The Monetary Sector

Learning Unit 2

Chapter 14: The Whole Chapter

Economics for South African Students

Phillip Mohr and associates
Principles of Microeconomics Workbook
IIE
If money makes the world go round,
why cant we just solve poverty by
printing more money??
Most people do understand that an oversupply
of something makes it lose value and would thus
cause inflation.

But have you ever thought why???

 Money Defined
Money is anything that is generally accepted as
payment for goods and services or as a
settlement of debt.

Figure 1

Figure 2
 Before Money??

We used to use the Barter System!

A barter system can be defined as a system where one good is traded
for another good. No money is used.

Think about what that meant, how it worked and why it is not possible
to exist in a modern economy.
The barter system requires a double coincidence of wants.

This means if I want something you have, I need to to have

something you want in order to swap.

In a monetary economy, money acts as a lubricant which makes

it much more convenient because it eliminates the need for a
double coincidence of wants.
 The Functions of Money
1) Medium of Exchange So we don’t need to barter
2) Unit of Account It is an agreed method of stating the value of goods
and services.

However, in times of inflation money does not work so

well for this function.
3) Store of Value It is a way to hold wealth (surplus production) to use
at a later stage.
Money is the most liquid form of storing wealth, but
wealth can be stored in other ways. Ie) art, property,
shares etc.

In times of inflation, money is not a good store of

value as money loses value, and so it is better to
choose a commodity that retains its value.
4) Standard of Deferred Payment It is a measure of value for future payments.
 What money is NOT!
• Money is not Income or wealth.

See page 283 of textbook to understand why.

 Different kinds of money
Throughout time different goods have been used as
money ie) shells, cows, cigarettes etc..

To be suitable as money the commodity should have the

following 4 properties:

• Uniform
• Divisible
• Durable
• Transportable
• This gave rise to the use of coins of different valuable
metals.
What could be the
negatives of using
valuable metal?

• Paper money was then invented, but initially it was

fully backed by gold (making goldsmiths the first
banks).
• Then paper money was partially covered by gold
stocks, called The Gold Standard.
• Since the 1930’s the Gold Standard was dropped and
we now use Fiduciary Money.
Why would the world choose to do this???
• Fiduciary or modern paper money is based
solely on Confidence.

• This means that a R100 note has that value

purely because I believe it does, and I know
others also believe it.

• What gives us this confidence?

• Think of the role the central bank might play in

maintaining people’s confidence in its currency.
• The way we make payments has evolved even
further.

• We use credit cards, EFT’s, cheque books etc.

Are they also money??
See Box 14.1
All of the above are a convenient way of
transferring money, but they themselves are
not money. Also, a demand deposit is not
created when one of the above is issued.
 Test Yourself
1) Which of the following is not a type of money
(a) Commodities
(b) Paper Money
(c) Fiduciary Money
(d) Cheque

2) If product prices in SA were stated in terms of sugar beans (instead of

Rands and cents), then sugar beans would be functioning primarily as:
(a) A store of value
(b) A unit of account
(c) A medium of exchange
(d) Fiduciary money
How money is defined or measured in SA
M1 Includes coins & notes (outside the monetary
sector) as well as all demand deposits
(including cheque & transmission deposits) of
the domestic private sector with monetary
institutions.

M2 M1 + all other short and medium-term deposits

of the domestic private sector with monetary
institutions.

M3 M2 + all long-term deposits of the domestic

private sector with monetary institutions.
 A summary
M1 = C + D
M2 = M1 + short and medium term deposits
M3 = M2 + long term deposits

Short term deposits = Less than 30 days

Medium term deposits = Less than 6 months
Long term deposits = Greater than 6 months

• A demand deposit is: A deposit that can be withdrawn immediately. It is liquid money.
• Quasi money is M2. This means “near money” because it can be withdrawn relatively
quickly.

• Which measure of money is mainly used as a medium of exchange?

• Which measure is mainly used as a store of value?
 Test Yourself:
3) Types of Supply Amount (millions)
Bank notes R50
Short term deposits R800
Cheques + deposits R250
Long Term deposits R300
30-day deposits R775
60-day deposits R375

(a) Calculate M1 (3)

(b) Calculate M2 (3)
(c) Calculate M3 (3)

4) Given the following:

M3 = 980 million
M2 = 738 million
M1 = 680 million
(a) Calculate the short and medium term deposits (2)
(b) Calculate the long term deposits
 Financial Intermediaries
These are defined as the links between surplus
units and deficit units.
Examples include:
• Banks
• Insurance companies
• Medical Aid
• The SARB
Interest rates are defined as The Cost of Borrowing Money, we tend to talk about “the interest
rate” as if there is only 1, but in reality there are many. (Repo rate, prime rate etc)
See Box 14.4 which explains the Inverse Relationship between I and Bond Prices
The SARB
• The SARB is South Africa’s Central Bank.

• Its main function is to maintain financial stability.

• That means, its first priority is to protect the

value of our currency in the interest of balanced
and sustainable growth.

• Enshrined in our Constitution is that, it must be

allowed to do this without fear, favour or
prejudice, but with regular consultation between
the bank and the Cabinet Minister responsible for
National Financial Matters.
The SARB Governor and The Minister of
Finance

Enoch Godongwana and Lesetja Kganyago

Minister of Finance and Governor of the SARB

Fiscal Policy Monetary Policy

 The SARB has 4 Functions
1) Formulation and Implementation of Monetary
Policy

This policy uses tools such as interest rates

(accommodation policy) and open market operations to
control the money supply (liquidity) in the economy.

It uses these tools to try and control our spending.

2) Service to the Government

I. Banker and Advisor: Holds most of Govt’s money

and advises Govt. with regards to exchange control
regulations.
II. Custodian of Gold and Forex Reserves: The level of
these reserves is the most NB barometer of the
country’s prospects for future economic growth.
III. Administration of Exchange Control: This restricts
the movement of FOREX to protect the country
from disruptive fluctuations and external shocks.
3) Provision of Economic and Statistical Services:

Stats SA, which is a division of the SARB, Collects,

processes, interprets and publishes data about the
economy for policymakers and businesses to use.
4) Maintaining Financial Stability

I. Bank Supervision: Issue banking licenses & monitor the

activities of these institutions.
II. The National Payment System: To reduce interbank
settlement risk by reducing the potential of a systemic crisis
emanating from default by one or more institutions.
III. Banker to other Banks: Holds the minimum cash reserves
that the commercial banks are required to keep. They also
act as a clearing bank and lender of the last resort.
IV. Bank notes & Coins: Sole right to make, issue & destroy legal
tender.
 The Demand for Money
The demand for money is the amount of wealth that
people decide to hold in the form of money.

• People need to decide how much of their wealth they

would like to store as financial assets (as opposed to other
assets like property)

• Of the wealth they store as financial assets they need to

decide how much should remain as liquid money and how
much should be converted into interest bearing assets (or
bonds).
• Bonds earn us interest, which means when we decide to
keep some money liquid, and not buy the bond there is
an opportunity cost.

• Why would we choose to give up the interest??

 John Maynard Keynes & The Liquidity
Preference Theory

• Transactions Motive
This means that we need money for daily transactions.
Basically we need money as a medium of exchange.
• Precautionary Motive
This is the money we need for a “rainy day” or unexpected
expenses.
These 2 motives make up the demand for Active
Balances.

Active Balances are related to the National

Income, but are independent of the interest rate.
• Speculative Motive
This relates to money as a store of value (asset/bond). Here we
are wanting to use money to earn interest.

If interest rates are high we want to spend less and rather use
that money to earn high returns. (ie as an asset or bond). We
therefore demand less money as liquid money because the
opportunity cost of holding money is high.

The above makes up the demand for

Passive balances.

Passive Balances are Inversely Related to

the prevailing interest rate
 You must be able to draw and Explain Fig 14.1

Summary of Keynes Liquidity Preference Theory

Function Motive Active / Passive Main Determinant
Medium of Transaction Active Balances Income
Exchange Precautionary
Store of Value Speculative Passive Balances Interest

The total demand for money can thus be written as such: L = f

 The Total Demand for Money
• This can be shown by Fig 14.1 (c)

• The total demand for money is the horizontal addition of the

two individual demand curves.

• The negative slope will reflect the changes in the demand for
money for speculative purposes. Ie) If the interest rate
changes there will be a movement along this curve.
• The position of the demand curve represents the level of
income in the economy. It shifts right when national income
increases and left when it decreases.
 The Supply of Money
The SARB
• The SARB prints our money. It is guided by the the daily
cash requirements of South Africans as to how much it
needs to print.

The Commercial Banks

• The reality is that many more purchases are made on
a daily basis than the actual amount of physical
money that is available.
• Banks create this money in the form of credit.
 The Role of banks in the money creation
process:
• When I deposit R1000 into a demand deposit, I still own that
money and it is available for me to use at any time.

• However, the bank is also allowed to loan out that R1000 to

someone else, which means they now also have R1000.

• This is usually safe because the bank knows that I am unlikely to

demand all, or part of my R1000 immediately.

• However, each bank is required to keep a % of my original

deposit on hand.

• This is called the Reserve Ratio, and in SA the Reserve Ratio is

 • So far the process looks a bit like this:
Imagine there was only 1 bank in SA:
Demand Deposit Addition to Cash Reserve Amount the bank can loan out
R1000 R25 975
R975 R24.38 R950.62
R950.62 R23.77 R926.85

• This process can continue for quite some time. In fact if you add
all the new demand deposits that have been created from my
original R1000, then the bank can make an additional R39 000
out of my initial R1000.

• It is important to note that the banks ability to create money

depends on the demand for money. This means that if no one
comes to the bank for a loan, then the R1000 remains in my bank
• The SARB can influence this demand by changing the Repo
Rate.

• The Repo Rate is the rate at which the SARB loans money to
the commercial banks.

• The Repo rate influences the rate at which commercial banks

loan money to us because the SARB keeps the banks in a
constant liquidity shortage. (They constantly borrow money
from the SARB for which they have to pay interest.)

• This means that the interest that they charge us has to be

higher than the repo rate, otherwise the banks would not
make any money.
• Remember, although the SARB prints money,
it is the banks that create or supply most of
the money in circulation.
 What are the limits to the ability of the
banks to create money:
• Each bank must have sufficient cash reserves
available to provide for cash withdrawals of its
customers.
• Each must ensure that it has enough cash to
provide for the claims of other banks.
• The SARB has mandated that 2.5% is kept aside
as cash reserves, to allow for the above.

If the reserve ratio it decreases the banks ability to

create money, and visa versa.
 Other factors that can influence the
Money Supply:
• Transactions with other countries:
Net Exports = MS because more money is
flowing into SA commercial banks
Net Imports = MS

• Transactions with Government:

If G > T = MS
If G < T = MS
 Equilibrium in the Money Market
• See Figure 14.2

Note:
• L shows the Demand Curve
• There is no supply curve. This is because money supply
is demand driven. Ie) If demand rises, supply will rise
too. (The banks will create more demand deposits)

• We can say that money supply is endogenous, which

simply means that money supply comes from the
demand.
 Test Yourself
5) Which of the following is correct?
a) Individuals can hold their wealth in money forms only.
b) The stock of money in the SA economy is fully backed by the amount of gold reserves
held by the SARB.
c) In a money economy there has to be a double coincidence of wants before exchange can
occur.
d) Payments for imports have a negative effect on the quantity of money in circulation.

6) The repo rate is the:

a) interest rate at which the SARB lends to commercial banks.
b) Interest rate at which the commercial banks lend to the public.
c) Interest yield on Government bonds.
d) Interest rate at which the SARB lends to the Government.

7) M1 includes:
a) only notes
b) only coins
c) only notes and coins
8) Use a diagram to show equilibrium in the
money market and use it to explain the effect
that a decrease in interest rates would have.

9) Use a diagram to show equilibrium in the

money market and use it to explain the effect
that a decrease in National Income would have.
• See Box 14.6 for an explanation of the Traditional
Approach to the Supply of Money and Equilibrium
in the Money Market.

(Note here we treat money supply differently – we say

it is exogenous ie) there is a Money Supply curve, and
its level is controlled by the SARB). Thus if the SARB
increases money supply the curve will shift right, and
it will intersect the demand curve at a lower
equilibrium interest rate.)
 Definition of Monetary Policy
Steps taken by the monetary authority (MPC) to
influence the money supply or interest rates with
a view to achieving:

• Stable Prices
• Full employment
• Economic Growth

The SARB follows a Formal Inflation Target Objective of 3 – 6%.

Thus the:

• Ultimate Objective is balanced and sustainable

growth.
• The Intermediate Objective is a pre-announced
inflation target.
• The Operational variable is short term interest rates,
which are governed by changes in the repo rate.

This system is called the Classical Cash Reserve System.

How it works:

• Commercial banks have to keep a minimum cash reserve

of 2.5%.
• SARB uses tools like Open Market Operations to ensure
that Commercial Banks constantly need to borrow money
from it.
• When they borrow money they are charged interest (The
repo rate).
• This repo rate therefore influences the interest rates they
charge their customers.
 Test Yourself:
10) When the repo rate increases, the prime lending rate
increases/decreases. When we have to pay higher interest
rates for borrowing money, we tend to borrow more/less.
When South Africans borrow less, total spending in the
economy increases / decreases.

Thus, the demand for credit and the demand for goods
falls/rises, and all this should control inflation.

Note the opposite process can be used to increase spending

and reduce unemployment by lowering interest rates.
 The Tools Available to the SARB
The SARB can use Direct or Indirect tools to
intervene in the Economy.

• Direct Tools refer to rules and regulations

• Indirect or market based tools refer to tools
used to influence our behavior.
Direct Tools Indirect Tools
Credit ceilings Accommodation Policy
Exchange Control Open Market Policy
Public debt management Moral Suasion

*Since SA is a market based economy, the SARB mostly uses indirect tools
 More on indirect tools:
• Accommodation Policy
This is the use of the repo rate to control consumers
demand for credit. It is referred to as the repurchase tender
system.
• Open Market Policy
This refers to the sale or purchase of Govt bonds in
order to increase / decrease the Money Supply or liquidity
in the economy.
When the SARB sells bonds MS __________.
When the SARB buys back bonds MS __________.
• Moral Suasion
This is an attempt to persuade banks to act morally in
terms of how they lend money.
 Test Yourself:
11)One of the key instruments of monetary
policy is Accommodation Policy. Explain who
is responsible for this policy, and what it
involves.
(5)
 Picture References:
Slide 4 Figure 1: Why the British Pound is stronger than the US Dollar
Investopedia
24 March 2019
Figure 2: Top currency Strategist flags buying opportunity in Rand after

big sell off

Biz News
7 April 2020
Slide 5 Figure 1: Barter Services – History of Barter System
Historyplex
pixfeeds.com/images/world-history/1280-186187368-barter.jpg
Slide 9 Figure 1: Why do most cows in a field face the same direction?
Science Focus
viewed 21 July 2020
Slide 17 Figure 1: SA could score $4bn chunk of Africa’s huge banking potential.
91.3Fm The Voice of the Cape
2 March 2018

Slide 18 Figure 1 – 4: Taken from the SARB website

Viewed 21 July 2020
 Picture References:
Slide 20 Figure 1: Maverick Tito Mboweni freewheeling on Budget 2019
Biz News
20 February 2019