Chapter 14: The monetary sector

Functions of money
What is money
❖ Anything generally accepted as payment for g+s / settlement of debt
❖ Convenient way of exchanging goods, allowing people to specialise in specific areas of
economic activity
❖ Intermediary that eliminates need for bartering
❖ Means to end & not FoP / wealth / income

Barter economy
❖ System where g+s directly exchanged for other g+s, & no money involved
❖ Requires double coincidence of wants

Functions of money
❖ Medium of exchange:
⬧ Intermediary to smooth process of exchange & make it more efficient
⬧ Most basic function of money
❖ Unit of account:
⬧ Agreed measure for stating prices of g+s
⬧ Common measure of cost of g+s used to decide how best to spend income
❖ Store of value:
⬧ Can be held & exchanged later for g+s
⬧ Standard of deferred payment = measure of value for future payments
⬧ More convenient & can be used immediately in exchange for other assets
⬧ Most liquid form of wealth kept (according to Keynes)

Different kinds of money

Commodity money
❖ Currency is commodity
❖ Intrinsic value of commodity = exchange value of it
Credit / fiduciary money
❖ Paper note is only partially backed by commodity
❖ Value of money in circulation ˃ value of gold backing it

Evolution of money
❖ Barter → gold → metal coins → paper money → plastic cards → electronic money → crypto currency

Money in SA

Monetary aggregates
❖ Broad categories that measure amount of money in circulation in country / economic sector

3 methods SARB uses to measure quantity of money

❖ Conventional measure (M1):
⬧ Coins & notes (in circulation outside monetary sector) + demand deposits (incl. cheque &
transmission deposits) of domestic private sector with monetary institutions
- SARB has sole right to make, issue, destroy banknotes & coins
- SARB guided by public’s cash requirements when deciding how many banknotes & coins
to issue
- Cash brought into general circulation & gain worth through purchase of assets by SARB
- Deposits immediately available & accepted as payment in SA by withdrawing from bank
through cheque / EFT
⬧ M1 = C + D
❖ Broader definition of money (M2):
⬧ M1 plus all other short-term & medium-term deposits of domestic private sector with monetary
institutions
⬧ M2 = M1 + quasi money
❖ Most comprehensive measure of money (M3):
⬧ Best measure of developments in monetary sector
⬧ M3 = M2 + all long-term deposits of domestic private sector with monetary institutions

Financial intermediaries

Financial intermediaries
❖ Institutions that specialise in purely financial transactions where no goods / non-financial
services involved
❖ Main function = act as go-betweens between surplus units & deficit units in monetary economy
Securities
❖ Paper certificates / electronic records that provide evidence of ownership of equity (stocks), debt
obligations (bonds), related financial instruments
❖ Tradable financial assets

Bonds
❖ Financial instrument that promises issuer will regularly
pay bond holder interest & will repay capital amount
at certain date
❖ Every bond has principle, maturity date, coupon rate
❖ Gvrn issues bonds to finance part of its expenditure

Demand for money

Amount of money various participants in economy plan to hold in form of money balances
Choices made by participants who earn income / possesses wealth
Doesn’t relate to amounts of money people want (demand ≠ want)
Active balances
❖ Holding money with purpose of actively spending it on transactions
Passive balances
❖ Holding money passively as store of value

Cost of holding money

❖ Opportunity cost
⬧ ↓ Interest rate = ↓ opportunity cost of holding money
❖ Impact of inflation

Components of demand for money

❖ Transactions demand / demand for active balances:
⬧ No money = can’t participate in economic transactions
⬧ Due to medium of exchange function of money
❖ Speculative demand / demand for passive balances:
⬧ Due to store of value function of money
⬧ ↓ Interest rate = ↓ opportunity cost of holding money = ↑ speculative motive for holding money
- Inverse relationship between interest rates & speculative demand for money
❖ Precautionary demand:
⬧ Act of holding real balances of money for use for unforeseen expenses
2 motives for holding money
❖ Transactions motive:
⬧ For holding & borrowing money to take part in economic transactions
⬧ Money as means of payment / medium of exchange
❖ Speculative motive:
⬧ Money as asset / store of value

Liquidity preference (demand for money)

❖ Demand for money is f(x) of income level & interest rate level
❖ Total money demand curve obtained by considering demand for active & passive balances
Liquidity requirement (shortage)
❖ Central bank compels private banks to borrow substantial funds
⬧ Ensures banks maintain certain level of liquidity over & above statutory level of reserves
compulsory to hold
❖ Ensures refinancing system’s influence on interest rates remains effective
❖ Open market transactions used to drain excess liquidity from money market
⬧ Always ensures liquidity shortage

Function Motive Active/passive Main determinant

Medium of exchange Transactions Active Income
Store of value Speculative Passive Interest rates

Interest rate (price of money)

❖ Amount of interest payable over certain period expressed as % of amount borrowed
❖ Price borrower pays to enjoy use of un-owned funds
❖ Return lender enjoys for deferring their consumption / parting with their liquidity
❖ Inverse relationship between:
⬧ Interest rates & bond prices
⬧ Interest rates & speculative demand for money

Stock of money: How is money created?

Total value of monetary assets available in economy at specific time / in circulation
Many misconceptions - created by banks, not by mint / printing press
Banks create deposits by granting loans
Banks limited by:
❖ Demand for loans
❖ Actions of central bank (varying repo rate)

Role of SARB in economy

SARB is monetary authority in SA current functions are
❖ Formulation & implementation of monetary policy
❖ Service to gvrn:
⬧ Banker & advisor
⬧ Custodian of gold & foreign exchange reserves
⬧ Administration of exchange control
❖ Provision of economic & statistical services
❖ Maintaining financial stability:
⬧ Bank supervision
⬧ National Payment System
⬧ Banker to other bankers
⬧ Banknotes & coins

Monetary authority
❖ Body that:
⬧ Controls money supply of given currency
⬧ Oversees banking system in nation
⬧ Implements monetary policy
Repo rate
❖ Interest rate at which central bank’s willing to extend credit to private banks
❖ Influences market interest rates

Monetary policy
Measures taken by monetary authorities to influence quantity of money / rate of interest to achieve
stable prices, full employment, economic growth
Manipulation of interest rates & should be applied in harmony with fiscal policy
Responsibility of SARB and Monetary Policy Committee
Main features
❖ Ultimate objective = balanced & sustained economic growth
❖ Intermediate objective = pre-announced inflation target
❖ Operational variable = repo rate
❖ Monetary control system = classical reserve system

Monetary policy framework

❖ Framework put in place by monetary authority to implement country’s monetary policy
Monetary growth targeting
❖ Instrument of monetary policy
❖ Short-term interest rates are main instrument of monetary policy
❖ Pre-announced targets pursued indirectly by changes in central bank’s official discount rate
⬧ Reduces amount of credit if central bank ↑ rate
Classical cash reserve system
❖ Min cash reserve requirement is 2.5% of bank’s liabilities
❖ Open market policy creates persistent liquidity shortage
⬧ Cash reserves provided through repo system
❖ Repo rate impacts short-term interest rates & short-term interest rates impact credit creation,
money stock, inflation
Cash reserve requirement
❖ Min amount of cash private bank legally required to hold with central bank
❖ Controls quantity of money available in market
❖ Central bank acts as lender-of-last-resort to bank with liquidity issues

Key instruments of monetary policy

❖ Accommodation policy / repurchase tender system (with repo rate as policy variable):
⬧ System whereby private banks tender weekly for SARB funds through repurchase
agreements (banks must borrow substantial amounts)
⬧ Repos are main means whereby banks obtain funds to comply with their cash reserve
requirements
⬧ System allows for central bank to meet liquidity needs of private banks
❖ Open-market policy (to render interest policy effective):
⬧ Sale / purchase of domestic financial assets (treasury bills & gvrn bonds) by central bank to
exert specific influence on interest rates & quantity of money
❖ Other instruments:
⬧ Includes non-market-oriented measures:
- Credit ceilings & deposit rate control
- Changes in exchange control regulations
- Central bank intervention in foreign exchange markets
- Public debt management
- Informal measure of moral suasion

Bank supervision
Issuing of banking licenses to banking institutions & monitoring their activities to achieve
efficient & stable banking system
❖ Benefits depositors of banks & economy as whole
❖ Capital asset holdings
❖ Liquid asset holdings