Economics

VARSITY COLLEGE
Economics 1B
Prepared by Abel Zumani
 Learning Unit 2: The Monetary
Sector
Learning Content:
Define money;
Describe the functions of money;
Discuss the process of different forms of money;
Define the M1, M2 and M3 money aggregates;
Discuss the functions of the South African Reserve Bank;
Discuss the factors which influence:
• The supply of money (how money is created);
• The demand for money.
Explain the causes of changes in equilibrium in the money market;
Discuss the instruments of monetary policy.
Define money
• Money is anything that is generally accepted as
payment for goods and services or that is accepted in
the settlement of debt.
• Money eliminated the cumbersomeness and double
coincidence of wants that the barter economy
functioned under.
• Money serves as a lubricant or intermediary to smooth
the process of exchange and to make it more efficient.
 What are the functions of money?
1. Money as a medium of exchange – is used for transaction purposes.
2. Money as a unit of account – is an agreed measure for stating the prices of
goods and services. During inflation, loses some of its usefulness as a unit of
account. As such nominal rand values need to be adjusted for inflation to
obtain real rand values.
3. Money as a store of value – means that money can as well be held in the form
of wealth. Wealth can also be held in other forms such as fixed property, real
assets, stocks, gold, etc. The advantage of using money as a store of wealth lies
in the fact that money is the most form in which wealth can be kept. The
function of money as a unit of account and the store of value function are both
derived from the medium of exchange function. This means that if money did
not fulfil the function of a medium of exchange, it could not serve as an
accounting unit or as a store of value.
What money is not
• Money is not income or wealth.
• Income is the reward earned in the production process (factors
of production) e.g. rent, wages and salaries, interest and profit.
• Wealth consists of assets that have been accumulated over time
e.g. fixed property, shares, bonds, gold coins, paintings, money,
etc. Wealth consists of real assets as well as financial assets.
• The confusion is based on the fact that wealth can be in the form
of money and that wealth is calculated in monetary terms.
Different kinds of money
• The earliest forms of money were commodities e.g. cocoa beans,
beads, seashells, tea, cattle, silver, gold, etc.
• The intrinsic value of the commodity was equal to the exchange value
assigned to it.
• Properties such as uniformity, durability, divisibility and portability
were not found in all commodities.
• Eventually, coins made out of different metals emerged as money.
• Due to greater dependence on trade and the large transactions, coins
became inconvenient and were replaced by paper money in the 16th
century.
• Today, bank notes and coins issued by the South African Reserve Bank (SARB) have
been declared by law as legal tender in that they must not be refused if they are
tendered for payment.
• Cheque accounts, as a form of money, constitute the largest part of the money stock.
Money in South Africa
The SARB uses three different measures of the quantity of money; namely, M1, M2
and M3 respectively.

1. The conventional measure (M1)

• M1 includes coins and notes (in circulation (outside the monetary sector) as well as
all demand deposits (including cheque and transmission deposits) of the domestic
private sector with monetary institutions.
• Only cash in the hands of the public can be used as a means of payment.
• The cash in bank vaults cannot be used directly to pay for goods and services.
• The monetary sector in South Africa includes the SARB, the Corporation for Public
Deposits, the Land Bank, Postbank, Private banking institutions and mutual
building societies.
• Demand deposits refer to deposits that can be withdrawn immediately by
means of a cheque or electronic fund transfer (EFT).
• Everything that normally serves as means of payment is included in the definition
of M1.
• Money (M) = C + D
where M = quantity of money
C = cash (coins and notes in circulation outside the monetary sector)
D = demand deposits
• D is the largest component of M1.
2. A broader definition of money (M2)
• M2 is equal to M1 plus all other short-term and medium term deposits of the
domestic private sector with monetary institutions.
• Short-term (invested for less than 30 days) and medium-term (invested for less than
6 months) deposits are not immediately available as a medium of exchange but can
only be withdrawn earlier than the maturity date at a cost.
• The short-term and medium-term deposits are called quasi money (near money)
due to their short maturity periods.
3. The most comprehensive measure of money (M3)
• M3 is equal to M2 plus all long-term deposits of the domestic private sector with
monetary institutions.
• Long-term deposits have a maturity of longer than six months.
• M3 is the most reliable indicator of developments in the monetary/financial sector
of the economy.
• M3 is a reflection of the store of value function and not only the function of money
The South African Reserve Bank
• The most important financial institution in any monetary economy in any
monetary economy is the central bank.
• South Africa’s central bank is the South African Reserve Bank (Reserve Bank, the
Bank or SARB) established in 1920.
• The Constitution of South Africa states in part that the primary object of the SARB
is to protect the value of the currency and perform its functions without fear,
favour or prejudice, but there must be regular consultation between the Bank
and the Minister of finance.
• The SARB has the following four major functions:
a. Formulation and implementation of monetary policy
b. Service to the government
c. Provision of economic and statistical services
d. Maintaining financial stability
Formulation and implementation of monetary policy
• The main instrument through which monetary policy is conducted in South Africa
is through the Bank’s accommodation policy (refinancing system or the repo rate
tender system).
• Through its refinancing system, the Bank meets the daily liquidity needs of private
banks.
• In order to ensure the refinancing system’s influence on interest rates remains
effective, the Bank compels banks to borrow huge amounts of money (liquidity
requirement) from itself.
• Other instruments like the open market transactions are used to drain excess
liquidity from the market so as to ensure a liquidity shortage at all times.

Service to the government

• The following are the three services that are provided by the SARB to central
government:
i. Banker and advisor
The SARB is the main banker for the government.
It grants credits and deals with weekly issues of treasury bills on behalf of the
Treasury.
It advises the government with regard to monetary and financial matters.
It is responsible for the administration of all exchange control regulations.

ii. Custodian of gold and foreign exchange reserves

The SARB keeps all the country’s gold and foreign exchange reserves except for
the balances held by bank and the Treasury.
The level of gold and other foreign reserves is one of the main barometers of the
state of the economy and of prospects of future economic growth.
The Bank is also responsible for the formulation of exchange rate policy.
iii. Administration of exchange control
Exchange control restricts the movement of foreign exchange in order to protect
an economy from disruptive fluctuations in capital movements and other
international economic shocks.

Provision of economic and statistical services

 The Bank collects, processes, interprets and publishes economic statistics and
other information.

Maintaining financial stability

 Price stability is SARB’s most important objective.
 In order to pursue this objective, the Bank plays a vital role in the following
areas:
a. Bank supervision – the SARB is responsible for bank regulations and
supervision in South Africa.
b. The National Payment System (NPS) – the Bank oversees the safety and
soundness of the NPS so as to reduce interbank settlement risks resulting from
settlement defaults by bank/s.
c. Banker to other banks – The Bank acts as custodian of the minimum cash
reserves that banks are legally required to hold or prefer to hold voluntarily
with the Bank. The Bank acts as a clearing bank in clearing the banks’ mutual
claims and obligations to one another. The Bank is also the lender-of-last resort
to banks experiencing liquidity problems.
d. Banknotes and coins – The Bank has the sole right to make, issue and destroy
banknotes and coins.
The demand for money
• The demand for money is the amount that the various participants in the
economy plan to hold in the form of money balances.
• Demand is not the same as wants.
• Therefore, the demand for money does not relate to the amounts of money that
people want, but is concerned with the choices of those participants who earn an
income or possess wealth.
• They must decide in which form to hold their income and wealth.
• Money consists of cash (C) and demand deposits (D).
• Holders of cash earn no interest on it while interest on demand deposits is
generally zero.
• The money could have been used to purchase bonds that earn higher interest
than money does.
• What is a bond?
• A bond is a financial instrument that promises that the issuer (the borrower)
will regularly pay the holder interest and will repay the capital amount at a
certain date.
• A bond has a few features:
The principal – is the amount that the issuer will repay to the bondholder when
the bond expires.
The maturity date – the date on which the bond will expire.
The coupon rate – the interest that the issuer promises to pay the bondholder
until maturity date.
• Bonds are a form of marketable debt and can be traded in the secondary bond
market e.g. the Bond Exchange of South Africa, which is part of the JSE.
• The bond market forms part of the capital market, which is a market for long-
term financial instruments.
• Four main categories of financial instruments traded in the capital market: bonds,
variable interest security, shares and negotiable documents.
• The opportunity cost of holding any money balance is the interest that could have
been earned had the money been used to purchase bonds instead.
• The demand for money is directly related to the functions that it performs.
• The two most important functions of money are the medium of exchange and the
store of value functions.
• Two basic components of the demand for money are distinguished on the basis of
these two functions:
The transactions demand for money which arises from the medium of exchange
function.
The demand for money as an asset which arises from the store of value function.
• John Maynard Keynes referred to the demand for money as a liquidity preference,
denoted by symbol L.
• Therefore, the first reason for holding money is the transactions motive which is
related to the function of money as a medium of exchange.
• At aggregate level, the transactions demand for money is therefore a function of the
total income (Y) in the economy and is largely independent of interest rates (i).
Transactional demand for money
i

Interest rate L1 (at Y1)

0 M
L1
• The second motive for the demand for money is the speculative motive, which is
related to the function of money as a store of value.
• Speculative demand for money; consider the choice between holding money
(which earns little or no interest) and holding bonds (which earns interest).
• Therefore, the choice between holding financial assets in the form of money or
bonds will depend on the interest rate (i).
• The opportunity cost of holding money is the interest that is foregone by not
holding bonds.
• The quantity of money demanded for speculative purposes will be low when the
interest rate is high since the opportunity cost of money is then also high; and the
opposite it true.
• There is a negative (inverse) relationship between the quantity of money
demanded for speculative purposes and the level of interest rate.
Speculative demand for money

i
Interest rate

L2

0 M
• The transactions demand for money is related to the need to actively employ
the money balances, no wonder it is also called active balances.
• The speculative demand for money is not directly linked to transactions because
the purpose is to hold the money passively as a store of value; hence they are
called passive or idle balances.
TheFunction
demand for money (or liquidityActive/Passive
Motive preference): a summary
Main determinant

Medium of exchange Transactions Active balances Income

Store of value Speculative Passive balances Interest rate

• The joint or total money demand curve or total liquidity preference (LL) is the
summation of the quantity of active balances (L1) and the quantity of passive
balances (L2) at each interest rate.
• The position of the demand curve is mainly determined by the demand for active
balances, which is determine by the income level.
The joint or total money demand
curve or total liquidity preference
(LL)
i
L
Interest rate

L = L1 + L2

0 M
• The demand for money is a function of the income level and the interest rate level as
expressed in the following equation:
L = f(Y,i), where
L = quantity of money demanded
Y = national income
i = interest rate

The interest rate

• Interest rates can be described as the prices of loanable funds.
• Lenders (suppliers of funds) aim to earn an income (interest) on their investment,
while borrowers (demanders of funds) are willing to pay a price for the right to use
these funds.
• There are different kinds of interest rates, e.g. the repo rate, the interbank lending
rate, the prime rate of banks, various rates on deposits, mortgage rates, the rate on
government stock, etc.
 The stock of money: how is money created?
• Money is largely created by banks and not by a mint or printing press.
• Money creation by the banks is limited by the demand for loans as well as the
actions of the central bank (SARB).
• The quantity of money demanded depends, inter alia, on the interest rate.
• Growth in money stock must not be excessive since it can lead to inflation.
• The central bank regulates the money creation process and attempts to inhibit
the excessive creation of money and inadequate amount of money being created.
• The SARB uses interest rates to influence the rate at which new money is created.
• There is no independent money supply curve since the stock of money is
determined by the interaction of the demand for money and the interest rate.
• This is called a demand-determined money stock or endogenous money.
 The determination of the quantity of money
.
i

i0 E0
Interest rate

i1 E1

0 Mo M1 M

Quantity of money
 Monetary policy
• Monetary policy is defined as the measures taken by the monetary authorities to
influence the quantity of money or the rate of interest with a view of achieving
stable prices, full employment as well as economic growth.
• Monetary policy is South Africa is formulated and implemented by the SARB.
• Monetary policy decisions are taken by the Monetary Policy Committee (MPC) of
the SARB and consists of the governor, deputy governors, and few senior officials
of the Bank.
• Through daily (since 2001) tenders, banks tender for central bank funds through
repurchase transactions (repos).
• A repo is the sale of an existing security (financial asset) at an agreed price,
coupled with an agreement by the seller to buy back the same security on a
specified future date (normally seven days later) at the same price.
• Repos are the main means through which banks obtain funds so as to comply
with their cash reserve requirements.
• Formal inflation targeting of between 3% and 6% was introduced in
the year 2000.
• The following are the main features of the South African monetary
policy framework:
a) The ultimate objective is balanced and sustainable economic
growth.
b) The intermediate objective is the pre-announced inflation target.
c) The operational variable is short-term interest rates, which are
governed by changes in the interest rate.
d) The monetary control system is a classical cash reserve system.
The traditional approach to the supply of money and equilibrium in the money
market
 The instruments of monetary policy
1. Accommodation policy (or the refinancing of the liquidity
requirement)
• Due to the classical cash reserve system, banks are obliged to hold 2.5%
of their total liabilities to the public in the form of cash reserve with the
Reserve Bank.
• Banks that are in need of funds source (borrow) funds from the overnight
interbank market at the interbank interest rate.
• If all banks have the same liquidity problems, the Reserve Bank, as
banker’s Bank, acts as lender of last resort and the banks obtain funds
through the repo rate system.
• Eligible underlying assets for these assets are restricted to bonds,
Treasury bills, Land Bank bills and the Reserve Bank debentures of all
maturities.
• The accommodation policy of the Reserve Bank mainly consists of
changes in the repo rate and other conditions on which cash is made
available to banks.
• The SARB uses this instrument to regulate the quantity of money
through variations in the cost of credit.
• Changes in the repo rate determine the interest rates at which credit
is made available to their clients.

2. Open-market policy
• Open-market transactions speak to the sale or purchase of domestic
financial assets (mainly Treasury bills and government bonds) by the
SARB in order to exert a specific influence on interest rates and the
quantity of money via its influence on the cash reserves of the banks.
• The SARB uses the open-market transactions to ensure persistent
shortages of liquidity (the money market shortage).
• If the SARB want to create or increase the banks’ liquidity shortage, it
sells government bonds or other securities to the banks.
• This compels banks to approach the SARB for repurchase agreements
thereby making the SARB’s accommodation policy more effective.
• When the SARB wants to stimulate the creation of bank deposits, it
uses the open market operations to ease liquidity conditions and lower
interest rates (quantitative easing) by buying government bonds and
other securities.
• In order to motivate banks to sell the securities, the SARB offers higher
prices for them.
• There is a negative relationship between the bond price and the yield
(interest rate).
Other instruments
• The SARB also uses other non-market-oriented measures such credit
ceilings and deposit rate control (discontinued), exchange control
regulations, intervention in foreign exchange markets and public debt
management.
• Moral suation – is the consultation and persuasion that the SARB
conducts in order to influence the banks in a certain direction when it
does not wish to use other policy instruments.
• As a supervisor of the banks, the SARB sees to it that banking
institutions adhere to the various requirements with regard to capital
and liquidity asset holdings.
Macroeconomics

• If Adam Smith is the

father of
economics, John
Maynard Keynes is
the founding father
of macroeconomics
 If economists could manage to get
Don’t you themselves thought of as humble,
think you are competent people on a level with
an Economist dentists, that would be splendid.
in the John Maynard Keynes
(The father of Macroeconomics)
making?
Economics
; The field
of the
Genius!!