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Limitations of Credit Creation Process

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Added on 2021/02/22

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The assignment discusses the limitations of the credit creation process in modern banking. It highlights various factors that affect a bank's ability to create credit, such as leakages of cash outside the system, public deposits, prudent management of lending operations, changes in legal requirements, and the power of central banks to control currency. The summary also mentions that people's habit of using cash can influence a bank's ability to create credit.

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MONETARY POLICY.
It is one of the public interventionist measures aimed at influencing the level and pattern of
economic activity so as to achieve certain desired goals.
It covers all the actions by the Central Bank and Government which influences the quantity, cost
and availability of money and credit in the economy specifically monetary policy works on two
principle economic variables, Aggregate supply of money in the economy, And Level of interest
rates.
Whereas monetarism is a doctrine it holds that in the monetary policy is the determinant of
aggregate demand. Keynes holds that in the short run fiscal policy is important and that monetary
policy matters only in as far as it affects fiscal variables. Presently in Kenya Central Bank Kenya
carries out the technical work of formulating and executing the monetary policy.
Objectives of Monetary Policy
It’s important to understand the distinction between objectives or goals, targets and instruments of
monetary policy. Where goals of monetary policy refers to the objectives which may be price
stability, full employment or economic growth targets refers to variables such as supply of money
or bank credit, interests rates which are sought to be changed through so as to attain the objectives.
The following are some of the goals or objectives which monetary policy may be expected to
attain; -
Attainment of Full Employment
Full employment can be said to be consistent with the some little unemployment as potential
workers search for employment. It is also argued that a certain amount of structural unemployment
is acceptable since individuals without jobs may not have the skills needed by employers at least
in the short run. Monetary policy can raise the level of employment by encouraging credit to labour
intensive sectors like rural agriculture. In addition a policy that lowers the rate of interest
constitutes expansionary monetary policy and it is likely to lead to increased investment and hence
more employment opportunities.

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Achievement of Price Stability
This is the problem of avoiding inflation. Inflation reduces the ability of money to effectively
perform its function, especially as a store of value and as a standard of deffered payments.
Moreover price stability can be maintained by regulating money supply through the tools of
Central Bank Such as discount rate, minimum reserve requirements and Open Market Operations.
Price stability however does not mean absolutely no change in price i.e. a certain rate of inflation
is inevitable.
A high degree of inflation has adverse effects on the account. First, inflation raises the cost of
living of the people and hurts the poor most. It sends many people below the poverty line. It also
makes the export costlier and therefore discourages them, on the other hand due to higher prices
at home people are induced to import goods to large extent.
Thus inflation has adverse effects on the balance of payments. Thirdly when due to a higher rate
of inflation value of money is rapidly falling, people do not have incentive to save. This lowers
the rate of saving on which investment and economic growth depend. Fourthly, a high rate of
inflation encourages businessmen to invest in the productive assets such as gold, jewellery, real
estate etc.
To Attain Economic Growth
This can be defined as a process where the real GNP per capital increases over a period of time.
Monetary policy can contribute to this end by providing investment funds through cheaper credit
and by mobilizing savings which can be used for investment. The investment funds can be
allocated to those sectors with the highest rates of return. This better allocation of resources brings
about increased output. Monetary policy can promote economic growth through ensuring adequate
availability of credit and lower cost of credit. There are two types of credit requirements for
businessmen i.e. Working capital for importing needed raw materials and machines from abroad.
Secondly, they need credit for financing investment in projects for building fixed capital.
Easy availability of credit at low interest rates stimulates investment and thereby quickens
economic growth. To ensure higher economic growth the adequate expansion of money supply

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and greater availability of credit at a lower rate of interest is needed. But large expansion of money
supply and bank credit lead to the increase in aggregate demand which tend to cause a higher rate
of inflation. This raises the question of what is acceptable trade off between growths and inflation.
It may noted that the context of the openness of the economy and floating exchange rate system as
is the case of the Kenyan economy today, the objective of achieving higher rate of economic
growth through monetary measures may also conflict with the objective of exchange rate stability
i.e. the value of Kenya shillings in terms of Us dollars and other foreign currencies.
Whereas prevention of depreciation of the Kenyan shilling requires tightening of monetary policy
that is; rising of interest rates, reducing liquidity of the banking system to that banks restrict their
credit supply. The promotion of economic growth requires low lending rates of interest and greater
availability of credit for encouraging private investment.
To Maintain Equilibrium in Balance of Payments, BOP
Until the early 90s, Kenya followed fixed exchange rate system and only occasionally devalued
the shilling with the permission of the International monetary fund. The policies of floating
exchange rate and increasing openness and globalization of Kenyan economy has made the
exchange rate of the shilling quite volatile. The changes in capital inflows and capital outflows
and changes in demand for and supply of foreign exchange, particularly the US dollars arising
from the imports and exports causes great fluctuations in the foreign exchange rate of the shilling.
In order to prevent large depreciation and appreciation of foreign exchange, the Central Bank of
Kenya has to take suitable monetary measures to ensure the foreign exchange stability. When there
is mismatch between demand for and supply of foreign exchange, external value of the shilling
changes.
For instance presently, in (July 2008) the depreciation of the Kenya shilling has been caused by
the increase in demand for dollars for financing the country’s imports, the surging inflationary
pressures and excess liquidity in the market. Through the rise in the cost of credit and reduction in
the availability of credit, borrowing from the banks can be discouraged and hence reduction in
demand for dollars. Higher interest rates in Kenya would also discourage foreign institutional
investors and Kenyan corporate to invest abroad which will work to reduce demand for dollars

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which will prevent the fall in shilling value. Alternatively to prevent the shilling depreciation the
central bank of Kenya can release more dollars from its foreign exchange reserves. This will
increase the supply of more dollars in the foreign exchange market which will correct the mismatch
between demand for and supply of US dollars. Hence the shilling exchange rate will stabilize.
Alternatively monetary policy can be used in such a way that credit is selectively directed to the
export sector and away from import sector. At the same time capital inflows can be encouraged
and outflows discouraged through exchange controls. Another related goal is that of exchange rate
stability which often requires the intervention of policy makers in the foreign exchange market.
The creation of sound banking and financial institutions is needed to mobilize savings for capital
formation. Thus for example banking should be encouraged in rural and urban areas. While the
objective would be regarded as a means of achieving the previous goals it is also a consideration
that appears to be an independent goal.
Role Monetary Policy in Economic Growth
Economic growth implies the expansion in productive capacity or capital stock in the economy so
that an increase in real national output or income is attained. As is well known economic growth
can be speeded up by accelerating the rate of savings and investment in the economy. This requires
the following steps
➢ Increase in the aggregate rate of savings
➢ Mobilization of these savings so that they are made available for the purpose of investments
and production
➢ Increase in the rate of investment
➢ Allocation of investment funds for productive purposes and priority sectors of the economy
Monetary policy and savings
Several monetary measures can be adopted to raise the aggregate level of savings. According to
Keynes the rate of interest represents the cost of investment and the lower the rate of interest the
greater will be the inducement to invest. This however may not produce the desired results because

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where inducement to invest may be promoted by lowering the interest rates the adequate amount
of resources or savings needed to finance large amount of investment may not be forthcoming at
lower interest rates. Further a lower rate of interest rates policy in a developing country like Kenya
is likely to promote more investment in inventories and luxury consumer goods such as cars, air
conditioners, luxury houses rather than capital goods. The interest rate should therefore be
relatively high to induce more savings so that so that more sources are made available for
investment in fixed capital.
Besides monetary policy can play a strategic role in increasing savings by promoting the expansion
of banking facilities and other financial intermediaries in the under developed countries, especially
in the rural areas. With more bank branches in under banked and under developed regions, the
people who consume away their surplus incomes, will be induced to save them inform of bank
deposits which are quite safe as a store of value. The commercial banking encourages thrift or
propensity to save by offering a return on savings inform of interests rate on bank deposits.
It also induces more savings by providing more outlets for fruitful investments of saving by people
who would otherwise put them to unproductive or wasteful uses such a buying land, gold and
jewellery. In order to facilitate mobilization of an increasing proportion of saving by the banking
system it is essential to maintain a reasonable rate of price stability. Further if banks are to mobilize
adequate amount of savings inform of bank deposits, interests’ rates on bank deposit must remain
positive in real terms (nominal rate of interest minus inflation). If there is excessive rise in prices,
real rate of interest become negative, and people will be discouraged to save.
Monetary policy and Investment
Monetary policy has an important role to play in boosting up the level of investment by making
available saving or resources mobilized by banks for purposes of investment and production. The
banks fulfill this by offering credit for investment in business and industry.
It may be noted that Keynesian theory of monetary policy emphasizes that the effect of a change
in money supply on the level of production and investment operates through the change in interest
rates. Increase in money supply by monetary authority will cause the market rate of interest to fall.

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At a lower rate of interest the entrepreneurs will be induced to invest more. However it has been
argues that investment in fixed capital is interest inelastic. That’s why Keynes did not have much
faith in monetary policy effectiveness and instead promoted the role of fiscal policy in influencing
the economic activity. Recent monetary policy emphasizes the credit availability effect on
investment of the changes in money supply. According to this, an increase in the supply of money
causing the expansion in the reserve money with the bank directly changes the availability of bank
credit for investment purposes and therefore raises the level of investment in the economy.
Allocation of Investment Funds
Mobilization of savings alone would not do enough. Proper channeling of these into suitable
direction of investment is more important than mobilization. The monetary policy should restrict
the growth of wasteful line of investment which is dangerous to economic growth. It should be
able to direct investment onto productive channels. In this regard the monetary policy should play
a selective and qualitative role in its operations in order to discriminate between productive and
unproductive outlays. It should be designed in such a way that it influences the specific sectors
and industries which are most significant to affect growth of the economy.
Therefore it’s necessary to operate the selective credit rationing with a view of influencing the
pattern of investment. This may be done by fixation of ceiling on the aggregate portfolio of the
commercial banks, thereby making its incumbent those loans and advances do not exceed the fixed
ceiling. Alternatively it may be done by directly allocating funds that can be granted and used.
Besides policy such as rediscount policy, prior deposit requirement and the fixation of deposit
requirement policy can also be adopted to achieve similar goals.
Measures such as lengthening the period of repayment, lowering of margin requirements,
providing rediscounting facilities at rates below the bank rates, provision of special loans to
commercial banks to be used for specific purposes are also used. However the extent to which
such measures can help provide resources for investment in the desired directions depends on the
extent to which the flow of credit towards the undesirable channels can be prevented.
Secondly such measures may go a long way in galvanizing the process of growth by restraining
inflation and its adverse effects. When inflationary tendencies set in, generally the bank advances

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to businessmen tend to rise. In this way certain undesirable and unproductive enterprises may grow
and flourish. For instance, activities such as speculative demand for building up inventories,
accumulation of precious metals for purchase of foreign exchange get a flip. Growth of such and
other unwanted industries can be held in check by raising the margin requirements for their
collateral.
Conflicting Objectives of Monetary Policy
Some of the objectives seem to be conflicting and mutually contradictory
E.g. price stability and economic growth. In the period of growth some price rise or inflation is
inevitable. Additional money has to be injected into circulation to finance development projects.
This results in price rise. Inflation which is mild first becomes higher after some time presetting
an obstacle to economic growth thus price stability and economic growth are not compatible
objectives.
Price stability and full employment - Economists argue that full employment can only be
improved under conditions of price wage stability. The Philips curve gives a negative relationship
between inflation and unemployment. Therefore some trade off between unemployment and
inflation need to be found. Price stability and full employment are conflicting objectives.
Full employment and balance of payment equilibrium - Similarly there is a designed to
maximize domestic employment and economic growth B.O.P deficit is bound to emerge. With the
rise of domestic income, imports increase fast hence expansionary monetarily policy will create
inflation and exports will decrease. In this case B.O.P equilibrium will be disturbed.
Full employment and economic growth - The objective of full employment and economic
growth will be found to be conflicting. Full employment is a static concept while economic growth
is a dynamic one.
Full employment is concerned with raising output to the level of production possibility, whereas
economic growth concerns itself with the raising of production possibility itself. If full

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employment increase income and imports and result in B.O.P disequilibrium the measure adopted
to correct it may work against economic growth.
There is also some conflict between exchange stability, price stability and economic growth in the
initial stages of economic development. Imports increase whereas exports are static. This results
in exchange instability. Artificially raising the exchange rate will worsen the B.O.P positions and
slow down the rate of economic growth.
CREDIT CREATION
It refers to the process by which banks are able to lend out amounts of greater magnitude than the
amounts they originally received as deposits.
The principle of credit creation was developed by the early goldsmiths. The use of gold for
transactions was considered unsafe and inconvenient for customers and merchants to carry given
that it needed to be weighed and assessed for purity each time a transaction took place. It therefore
became common to deposit ones gold with goldsmiths who possessed strong warehouses which
they made available for a fee. At certain points the goldsmiths became aware that the gold they
stored was rarely redeemed and that the amount of gold deposited over a given period of time was
likely to exceed the amount withdrawn during the period.
The goldsmiths realized that paper money could be issued in excess of the amount of gold held
and hence creating money. An example can be used to illustrate the process of credit creation in
modern banking.
Assume a country with a single bank where customers deposit a total of Kshs. 10M. Assuming
that the bank lends all these deposits to other customers, those customers in turn will use the money
to buy commodities and they will pay various firms and individuals for these purchase. Assuming
that the firms and individuals in turn put the money into their own accounts with the bank, the
bank deposits will have doubled.

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Limitations of the Process of Credit Creation
➢ There may be leakages of cash outside the banking system. E.g. some money lent out may
not be re-deposited into the banking system. This is particularly so where many people
does not keep money in the banks.
➢ Another important limitation on credit creating power of banks is the amount of money
which the public choose to hold as deposit in the banks. The more the money the public
deposits with the bank, the more the reserves banks would have and therefore more credit
they will be able to create and vice versa. It can be noted that the public can use their saved
money in more than one way. The public can buy shares or debentures or invest in mutual
funds of both public and private companies. But the credit creation by the banks depends
on the money the public deposit with them. It is important to note that rate of interest paid
by the banks on the deposits determine to a good extent the amount of money deposited
with them by the public. Other things being equal, the higher the rate of interest, the greater
the amount of money the public will deposit money with the banks.
➢ Prudent management of lending operations by the banks themselves. Banks may be
demanding substantial security in order to lend especially where risk of default is
substantially high. Many banks in developing countries have a considerable proportion of
non – performing loans and therefore tend to be cautious in rending.
➢ A change in legal requirements regarding cash reserve ratio which in turn influence the
credit creation.
➢ It may be said that credit can be created on the basis of cash. The larger the cash (e.g. the
legal tender money) the larger the amount of credit that can be created. But the amount of
cash that that a bank may have is subject to the control of central bank. The central bank
has the monopoly of the issue of cash. It may increase it or decrease it, and credit will
contract or increase accordingly. The power of central bank to control currency helps it to
control the extent of credit that the banks have the power to create.
➢ The habit of people regarding the use of cash might be another limitation. If people are in
the habit of using cash not cheques, as in Kenya, then as soon as credit is granted by the
bank to a borrower, he will draw cheque and get cash. When the bank cash reserve is thus
reduced, its power to create credit is correspondingly reduced. On the other hand if people

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use cash for only small and odd transactions then the cash reserve of the banks is not much
drawn upon and their power of creating credit remains unimpaired.
➢ The bank cannot create credit without acquiring some asset. An asset is a form of wealth.
Thus the bank only turns immobile wealth into mobile wealth. In fact bank does not create
money out of thin air, it transmit other forms of wealth into money. However the banking
system has become quite advanced, they can give credit on the basis of personal goodwill
rather than on the basis of any form of wealth.

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Limitations of Credit Creation Process

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