Chapter 14_ eco .pdf

© VAN SCHAIK PUBLISHERS Chapter 14: The monetary sector  Learning outcomes Once you have studied this chapter you should be able to Describe the functions of money Define money Describe the main functions of the South African Reserve Bank Explain th...

© VAN SCHAIK PUBLISHERS Chapter 14: The monetary sector  Learning outcomes Once you have studied this chapter you should be able to Describe the functions of money Define money Describe the main functions of the South African Reserve Bank Explain the demand for money Explain how money is created Explain the basic instruments of monetary policy © VAN SCHAIK PUBLISHERS  The functions of money To be able to define money we must first understand its functions. 1. Money as a medium of exchange Before money came, economies had a barter system (exchange goods for goods) of trade which had the problem of double coincidence of wants (a person must want what you have and you must want what he has). With money it becomes easy to buy and sell and so it acts as a medium of exchange. According to this function of money, money can be defined as anything accepted as payment for goods and services/settlement of debt. 2. Money as a unit of account Money enables us to give value to goods/services with a common measure. It enables us to calculate and compare opportunity cost. This function is linked to the first one. Anything accepted as medium of exchange will also be useful as unit of account. © VAN SCHAIK PUBLISHERS  The functions of money 3. Money as a store of value Money acts as a store of wealth because it can be easily converted to other assets at later stages. Money acts as standard of deferred payment (measure of future payments) e.g. when you buy something on credit or when u get a loan an agreed future payment/price is agreed on (interest). It is the most liquid asset and its an advantage to store wealth in the form of money when there is no high inflation. What money is not Money is not income or wealth. o Income is the salaries and wages or reward earned by factors of production. It is calculated in monetary terms but is not the same as money. o Wealth is assets accumulated over time and can take any form, it can be money, physical assets, bonds, investments etc © VAN SCHAIK PUBLISHERS  Different kinds of money Money has properties that make it the best medium of exchange. These are: uniformity, durability, divisibility and can be easily carried. Evolution of money Coins where the first form of money but quickly abandoned because they where difficult to handle and carry. Deposits which were used in the 16th century. One would deposit his/her coins for safe keeping and get a certificate of deposit used to pay for goods and services. These were the first paper money. Fiduciary/credit money money was backed by gold reserves and at times the paper money issued would be greater than the gold that backed it and hence credit money. Cheque accounts is the most important evolution and technology still brings more with electronic fund transfer (EFT), debit cards etc. coming into the system. Box 14-1 Cheques and EFTs, debit cards and credit cards (Textbook page 258) © VAN SCHAIK PUBLISHERS  Money in South Africa Various definitions of money presented in SA The SARB is in charge of monetary matters in SA has three measures of the quantity of money which are M1, M2, and M3. 1. The conventional measure (M1) Coins and notes in circulation (used as medium of exchange i.e. cash in the public) plus demand deposits of domestic private sector (households) with banks. Demand deposits can be withdrawn immediately. 𝑴 = 𝑪 + 𝑫 … … … … … … … (𝟏) Where M is quantity of money, C is cash(coins and notes) and D is demand deposits © VAN SCHAIK PUBLISHERS  Money in South Africa 2. A broader definition of money (M2) M2 is M1 plus other short and medium term deposits of households that is fixed deposits for short time, less than 30 days for short term and less than 6 months for medium term. Also called quasi money (near money). 3. The most comprehensive measure of money (M3) M3 is M2 plus long-term deposits. These deposits mature over (longer than) 6 months. This is the most broad and hence most useful when evaluating policies and stocks of money in the economy. It is also the best measure of developments in the financial sector. © VAN SCHAIK PUBLISHERS  Financial intermediaries Financial Intermediaries are institutions that specialise in purely financial transactions, in which no goods or non-financial services are involved. The main function of financial intermediaries is to act as go-betweens (intermediaries) between the surplus units and the deficit units in the monetary economy. Specialise in financial transactions. Act as intermediary between the surplus units (those that save) and the deficit units (those that borrow) in the monetary economy. They charge interest for loans issued and earn themselves money. Box 14-2 More about financial intermediaries (Textbook page 260) © VAN SCHAIK PUBLISHERS  The South African Reserve Bank Central bank is the most important financial institution in any economy. SARB was established in 1921 and the constitution of SA stipulates that it must be independent and must protect the value of the rand in the interest of bringing economic growth. There are four major of the functions of a central bank: 1. Formulation and implementation of monetary policy § Formulates goal of monetary policy and implements. § Policies to meets the daily liquidity needs of all other banks, control money in circulation/liquidity. 2. Service to the government § Banker and advisor - handles finances for the government. § Custodian of gold and foreign exchange reserves (Formulation of exchange rate policy). § Administration of exchange control. Restricting movement of foreign exchange so as to protect the economy from international shocks/fluctuations. © VAN SCHAIK PUBLISHERS  The South African Reserve Bank 3.Provision of economic and statistical services § The bank collects and publishes statistics and other financial information 4. Maintaining financial stability § Bank supervision/regulation to ensure efficient banking system. § Overseeing safety of the National Payment System. § Banker to other banks and helper to banks facing liquidity problems as the lender of last resort. § Make Banknotes and coins and also has the sole right to destroy them. © VAN SCHAIK PUBLISHERS  The demand for money People can keep money in real form or invest it. The opportunity cost of holding money is the interest it could earn had it been invested in bonds for example. Demand for money is the amount of money that people plan to hold/keep in the form of money balances. 1. Transaction motive- the desire to hold money in its real form for transaction purposes. It is determined by the level of income. 2. Precautionary motive- holding money for unplanned/unforeseen/contingency. It is determined by the level of income. 3. Speculative motive – holding money in real terms or investing it in bonds for example where it will earn interest. This depends on interest rate (IR). There is a negative relationship between demand for money for speculative purposes and IR. When IR is high people would rather invest in bonds and earn interest, when IR is low an individual would rather hold money and wait till IR is high enough.  The demand for money The transaction and precautionary motive are related to the function of money as a medium of exchange and they are called active balances. The speculative motive is related to the store of value and is called passive balances. Demand for money is also called liquidity preference and is summarized in the table below:  The demand for money Figure 14-1 The demand for money (Textbook page 265) Transactions motive/ demand for active balance Transaction motive and precautionary motive are mainly for the day to day needs of an individual (money as a medium of exchange. The greater the level of economic activities the greater the demand for money for transactions motive. It does not depend on the interest rate but on economic activities. © VAN SCHAIK PUBLISHERS  The demand for money Figure 14-1 The demand for money continued Speculative motive/ demand for passive balance Related to the function of money as a store of value. People hold money to be able to use it for speculative purposes. They choose to hold it or to buy bonds and earn interest on those bonds. Depends on the interest rate which is the opportunity cost of holding money. When IR are high people will hold less money for speculation but will buy bonds and earn interest. © VAN SCHAIK PUBLISHERS  The demand for money Figure 14-1 The demand for money continued Total demand for money Adds demand for active and passive balances. The negative slope shows the negative relationship between IR and demand for passive balances. The position of the curve shows the demand for active balances which depend on income level Y. increase in Y will shift curve to the right and decrease in Y shifts it to the left. © VAN SCHAIK PUBLISHERS  The stock of money: how is money created? Banks create money, in the form of bank deposits, by making loans. Banks can create loans only when there are demands for loans by creditworthy borrowers, which depends on the IR. Central bank however controls the money creation process to avoid excess money (which causes inflation) and also little money created (which stifles growth). It restricts money creation through changes in IR -Monetary policy. The quantity of money supplied/stock of money depends on the demand for money and cost of credit (IR). This is called demand - determined money stock/ endogenous money.  The stock of money: how is money created? Money supply/ quantity of money/ stock of money is determined by the interaction of the demand for money and IR. LL is the demand curve, when IR is high money supply will be low because people are not holding money as it is attractive to invest and earn interest. A reduction in IR will therefore increase the money supply/ quantity of money ceteris paribus. © VAN SCHAIK PUBLISHERS  Monetary policy Monetary policy refers to measures taken by monetary authorities to influence the quantity of money or the rate of interest with a view of achieving stable prices, full employment and economic growth. The monetary policy framework in South Africa. Done by Monetary Policy Committee (MPC) of the SARB o The ultimate objective is balanced and sustainable economic growth. o Intermediate objective is a pre-announced inflation target. o Operational variable is short-term interest rates, which are governed by changes in repo rate (rate at which central bank lends money to commercial banks). © VAN SCHAIK PUBLISHERS  Monetary policy The instruments of monetary policy – Accommodation policy/ refinancing of the liquidity requirements Banks can have liquidity problems and borrow from other banks to be able to meet demand from their customers. At times other banks may not be able to help the bank with liquidity problems and it turns to the central bank as the lender of last resort. Central bank provides loans by means of repurchase agreements (repos) between Reserve bank and its banking client and charges an interest called repo rate. The accommodation policy mainly comprises of changing the repo rate and other conditions for issuing loans to banks, thereby controlling quantity of money. Changes in repo rate will also affect other interest rates e.g. the cost of credit.  Monetary policy The instruments of monetary policy – Open-market policy ✓ Consists of the sale or purchase of domestic financial assets mainly bonds and treasury bills, by the central bank so as to influence IR or quantity of money via its influence on the cash reserves of the banks. ✓ If the Bank wishes to reduce money supply it may sell bonds to banks, forcing them to have liquidity problems and hence enter into repurchase agreements with the bank enabling the central bank to control money supply. ✓ If it wishes to increase money supply it can do an open market operation and buys bonds at high prices to attract bondholders to part with their bonds. – Other instruments ✓ Credit ceilings ✓ Deposit rate control ✓ Exchange control regulations etc.  Important concepts Medium of exchange South African Reserve Bank Barter economy Stock (quantity) of money Unit of account Repurchase tender system Store of value Repo rate Commodity money Classical cash reserve system Credit money Bonds Notes and coins in circulation Demand for money Demand deposits Liquidity preference Monetary aggregates Liquidity requirement Financial intermediaries (shortage) Securities Transactions demand Monetary authority Precautionary demand © VAN SCHAIK PUBLISHERS  Important concepts Speculative demand Active balances Passive balances Interest rate Monetary policy Monetary policy framework Monetary growth targeting Inflation targeting Cash reserve requirement Accommodation policy Open-market policy Interest rates and bond prices Bank supervision © VAN SCHAIK PUBLISHERS