CHAPTER 14 The Monetary Sector PDF

CHAPTER 14 The Monetary Sector 1  Objectives 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...

CHAPTER 14 The Monetary Sector 1  Objectives 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. 2  Money and its functions What is Money? Money is anything that is generally accepted as means of payment/medium of exchange or that is accepted in settling of debts. It therefore eliminates the problem of double coincidence of want that exists in barter economy. In a barter economy, goods are exchanged for goods. Earlier forms of money were commodities such as cocoa, beans, silver, cattle etc. However, such commodities lacked properties such as: uniformity, durability, divisibility and transportability (ability to be carried). The bank notes and coins used today have been declared as legal tender. Legal tenders are legally acceptable means of payment (Cannot be refused when used for payment). Functions of money. The 4 functions of money include:  Money as a medium of exchange - money is used to pay for goods and services and because it generally acceptable, it eliminates the problem double coincidence of want which exists in barter trade. 3   Money as a unit of account – Money is used as measure to state the prices of goods and services. Money can lose its usefulness as a unit of account during inflation.  Money as a store of value or wealth – A common form of holding wealth is money. Wealth can be held in other forms (i.e. property, shares, etc.) However, money is the most liquid form of holding wealth. Liquidity is the ease with an asset can be converted from one asset to another. But money losses value during inflation (negative relationship between inflation and purchasing power of money).  Money as a standard for deferred payment – measure of value for future payment and means by which credit is granted. Note: Income and wealth are not money, but are expressed in money terms. Money in South Africa The South African Reserve Bank which is responsible for monetary matters (the monetary authority) uses the following 3 definition/measures of quantity of money: The conventional measure (M1): M1 includes coins and bank notes in circulation (C) and demand deposit (D) of the domestic private sector with monetary institutions Therefore M1 = C + D Demand deposits refer to deposits that can be withdrawn immediately by cheque, or electronic fund transfers (EFT). Demand deposit is the largest component of M1 4  M1 reflects function of money as a means of payments. The broader definition of money: M2 is equal to M1 plus all other short-term and medium-term deposit of the domestic privates with monetary institutions. Short-term deposits are deposits for less than 30 days and medium-term deposits are less than 6 months – they are also referred to as Quasi money or near money. Therefore, M2 = M1 + quasi money The most comprehensive measure of money M3: M3 is equal to M2 plus all long-term deposits of the domestic private sector with the monetary institutions. Therefore, M3 = M2 + long-term deposits Long-term deposits have maturity of over 6 months. M3 is the most reliable indicator of developments in the monetary sector of the economy. M3 reflect more of the function of money as a store of value than as medium of exchange. And as we move from M1 to M2 and to M3, there is more emphasis on the store of value than the function of money as a medium of exchange. 5  Exercise 1. Calculating M1, M2 and M3. The South African Reserve Bank regarded the following as the quantities of money available in South African economy in 2019. Cash in circulation ………………………………………….50m Demand deposit…………………………………………………125m Fixed deposit for over 1yr………………………………………200m Medium term deposits………………………………………….100m Deposits for less than 30 days………………………………….80m Calculate M1, M2, and M3 Financial intermediaries Financial intermediaries act as link/intermediary between the surplus unit (lender/savers) and the deficient units (borrowers) in the monetary economy. 6  Surplus units include households and firms who have surplus fund and have saved. Deficit units are households, firm or government who have a shortage of funds and are in search for funds to finance their expenditures. Savings are channelled to financial intermediaries who then lend it out to the deficit units – referred to as indirect finance. Or saving could be channelled directly from the savers (surplus units) to the borrowers (deficit units) – referred to as direct finance. See box 14-2: the flow of funds through the financial system. South African Reserve bank/the Central bank (SARB) The SARB is the main monetary authority in South Africa. Its primary object is to protect the value of the currency (financial stability) in the interest of a balanced and sustainable economic growth. 7  The 4 functions of SARB 1.The Formulation and implementation of monetary policy – Monetary policy is a macroeconomic policy that involves the control of money supply and interest rates to achieve economic growth, employment, price stability etc. Main instrument of monetary policy is the repo rate tender system. 2. Service to the government – the SARB provides the following services to the government: ▪ Banker and advisor. ▪ Custodian of gold and foreign exchange reserves. ▪ Administration of exchange control. 3. Provision of economic and statistical data – The SARB collects, processes, interprets and publishes economic statistics and other information. 4. Maintain financial stability – the main objective of the SARB. In maintaining financial stability, the SARB plays the following roles: ▪ Bank supervision. ▪ The national payment system. ▪ Banker to other banks. ▪ Banknotes and coins – The SARB has the sole right to print, issue and destroy banknotes and coins. 8  The Demand for money Demand for money is the amount that the various participants in the economy plan to hold in the form of money balances/cash. Demand for money is also referred to as liquidity preference. Demand for money is explained by examining the choice between holding money and other assets (i.e. bonds which is interest bearing). The cost of holding money balances is the interest rate that could have been earned if the money was used to buy bonds, an interest bearing asset. The opportunity cost of holding money balances/cash therefore is the interest rate that could have been earned. NOTE: more money is demanded when interest rates is lower than when interest rates is higher (a negative relationship between demand for money and interest rates). The motives for holding money according John Maynard Keynes.  The transaction motive –money held as a means of payment. The quantity of money required for transaction purposes depend on the level of national  income in the economy (Y). See fig. 14-1 (a) Pg. 265. Money held for transaction purpose is also referred to as active balances.  Speculative motive – speculation is holding an asset with expectation of significant gains with substantial risks involved. Speculative motive therefore involves the choice between holding money balance/cash or bonds depending on interest. Quantity of money demanded for speculative purpose will be lower when interest rates are higher and vice versa (negative/inverse relationship between money held for speculative purposes and interest rates). See fig. 14- 1(b) pg. 265. Money held for speculative purposes is money held7 as a store of wealth. It is also referred to as passive balances. Total Money demand and money demand Curve Remember money demand is also referred to as liquidity preference. Total money demand (L) = money held for transaction (L1) + money held for speculation motive (L2) Therefore, L = L1 + L2. Or a horizontal addition of fig. 14-1(a) and fig. 14-1(b) = demand curve fig.14-1(C), 10  The position of the demand curve for money is determined by the level of national income and its slope is determined by interest rates. The negative slope of the money demand curve shows the negative/inverse relationship between interest rates and quantity of money demanded. Therefore, demand for money is symbolically represented as: L = f(y, i) Where: L = quantity of money demanded Y = National income i = Interest rate Interest rate is the cost of borrowed capital (price/cost of loanable funds). Note that there are numerous types of interest rates (i.e. repo rate, lending rates, deposit rates, etc. The stock of money: how is money created? M1, M2, and M3 are used to determine the quantity of money in an economy. 11  Money is created by banks. Banks create deposits and make out loans to creditworthy prospective borrowers. See box 14-5 Money creation: an example Pg. 267. The quantity of loan demanded depends on the interest rate (price/cost of the loan). A negative relationship. The Reserve bank uses interest rates to influence/control the rate at which new money is created. The reserve bank therefore regulates the amount of money created by affecting the demand for money through interest rates/price of loans Quantity of money is determined by the interaction of interest rates and demand for money. See box 14- 6 Pg. 269, The traditional approach to the supply of money and equilibrium in the money market. Monetary policy Monetary policy is the measure taken by the reserve bank to influence the quantity/supply of money and interest rate, with the view of achieving stable prices, full employment and economic growth. 12  Monetary policy instruments include:  The accommodation policy: Banks obtain funds from the reserve bank (lenders of last resort) by means of the repurchase tender system or the repo system. This is done at a rate referred to as the repo rate. The repo rate is the rate at which the reserve bank lends funds at banks. – when affects other interest rates and therefore the quantity of money.  Open market policy: It consists of the sale and purchase of domestic financial assets (treasury bills and government bonds). To increase money supply, the reserve bank purchases/sells the treasury bills and government bonds from the public and buys them from the public to reduce money supply.  Others instruments are credit ceiling, deposit rate, public debt management and intervention in the foreign exchange market. Thank you 13