Transcript Money and Monetary Policy

Money as a Medium of Exchange
Money is an intermediary and acts as a medium
of exchange.
This is unique to and defines money.
Money: anything that is generally accepted as
payment for goods and services or that is
accepted in settlement of debt.
Unit of account: an agreed measure for stating the
prices of goods and services.
Prices expressed in monetary terms.
Common measure of cost allows decisions on how best to
spend our income.
Could you measure GDP in a barter economy???
Accounting unit – when prices increase, nominal values
adjusted for price increases to obtain real values; only
possible with money.
Wealth can be held property, shares etc.
BUT, money is liquid
When inflation is high money loses purchasing
power and is not a good store of value.
Money can serves as a standard of deferred
payment – credit can be granted.
Income
Natural resources, labour, capital and
entrepreneurship = rent, wages and salaries,
interest and profit.
Wealth
Includes ALL assets
Earliest forms of money were commodities.
Suitability depended on…
• Uniformity
• Durability
• Divisibility
• Portability
Standardised coins produced, but not ideal for large
transactions
Paper money created by goldsmiths in exchange gold/silver
deposits they received (certificates of deposit).
Initially, paper money backed fully backed by gold – gold
standard
Followed by fractional reserve system - total value of the
paper money > value of gold backing it. (fiduciary or credit
money).
Modern banknotes based solely on confidence of SARB to
control supply of notes so that purchasing power not eroded.
Then came cheque accounts - bank deposits now accessed by
cheques, electronic transfers, debit cards.
SARB uses three measures of the quantity of money.
The conventional measure (M1)
M1 quantified on basis of money as a medium of exchange.
M1: 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.
In circulation outside the monetary sector – can’t include cash in bank
vaults until withdrawn.
Demand deposits - deposits that can be withdrawn immediately.
Calculating M1…
M=C+D
M = quantity of money
C = cash (coins/notes outside monetary sector)
D = demand deposits (eg by cheque, debit card,
electronic)
A broader definition of money (M2)
M2 = M1 + short and medium-term deposits of
the domestic private sector with monetary
institutions.
•
•
•
•
Short-term deposits: < 30 days
Medium-term deposits: < 6 months
Can be withdrawn earlier only at a cost.
Regarded as quasi money
The most comprehensive measure of money
(M3)
M3 = M2 + long-term deposits of the domestic
private sector with monetary institutions.
• Long-term deposits > six months.
• Used to evaluate success of monetary policy
• M3 reflection of store of value function and
not only the function of money as a medium
of exchange.
Money led to advent of financial institutions
specialising in purely financial transactions.
Financial transactions: no goods or nonfinancial services are involved.
Financial institutions act as an intermediary
between surplus units and deficit units in the
monetary economy.
Lesetja Kganyago
Watch this video on the functions of the SARB
https://www.youtube.com/watch?v=Scz_DE0So
14
Established in 1920
Constitution states…
• Primary object of SARB is to protect the value of the currency in the
interest of balanced and sustainable economic growth in the Republic.
• SARB must perform its functions independently and without fear, favour
or prejudice, but there must be regular consultation between the Bank
and the Cabinet member responsible for national financial matters.
Functions…
 Formulation and implementation of monetary policy
 Service to the government
 Provision of economic and statistical services
 Maintenance of financial stability
 Provider of economic and statistical service
Price stability = primary objective.
How does the SARB do this?
Bank supervision
• responsible for bank regulation/supervision
The National Payment System
• Oversees safety and soundness of system.
Banker to other banks
• Custodian of minimum cash reserves of commercial banks
• SARB provides liquidity to banks
Banknotes and coins
• SA Mint Company & SA Bank Note
• Cash comes into circulation through the purchase of assets (usually financial
assets) by the Bank.
Demand for money: amount that participants in the economy plan to
hold in the form of money balances (i.e. cash or bank deposits).
Opportunity cost of holding money?
• Interest that could have been earned from bonds.
Money held if it provides a service as good as opportunity cost of
holding it.
2 basic components of demand for money…
• 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
2 main motives identified by JMK (liquidity preference)
1. Transactions motive
• Participants hold money as a medium of exchange needed to enter
into transactions.
• Money held to buy goods/services between paydays.
• How much money is needed depends on the level of income.
At macro level - transactions demand for money is a function of the
total income in the economy.
> level of economic activity = > demand for bank loans.
2. Speculative motive
• Demand for money as an asset.
• Money as a store of value.
• Holding money (little or no interest) VS.
holding bonds (which earn interest)???
– Depends on interest rate
Transactions demand - purpose is to spend the
money.
Known as active balances.
Speculative demand - purpose to hold money
passively as a store of value.
Known as passive balances (idle balances).
 Represents
demand
for active balances.
The quantity of money
demanded
for transactions
purposes depends on the
For a given level of income (Y1) there is thus a given quantity of money
not sensitive
to interest
rate
variations. of the interest
level of incomein (L1)
the economy
(Y) and
is largely
independent
demanded (L1).
 Position of L1 is determined
by the income level
rate.
 Represents demand for passive balances.
Negative of
(inverse)
Quantity
relationship
of money
between
demanded
quantity
for
speculative
of money
for
Quantity
money
demanded
for
speculative
purposes
low demanded
when interest
 Inverse relationship btwn. interest rates & Q of passive balances demanded.
purposes higher
speculative
when
purposes
rate&lower
levelof
(opportunity
ofmoney
the interest
cost
rate.
of money low).
rate
is
highinterest
(opportunity
cost
is also
high)
 At (i1) no funds will be demanded to be used for speculative purposes.
Position: determined by demand for active balances (i.e.
Negative
slope: inverse
rate(LL).
level &
Total money
demandrelationship
curve/totalbetween
liquidity interest
preference
for transactions purposes) - determined by the income level.
Q of money
demanded
for speculative
purposes
(i.e.(Las
Add demand
for active
and passive
balances
1 +an
L2)asset).
Increases in income shifts total demand curve to the right (vica versa)
L = f(Y, i)
• L = quantity of money demanded
• Y = national income
• i = interest rate
Demand for money is a function of the income
level and the interest rate level.
Demand deposits constitute >90% of quantity of
money.
What determines the size of these deposits?
Money is created largely by banks and not by a
mint or printing press.
How do they do it?
Banks create deposits by making loans.
Watch this short video that explains how money
is created. https://youtu.be/pZRvja7Mvrw
How many loans can banks create?
• Banks can create loans only if demand from
creditworthy borrowers exists.
• Quantity of loans demanded depends on
interest rate.
• Quantity of money demanded inversely
related to interest rate.
• Instability of banking system necessitates
central bank.
• Growing economy requires growing money
stock.
• BUT… excessive money = inflation.
• SO… SARB regulates money creation process.
Sounds great – how do they do this???
• Interest rates influence the rate at which new
money is created.
• Affects demand for loans via the price of
loans, i.e., the interest rate.
• This is the essence of monetary policy.
No independent money supply curve.
Quantity of money depends on demand for money & interest rate.
Known as a demand-determined money stock or endogenous money.
Monetary policy: measures taken to influence
quantity of money or the rate of interest with a
view to achieving stable prices, full
employment and economic growth.
Formulated and implemented by SARB’s
Monetary Policy Committee
Primary objective of the SARB to protect value
of R in the interest of balanced and sustainable
economic growth.
1960’s - 70’s: direct intervention limits to extension of bank credit)
1970’s – 80’s: more market-oriented policy approach through creation of
incentives for financial institutions to react in the desired manner.
1986 onwards: explicit monetary growth targets for M3 announced annually.
pursued by changes in Bank rate.
March 1998: informal inflation target of 1 - 5 % set.
23 February 2000: formal inflation target 3 – 6% set by Minister of Finance
balanced and sustainable
economic growth.
pre-announced
inflation target.
short-term interest
rates, governed by changes in repo rate.
is a classical cash
reserve system.
The key instruments include…
• accommodation policy (refinancing of the
liquidity requirement)
• open-market policy
• Classical cash reserve system - banks obliged to
hold 2,5% of their total liabilities with Reserve
Bank.
• Shortage of cash reserves? Change financial
assets into cash or borrow funds.
• Borrow from overnight interbank market borrow from other banks with excess funds.
• If all banks experience liquidity shortage, Reserve
Bank, acts as lender of last resort
• Banks obtain funds by means of the repo system.
• Fixed rate determined SARB represents interest
rate that banks pay for reserves they need.
Read Box 6.7 on page 150
Changes in repo rate regulate quantity of money
through variations in cost of credit.
Changes in the repo rate → changes in interest
rates at commercial banks
∴ cost of credit directly linked to the repo rate.
Open-market transactions: sale/purchase of
domestic financial assets (eg. Treasury bills/
government bonds) by SARB to influence
interest rates & quantity of money, via influence
on cash reserve of the banks.
Repo system (accommodation policy) only effective if
banks “forced” to approach SARB for funds.
Through open-market transactions SARB ensures
persistent shortages of liquidity (money market
shortage).
• SARB sells government bonds/other securities to the
banks, reducing cash reserves (directly or indirectly).
• banks compelled to use SARB’s financing facilities
through repurchase agreements
• SARB’s accommodation policy more effective.
• SARB buys government bonds and other
securities - offers high prices - bondholders
part with bonds.
• Bond prices rise
• Inverse relationship between bond prices and
the yield (interest rates)
• Interest rates will drop.