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A central bank, reserve bank, or monetary authority is an institution that manages a state’s currencymoney supply, and interest rates. Central banks also usually oversee the commercial banking system of their respective countries.

The assets and liabilities of a central bank include:

Assets Liabilities

Bankers’ Bank – Loans – Banks’ Deposits

Government’s Bank – Government Securities – Government accounts

-Foreign Exch. Reserves

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THE SUPPLY AND DEMAND FOR CENTRAL BANK MONEY

  • The demand for central bank money is equal to the demand for currency by people plus the demand for reserves by banks.
  • The supply of central bank money is under the direct control of the central bank.
  • The equilibrium interest rate is such that the demand and the supply for central bank money are equal. This produces the LM curve

Money Supply and Interest Rates

The LM curve gives the combinations of income and the interest rate for which the demand for money (or desired liquidity) equals the money supply. The LM curve represents equilibrium in the money market.

Interest Rate

LM

Real National Income (y)

The LM curve is upward shifting. An increase in interest rate increases income in the money market.

Equilibrium in the goods market is given by the IS curve. The IS curve gives the combinations of income and the interest rate for which the goods market is in equilibrium.

Real National Income (y)

Interest

Rate

y1

yo

LM0

LM1

IS

r0

r1

An increase in the money supply holding the real interest rate constant requires a higher level of income to make the demand for money equal to that greater supply, shifting LM to the right.

Money Supply and Interest Rates: interaction of the LM and the IS curves give the prevailing interest rate and income in the economy.

THE COMPLEX MONEY MULTIPLIER

Money Supply is composed of currency and demand deposits i.e.

Ms = Cp + D

Where:

Ms = Total Money supply

Cp = Currency with the public

D = Demand deposits

The two important determinants of money supply are High powered money and the Size of the money multiplier

High powered money (H)

This consists of currency issued by the government. Part of the currency issued is held by the public and the rest by banks as reserves.

H = Cp + R

Cp – Currency held by the public

R – Cash reserves with banks.

The government is the producer of high powered money while commercial banks are the producers of demand deposits

In order to produce credit banks have to keep with themselves reserves which serve as the basis for multiple creation of demand deposits. This provides high poweredness to the currency issued by the government.

It is against these reserves that banks create multiple expansions of credit which creates Money supply in an economy

The Money Multiplier Theory expresses Money supply as a multiple of H. This is graphically represented as below

R

Cp

Dp

Cp

Ms =Cp +Dp

H Cp = Cash held by the Public

R = Cash Reserves

H = High powered money

Dp = Demand Deposits

The top of the above graph shows the total stock of Money supply while the base shows the supply of High powered money. The top is a multiple of the base

It can be seen that cash reserves (Cp) does not grow. However demand deposits are a multiple of reserves i.e. a shilling of it kept as bank reserves give rise to much more amount of demand deposits. The relationship between Ms and H is determined by money multiplier i.e the ratio of Ms to H, m =

Size of Money Multiplier

It is the currency reserve ratio and the currency deposit ratio which determines size of money multiplier. Note that Ms = Cp +Dp. From the formula for m:

But reserves at commercial banks are in two forms; the required reserves (RR) and excess reserves (ER). Required reserves are a mandatory requirement by the government through the central bank while excess reserves are created by commercial banks if they lack the capacity to invest all the legally allowable deposits. Thus:

R = RR + RE

Our multiplier equation becomes:

Divide through by Dp

If Cp/Dp = c, RR/Dp = r and RE/Dp = e, the multiplier formula becomes:

Accordingly money supply is determined by:

  • High powered money
  • The currency deposit ratio (c)
  • The Reserves/deposit ratio (r) and (e)

DETERMINANTS OF MONEY SUPPLY

Deposit Multiplier

The change in credit created as a result of change in reserve is called the deposit multiplier which depends upon the cash reserve ratio.

Where dm is deposit multiplier. If r = 10% then dm =10.

Bank Rate Policy

It is the maximum rate at which the Central Bank of a country provides loans to commercial Banks in an economy. It is also called the discount rate because in earlier times Central Banks used to provide finance to the commercial banks by rediscounting rate of discount. Through changes in the bank rate the Central Bank influences the amount of credit created.

When the Central Bank raises the bank rate, the cost of borrowing by commercial banks from the Central Bank increases discouraging borrowing. Banks also raise their lending rates. Eventually businessmen and individuals will feel discouraged to borrow from commercial banks. This leads to a contraction in bank credit resulting in a reduction in aggregate money supply.

Open Market Operations (OMO)

It is the purchase and sale of government securities by the Central Bank of a country. The sale of securities leads to a contraction of credit and purchase leads to an expansion of credit thereof.

Deficit Financing

When government expenditure exceeds revenue and there is a deficit in government budget, the government results to borrowing from the Central Bank which creates new currency notes for the purpose. The creation of new currency to finance the government budget is known as monetization of deficit.

The government also borrows from ordinary commercial banks. When banks lend money to the government they create credit. The creation of deposits by the banks when they advance credit leads to increases in money supply.

Selective Credit control

Selective credit control is meant to regulate the flow of credit to specific sectors. If credit is directed to the productive sectors of the economy, money supply increases at a faster rate. If on the other hand credit is directed to the less productive sectors, money supply is curtailed.

TOPIC FIVE: THE CENTRAL BANK OF KENYA

History of the Central Bank of Kenya

The East African Currency Board was established in 1919. At this time, the Sterling was the exchange standard. The role of the sterling exchange standard was to keep the exchange rate of the East African Shilling fixed in terms of the sterling. This was through a mechanism under which the currency board was required to convert into sterling any amount of its local currency issues.

The operations of the East African Currency Board were executed in London. The board had to deposit in London the equivalent of any money withdrawn from the East African states. The Board’s monetary functions were entirely passive, and it had no discretionary power at all in the matter of control of the monetary base.

Since the Currency Board lacked monetary and financial independence, after Kenya attained her independence, the government found it necessary to establish a national monetary control aimed at efficient operation of the monetary system.

In May 1966, the Central Bank of Kenya was established by an Act of Parliament with only 10 (mainly foreign owned) commercial banks. The set goal for the financial sector was to ensure its growth and stability so that it could stimulate growth in other sectors of the economy thus achieving a high economic growth rate.

Different rules were put in place to regulate and aid in the operations of the Central Bank of Kenya. As regards financial intermediaries, the rules were to govern reserve requirements, regulations of the interest rates paid on liabilities, refinancing and credit control and generally supervise and regulate depository institutions.

The financial system expanded and became more diversified in the 1970s and 1980s especially with the government policy to encourage local participation in the financial system and setting up of specialized institutions to collect savings and finance investment.

Evolution of Monetary Policy in Kenya

In 1966 the Central Bank of Kenya (CBK) was established by an act of parliament. The statutory powers of CBK were further strengthened by the Banking act of 1968. Between 1966 and 1969 the CBK took over the responsibility of issuing currency from the EACB. It also consolidated its role as the major holder of foreign exchange. CBK introduced the Treasury bill (a short term financial instrument) to help in relieving the government from short term financial needs.

CBK also introduced a liquidity ratio of 12.5% as an instrument of credit control. The period from 1970 to 1975 was a period when CBK tried to effect strict BOP management. In 1970 the government recorded a BOP deficit of Shs. 362 million. In addition the consumer price index rose by 7%. In an attempt to correct the BOP deficit and reduce pressure on prices, the central bank took measures such as eliminating the minimum cash ratio.

Its role was now performed by the liquidity ratio which was raised to 15% in 6 months. As a result of the credit measure adopted combined with the de-evaluation of the shilling in 1971, CBK succeeded in reducing the growth of credit to 21% from 34% in the previous year. This further resulted in a remarkable position of Kshs. 191 million surpluses in 1973 from a deficit of 491 million. Meanwhile consumer prices rose by a lower rate of 4% compared to a rate of 7% in the previous period.

In 1973 inflation rate increased to 15 percent reflecting a sharp rise in money supply that was caused by a surplus in the BOP. There was deliberate effort by the CBK to increase local private sector borrowing. The CBK controlled local borrowing by foreign controlled companies to a maximum of 60 percent of the amount of their foreign investment.

The coffee boom period which lasted from 1976 – 1977 marked another distinct phase in Kenya’s monetary policy. A temporary frost in Brazil caused world coffee prices to rise sharply thereby increasing the forex reserves held by CBK by Kshs 2.8 million which led to a surplus in BOP to 2.176 billion from 787million in 1977.

To avoid inflation associated with the buildup of surpluses, the CBK raised the liquidity ratio of commercial banks and non – banking financial institutions from 15 percent to 18 percent. The lending rate was raised to a maximum of 10 percent. The year 1978 recorded a BOP deficit of Kshs 496 million. Domestic credit grew by 35 percent in 1978, money supply increased by 14 percent while the GDP grew by 7 percent.

The exceptional increase in government borrowing in 1979 marked the beginning of a new period for the management of monetary policy with budgetary operations tending to undermine monetary policy. Hence the government combined fiscal and monetary policy to effect changes in the economy e.g. in 1981 the CBK adjusted downwards the exchange rate and raised interest rates substantially. The devaluation measure was supposed to correct BOP developments but inflationary consequences of fiscal policy tended to undermine the attempt to bring positive returns on saving deposits.

Since 1984 an important objective of fiscal and monetary policy has been to check the allocation of banking system credit between GOK and private sector by progressively limiting the government share. For example by the end of 1984 GOK share of credit amounted to 28.7 percent of the total banking sector credit. New government debt instruments namely treasury bonds (1, 2 and 5 year maturity bonds) primarily intended for modern policy management were introduced in 1986.

Money Supply and Interest Rates

Interest rates were liberalized and de-controlled in July 1991 following the introduction of OMO a month earlier. However despite the introduction of new instruments, domestic credit and money supply continued to expand between 1987 and 1991 owing to expansionary monetary policy.

Fundamental changes in the conduct of monetary policy were introduced through the amendment of CBK Act of 1996. These amendments were aimed at enhancing the efficiency of operations of the financial systems. Following the amendment the CBK now has the responsibility and the operational independence required to formulate and implement monetary policy. At present the main instrument used by CBK in the conduct of monetary policy are minimum reserve requirements, O.M.O, rediscounting and advanced facilities.

Policy Reforms and Financial institutions in Kenya

There was a review of the Banking Act in 1985, 1988 and 1989. This was aimed at reducing the regulatory differences between banks and NBFIs, and strengthening the role of Central Bank in the financial sector. There was a review of interest rates in line with inflation. Interest rates were also streamlined to reduce the differences between commercial banks and NBFIs’ rates. Election of Monetary Committee in 1988 was also undertaken to develop a database and other internal infrastructure necessary for an effective management of the reserve money.

The Central Bank also aimed at creating a level ground for both the Commercial Banks and the NBFIs to enhance competition and ensure stability of the industry. The capital requirement for both cadres of institutions was therefore raised and the margin of difference reduced. Due to this, a number of banking institutions merged to meet the new capital requirement and to boost their competitiveness.

The reforms also aimed at the development and implementation of specific restructuring programmes for weak and solvent banking institutions. Some of the weak institutions were placed under statutory management, while others received capital injections from new investors or existing shareholders. The government adopted an even better approach when it incorporated the Consolidated Bank of Kenya in 1989. The bank was formed through the acquisition of seven insolvent institutions, which it restructured into a commercial bank.

Restructuring of the financial system in Kenya resulted to mergers and acquisitions involving various banking institutions. The basic reason for the mergers was to stabilize the banking industry in Kenya, which was considered to be largely unstable. However, the government went further and raised the core capital requirement to further enhance stability in the industry.

This resulted to more mergers as banking institutions worked towards raising the core capital requirement. In 2006, the Minister for Finance directed that all commercial banks should increase their minimum core capital to Ksh. 1 billion by the year 2012. This move was taken to further stabilize the industry.

In recent times, reforms have taken cognizant of financial innovation within the financial sector. The agency banking model, mobile banking and introduction of derivatives are some of the new features in the financial sector in Kenya that have received policy concern and backing. The Kenyan financial system has consequently adopted these instruments and used them to increase efficiency in financial service delivery and foster financial inclusion.

Interest rate liberalization

Before the liberalization of interest rate in Kenya in 1991, Kenya followed a policy of low interest rates, adjusting for inflation to maintain positive real rates. The main aim of this policy was to keep the costs of funds low, with the belief that cheap credit promoted development through increased investment. The use of interest rates to manage monetary conditions and mobilize and allocate financial resources in an efficient manner was neglected.

Interest rates remained under the administration of the government through a regime of fixing minimum savings rates for all deposit-taking institutions and maximum lending rates for commercial banks and non-bank financial intermediaries. Levying of extra charges on loans was not allowed. Deposit savings rates were too low compared with the lending rates, widening the spread between the two.

The inflationary pressure created by the first oil crisis made the interest rate negative in real terms. As indicated in the 1974–1978 Development Plan, the government saw the need to review the interest rates to encourage savings through the banks and to create a disincentive to forestall speculation and uneconomic use of savings by borrowers. Starting in 1989, the interest rate policy was reviewed with the following objectives:

  1. To keep the general level of interest rates positive in real terms in order to encourage savings and to contribute to the maintenance of financial stability;
  2. To allow greater flexibility and encourage greater competition among the banks and non-bank financial institutions to enhance efficient allocation of financial resources – in particular, the policy strove to ensure that funds flowed into those areas that are most productive, with the biases against long term lending and lending to small business eliminated; and
  3. To reduce the differential to maximize lending for banks and non-bank financial intermediaries.

With liberalization, the interest rate policy aimed to harmonize the competitiveness among the commercial banks and non-bank financial intermediaries by removing the differential that had existed for maximum lending rates to allow greater flexibility and encourage greater competition in interest rate determination so that the needs of both borrowers and lenders could be better met through the cooperation of market forces and to maintain the general positive levels of interest rates in real terms in order to encourage the mobilization of savings and contribute to the maintenance of financial stability.

Interest rates were finally liberalized in July 1991. The immediate experience with interest rates was very promising, as they recorded positive real rates and the spread between the lending and the deposit rates narrowed. This was short lived, however, with the high inflationary conditions. A tight monetary policy was adopted to mop up the excess liquidity.

Treasury bill rates therefore increased, thus pushing up the interest rates. Moreover, Commercial banks increased their deposit rates as they competed for deposits from the non-banking sector. The depreciation of the exchange rate and the increasing Treasury bill rates worsened the inflationary condition. The interest rates became negative in real terms and the spread between the lending and deposit rates widened. The desired goal was not met.

Functions of the Central Bank

  1. Central banks generally formulate and implement the monetary policy in a given country. This function is usually directed at achieving and maintaining price stability. In this regard central banks have sometimes issued guidelines on credit and interest rates. In addition, they have often been agencies of governments for issuing and underwriting of government borrowing instruments such as treasury bills. They therefore play a vital role in controlling the level of money supply in a given country.
  2. Central banks have a role of encouraging liquidity, solvency and proper functioning of the financial system. Central banks thus inspect commercial banks and other financial institutions and in this way become principal advisors on whether or not to issue or renew licenses of financial institutions. In addition authorized dealers in the banking markets are usually supervised by the central bank.
  3. Central banks usually formulate and implement a country’s foreign exchange policy. In countries that have exchange control, the central bank may be responsible for enforcing such controls. A related aspect is the management of a country’s foreign exchange reserves which is usually conducted by the central bank.
  4. Central banks also usually act as banks advisers and fiscal agents of the government.
  5. Central banks issue currency notes and coins in their respective countries. In this regard central banks have taken over from currency boards which originally had the function of issuing currencies.

Central Bank Independence and Macroeconomic Performance

Essentially, central banks are government banks. Central Bank independence therefore refers to the extent to which the central bank of a country carries out its functions independent of executive and legislative control. This is also called ‘central bank autonomy’. Central bank independence is important since it ensures that various key macroeconomic targets are achieved with more efficiency.

Central bank independence can be achieved through various ways:

  1. Legal Aspect – refers to the freedom or flexibility permitted to a central bank by legislation.
  2. Political Aspect – The political independence reflects the degree to which the central bank is allowed to pursue its functions without interference from the political authorities. The central bank’s political independence is determined by a number of factors, including the procedures for appointing the central bank’s governor, independence of board members and the term of office of central bank officials.
  3. Price Stability Aspect – a low inflation regime is pursued by most central banks. The delegation of monetary policy power to central banks is believed to lower inflation and ensure independence
  4. Exchange Rate Policy Aspect – Traditionally finance ministries (or treasuries) have held ultimate responsibility for the exchange rate policy of a country. The degree of independence afforded to the central bank is critical in the ability of the government to pursue exchange rate targets

The Central Bank of Kenya is independent by law. The Kenyan Constitution [231(3)] says;

Money Supply and Interest Rates

‘ The Central Bank of Kenya shall not be under the direction or control of any person or authority in the exercise of its powers or in the performance of its functions.’

The independence of the central bank is a fundamental principle in modern central banking. Empirical evidence shows that Central Banks that are independent have better control of inflation and are able to independently motivate economic growth in their jurisdictions. Such central banks are also able to manage a coherent and sustainable foreign exchange policy that is responsive to economic needs and performance.

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