Money and Monetary Policy

Money and Monetary Policy

• Money has taken various forms, including cattle, cigarettes, gold, and paper money.
• Money is not a factor of production.
• Money eliminates the double coincidence of wants.

What is Money?

• Money eliminates the double coincidence of wants that occurs in a barter system.
• Barter economies can lead to unnecessary and inefficient exchange transactions.
• Money is generally accepted as payment for goods and services or in settlement of debt.
• Money is accepted because people believe others will accept it as payment.

Functions of Money

• Medium of exchange
• Unit of account
• Store of value
• Money and trust are closely related.

Money as a Medium of Exchange

• Money eliminates the double coincidence of wants.
• Barter economy transactions can be unnecessary, cumbersome, and inefficient.
• Money is defined as anything generally accepted as payment for goods/services or debt settlement.
• Money is accepted as payment as people believe it will be accepted by others.

Money as a Unit of Account

• Money serves as a measure for stating the prices of goods and services.
• Money enables the measurement of the total value of goods/services in an economy, like GDP.
• Inflation can reduce the usefulness of money as a unit of account.
• Nominal values need adjustment to real values in times of inflation.

Money as a Store of Value

• Money is not wealth.
• Wealth includes fixed property, real estate, and shares.
• Money is a common, convenient, and liquid form of holding wealth.
• High inflation periods make money a poor retainer of wealth.
• Money serves as a standard of deferred payment for future obligations in a specific currency.

Functions of Money: Additional Notes

• Money is distinct from income.
• Money constitutes one form of wealth, alongside property and shares.

Different Kinds of Money

• Money has taken various forms over time, such as cattle, silver, and gold.
• An efficient monetary system needs uniformity, durability, divisibility, and portability.
• Coin systems developed over time using different metals.
• Reliance on coins as a medium of exchange became inconvenient.
• Paper money developed as owners of gold and silver made deposits for safekeeping.
• Goldsmiths issued certificates of deposits, which were transferable and fully covered by the metal.

Evolution of Money

• Paper money fully backed by gold transitioned to notes only partially backed by gold.
• Goldsmiths provided loans, issuing 'gold receipts' or certificates of deposit.
• Goldsmiths issued receipts exceeding their gold reserves, creating a fractional reserve system and fiduciary or credit money.
• Modern banknotes don't relate to any commodity.
• The value is based on confidence in monetary authorities to control money supply.

Legal Tender

• Notes and coins issued by the central bank are legal tender and must be accepted as payment.
• The use of cheque accounts marked the next development in money.
• Further innovations encompass credit/debit cards and electronic payments.
• Electronic money like Bitcoin has emerged.

Money in South Africa

• M1: Conventional measure (medium of exchange), includes cash (C) plus deposits (D).
• M2: Broader definition (M1 + short-term and medium-term deposits).
• M3: Most comprehensive (M2 + long-term deposits).

M1 Details

• Defined by its function as a medium of exchange.
• Includes notes/coins (in circulation outside the monetary sector) and demand deposits.
• In circulation outside the monetary sector means held by the public.
• The monetary sector includes the South African Reserve Bank, Postbank, Land Bank, and private banking institutions.
• Demand deposits can be withdrawn via debit card, electronic transfer, or cheque and are generally accepted in South Africa.

M2 Details

• M2 is a broader definition of money.
• M2 = M1 + all other short-term and medium-term deposits of the domestic private sector with monetary institutions.
• Short term is less than 30 days.
• Medium term is less than 6 months.
• Short maturity makes these deposits quasi money.
• M2 is defined as M1 plus quasi money.

M3 Details

• M3 is the most comprehensive measure of money.
• M3 = M2 + all long-term deposits of the domestic private sector with monetary institutions.
• Long-term deposits - maturity of more than 6 months.
• M3 is seen by monetary authorities as the most reliable indicator of monetary sector developments.
• M3 is also used to assess the success of monetary policy.
• M3 reflects money as a store of value.

Financial Intermediaries

• Institutions specializing in financial transactions.
• They act as an intermediary between surplus and deficit units in the monetary economy.
• They accept deposits and grant credit.
• Credit involves lending funds with agreed interest and repayment terms.
• A security is issued specifying these terms.
• The focus is on institutions that directly impact the quantity of money in the economy.
• Focus on the demand/supply of money.

Microeconomics Overview

• Law of demand: Price increases, quantity demanded decreases, ceteris paribus.
• Law of supply: Price increases, quantity supplied increases, ceteris paribus.
• Ceteris paribus: All other things being equal

Demand for Money

• Wealth can be held in real assets (property, goods, shares) or financial assets (money, bonds).
• The cost of holding money includes opportunity cost (interest forgone) and inflation impact.
• Two components of demand for money: transactions (medium of exchange) and asset (store of value).

Holding Wealth

• Holders of wealth choose how to hold it:
• Real assets: property, valuables, antiques.
• Financial assets: money or interest-bearing bonds.

Understanding Demand for Money

• Demand for money refers to the quantity that participants intend to hold as money balances.
• Demand for money stems from decisions by those who earn income or possess wealth.

Key Aspects of Money Demand

• Households and firms hold money despite the cost.
• The cost of holding money is the forgone interest (C+D) from bonds.
• Cash (C) earns no interest, and demand deposits (D) earn virtually no interest.
• Opportunity cost is the potential interest from bonds.
• Money is held if its service exceeds its opportunity cost.

Functions and Demand

• Demand for money is linked to its medium of exchange and store of value functions.
• Transactions demand is related to money as a medium of exchange.
• Demand for money as an asset relates to its store of value function.

Keynes' Motives for Holding Money

• Transactions motive: money for exchanges.
• Precautionary motive: money allows for unpredictable expenditure.
• Speculative motive: money as a store of value.
• Quantity of money demanded for speculative purposes and interest rate have an inverse relationship.
• The demand for money or liquidity preference includes:
  • Demand for active balances (transactions + precautionary): L1
  • Demand for passive balances (speculative): L2
• L1 isn't sensitive to the interest rate, but L2 is.

Money Demand: Graph and Equation

• Total money demand, LL, is the sum of two curves.
• Equation: L = f(Y, i), where L is the quantity of money, Y is national income, and i is the interest rate.
• The demand for money is a function of income and interest rate.
• REPO rate versus prime rate.

Aspects of Money Demand

Money Creation

• The quantity of money is a stock concept, measured at a specific point in time.
• Demand deposits make up 93% of money (M1).
• Banks, not the mint, create money.
• Banks create deposits by granting loans.
• Banks are limited by demand for loans and central bank actions via the REPO rate.

The Supply of Money

• Demand deposits are created through bank deposits or loans to deficit units.
• There are limits to bank's ability to create money.
• Demand deposits can be withdrawn at any time.
• Banks ensure sufficient cash reserves for withdrawals.
• Banks must also provide for claims to other banks.

Additional Considerations

• Based on experience, banks know the required cash reserves relative to total deposits.
• It is not left up to banks - is a legal requirement by the monetary authority.
• Reserves include proportion of bank liabilities and account with the central bank.
• Confidence in credit worthiness is important to avoid entire system disruption.
• South African banks hold 2.5% of total liabilities as cash reserves.

Controlling Money Supply

• Control the amount of demand deposits by influencing the cost of additional cash reserves.
• Increased demand deposits from overdraft facilities force banks to acquire additional reserves.
• Reserves are borrowed from the SARB at the repo rate (6.25%).
• When repo rates increase, the credit becomes expensive and the demand for credit comes down.
• The money supply is driven by demand credit rates.
• Money is demand driven.

South African Reserve Bank (SARB)

• SARB is the central bank and main monetary authority in South Africa.
• The South African Constitution defines the SARB's primary goal.
• The primary objective is to protect the value of currency for balanced, sustainable economic growth.
• The SARB must perform independently and consult regularly with Cabinet members responsible for financial matters.
• Governor: Lesetja Kganyago

SARB's Key Functions

• Formulation and implementation of monetary policy.
• Service to the government as banker/custodian of gold/foreign exchange reserves.
• Provision of economic and statistical services.
• Maintenance of financial stability.
• Bank supervision.
• National payments system.
• Banker to other banks and issuer of banknotes/coins.
• Lender of last resort.

Monetary Policy

• Monetary policy encompasses measures by monetary authorities to influence money quantity or interest rates.
• This promotes stable prices, full employment, and economic growth.
• The ultimate objective is balanced and sustainable economic growth.
• Intermediate goal: Pre-announced inflation target.
• Operational variable: short-term interest rates, governed by the repo rate.