Economics Chapter 14 Flashcards
The monetary sector
The functions of money
Medium of exchange
Unit of account
Store of value
Medium of exchange
Due to the inadequacies of the barter system
Money therefore serves as a lubricant or intermediary to smooth the process of exchange and to make it more
efficient
Barter system
An economy that functions without money where goods are exchanged for other goods
Shortcoming of the barter system
Required double coincidence of wants
Trade was inefficient ,cumbersome
Transaction costs were high
What is money?
Money is anything that is generally accepted as payment for goods and services or that is accepted in
settlement of debt
Unit of account
Is an agreed measure for stating the prices of goods and services
enables us to obtain measures of the total value of all goods and services produced in the economy, such as GDP. Makes it easier to calculate the opportunity cost. Values of good and services can be standardized
Store of value
A common form for holding wealth is money, since it can always be exchanged for other goods and
services at a later date. Wealth can, however, also be held in other forms, such as fixed property, real assets, stocks
and shares
money serves as a standard of deferred payment
The advantage of store of value
It is usually more convenient and can be used immediately in exchange for other assets. We therefore say that money is the most liquid form in which wealth can be kept
The disadvantages of store of value
In times of high inflation money loses its
purchasing power and is not a good store of value
Standard of deferred payment meaning
Money is the measure of value for future payments
What money is not
Money is not income/wealth because income and wealth are usually measured or expressed in monetary terms (eg in rand), they are often confused with money
Income
is the reward earned in the production process. Natural resources, labor, capital and entrepreneurship are rewarded in the form of rent, wages and salaries, interest and profit
Wealth
consists of assets that have been accumulated over time. Wealth can take many forms, such as fixed property, shares, oriental carpets or paintings
Different kinds of money
The earliest forms of money were commodities, where the intrinsic value of the commodity was equal to the
exchange value assigned to it
Properties of the commodities
Properties such as uniformity, durability, divisibility and the ability to be carried (which is determined by size and weight) were not to be found in all commodities
Fiduciary/credit money
The total value of the paper money in issue was thus greater than the value of the gold backing it.
Modern bank notes
Declared by law as legal tender. This means that such notes or
coins cannot be refused if they are tendered as payment
The conventional measure (M1)
M1 is defined solely on the basis of the function of money as a medium of exchange.M1 includes 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. Everything that normally serves as a means of payment is included in the definition of M1
Who does the monetary sector in SA include?
The monetary sector in South Africa includes the South African Reserve Bank, the Corporation for Public Deposits, the Land Bank, Postbank, private banking institutions and mutual building
societies
Coins and notes (in circulation outside the monetary sector)
Only coins and notes in circulation outside the monetary sector constitute a part of the money stock. Only cash in the hands of the public can be used as a means of payment
Demand deposits
Refer to deposits that can be withdrawn immediately by means of a cheque or electronic fund transfer (EFT)
Definition of money can be written in the form of an equality, as follows
M=C+D
M=Quantity of money
C=Cash(coins and notes in circulation outside the monetary sector)
D=Demand deposits(deposits that can be withdrawn immediately and are generally accepted as payment in SA)
A broader definition of money (M2)
M2 is equal to M1 plus all other short-term and medium-term deposits of the domestic private sector with monetary institutions. They are therefore regarded as quasi money (or near money). M2 can thus be defined as money plus 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 monetary institutions. Reflection of the store of value function and not only the function of money as a medium of exchange. As we move from M1 to M2 and M3, the emphasis on the medium of exchange function decreases while the emphasis on the store of value function increase. Economists use it as a reliable measure of financial sector development
Financial intermediaries
With the advent of money, a group of institutions emerged that specialized in purely financial transactions
Financial Sector
In the financial sector there is a multitude of different kinds of institutions each specialising in a particular service or segment of the market. All these institutions have one main function, namely to act as an intermediary between the surplus units and the deficit units in the monetary economy
Surplus units
Include households, firms and governments that have excess funds available(lenders),however ,governments are generally borrowers
Deficit units
Include households ,firms and governments that need funds(borrowers).When the government borrows money it uses
Treasury bills and government stock or bonds as security
Demand
Money is the amount that the various participants in the economy plan to hold in the form of money balances. It is based on choices of economic agents who earn an income and hold wealth. They must decide how they want to hold their income/wealth
Bonds
A bond is a financial instrument that promises that the issuer (the borrower) will regularly pay the holder interest
and will repay the capital amount at a certain date. The government, for example, issues bonds to finance part
of its expenditure.
Opportunity cost
The opportunity cost of holding any money balance is the interest that could have been earned had the money been used to purchase bonds instead
The Constitution of the Republic of South Africa clearly states that:
(1) The primary object of the South African Reserve Bank is to protect the value of the currency in the interest of balanced and sustainable economic growth in the Republic.
(2) The South African Reserve Bank, in pursuit of its primary object must perform its functions independently and without fear, favor or prejudice, but there must be regular consultation between the Bank and the Cabinet member responsible for national financial matters.
Functions Of SARB
Formulation and implementation of monetary policy
Service to the government(banker and advisor, custodian of gold and foreign exchange reserves, administration of exchange control)
Provision of economic and statistical services
Maintaining financial stability(Bank supervision, National payment system, banker to other banks, banknotes and coins)
Basic components of the demand for money:
Economic agents will hold money for 2 reasons:
Transactions demand for money which arises from the medium of exchange function
Demand for money as an asset which arises from the store of value function
The demand for money can be investigated in more detail by examining the two motives for holding money(Keynes 1930)
Transactions motive
Speculative motive
Transactions motive
The amount of money required for transaction purposes will depend mainly on the total value of the transactions concerned.
This, in turn, will depend on the level of income. At the macro or aggregate level, the transactions demand for
money is therefore a function of the total income in the economy
Speculative motive
Is related to the function of money as a store of value. Is that the choice between holding financial assets in the form of money or bonds will depend on the interest rate. When the level of interest in the economy is high(low),there will be less(more) money held for speculative purposes
Our conclusion is therefore that there is a negative (or inverse) relationship between the quantity
of money demanded for speculative purposes and the level of the interest rate
The properties of the demand
curve can be summarized as follows:
The negative slope reflects the inverse relationship between the interest rate level and the quantity of money demanded by the speculative purposes
The position of the demand curve mainly determined by the demand for active balances, which is determined by the income level Any increase in income shifts the total demand curve to the right, while a decrease in the income level will cause the LL curve to shift to the left
Transactions vs Speculative motive
The transactions demand is related to the need
to actively employ the money balances concerned. Active balances
By contrast, the speculative demand is not directly linked to
transactions. In this case the purpose is to hold the money
passively as a store of value. Passive balances
What does the equation state
The equation states that the demand for money is a function of the income level and the interest rate level
Different types of interest rates
Repo rate (which plays a dominant role in the money creation process)
The interbank lending rate
The prime rate of banks
Various rates on deposits
Mortgage rates and the rate on government stock, to mention only a few
What are loans dependent on?
Loans are dependent on credit demand, creditability of prospective borrowers and SARB’s regulations(regulate money creation through interest rates)
What happens when money is nor regulated properly
If there is excessive(too little) money creation SARB increase(decreases) interest rates to promote price stability (economic growth)
What is monetary policy about?
The central bank tries to regulate money creation by affecting the demand for loans via the price of loans, that is, the interest rate
Demand-determined money stock or endogenous money
Demand of money and the interest rate
Monetary policy
as the measures taken by the monetary authorities to influence the quantity of money or the rate of interest with a view to achieving stable prices, full employment and economic growth.
Is formulated and implemented by the SARB. Decisions on the appropriate monetary policy stance are taken by the Monetary Policy Committee (MPC) of the SARB. The MPC consists of
the governor, the deputy governors and a few senior officials of the Bank
The main features of the South African monetary policy framework at the time of writing can be summarized
as follows:
Ultimate objective is balanced and sustainable economic growth.
Intermediate objective is a pre-announced inflation target.
Operational variable is short-term interest rates, which are governed by changes in the repo rate.
Monetary control system is a classical cash reserve system
Direct intervention vs market-oriented policy approach
When banks were simply instructed not to exceed certain quantitative restrictions on the extension of
bank credit vs where the authorities, through their own buying and selling conditions on financial markets, created incentives for financial institutions to react in the desired manner
The main elements of the classical cash reserve system are:
1.Minimum cash reserve requirement of 2,5% of banks total liabilities
2.Various policy instruments(mainly open market policy) aimed at creating a persistent liquidity shortage
3.The provision of cash reserves through the repo system(accommodation policy)
4.The impact of the repo rate on short-term interest rates
5.The impact of short-term interest rates on credit creation, the money stock and other variables and, ultimately on the rate on inflation
The instruments of monetary policy
Accommodation policy(Reserve Bank provides cash reserves to the banks)
Open-market policy(provide a summary of other policy instruments that are used to create a persistent
liquidity requirement )
Accommodation policy
banks are obliged to hold 2,5 per cent of their total liabilities to the public in the form of cash reserves with the Reserve Bank. When a bank experiences a shortage of cash reserves, it can either change other financial assets into cash or borrow funds on the interbank market to eliminate the shortage
What happens when all banks experience a shortage?
However, if all banks have the same liquidity problems, the
Reserve Bank, as bankers’ bank, acts as lender of last resort and the banks can then obtain funds by means of the repo system
Through the repurchase tender system (repo system)
liquidity is provided to the banks by means of repurchase agreements (repos) between the Reserve Bank and its banking clients
Open market policy
Open-market transactions as an instrument of monetary policy consist of the sale or purchase of domestic financial assets (mainly Treasury bills and government bonds) by the central bank in order to exert a specific influence on interest rates and the quantity of money, via its influence on the cash reserves of the banks
When bank wishes to enlarge its liquidity shortage
If it wishes to create or enlarge the banks’ liquidity shortage, the central bank sells government bonds or other
securities to the banks, thereby reducing their cash reserves (directly or indirectly)
When bank wishes to stimulate the creation of bank deposits
It can also use open market operations to ease liquidity conditions and lower interest rates. In such a case (which is sometimes called quantitative easing) the central bank will buy government bonds and other securities
Other instruments
Credit ceilings and deposit rate control (which were discontinued in South Africa some time ago)
Changes in exchange control regulations, central bank intervention in foreign exchange markets and public debt
management.
A final instrument at the Reserve Bank’s disposal is the informal measure of moral suasion
Repo
A repo may be defined as the sale of an existing security (financial asset) at an agreed price, coupled with an agreement by the seller to purchase (buy back) the same security on a specified future date (normally seven days later) at the same price. The maturity value of the repo is determined in the initial agreement and consists of the price plus an agreed amount of interest. The interest represents the cost of obtaining the funds for a week
