-curve.
v. Differentiate between:-
(a) Expansionary monetary policy and contractionary monetary policy.
(b) Expansionary fiscal policy and contractionary fiscal policy
vi. With the aid of diagrams explain the effects of expansionary monetary policy and
contractionary monetary policy.
Reference:
77
India
78
CHAPTER NINE (WEEK 14)
FORMATION OF FUTURE EXPECTATION

OBJECTIVES
 Appreciate the effect of future expectation on supply and demand in financial market.
 Describe three theories of expectation formation
 Explain the mechanics of rational expectations
 Appreciate the relationships between rational expectation and the efficient market
hypothesis.
9.0 Introduction
The expectation of consumers, banks and other businesses have pronounced effects on supply
and demand in financial markets. If inflationary expectations increase, the supply of and demand
for loanable funds shift, and higher interest rates result. Also bank‟s portfolio of assets and
liabilities depends in part on the expected return to various assets and the expected cost of
various liabilities. For example, a bank‟s amount of excess reserves is determined partly by the
expected return on alternative assets such as loans and bonds and partly expectation of the rate of
deposit withdrawals. Price of a corporate bond will depend on investor‟s expectations about the
bond‟s default risk.
8.1 Three theories of expectation formation

Suppose you want to forecast the inflation rate for the current year to determine the expected real
rate of interest on your saving deposits. By the fisher equation, your expected real interest rate
(R) is the difference between the nominal interest rate (i) paid by the bank and your inflationary
expectations ∏e.
r= I -∏e
If your bank pays 3 percent on saving deposits and you expect inflation to be 2 percent over the
next year, you expected real interest rate is only 1 percent. Obviously your incentives to deposit
money in a saving account depend not only on the rate the bank offers but on your inflationary
expectations as well. The same is true or other savers, including large investors like mutual
79
funds, insurance companies and traders. Furthermore, there is cost of making errors in your
inflationary expectations. If your inflationary expectations are too low on average during the
course of your life, your errors may lead you to make investment decisions that yield a negative
real return.
How, then, do you go about forming expectations of inflation?
There are several ways to form expectations. These include the Markov expectations, Adaptive
expectations and rational expectation hypotheses. Each approach requires a different level of
sophistication on the part of those firming expectations.
MARKOV EXPECTATIONS
The simplest way to form expectations about future events is to form Markov expectation. The
Markov expectations hypothesis asserts that individuals expect the future to be like the most
recent past. For instance, if the inflation rate last year was 3.5%, you can simply presume the
future rate will be the same as last year‟s 3.5%. With Markov expectations, individuals expect
tomorrow to be exactly like today.
An obvious shortcoming of Markov expectations is that they do not take into account knowable
events that might change the future environment. For instance, if the inflation rate is rising,
Markov expectations will continually miss the mark.
Each year you will expect the inflation rate to remain at its previous level, but each year you will
be surprised to find it higher than expected.
This hypothesis ignores other information that might be useful in predicting the future. Markov
expectations are based solely on the most recent value of the variable being forecast.
ADAPTIVE EXPECTATIONS
The adaptive expectations approach assumes expectation evolve over time in light of past
experience. It allows past trends in variables as well as previous forecast errors to affect future
expectation as people slowly learn from past mistakes. For instance, a person may notice that her
expectation of inflation was too high previous period and thus revise downward her expectation
of the future inflation rate. Since adaptive expectations look backward, they take into account the
past history of a variable and of forecasts of that variable.
80
A potential problem with adaptive expectations is that when the future is continually changing,
past history is not always a good forecast of the future. Another problem is that adaptive
expectations do not use all the information that is useful in forecasting the future.
RATIONAL EXPECTATIONS
The main criticism of Markov and adaptive expectations is that they may not be based on
variables economic theory suggests are useful in forming more accurate expectations. This has
led to the idea of rational expectations, which is the most sophisticated of the three methods of
forming expectation.
The rational expectations hypotheses asserts that when people form expectations, the use all
knowable information, including variables economic theory suggests are relevant for making
predictions. Since rational expectations incorporate all relevant information, any deviations from
what is expected are purely random in nature; any forecast errors that arise are just as likely to
positive as negative.
People will use all available information to formulate expectations of economic variables such as
inflation, interest rate and money supply. Individuals have strong incentives to make rational
forecasts and will act accordingly. If their expectations are consistently wrong, they will
reformulate the expectations model to include other variables. Therefore, increasing inflation
would lead to a rational conclusion that the monetary authorities like central bank will engage in
restrictive monetary policy to reduce inflationary pressure.
Such expectations would be considered rational because they include information that is relevant
for properly forecasting inflation.
THE MECHANICS OF RATIONAL EXPECTATIONS

In forming a rational expectation about interest rates, bond prices, or exchange rates an
individual would list all the determinants of demand and supply. All available information about
this determinant would be used to help predict the location of demand and supply curve to form
an expectation of the equilibrium interest rate, bond prices, or exchange rate. In this way rational
expectations are based on the known variables economic theory various as relevant, thus there
are no systematic forecasting errors.
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8.2 Rational Expectation and the Efficient Market Hypothesis
The efficient market hypothesis states that the current price of an asset such as a share of stock
reflects all available information about the value of the asset. More generally, according to the
efficient markets hypothesis, the risk adjusted expected return on all investments will be equal;
that is, the return you should expect to earn you could earn on this stock exactly equals the return
you could earn on any other asset with similar risk characteristics. The reason is that if one asset
earns a higher risk-adjusted expected rate of return than other asset, investors will quickly
attempt to purchase that asset, driving up its price and thus lowering its expected return.
The efficient markets hypothesis is closely related to the rational expectations. In fact, for a
market to be efficient, expectations must be based on all known relevant information, which
rational expectations require. Thus rational expectations are necessary for efficient markets.
Review questions
i. Explain the effects of the expectation of consumers, banks and other businesses on
supply and demand in financial markets
ii. Discuss briefly three theories of expectations expectation formation.
iii. Describe the relationship between rational expectation and the efficient market
hypothesis
iv Explain the mechanics of rational expectations
v Outline the problems experienced in adaptive expectations
Reference:
India
82
Sample Questions for Revision
SECTION A
Question 1
(a) i. Differentiate between money and individual wealth. (1 mark)
ii. Explain clearly why money is a good medium of exchange (4 marks)
(b) i. What is the meaning of financial service market (1 mark)
ii. Differentiate between security market and primary market (2 marks)
iii. There are two types of commercial paper, direct commercial paper and dealer commercial
paper. Differentiate between the two types. (2 marks)
(c) i. Write in brief the difference between Markov expectations and Adaptive
expectation (5 marks)
(d) i. What is LM-curve? State any one factor which can cause a shift in LM-curve (2 marks)
ii. Differentiated between expansionary monetary policy and contractionary monetary
policy (3 marks)
(e) (i) Define money and differentiate money and income (2 marks)
(ii) State and briefly explain two physical properties of money (3 marks)
(f) i. Differentiate between the following terms
 Debts market and Equity market

 Money market and capital market ( 3 marks)
ii. Give the meaning of money market instruments and capital market instruments. In each
case give one example. (2 marks)
(g) i. Explain the important function of financial markets (1.5 marks)
ii. What do you understand by the term financial intermediation (1.5 marks)
iii. Distinguish between money supply and money demand (2 marks)
(h) i. People are normally in confusion between inflation and economic growth. As a financial
consultant of XYZ Company give the difference between:-
 Inflation and economic growth
83
 Nominal output and real output (3 marks)
ii. Explain the meaning of aggregate demand and aggregate supply (2 marks)
(i) i. An IS-Curve shows the combination of interest rate and income/output that equilibrates
the goals the goods market. State any four factors that can cause shifting of IS-curve. (3 marks)
(ii) Differentiate between expansionary fiscal policy and expansionary fiscal policy (2 marks)
(j) i. State and briefly explain any two Monetary Policy Instruments that can be used by central
bank to achieve its objectives. (4 marks)
ii. What is a central bank? (1 mark)
(k) i. Write brief notes about price level (4 marks)
ii. Differentiate between inflation rate and growth rate (1 mark)
(l) i. Differentiate between exchange rate policy and monetary policy (2 marks)
ii. State any three advantages of using open market authorities to influence short-term interest
rates. (3 marks)
SECTION B
Question 2
i. While classical economists tended to emphasize the use of money in making transactions,
Keynes identified three motives for holding money. State and explain the three motives he
identified. (9 marks)
ii. Differentiate between 100-percent reserve and fractional-reserve banking (4 marks)
iii. Write the meaning of the following as used in the model of the money supply
 The monetary base (B)

 The reserve-deposit ratio (rr)
 The current-deposit ratio (cr) (6 marks)
iv. Suppose that the monetary base (B) is $ 1000 billion, the reserve deposit ratio (rr) is 0.2, and
the currency-deposit ratio (cr) is 0.12. Find the total money supply. (4 marks)
v. What differentiate bank from other financial institutions. (2 marks)
84
Question 3
i. Briefly explain four functions of money (8 marks)
ii. Write brief notes about treasury bills (6 marks)
iii. State three advantages and two disadvantages of issuing commercial papers (5 marks)
iv What do you understand by the financial instrument know as repurchase agreements (3 marks)
v. Bank A borrow an overnight loan of 200 million from bank B in form of repurchase
agreement. The repo rate was 7%. Compute the interest income to bank B from this
overnight lending. (2 marks)
Question 4
i. State and briefly explain with the aid of a diagram two factors or events that can cause shifts in
aggregate demand (5 marks)
ii. Explain why aggregate supply curve is vertical in long-run (3 marks)
iii. Suppose, suddenly firms experience a decrease in the costs of production as a result of
decrease in price of petroleum and electricity bills. As result of this the aggregate supply
curve shifts to the right. Illustrate this shifting in an aggregate demand (AD) – aggregate
supply (AS) model. Discuss the effects of this shifting on price level and income/output. (6
marks)
iv. Using IS-LM model, explain the effects of contractionary monetary, which involves the
central bank decreasing money supply, on interest rate and income/output (6 marks)
Question 5
i. State and explain three physical properties of a commodity that can be used as money (6
marks)
ii. Name any three users of debt market (6 marks)
iii. Write notes about common stocks and preferred stocks (6 marks)
iv. State any two money markets instruments (2 marks)
Question 6
85
i. Assume you are a financial consultant. Explain to a layman why individuals in the economy
can buy $ 3,000 worth of goods and services if the money stock is only $600. (6 marks)
ii. Using your own example explain what will happen to money demand (Md) if:-
 Price level (p) increase holding income (Y) and velocity (V) constant (3 marks)
 Velocity (V) increase holding price (p) and income (Y) constant (3 marks)
iii. Differentiate between precautionary and speculative motive of holding money (4 marks)
iv. What do you understand by the term fractional-reserve banking? (2 marks)
v. Differentiate between the reserve deposit (rr) and the currency-deposit ratio (cr). (2 marks)
Question 7
i. What is real output (2 marks)
ii. If the projected GDP of a country is 800 billion in 2011 and the projected consumer price
index (CPI) is 1.25 in the same period. Find the expected real GDP. (3 marks)
iii. Assuming that the real output was 5000 billion in 2010 and this is expected to be 4800 billion
in 2011. Calculate the growth rate between 2010 and 2011. What does the result imply? (3 mks)
iv. Write brief notes about the relationship between inflation and economic growth (6 marks)
v. State any 3 cause of inflation (3 marks)
vi. What is the meaning of equation of exchange? (3 marks)
Question 8
i. With the aid of an example explain how growth in money stock causes inflation (5 marks)
ii. Explain the meaning of velocity of money (2 marks)
iii. Differentiate between monetary policy and fiscal policy (3 marks)
iv. State and clearly explain three main objectives of monetary policy undertaken by central
bank (9 marks)
v. Distinguish between goal independence of a central bank and instrument independence of a

central bank (3 marks)
vi. Differentiate between adaptive expectations and rational expectations (3 marks)
86
Question 9
i. State and briefly explain with the aid of a diagram two factors or events that can cause shifts in
aggregate demand (5 marks)
ii. Explain why aggregate supply curve is vertical in long-run (3 marks)
iii. Suppose suddenly firms experience an increase in the costs of production as a result of
increase in price of petroleum and electricity bills. As result of this the aggregate supply curve
shifts to the left. Illustrate this shifting in an aggregate demand (AD) – aggregate supply (AS)
model. Discuss the effects of this shifting on price level and income or output. (6 marks)
iv. Using IS-LM model, explain the effects of expansionary monetary, which involves the
central bank increasing money supply, on interest rate and income/output (6 marks)
87

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DEPARTMENT OF ACCOUNTING & FINANCE

COURSE CODE: BFM 412

COURSE TITLE: Monetary Theory and Policy

BY: Mr. MBURU PETER

Cell phone No.:0723135375

Expected learning outcomes of the course

Harris L (2004), Monetary Theory, McGraw Hill

Mankiw N. G. and Mark P. T. (2006) Economics, Thomson Learning, UK.

MONEY AND BANKS

At the end of this chapter a student should be able to:

 Define money and differentiate money from income and wealth

1.2 Functions of money

ii. Unit of account

iii. Store of value

iv. Standard of deferred payment

1.3 Physical properties of money

i. Money should be portable

1.4 Review questions

ii. Explain the functions of money in the economy.

iii. Describe the properties of a commodity that can be used as money.

Iv Money is used as a store of value but this function is inefficient.Discuss

FINANCIAL MARKETS, FINANCIAL INSTITUTIONS AND FINANCIAL

At the end of the chapter, a student should be able to:

 Define financial market

2.1 Financial markets

Classification of financial markets

i. Classification of the markets based on the type of instrument or service as follows:

Debt markets are used by:

(b) Equity markets

(c) Financial service markets

(b) Secondary markets

This method categories financial market into:-

2.2 Financial instruments

Money market instruments

(a) Treasury bills

Types of treasury bills

There are several types of bills that are issued by governments:

Calculating the yield on bills

Would have a discount rate of:

For the above bill,

(c) Commercial paper

Types of commercial paper

There are two types of commercial paper:

Advantages of commercial paper

Disadvantages of issuing commercial paper

A repurchase agreement(repo) is a short-term loan where by the borrower sells marketable

RP interest income = (Amount of loan xCurrent RP rate) )

(100,000,000 x 0.07) x =ksh. 19,444.44

2.2.2 Capital market instruments

(b) Preferred stock

MONEY DEMAND AND MONEY SUPPLY

At the end of this chapter, the student should be able to;

 Define money demand

3.1 Money demand

3.1.2 The classical view of money demand

The simple quantity theory

We can write the equation of exchange as M x V =TS

Using this formula, we can write the equation of exchange as

Then the simple quantity theory of money demand becomes

velocity is 5, so money demand is $ 200, calculated as

What happens if the prices of the goods double to $ 2 each?

3.1.2 Keynes’s view of money demand

3.2 Money supply