ecs 3701 monetary economics

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MONETARY ECONOMICS

Only Study Guide for ECS3701

Compiler: Lydia Temitope Leshoro

Department of Economics

University of South Africa

Pretoria



ii

© 2013 University of South Africa

All rights reserved

Printed and published by theUniversity of South Africa

Muckleneuk, Pretoria.

ECS3701/GD/001/2013-2015

Special thanks to Dr Sandra Mollentze of the South African Reserve Bank College who read large parts

of this study guide and provided numerous valuable comments.



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TABLE OF CONTENTS

Page

OVERVIEW OF THE COURSE .................................................................................................. iv

Prerequisites for this course .................................................................................................................. iv

The prescribed book .............................................................................................................................. iv

Purpose of the study guide .................................................................................................................... iv

Contents and goals ................................................................................................................................ v

PART 1: INTRODUCTION ...................................................................................... viii

Chapter 1: Why study money, banking and financial markets? ........................................................ 1

Chapter 2: An overview of the financial system ................................................................................ 5

Chapter 3: What is money? .............................................................................................................. 9

PART 2: FINANCIAL MARKETS ............................................................................................ 20

Chapter 4: Understanding interest rates ......................................................................................... 21

Chapter 5: The behaviour of interest rates ..................................................................................... 24

Chapter 6: The risk and term structure of interest rates ................................................................. 29

PART 3: FINANCIAL INSTITUTIONS ..................................................................................... 33

Chapter 8: An economic analysis of financial structure .................................................................. 34

Chapter 9: Financial crises in Advanced economies ...................................................................... 40

Chapter 10: Financial Crises in emerging market economies .......................................................... 41

Chapter 11: Banking and the management of financial institutions .................................................. 42

PART 4: CENTRAL BANKING AND THE CONDUCT OF MONETARY POLICY .................. 48

Chapter 14: Central banks: a global perspective .............................................................................. 49

Chapter 15: The money supply process ........................................................................................... 58

Chapter 16: Tools of monetary policy ............................................................................................... 69Chapter 17: The conduct of monetary policy: Strategy and tactics .................................................. 77

PART 6: MONETARY THEORY .............................................................................................. 85

Chapter 20: Quantitty theory, Inflation and the demand for money .................................................. 86

Chapter 21: The IS Curve ................................................................................................................. 90

Chapter 24: Monetary Policy Theory ................................................................................................ 95

Chapter 25: The Role of Expectations in Monetary Policy ............................................................. 113

Chapter 26: Transmission mechanisms of Monetary Policy ........................................................... 114



iv

OVERVIEW OF THE COURSE

Prerequisites for this course

The formal prerequisites for this third level monetary economics course are the second-level macro- and

microeconomics courses. The reason is that monetary economics draws heavily on the concepts andtools of analyses of both micro- and macroeconomics.

There is also some overlap between monetary economics and Unisa's ECS2605: The South African

financial system. Although ECS2605 is not a formal prerequisite for this course, it deals with some of the

financial institutions and financial instruments also dealt with in this course.

As in the case of second-level macro- and microeconomics you must have the basic mathematical skills

in order to deal with equations and graphs. Economic models are an integral part of monetary

economics.

The prescribed book

The prescribed book for this course is:

Mishkin, SF. 2012. The Economics of Money, Banking and Financial Markets. 10th edition, Global

edition. Boston: Pearson Addison Wesley.

Mishkin is probably one of the best and most widely used international undergraduate texts on monetary

economics and Money & Banking. It is a US textbook which focuses on the situation in the USA,

although it also has an international slant. It does however not deal with the South African situation. Thisstudy guide follows the same structure as the Mishkin textbook, but also includes additional material that

addresses the South African situation in detail.

Purpose of the study guide

Each unit of the study guide (a unit is roughly equivalent to a chapter of the textbook) will consist of the

following sections:

A Purpose of study unit

…provides the goals of the study unit, and effectively provides a brief summary of what is covered

in the study unit. In some chapters an "Economics in action" statement is given as well, which

focuses on some practical aspects relevant to the study unit.

B Prescribed sections

In most cases the corresponding headings and subheadings of the textbook are used to indicate

the prescribed content.

C Additional explanations

…either wraps up some important aspect/s and/or discusses the South African situation where it

differs from the USA/international one. In cases where an "Economics in action" statement has

been provided (section A) it may also provide feedback on this statement.



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D Activities

This section either provides a list of statements which you must evaluate and/or it provides

practical problems. The answers are provided in this study guide.

E Examination questions

…provides a list of possible examination questions. This list probably covers more than 80% of thequestions which may appear in the exam and provides a good idea of what is expected of you in

the exam. However, it is not an exhaustive list of exam questions – questions may be phrased

differently in the exam, possibly requiring less or more detail or a slightly different approach from

the "original" questions listed here. Please use this list of questions to test your understanding of

the study material and to prepare effectively for the exam. It is strongly suggested that you use

sections D and E as a “checkpoint” after each chapter to test your understanding.

Contents and goals

The prescribed book is divided into six parts, the following parts and chapters of which are prescribed.Note that part 5 (International finance and monetary policy ) and the chapters in it are not prescribed.

Chapters which are not prescribed are marked with a double hash (##), either at the beginning of a

section header or as a superscript at the end of a section/chapter header ## or number (7##).



vi

Part Chapter in textbook Goals

1 Introduction

1 Why study money, banking, and

financial markets?

2 An overview of the financial

system

3 What is money? A comparative

approach to measuring money.

Explain the meaning of financial markets

and financial instruments.

Explain the basic concepts relating to

monetary policy.

What functions does money perform? A

brief history of money. How money is

measured.

2 Financialmarkets

4 Understanding interest rates

5 The behaviour of interest rates

6 The risk and term structure of

interest rates

7## The stock market, the theory of

rational expectations and the

efficient market hypothesis

The meaning of interest rates.

How the interest rate is determined on

the bond and the money markets.

Explain why interest rates differ.

Not prescribed

3 Financial

institutions

8 An economic analysis of financial

structure

9 Financial crises in Advancedeconomies

10 Financial crises in emerging

market economies

11 Banking and the management of

financial institutions

12## Economic analysis of financial

regulation

13## Banking industry: structure and

competition

Explain how financial structure affects

the economic efficiency of markets.

Explain why financial crises occurred inadvanced economies.

Explain the dynamics of financial crisis in

emerging economies.

Explain the functioning of banks.

Not prescribed

Not prescribed

4 Central banking

and the conduct

of monetary

policy

14 Central banks: A global

perspective

15 The money supply process

Explain the role of the central bank in the

banking system.

Explain the money supply process and

derive two simple formulas



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16 The tools of monetary policy

17 The conduct of monetary policy:

Strategy and tactics

∆D = (1/r)∆R

( ) MBcer

c M

++

+=

1

Explain how the three instruments of

monetary policy are applied (open-market operations, changes in the

borrowed reserves and changes in the

reserve requirement).

Consider the goals of monetary policy.

5## International finance and monetary policy Chapter 18 -19 not prescribed

6 Monetary theory

20 Quantity Theory, Inflation and the

demand for money

21 The IS curve

22## The Monetary Policy and

Aggregate Demand Curves

23## Aggregate demand and supply

analysis

24 Monetary Policy Theory

25 The Role of Expectations in

Monetary Policy

26 Transmission mechanisms of

monetary policy

Determine which factors affect the

demand for money

Explain the IS model and use it to

analyse the impact of fiscal policy on

output and the interest rate.

Not prescribed

Not prescribed

Explain the role of monetary policy in

preventing inflation

Explain the role of monetary policy in

time-inconsistency and nominal anchor

Explain alternative transmission

mechanisms of monetary policy.

Note that not all chapters are prescribed. Similarly, if a chapter is prescribed, it does not imply that all its

sections are prescribed. The prescribed sections are clearly indicated in each chapter of this study

guide.

There are six parts in this one-semester course. Please note that the semester has at the most 15, but

effectively only 12 weeks in which to complete this course. This means that you have to complete at

least one part every two weeks. You will find a suggested study programme included in Tutorial letter

101.



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PART 1: INTRODUCTION

Chapter Goals

1 Why study money, banking and

financial markets?

2 An overview of the financial

system

3 What is money?

Explain the meaning of financial markets and financial

instruments.

Explain the basic concepts relating to monetary policy

What functions does money perform? A brief history of

money. How money is measured.



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Chapter 1: Why study money, banking and financial markets?


This introductory chapter explains basic concepts related to money, banking and financial markets,and to monetary policy.

• What is a financial market? What are bonds and stocks? What is the meaning of the interest rate

on securities?

• What is the role of financial institutions?

• Why and how do we measure the stock of money, aggregate income and the aggregate price

level?

• What is the meaning and the purpose of monetary policy?

Economics in action:

Bankers have a bad habit of making economic cycles worse. They are notorious for lending

people umbrellas when the sun is shining and asking for them back when rain starts to fall.

When the economy is strong and asset prices are rising, banks are only too eager to lend to

those wanting to buy assets, helping to push prices higher. In bad times, when prices are

falling, banks ask for their loans back, forcing the borrowers to sell assets and driving prices

down further.

Source: Bank capital: adjusting banking regulation for the economic cycle (2008:19)


Why study financial markets?

The bond market and interest rates; The stock market

Why study financial institutions and banking?

Structure of the financial system (financial intermediaries); Financial crises; Banks and Other

Financial institutions; Financial innovation

Why study money and monetary policy?

Money and business cycles; Money and inflation; Money and interest rates; Conduct of monetary

policy; Fiscal policy and monetary policy

## Why study international finance?

Not prescribed

## How we will study money, banking and financial markets

The sections on exploring the web and collecting and graphing data are not prescribed.

Appendix to chapter 1

Aggregate output and income; Real versus nominal magnitudes; Aggregate price level; Growth

rates and the inflation rate



2


Key things to note are the following:

1 This chapter introduces some basic concepts of the world of money, banking and financial

markets. Make sure that you understand these concepts well, as it forms the foundations of this

module. In particular, make sure you understand the meaning of a security and how it facilitates

direct borrowing and lending.

2 Money, banking and financial markets are heavily regulated and are substantially affected by

monetary policy. The reasons for, and the forms of regulation, will be dealt with in later chapters.

3 The goal of monetary policy is to attain a number of economic goals (for example price stability and

economic growth). Some of these goals, however, may appear to conflict and will be discussed in

later chapters.

4 In South Africa the major instrument of monetary policy is the control of an interest rate called therepo rate. The central bank of South Africa – the South African Reserve Bank (SARB) – sets the

repo rate. The repo rate in South Africa is the equivalent of the federal funds rate in the USA. The

repo rate is a short-term interest rate which represents an interest rate paid by commercial banks

to the SARB to obtain reserve funding (i.e. borrowing money from the SARB), yet it impacts on all

interest rates in the economy. Thus changes in the repo rate impact the economy at large.

5 This impact is largely on two aspects of the economy, that is, its impact on the volume of output

(real production) and on the aggregate price level. This explains why the appendix to chapter 1,

which explains measures of real output and of the aggregate price level, is prescribed.

6 A note on the Economics in action statement:

This statement is correct. Banks are profit driven by and behave according to the conditions they

face. Thus some form of monetary control is important.

7 Essentially, the monetary authority in South Africa is the South African Reserve Bank (SARB)

although the National Treasury (Ministry of Finance) also provides inputs to the SARB. The

monetary policy committee of SARB is responsible for formulating South Africa's monetary policy,

and is largely responsible for implementing this policy. The National Treasury is responsible for

managing South Africa's national government finances.

D Activities

Evaluate whether the following statements are correct or incorrect.

Money:

1 Monetary economics primarily teaches students how to make money quickly and effortlessly.

2 A decrease in the interest rate normally increases the money stock in the economy.

3 Because money is complex, it is difficult to demonstrate the real advantages of money within the

economy.

4 The use of money introduces sources of instability in the economy.

5 When interest rates rise, then all households are worse off.



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Securities:

6 A security is a financial instrument. In simple terms it is a "piece of paper" which is sold by the

issuer to investors in exchange for funds. The security promises to repay these funds (plus

interest) over the term of the security by means of a number of (one or more) future payments to

the holder of the security.

7 A security is issued mostly by firms and government that wish to borrow money.

8 The issuer of a security promises to make future payments to the holder (purchaser) of the

security.

9 The purchaser of a security provides cash to the issuer of a security.

10 The purchaser of a security is the lender (provider of funds).

11 The issuer of a security is the borrower of funds.

12 The holder (purchaser) of the security receives future payment/s from the issuer of the security.

13 Securities can be traded on the financial market. When holder A of a security sells the security in

the financial market at the going market price to B then B pays cash to A and B receives theremaining payments of the security.

Answers:

1 Incorrect . Monetary economics deals with the role of money in the economy. Economists are

interested in money because money facilitates the buying and selling of goods and

services, and saving and investment. Money plays a huge role in a modern

economy. In normal times the interest rate (the price of money) impacts on

investment and the level of domestic production, and surprisingly, also on the

general price level. If the monetary system collapses, or partly collapses, then thisimpacts very negatively on the performance of the economy. It leads to

unemployment and an economy which performs far below its capacity to produce

goods and services. The purpose of this course is to better understand the role of

money in the economy, and to provide guidelines for monetary policy.

2 Correct . There is a strong relationship between interest rates and the money stock. A

decrease in the interest rate usually increases the amount of lending (and the

money stock), simply because lending becomes cheaper. An increase in net lending

(new lending minus the repayment of debt), increases the stock of money. This will

be explained in more detail in later chapters.

3 Incorrect . The use of money as a means of payment has many advantages. It facilitates trade

and creates scope for a much enhanced degree of labour specialisation. Labour

specialisation ("the division of labour"), in turn, encourages skills improvement,

technological advancement and, ultimately, the capital-intensive, industrialised

mode of production of modern economies.

4 Correct . The tremendous advantages of monetary exchange come at a price. Money

introduces potential sources of instability into the economy, which is partly why

modern societies have instituted a central bank and assigned it the task of

regulating and stabilising the world of money and banking. The textbook refers to

financial crises (major disruptions in financial markets) which have occurred in the



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past and which cause sharp declines in asset prices as well as substantial

decreases in real GDP and increases in unemployment. Another source of instability

occurs when governments attempt to finance their expenditure by the excessive

issue (printing) of money. This always causes a tremendous increase in inflation and

ultimately, if left unchecked, a collapse of the financial system and a breakdown of

the economy.

5 Incorrect . Some households are net borrowers (who are worse off having to pay more interest

on loans which reduces their net income), but some are net lenders (who gain by

higher interest rates).

6-13 All are correct .


1.1 Explain briefly and in general terms what is the meaning of a security and how it facilitates directlending and borrowing. (5)

1.2 Explain briefly what is a common stock, what purpose it serves and how it affects business

investment decisions. (4)

1.3 List two ways in which the quantity of money may affect the economy. (2)

1.4 Explain the difference between nominal and real GDP and the purpose for which each should be

used. (4)

1.5 List and define three commonly used measures of the aggregate price level. (6)



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Chapter 2: An overview of the financial system


The goal of this unit is to explain the financial system in more detail.

• The functions and structure of financial markets

• The meaning of a number of financial instruments

• Financial intermediaries and how they function

• Regulation of the financial system


After you have studied this unit consider the merits/demerits of the following statement:

As part of the wider trend towards globalisation, the financial systems of different countries havebecome increasingly similar and interrelated. This has been especially marked since the almost

universal abandonment of alternative economic orders such as socialism and communism.

Source: Van Zyl, Botha, Skerrit & Goodspeed. 2009. Understanding South African Financial

Markets. Van Schaiks. Page 2.


Function of financial markets

Structure of financial markets

Debt and equity markets: Primary and secondary markets; Exchanges and over-the-counter

markets: Money and capital markets

Financial market instruments

Money market instruments; Capital market instruments

## Internationalisation of financial markets

Not prescribed

Functions of financial intermediaries: Indirect finance

Transaction costs; Risk sharing; Asymmetric information

Types of financial intermediaries

Depository institutions (focus only on banks and exclude the typical US institutions like S&Ls,

Mutual savings banks and credit unions); Contractual saving institutions; Investment intermediaries

Regulation of the financial system

Focus on the broad principles. The detailed regulations that apply to South Africa are beyond the

scope of this course.

Increasing information available to investors (omit table 5: The principal regulatory agencies in the

US); Ensuring the soundness of financial intermediaries.



6


1 Make sure you have a good understanding of financial markets, both with regard to its functions

and its structure (type of markets). You must also know how the different financial market

instruments operate.

2 Most of business firms' lending occurs through indirect finance, that is, through bank loans to firms.

This occurs because banks have three types of advantages.

a Banks have relatively lower transactions costs.

b Lending from banks involves the sharing of risk.

c Banks can partly overcome the problem of asymmetric information.

Asymmetric information occurs in finance because borrowers have a better idea whether they

can/will repay loans than lenders. Banks can partly overcome this problem because of their

expertise and because of their access to information. Lending will always remain risky because of

the uncertainty of whether the borrower can/will repay the loan. This risk can be reduced by goodinformation.

3 The financial sector is heavily regulated. Its purpose is to reduce the problem of asymmetric

information through the provision of information and to enforce standards to increase the

soundness of the financial system. This is often misunderstood by students. It is not, for example,

a government department that publishes information but government rather requires through

legislation, for example, that public firms, amongst others, disclose their activities by adhering to

good accounting practice. For this reason financial statements must be audited by qualified

accountants.

4 The problem of asymmetric information in the context of lending deals with the problem that the

information available to the borrower differs from the information available to the lender.

Asymmetric means not equal. The problem is not the inherent risk in lending. Any lending

transaction involves a future (and uncertain) stream of income. Many things may change, for

example, markets and technology. The problem is rather that of (1) preventing loans to bad risks,

and (2) to prevent borrowers from using funds in ways that were not originally intended (and are

more risky).

The first form of asymmetric information is adverse selection. Adverse selection has to do with the

screening of the bad from the good risks before the debt contract is awarded. It is, for example,more likely that the borrower has better information than the lender on the probability that the loan

will be repaid. If lenders would know as much as borrowers then the true risk would be known to

lenders and the adverse selection problem could be prevented. The second form of asymmetric

information is moral hazard. Moral hazard occurs after the loan has been granted. Moral hazard

occurs when borrowers engage in undesirable activities – unforeseen and unknown to the lender –

that reduce the probability that the loan will be repaid. Moral hazard is an information problem

because the lender does not know about it. To prevent moral hazard, the lender must monitor the

borrower.



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5 A note on the Economics in action statement:

As part of the wider trend towards globalisation, the financial systems of different countries have

become increasingly similar and interrelated. This has been especially marked since the almost

universal abandonment of alternative economic orders such as socialism and communism. It is

true that more and more countries have adopted the economic and financial systems of the more

economically successful countries. One reason is that the communist system has been exposed

for what is really is, at least to all but its ideological fanatics. It promised an abundance of goods

and services, but rather spread poverty. It promised freedom but instead lead to oppression and

tyranny. This does not mean that either the free-market system or its supporting financial systems

are perfect. The most recent financial crisis – the Subprime crisis – caused shockwaves throughout

the world and led to a lot of economic misery.

D Activities

Evaluate the following statements (true/false):

1 If a firm borrows money from a bank to finance its debt, it is an example of indirect finance.

2 If government sells treasury bills to investors to finance a deficit, then it engages in direct financing.

3 If a firm issues a bond that repays the debt over a five-year period, then the firm engages in

indirect financing.

4 The term to maturity of a bond remains constant over the term of the bond.

5 The existence of a well-functioning secondary market for a financial instrument ensures the

liquidity of the financial instrument.

6 Over-the counter-markets which simultaneously operate in different locations, buy and sell at fixed

prices and ignore market conditions.7 US government securities are long-term debt instruments and are the most liquid securities traded

on the capital market.

8 Primary bond markets are more important than secondary bond markets. New lending and

borrowing occur in primary markets only, and it is these new issues which are ultimately important.

The secondary market does not create new lending and borrowing.

9 In a world of no information and transaction costs, financial intermediaries would not exist.

10 If there were no asymmetry in the information that a borrower and a lender had, there could still be

a moral hazard problem.

Answers:1-2 Correct

3 Incorrect . A bond is direct financing. It directly involves both the ultimate lender and borrower.

4 Incorrect . The term to maturity refers to the remaining time (term) to maturity. For example, the

term to maturity of a bond which was initially issued as a five-year bond, was initially

five years, changes to four years, then three years et cetera, as time proceeds.

5 Correct

6 Incorrect . Over-the counter-markets function effectively as organised exchanges.

7 Correct

8 Incorrect . Secondary markets are at least as important as primary markets. Prices in

secondary markets determine the prices that firms issuing securities receive in

primary markets. In addition, secondary markets make securities more liquid and

thus easier to sell in the primary markets.



8

9 Correct : If there were no information or transactions costs, people could make loans to each

other at no cost and there would be no need for financial intermediaries.

10 Correct . Moral hazard occurs when borrowers, after the loan has been granted, engage in

undesirable activities that reduce the probability that the loan will be repaid. Even if

a lender knows that a borrower is doing things that might jeopardize paying off the

loan, the lender must still stop the borrower from doing so. Because that may be

costly, the lender may not spend the time and effort to reduce moral hazard. Thus

the problem of moral hazard may still exist.


2.1 Briefly explain the function of financial markets, the meaning of direct and indirect financing and

the meaning of a financial intermediary. (5)

2.2 Explain the differences between debt and equity markets, primary and secondary markets,

exchanges and OTC markets, and money and capital markets. (10)

2.3 List and explain the operation of any three money market instruments. (3x5=15)2.4 List and explain the operation of any three capital market instruments. (3x5=15)

2.5 Explain the functions performed by financial intermediaries and how and why these promote

economic efficiency in financial markets. (8)

2.6 Explain the broad purpose and methods used in government regulation of the financial system. (6)



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Chapter 3: What is money?


To explain the meaning of money

• The functions money must perform

• The evolution of the payment system

• How money is measured (only in South Africa)

• The reliability of the measures of money


Read the following passage and then decide whether the meaning of money in this passage

corresponds to the meaning we give to it in this course.

Over a 30-year career, worldly philosopher Jacob Needleman has counseled the rich and

successful on matters of money and meaning. His conclusion: "Money is like a mirror to our

culture. What we see tells us who we are."

As a "worldly philosopher," Needleman has made a career out of talking honestly about a subject

that eludes most people and listening thoughtfully to people talk about a subject that most find hard

to discuss. In fact, says Needleman, "Money today has become like sex was to previous

generations. It's damn hard, in fact nearly impossible, to think about money honestly. It has an

immense influence on everything we do. Yet few people are able to acknowledge the power of

money."

"Having lots of money can be like a drug. It can make you feel powerful and giddy."

Source: http://www.fastcompany.com/magazine/09/meaning.html


Meaning of money

Functions of money

Medium of exchange; unit of account; store of value

Evolution of the payments system

Commodity money; Fiat money (paper currency); Cheques; Electronic payment; E-money

Measuring money##.



10

Additional for South Africa

C7 Measuring money in SA.

C8 What causes the money stock to increase?

C9 Can government effortlessly "print" money?


Definition of money

1 The functions of money (medium of exchange, unit of account, store of value) explain why money

is useful and why it facilitates exchange. It does not, however, explain exactly how money should

be defined. For practical reasons, economists have decided to define money as Currency (notes

and coins) plus Deposits (positive balances held in bank accounts): M=C+D. This definition

focuses on money as a liquid asset.

2 This definition is not perfect. If we approach money as a medium of exchange – money facilitatesthe exchange of goods and services – then we should include certain forms of credit within the

definition of money. But not all forms of credit are counted as money. Broadly speaking these

come in two forms. The first form of credit which facilitates exchange is credit cards held by

consumers. In South Africa it is customary that households pay for goods and services by credit

cards. Credit cards normally provide credit up to some limit, say R10 0000, against which

purchases can be made. The credit provided only have to be settled, say in a month's time. It may

appear that the amount of available credit must be counted as money since it facilitates exchange

and provides access to real purchasing power. The second important form of credit not counted as

money is trade credit. Trade credit is when firms sell their products to the trade sector, on condition

that payment for the goods is made at a future date, say in three months’ time. Credit in both thesetwo forms serves as a medium of exchange and consequently credit should, in principle, qualify as

a form of money. These forms of credit allow the immediate exchange of goods although they

require payment at a later date. But because these forms of credit do not lead to an increase in

cash or deposits, the money stock (M=C+D) is not affected by any of the two.

3 The reason why these two forms of credit are not included within the practical definition of money

is because of practical difficulties of measuring these forms of credit. Thus, for reasons of

simplicity, money is practically defined as Currency held plus Deposits (positive balances) only

(M=C+D). Both these quantities are relatively easy to measure. The amount of currency in

circulation is known since only the central bank issues currency. Because deposits are always heldat banks, banks know the exact amount of deposits held by the non-bank (private) sector.

The provision of trade credit, for example, may lead to indirect increases in money supply. Assume

a firm provides trade credit to the value of R50 million to be paid in three months’ time. The

provision of trade credit itself does not increase the money supply. But the firm has to finance its

operating costs. It must pay, for example, for labour and material costs during the three-month

period. If the firm now borrows, say R35 million from the bank, then this amount is counted as

money because these borrowings lead to an increase in deposits.



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4 The definition of money (M=C+D) views money as an asset. All assets are stock variables, that is,

they are measured at a point in time. This differs from flow variables, for example income and

expenditure, which are measured over a time period. To understand the difference between stock

and flow variables, think in terms of a bath of water. The volume of water held in the bath is a stock

variable which is measured at a point in time. The inflows into and outflows out of the bath are flow

variables which affect the stock of volume of water held.

Stocks and flows are related. In the case of money

Stock31 dec 2010 = Stock31 dec 2009 + Inflows2010 – Outflows2010.

The major reason why the money stock changes from the beginning to the end of 2010 is because

of two flows which occur during 2010. New loans granted by banks during 2010 increase the

money stock (money creation) while the repayment of loans to banks during 2010 decreases the

money stock (money destruction).

5 Economic transactions in principle do not affect the money stock. If, within an economy, Person Aor Firm A pays Person B or Firm B, then the stock of money does not change. The account

balance of A will decrease, but is exactly matched by the increase in the account balance of B.

Consequently, the total money stock remains the same.

6 A note on the Economics in action statement

Jacob Needleman uses the term "money" as a synonym for wealth. Our approach to the meaning

of money is different. Economists are interested in money as a medium of exchange and to direct

monetary policy.

7 Measuring money in SA

a In South Africa, the money stock is, in principle, defined as currency (coins and banknotes) plus

deposits held by the domestic, private, nonbank sector at commercial banks: M=C+D.

Commercial banks differ from the monetary sector. The monetary sector is a broader concept

which includes all registered banks and mutual banks, the Land and Agricultural Development

Bank of South Africa (Landbank) and the Postbank, the SARB and its subsidiary, the Corporation

for Public Deposits (CPD). The SARB and the CPD are referred to as the monetary authorities andare not commercial banks. Only registered banks and mutual banks, the Landbank and the

Postbank are classified as other depository institutions, broadly referred to as banks.

The qualification that money is only held by the "domestic, private, nonbank sector" has three

important implications. It means that money excludes deposits held by government and foreigners

at commercial banks as well as cash held by commercial banks themselves (vault cash).

Government and foreign deposits are excluded, because economists are mainly interested in the

behaviour of the domestic, private nonbank sector. Both vault cash and interbank deposits are

excluded because these are not available for spending by the private sector and therefore cannot

act as a medium of exchange.



12

The examples below assume that payments to the private sector increase the deposits of the

private sector, while payments by the private sector to government and the international sector

decrease private sector deposits. These transactions are likely to affect deposits rather than

holdings of currency because transactions are unlikely to be made in currency.

If A (a member of the domestic, private, nonbank sector) pays R10 000 of taxes to government

then the money stock decreases by R10 000 because the deposits of A will decrease. If, on the

other hand, the government pays contractor B (also a member of the domestic, private, nonbank

sector) R50 000, then the money stock will increase by R50 000 because the deposits held by B

increase by R50 000.

With respect to imports and export: If South African firm C exports R2 million of goods, then the

money stock will increase because the deposits held by C will increase by this amount. If South

African firm D imports R2 million of goods then the SA money stock will decrease because the

deposits held by firm D will decrease to pay for the imports.

What happens when the private sector decides to hold R20 million less notes and coins? Because

it requires less currency, the private sector will deposit R20 million with banks. The bank's vault

cash (or its reserves) will increase by R20 million while the deposits held by the private sector will

increase by R20 million. The money stock will remain unchanged on account of M = C + D = -20m

+ 20m = 0.

b As in the case of the USA, in South Africa we have the customary M1, M2 and M3 measures of

money. Each of the measures of money is based on the relationship: M=C+D where M= money,

C=currency and D=deposits. The measures of money differ as to which type of deposits are

included in D.

(i) M1A monetary aggregate

M1A consists of cash (token coin and banknotes) plus cheque and transmission deposits held by

the domestic, private, nonbank sector at commercial banks.

Cheque and transmission deposits are the type of deposits most commonly used for making

payments (deposit transfers). Although low interest is earned on cheque and transmission

deposits, it is extremely easy to transfer money from such deposit accounts to interest-bearing

medium and long-term deposits. Hence, when the interest rate on medium- to long-term depositsrises, there may be a large shift of deposits from cheque and transmission accounts into interest-

bearing, medium- to long-term deposits.

(ii) The M1 monetary aggregate

M1 consists of M1A plus "other demand deposits" held by the domestic private sector with the

banks. Demand deposits can be defined as deposits that are convertible into cash on demand;

deposits holders can withdraw cash from their deposit accounts whenever they wish. Demand

deposits normally also function as money; they are the deposits with which payments can be

made. Demand deposit accounts normally carry a payments facility, which basically means that

deposit holders can order their bank to transfer deposits directly out of these accounts.



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Deposits that function as money are also referred to as monetary deposits, transaction deposits or

cheque-able deposits (deposits on which cheques can be written); monetary deposits are mostly

(not always) demand deposits too. While the cheque and transmission deposits included in M1A

are monetary demand deposits, they are not the only ones. There are "other demand deposits"

that also function as money and can be added to M1A to form M1. M1 thus includes all monetary

demand deposits, which is why it is also described as the "narrow definition of money". M1

conforms to its payment function. The amount of M1 deposits will be sensitive to the interest rate

level. When the interest that can be earned on other assets is high, the opportunity cost of keeping

funds in the form of monetary demand deposits is high, and may cause funds to be shifted from

demand deposits to interest-bearing deposits.

(iii) M2: a broader definition of money

M2 is a broader definition of money. It consists of M1 plus deposits, which are almost money or

"near money". Apart from coins, banknotes and demand deposits (M1: money or narrow money), italso includes short-term and medium-term deposits (including savings deposits, savings bank

certificates and "share" investments) held by the private domestic sector at monetary institutions,

commercial banks and savings institutions. Short-term deposits have maturities of between 1 and

31 days and medium-term deposits are from 32 up to and including 180 days maturity. These

short- and medium-term deposits are not demand deposits, which means that they cannot be

converted into cash on demand; instead, such a deposit can be turned into cash only after some

time (its "term"). Moreover, term deposit accounts are not monetary or transaction deposits either;

they do not normally carry a payment facility. Hence term deposit holders cannot order their bank

to make payments (deposit transfers) directly out of these accounts. Only once the term has come

to an end and the funds are returned to a monetary deposit account (as they normally are), canpayments be made with these funds. However, because the term to maturity of these deposits is

not that long, they are, nonetheless, closely related to monetary deposits and hence to M1. Short-

and medium-term deposits, therefore, are also known as "near money" – in other words they are

near to being the type of deposits that function as money. Again, foreign and government deposits

are excluded from M2.

The M2 measure arose because short- and medium-term deposits are regarded as reasonable

substitutes for money in its M1 representation. The liquidity of term deposits — in other words, the

rapidity and ease with which they can be converted into a generally accepted medium of exchange

(i.e. be changed into cash or demand deposits) — are extremely important here.

(iv) M3: the most comprehensive measure of money

For many years, M1 and M2 were the only measures of the stock of money in South Africa. In

1984 the monetary authorities began to look for an even more reliable measure for the money

stock1, and official reports began to refer to M3 as such a measure. M3 is an extension of M2, and

includes, in addition to short- and medium-term deposits, long-term deposits held by the private

domestic sector with monetary institutions. Basically, M3 includes all the deposit liabilities of the

monetary banking sector, monetary as well as nonmonetary deposits. Both M2 and M3 also

include negotiable certificates (NCDs) and promissory notes (PNs) of the private sector.

1 Reliability, in this context, refers to the relative stability of the M/Y ratio over time.



14

The monetary aggregates are stock variables measured at month ends.

It is relatively easy to move funds between monetary deposits and nonmonetary short-, medium-

and long-term deposits, and the latter deposits can therefore be considered to be relatively liquid,

in the sense of being close to money. However, the assets that can be regarded as less liquid

substitutes for long-term deposits include instruments such as bonds and shares. It is considerably

more difficult and involves a notably higher cost to convert shares and bonds into monetary

deposits and/or cash than it is to convert short-, medium- and long-term deposits into cash or

monetary demand deposits. It involves considerably more effort and cost to move funds between

the components of M3 and financial assets that do not form part of M3. Therefore, in total, the M3

monetary aggregate is much more stable than its components, and may be a much better indicator

of domestic spending.

Table 3.1 The relative importance of each of the measures of money in South Africa2.

Monetary aggregates in South Africa End of 2009

(Money stock held by the private sector) R billion3 Share of M3

Currency (coins and banknotes) in circulation 61,8 3,2%

plus cheque and transmission deposits 359,6

M1A 421,4 21,6%

plus demand deposits 384,6

M1 805,9 41,4%

plus other short- and medium-term deposits 782.0

M2 1 588.0 81,5%

plus other long-term deposits 360,0

M3 1 947,9 100,0%

Currency plus demand deposits (ie the sum of cheque and transmission deposits and other

demand deposits) constitute the largest part of the M3 money supply (just less than 42%). Short-

and medium-term deposits are also quite important at just more than 40%). In 2009, long-term

deposits made up a little more than 18% of the total M3 money supply, while currency formed only

a tiny part (less than 4%) of the total M3 money supply. Thus currency constitutes only a minuscule

part of the total money supply in its M3 definition.

8 What causes the money stock to increase?

Another important perspective on the meaning of the money stock can be gained by considering

the factors which cause it to change. This is dealt with in more detail in chapter 14. There it will be

shown that net increases in bank loans to the private sector contribute, by far, most of the increase

in M3.

2 Quarterly Bulletin of the South African Reserve Bank . June 2010: table S-23.

3 R1 billion is equivalent to R1 000 million, or R1 x 109.



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The money stock consists of cash plus deposits (M=C+D) held by the private nonbank sector with

the banks. Only when the amount of deposits (or cash) changes then the money stock will change.

Total private sector deposits change because of four reasons.

a Banks' loans to firms and individuals (called the private nonbank sector): When individual A obtains

a new housing loan of R1m from a bank, then the bank creates a deposit of R1m in A's account –

ready to be paid to the seller, or alternatively creates a new deposit of R1m in the seller's account.

Consequently, new loans directly increase deposits. However, each repayment of A, say over a 20

year period, will decrease the deposits of A. Thus a net increase in the amount of loans to the

private sector will increase the money stock.

b Transactions in financial assets (say securities) between the banking sector (central banks and

commercial banks) and the private sector: When firm B buys R2m of securities from the central

bank, then private sector deposits decrease by R2m. When individual C sells R1m of securities to

banks, then private sector deposits increase by R1m.

c Government transactions with the private nonbank sector: Changes in government deposits do notchange the money stock as only private sector deposits are counted as money. When the

government pays services provider D an amount of R500, then government deposits decrease by

R500 (not counted as money) but private sector deposits and the money stock will increase by

R500. Also, when taxpayer E pays tax of R700 then the private sector deposits and the money

stock decrease by R700.

d Foreign exchange transactions: When exporter F exports R1m of goods, then F's deposits and the

money stock will increase by R1m. When G imports R2m of goods, then the private sector deposits

(and money stock) will decrease by R2m.

The relative importance of the factors underlying the growth in the South African money stock isprovided in table 14.3 (see chapter 14). Private sector loans contributed the most to the growth in

M3 in 2009, while flows of foreign capital (reason d), and the government sector (reason c) are

relatively small. Although there is considerable variation from year to year in the relative

importance of the factors that cause changes in M3, the contribution of the private sector always

remains dominant by far.

In summary: The most important reason why money stock changes is because of changes in the

net loans of banks to the private sector.

9 Can government effortlessly "print" money?

Another issue which requires clarification is the meaning of the government "printing" money. Yes,

government can print money to finance its expenditure. The first type is when government prints

banknotes and coins to finance its expenditure. The process is as follows:

(a) The first thing to note is that the government itself does not print money. Only the SARB has the

right to print money. Assume the SARB prints new money to the value of R10m. Is it immediately

counted as money? No, not yet. Only cash and deposits held by the private nonbank sector are

counted as money.



16

(b) The SARB sells the new money to the banks. The banks pay R10m to the SARB and the SARB

earns a "profit" of R10m. Well, the "profit" is in fact less than R10m because of manufacturing

costs, of say R0,1m. The remaining R9,9m does, however, not accrue to the SARB but is paid to

government, which increases government deposits. Has the money stock increased? No, not yet,

as only cash and deposits held by the private nonbank sector are counted as money.

(c) The banks now have an additional R10m of new notes in their vaults. They will use it to replace old

worn notes, or they will issue it to the private sector when the private sector requires cash. Neither

of these transactions. however, affects the money supply. When they issue it to the private sector

they do it in exchange for deposits, or when they replace notes they receive the old notes in

exchange.

(d) Government deposits have increased by R9,9m, though. Because government deposits are not

counted as money, the money stock has not changed. Only when government spends the money,

it enters circulation and increases the money stock because the private sector deposits increase.

If, for example, government pays R3m to a building contractor to build a school, then the depositsof the contractor and the money stock will increase by R3m.

Government gets the advantage of printing new money. Is this not dangerous? Yes, it is dangerous

when government is corrupt and misuses the "printing press" to create excessive money. But

normally this is not a problem. Because the cash component of the money supply is of relatively

small significance in terms of its share of the total money stock, printing banknotes to serve the

cash requirements of the private sector is usually kept within limits.

The second form of "printing money" is when government forces the central bank to buy excessive

issues of government securities. In simple terms, the government borrows excessively from thecentral bank. This form of money creation is usually much more important than the printing of

physical banknotes. Both forms were used in Zimbabwe from 2001 onwards to finance government

expenditure, which eventually led to runaway inflation. Another name for this is the monetisation of

government debt. When government continuously issues new government securities, then, over

time, this greatly multiplies the money supply.

How does this second form work? Let's first look at one round of this process. The starting point is

when government forces the central bank to buy a new issue of government securities. In the case

of Zimbabwe the central bank was not independent enough to withstand the wishes of government,

although the central bank must have known that these securities would, in due time, quicklybecome worthless due to the high inflation rate. In terms of the balance sheet of the central bank

(see chapter 10), both government securities (assets) and government deposits (liabilities)

increase. When government spends its newly acquired deposits, say by paying its government

employees, then private sector deposits (and money stock) increase.

The consequences of this form of money creation are predictable. The quantity equation: MV = PY

(see chapter 19) explains it well. If V and Y are constant, then increases in M (money stock) cause

increases in P (the price level).



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Hyperinflation occurs when, over the medium to long term, this process is repeated many times

over. It then becomes a vicious cycle of money creation → inflation → money creation. Once

inflation takes off, it requires further rounds of government selling ever-increasing volumes of

government securities to the central bank. This leads to a further acceleration of the rate of inflation

and, ultimately, to hyperinflation.

In Zimbabwe its consequences were disastrous. Ultimately, it destroyed both the financial sector

and the economy. It caused untold hardship and misery to the population, with the poor, being

unable to protect themselves against the ravages of high inflation, suffering most. Zimbabwe offers

a textbook example of how government can misuse the financial system. But Zimbabwe is not

unique in this respect. Germany, for example, also experienced hyperinflation in the 1920s, due to

serious economic problems and government resorting to – as in Zimbabwe - the monetisation of

the debt. This is discussed in more detail in chapter 20, which deals with money and inflation.

D Activities

1 Person A, a professional gardener, performs a landscaping task for person B. At its completion B

pays A R50 000 for the job. Explain how this transaction affects

(a) domestic income (value added)

(b) the money stock

Explain if the following statements are correct / incorrect:

2 In principle, economists are not exactly sure how to measure money.

3 The use of a credit card to purchase goods does not affect the money stock.

4 The following transactions typically increase the money stock:

a trade credit

b payment of taxes

c government expenditure

d exports

e imports

5 An increase in the interest rate will cause increases in M1A and M3.

Comment on the following statement:

6 In many second-year macroeconomics courses it is implied that M changes mostly because of

government buying/selling of bonds (open market transactions). Is this correct?



18

Answers:

1a Yes, additional income is created. The value added by the professional gardener may, however, be

less than R50 000. Professional gardeners use intermediate inputs like plants, fuel, fertilizer and

earthmoving contractors, the value of which should be subtracted from the R50 000.

1b Economic transactions4 do not affect the money stock M = C + D. When A pays R50 000 to B, then

A's deposits will decrease while those of B will increase, offsetting each other.

2 Correct . The definition of money M=C+D is convenient to measure for practical reasons and is

thus generally accepted. Economists recognise, however, that certain forms of money,

like credit, should theoretically be included with money, which is not the case.

3 Typically, credit cards provide short-term credit to households. It allows households to make

purchases of goods and services and to pay for these, say a month later.

Money is defined as: M=C+D. When credit card purchases are made, then neither C or D are

affected, and consequently M remains constant. When households pay for these purchases amonth later, then household deposits will decrease, while the deposits of the credit card institution

will increase, with no effect on M either.

4 Which transactions increase the money stock?

a Incorrect . Like typical credit card transactions, trade credit does not affect M because it is not

included in the measurement of M.

b Incorrect . The payment of taxes decreases M.

c-d Correct . Both government expenditure and exports increase the deposits (or currency) held

by the private sector, and thus increase M.e Incorrect . Imports typically decrease M.

5 Incorrect . Because M1A deposits do not earn interest, an increase in the interest rate is likely

to cause a shift of M1A deposits into M2 deposits which earn interest. An increase in

M3 is, however, unlikely although its composition may change.

Comment

6 The most important reason by far why the money stock (M) changes is not because of open

market transactions but because of changes of banks' net loans to the private sector. New loans

increase M, while loan repayments decrease M.

4 We assume for the moment that these are transactions between members of the private sector. The privatesector can also engage in transactions with government, the external sector or the monetary sector. Thesecases can affect the money stock and will be dealt with.



ECS3701/001

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3.1 Provide a formal definition of money. Then explain how the money stock is measured in principle.

(5)

3.2 Briefly distinguish between money and income, and money and wealth. (4)

3.3 List and explain the three primary functions of money. (3x2=6)

3.4 Explain the meaning of the following terms as well as the advantages/ disadvantages of each in

facilitating payments: (5x3=15):

Commodity money, fiat money, cheques, electronic payment, e-money.

3.5 Define the following measures of aggregate money stock in South Africa: M1A, M1, M2, M3.

(4x2=8)

3.6 Explain the meaning and implications of the government "printing" money. (10)



20

PART 2: FINANCIAL MARKETS

Chapter Goals

4 Understanding interest rates

5 The behaviour of interest rates

6 The risk and term structure of interest rates

7##

The stock market, the theory of

rational expectations and the efficient

market hypothesis

Explain the meaning of interest rates.

Explain how the interest rate on an asset is

determined on the market.

Explain why interest rates differ.

Not prescribed



ECS3701/001

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Chapter 4: Understanding interest rates


To explain the meaning of interest rates.Measuring Interest Rates

The distinction between

(i) interest rates and returns

(ii) real and nominal interest rates


Read the following section and explain whether this supports the concept of the time value of

money.

Forces Behind Interest Rates

Interest is a cost for one entity (the borrower) and income for another (the lender). The lender of

money is taking a risk that the borrower may not pay back the loan. Thus, interest provides a

compensation for bearing risk. Coupled with the risk of default is the risk of inflation. When you

lend money now, the prices of goods and services may go up by the time you are paid back your

money, whose original purchasing power would have decreased. Thus, interest protects against

future rises in inflation. The borrowers pay interest because they must pay a price for gaining the

ability to spend now as opposed to having to wait years to save enough money. For example, a

person or family may take out a mortgage for a house for which they cannot presently pay in full,

but the loan allows them to become homeowners now instead of far into the future. Businessesborrow for future profit. They may borrow now to buy equipment so they can begin earning

revenues today.

Source: http://www.investopedia.com/articles/03/111203.asp


Measuring interest rates

Present value (calculations are NOT included);

Four types of credit market instruments

Yield to maturity

Simple loan

The amount borrowed (PV: present value) is repaid by one payment (CF) at the end of n years.

( )ni

CF PV

+

=

1

where CF: cash flow at end of period n.

Fixed payment loan

A loan value (LV) is repaid by n fixed payments (FP) at the end of each period.

( ) ( ) ( )ni FP

i

FP

i

FP

i

FP LV +

++

+

+

+

+

+

=

1...

111 32

where i: interest rate per period.



22

The distinction between interest rates and returns

Maturity and the volatility of bond returns: interest rate risk

The distinction between real and nominal interest rates


Interest rates

1 This chapter on interest rates is not difficult material, although interest rates are technical and

mathematical. You must first understand interest rates to be able to understand many of the

concepts in monetary economics.

2 In principle, you must understand each of the four types of credit market instruments. You do not

need to know the respective formulas nor be able to apply them. Although it is fun to use a

financial calculator to perform these calculations (which typically has standard buttons for PV,

PMT, FV, i, n and Payment at beginning/end), which may be used to deal with all four credit marketinstruments, you will not be required to use financial calculators in the examination.

3 You are not required to know the formula for calculating the distinction between interest rates and

returns.

6 You must understand the meaning of interest rate risk and why returns on long-term bonds are

more volatile than those on short-term bonds

Real and nominal interest rates

7 You must understand

a the difference between nominal and real interest rates

b why a low real interest rate provides more incentives to borrow but fewer incentives to lend

c the meaning of indexed bonds

8 Economics in action:

This quote, which explains that interest is a cost for borrowers and an income for lenders, does

support the concept of the time value of money. According to the time value of money, the value of,say, R100 now is worth say R120 in future, the difference being the amount of interest.

The interest amount makes sense both for the lender and the borrower. To the lender interest

provides compensation for bearing risk, and for the possibility of future inflation (i.e. being repaid in

money that is worth less). To the borrower, a loan enables a household to, say, purchase a house,

or for the firm to purchase equipment now instead of in the future, and to immediately enjoy the

benefits thereof.



ECS3701/001

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D Activities

Evaluate the following statements:

1 The yield to maturity (i) of each of the four types of credit market instruments and its price (P, PV or

LV, whatever applies) are inversely related.

2 Investors cannot ever be worse off when investing in bonds.

3 A negative real interest rate on coupon bonds implies that the interest earned on the bond does not

fully compensate for the loss of purchasing power of money. Thus the investor is worse off.

Answers:

1 Correct 2 Incorrect . If the bond is not held for the full holding period then the return on a bond could be

negative when interest rates increase. Secondly, if the inflation rate increases

unexpectedly, say to 8% while the yield to maturity is 5%, then the real interest rate

is 5%-8% = -3%.

3 Correct


4.1 Explain the meaning of the following four types of credit market instruments (4x3=12)

Simple loan, fixed payment loan, coupon bond, discount bond.4.2 Explain the meaning of the following concepts in the context of a coupon bond: coupon rate, yield

to maturity and the return on a bond. (7)

4.3 Distinguish between the nominal and the real interest rate. Which one is more important and why?

(5)



24

Chapter 5: The behaviour of interest rates


To explain why interest rates change.

• Interest rates in the bond market

• Supply and demand in the bond market

• The interest rate in the money market

• Supply and demand in the market for money (using the liquidity preference framework)


Interest rates are important. Do the reasons below also apply to South Africa?

Why are long-term interest rates so important to the health of the economy?Lower interest rates stimulate business investment by borrowing and also to greater consumer

consumption which can be inflationary. Lower interest rates also tend to boost the stock market

because higher returns are found there. When productivity costs are lower, which is a result of

lower interest rates, business is more competitive internationally and can sell more products

abroad and this leads to a stronger currency. Higher interest rates are deflationary and dampen

consumer spending. Long term rates are important because business thrives when there are fewer

uncertainties.

Source: Answers.com

Why Central Banks and Interest Rates Are So Important

The one factor that is sure to move the currency markets is interest rates. Interest rates give

international investors a reason to shift money from one country to another in search of the highest

and safest yields. For years now, growing interest rate spreads between countries have been the

main focus of professional investors, but what most individual traders do not know is that the

absolute value of interest rates is not what's important - what really matters are the expectations of

where interest rates are headed in the future.

Source:http://uk.biz.yahoo.com/24022009/389/central-banks-interest-rates-important.html


Determinants of asset demand

Wealth; Expected returns; Risk; Liquidity; Theory of portfolio choice

Supply and demand in the bond market

Demand curve, Supply curve, Market equilibrium, Supply and demand analysis [The calculations

are not prescribed##].



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Changes in equilibrium interest rates

Shifts in demand for bonds, Shifts in supply of bonds, Applications: Changes in the interest rate

due to expected inflation: The Fisher effect; Changes in the interest rate due to a business cycle

expansion.

Other two applications “Explaining low Japanese Interest Rates” and “Reading the wall street

Journal ‘Credit Markets’ columns are not prescribed##

Supply and demand in the market for money: the liquidity preference framework

Changes in equilibrium interest rates in the liquidity preference framework

Shifts in the demand for money, Shifts in the supply of money, Changes in income, Changes in the

price level, Changes in the money supply, Application: Money and interest rates, Does a higher

rate of growth of the money supply lower interest rates?

Additional materialC5 How is the interest rate determined in South Africa?


1 This chapter deals with two partial equilibrium approaches to the determination of interest rates:

supply and demand in the bond market and the liquidity preference framework (supply and

demand in the money market). These two approaches complement each other in the sense that it

allows us to determine the effects of different casual factors on interest rates.

2 To keep things as simple as possible, Mishkin assumes a one-year discount bond for which

P=F/(1+i). In this case there is an uncomplicated inverse relationship between P and i. The inverse

relationship between P and i applies to all types of bonds although its mathematical form may be

more complex.

3 The framework of the demand for and the supply of assets is used for the determination of interest

rates in the bond market. This approach allows us to determine the effect of factors which shift the

demand for or the supply curves of bonds. An interesting and practically relevant application is the

effect of the expected inflation rate on interest rates. Make sure you understand the distinction

between factors that shift the supply and demand curves, and movements along a demand orsupply curve.

4 The liquidity preference framework is used to determine interest rates in the market for money.

This approach is useful to determine the effects of the macroeconomic variables of income, the

price level and the supply of money on interest rates.



26

5 How is the interest rate determined in South Africa?

As far as the bond market is concerned, the approach of Mishkin (the demand for and supply of

assets explain bond interest rates) is a good approximation of reality in the case of South Africa.

In the case of the market for money, however, the liquidity preference framework does not apply in

South Africa. We can accept the realism of the downward sloping demand for money curve. But

Mishkin's assumption that the supply of money curve is vertical, that is, the supply of money is

controlled by the Reserve Bank, is unrealistic. This matter is dealt with in more detail in Part 4:

Central banking and the conduct of monetary policy. In essence, the Reserve Bank cannot, and

does not, control the supply of money but it rather controls interest rates. The Reserve Bank sets a

short-term interest rate – called the repo rate – which has a dominant effect on all interest rates in

South Africa. The level of the repo rate determines the demand for money – the amount the private

sector wishes to borrow. We will return to this issue later.

6 Economics in action:

Yes, interest rates are important for South Africa. Interest rates directly affect the domestic

economy but also exchange rates and therefore South Africa's relation with foreign economies. In

the case of South Africa, about 25% of its output is exported in exchange for imports.

D Activities

Evaluate the following statements:

Bonds: Asset demand and supply

1 The demand curve for bonds indicates the willingness of lenders to buy bonds. If a lender buys a

bond then the lender supplies funds to the borrower, which the borrower must repay over time. The

price of bonds in figure 1 (p 134 of the prescribed text book) is the discount price the lender pays

for the bond (the term discount bond applies in the case of a simple one-year bond). The lower the

price, the greater is the discount, the higher is the interest rate (P=F/[1+i]) and the more willing

lenders are to purchase bonds – and to supply funds to the issuers of bonds (the borrowers).

2 The supply curve for bonds indicates the willingness of borrowers to sell bonds. When a bond is

sold to an investor, then the investor provides funds to the borrower. The price of a bond in figure 1(p 134 of the prescribed text book) is what the borrower receives for the bond. The higher the price

of bonds, the more the borrower receives and the lower ithe interest rate which the borrower must

pay.

3 If the interest rate is expected to increase, then the price of bonds can be expected to fall. In the

case of longer-term bonds, this may imply a lower return on bonds than initially expected. This will

shift the demand curve for bonds to the left and the supply curve of bonds to the right.

4 A higher expected inflation rate will shift the demand curve for bonds to the left and the supply

curve of bonds to the right. The demand curve will shift to the left because investors will be less

willing to supply funds. The supply curve will shift to the right because this allows borrowers to

obtain funds at a lower real cost.



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5 The more liquid a bond, the more desirable it becomes for borrowers.

6 When a bond price increases, its yield also increases, because yield is calculated as a fixed

percentage of price.

7 The Fisher effect unambiguously states that when the inflation rate is expected to increase, both

the quantity and the price of bonds will decrease.

8 A business cycle expansion is likely to lead to a decrease in the supply of bonds because of a

reduced need for bonds.

Liquidity preference

9 When the central bank increases the money supply, the initial short-term effect is that the supply

curve of money shifts to the right, so that the interest rate falls. This is called the liquidity effect.

10 When the interest rate falls, then over time, this has an expansionary effect on the economy. When

income increases, then the demand curve for money will shift to the right, which causes an

increase in the interest rate.11 When income increases then this might also cause an increase in the general price level. The

expected increase in inflation, according to the liquidity preference model, leads to an increase in

interest rates.

12 The short-term expansionary effect of an increase in the money supply may thus be partly reduced

or even completely overcome by longer-term increases in the interest rate due to the income and

expected-inflation effects.

Answers:

1-4 Correct

5-8 Incorrect 5 The liquidity of bonds is important for lenders because lenders might want to sell the bond during

its lifetime. The more liquid the bond, the easier it is to sell.

6 The bond price and its yield are inversely related.

7 The Fisher effect only states that when the inflation rate is expected to increase, the prices of

bonds will decrease and their interest rates increase.

8 A business cycle expansion is likely to lead to an increase in the supply of bonds.

9-10 Correct .

11 Incorrect . The expected increase in inflation is predicted by the bond supply and demand

framework, and not by the liquidity preference model. It predicts that higher expected inflation

leads to an increase in interest rates.12 Correct .


5.1 Briefly explain how four major factors affect the demand for an asset. (4x2=8)

5.2 Derive a bond demand curve (price of bond versus its quantity demanded) and a bond supply

curve and explain how the equilibrium P and Q for the bond is determined using the asset market

approach. Explain which curve may be associated with borrowers/lenders respectively. Illustrate

graphically. (10)



28

5.3 Briefly explain the demand/supply for assets framework and then use it to predict (provide reasons)

how the demand for and supply of bonds are affected by each of the following:

a A business cycle expansion (also predict the equilibrium P,Q as well as i) (5)

b An increase in the public's propensity to save (2)

c Higher expected future interest rates (maturity of bond n>1) (2)

d An increase in the expected inflation rate (also predict the equilibrium P,Q) as well as i) (6)

e An increase in the riskiness of bonds relative to other assets (2)

f An increase in the government's budget deficit (2)

5.4 Explain Keynes' liquidity preference framework, that is, its simplifying assumptions, the derivation

of the demand and supply curve and how equilibrium is determined. (8)

5.5 Explain how Keynes' liquidity preference framework can be used to explain the effects of an

increase in income, a rise in the price level and an increase in the money supply (assume that all

other economic variables remain constant). Then explain why an increase in money supply does

not necessarily lead to a decrease in interest rates over the longer term. (12)



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Chapter 6: The risk and term structure of interest rates


Why do interest rates on bonds vary?

Risk structure of interest rates

The interest rate on bonds of the same term to maturity, is affected by their risk.

The term structure of interest rates

It explains (as represented by the yield curve) why interest rates differ among bonds of similar

quality, but with different terms to maturity

Three different theories may be used to explain the characteristics of yield curves observed over

time


Read the following two quotes. After studying this chapter you should have a better idea exactly

what they mean.

Standard & Poor's (S&P), a leading rating agency, today announced that it affirmed South Africa's

long term rating at BBB+ and foreign currency issuer rating of A+ with a negative outlook. S&P last

upgraded South Africa in August 2005 and changed the outlook on South Africa's credit to

negative in November 2008 as a result of the global financial crisis. S&P indicated that the

affirmation reflects the country's sovereign prudent macroeconomic policies, moderate debt burdenand stable political institutions.

Source: http://www.treasury.gov.za/comm_media/press/2009/2009061701.pdf

The yield curve, a graph that depicts the relationship between bond yields and maturities, is an

important tool in fixed-income investing. Investors use the yield curve as a reference point for

forecasting interest rates, pricing bonds and creating strategies for boosting total returns.

Source: http://www.pimco.com/LeftNav/Bond+Basics/2006/Yield_Curve_Basics.htm


Risk structure of interest rates

Default risk, Liquidity, Income tax considerations

Term structure of interest rates

Expectations theory, Segmented markets theory, Liquidity premium and preferred habitat theory,

Application: Interpreting yield curves, 1980-2011



30


Risk structure

No additional explanations are necessary.

Term structure

The South African yield curve is extremely volatile. See chart 6.1 as an illustration.

Chart 6.1: Yield curves for South Africa, Jan 2009-Mar 2009

Mar. 2009

Feb. 2009

Jan. 2009

Source: Bond Exchange of South Africa

Some remarks on chart 6.1:

1 The vertical axis (Y) denotes the yield but where is the time (X) axis? The X-axis shows different

bonds (R153, R201, R206, ...). These bonds, however, do roughly represent the time to maturity.

The R153 bond, for example, was issued in 1989 and it matured in August 2009. In March 2009 it

had a remaining maturity of six months. Similarly the R157 matures in 2015, and the R186 in 2026.On the chart, the remaining time to maturity varies from, approximately 6 months (left of X-axis) to

25 years (right of X-axis).

2 The bonds are of similar quality. They are all issued by the South African government. The only

difference is that they have different remaining times to maturity.

3 Three yield curves are shown in chart 6.1, that is, for three different points in time: January 2009,

February 2009 and March 2009. The current yield curve (for today) is likely to be different.

4 The yield curves above have more or less a normal shape (upward sloping). The yield of longer

term bonds is generally higher than those of short-term bonds. During 2008, however (not shown

in the chart), the yield curve was inverted, that is, generally downward sloping because the short-

term interest rate was very high.5 The yield curve can shift over time. As shown above, it generally shifted upward from January

2009 to March 2009 by almost 1% in the case of the longer term bonds.

6 The short-term bond yield is very much affected by monetary policy, and in particular by the level

of the repo rate which is set by the SARB.

7 The long term bond yield is very much affected by expected inflation, the foreign exchange market

and by the general economic outlook.

8 If you can successfully predict (bond) interest rates, then you can make lots of money. Current

interest rates affect the current price of bonds. However, if your interest rate predictions are

incorrect, you can lose lots of money! Investment institutions employ many highly skilled financial

specialists, mathematicians and so forth, who try to forecast interest rates.



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1 International credit rating agencies (like Standard & Poor) are important providers of financial

market intelligence, including independent credit ratings. This provides investors with independent

benchmarks about their investment and financial decisions.

2 Investors use the yield curve as a reference point for forecasting interest rates.

D Activities

For each of the following questions, which one of the options is the most correct?

1 The risk structure of interest rates explains why the interest rate on bonds differs because the

(a) quality of bonds are different although their time to maturity is similar

(b) time to maturity is different but their quality is similar

2 The R157 bond was issued during 2005 and it matures in September 2015. In March 2009, theterm to maturity of the R157 bond was approximately

(a) cannot be derived

(b) 10 years

(c) 6½ years

(d) 5¼ years

3 Which of each of the following is confirmed by chart 6.1?

(a) the interest rates on bonds of different maturities tend to move together

(b) the typical form of a yield curve is upward sloping

(c) when short-term interest rates are low, the yield curve is upward sloping; and when short- term interest rates are high, yield curves tend to be downward sloping

4 Which characteristics apply to the yield curve? In each case select the most appropriate one of the

two options which are underlined.

A yield curve shows the

(a) relationship / difference between

(b) the yield to maturity / current return

(c) measured in terms of percentage per year / a price index

(d) and the remaining / original term to maturity

(e) of bonds / three bonds(f) of similar quality / different quality

(g) on a specific date / over a specified period

Which of the following is correct?

5 The yield curve can change significantly over time.

6 The expectations theory assumes that the yield on long term bonds is related to the yields of short-

term bonds.

7 An assumption of the segmented market theory is that the yield on long term bonds is independent

of the yield on short-term bonds.

8 The liquidity premium theory offers relatively better explanations than the expectations and

segmented market theorems.



32

Answers:

1a Correct

2c The term to maturity of the R157 bond is the remaining term from March 2009 to September 2015.

This is 6½ years.

3 Only (a) and (b) are confirmed by chart 6.1.

4 In each case the first option applies to the yield curve.

5-8 Correct


6.1 Explain the meaning of the risk structure of interest rates. List and explain the three factors which

affect the risk structure of interest rates using a supply of/demand for bonds-framework. (18)

6.2 Explain the meaning of the term structure of interest rates and the yield curve. Draw a normal yield

curveand explain why its shape applies. List three empirical observations of the yield curve. (10)

6.3 Explain the assumptions and predictions of the expectations theory and how well it explains thethree empirical observations of the yield curve. (9)

6.4 Explain the assumptions and predictions of the the segmented market theory and how well it

explains the three empirical observations of the yield curve. (7)

6.5 Explain the assumptions and predictions of the liquidity premium theory of the term structure and

the preferred habitat theories of the term structure and how well they explain the three empirical

observations of the yield curve. (18)



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PART 3: FINANCIAL INSTITUTIONS

Chapter Goals

8 An economic analysis of financial structure

9 Financial crises in Advanced economies

10 Financial crises in emerging market

economies

11 Banking and the management of financial

institutions

12## Economic analysis of Financial regulation

13## Banking industry: Structure and competition

How financial structure affects the economic

efficiency of markets.

What causes financial crises? And what are its

consequences?

Explain the dynamics of financial crisis in emerging

economies.

The basic functioning of banks.

Not prescribed

Not prescribed



34

Chapter 8: An economic analysis of financial structure


•

To explain how financial structure affects economic efficiency in financial markets.

• How financial intermediaries overcome the problem of high transaction costs in financial

transactions

• Asymmetric information in financial transactions: The problems of adverse selection and moral

hazard

• How adverse selection influences financial structure

• How moral hazard affects the choice between debt and equity contracts

• How moral hazard influences the financial structure in debt markets

• Why conflicts of interest may arise in financial institutions and why they may cause an adverse

impact

• Why the financial systems in developing and transitional economies face difficulties


Read the following quotes and then decide whether access to information could play a significant

role in the banking industry.

(1) ... moral hazard is presented when managers possess information about the firm's future value

not yet available outside of the firm.

(2) ... a banker serves as an external auditor, passing judgment on the firm's present condition and

future prospects for loan repayment.

(3) ... banks may be in possession of superior information which is transmitted to potential

investors by the announcement of the granting of a bank loan.

Source: http://www.studyfinance.com/jfsd/pdffiles/v7n3/mcdonald.pdf



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Basic facts about financial structure throughout the world

1 Stocks are not the main source of external financing

2 Marketable securities are not the primary source of finance

3 Indirect finance is more important than direct finance

4 Banks are the principal source of external funds

5 The financial system is heavily regulated

6 Only large, well-established firms have access to securities markets

7 Collateral is prevalent in debt contracts

8 Debt contracts have numerous restrictive covenants

Transaction costs

How transaction costs influence financial structure; How financial intermediaries reduce transaction

costs.

Asymmetric information: Adverse selection and moral hazard

The lemons problem: How adverse selection influences financial structure

Lemons in the stock and bond markets; Tools to help solve adverse selection problems

How moral hazard affects the choice between debt and equity contracts

Moral hazard in equity contracts: The principal-agent problem; Tools to help solve the principal-

agent problem

How moral hazard influences the financial structure in debt markets

Tools to help solve moral hazard in debt contracts

Application: Financial development and economic growth

## Application: Is China a counter-example to the importance of financial development?


1 The purpose of this chapter is to provide an economic understanding of the structure of thefinancial system. In particular it attempts to explain the eight basic facts about financial structure

worldwide. It uses the basic economic concepts of transaction costs and asymmetric information

(adverse selection and moral hazard), which are useful in understanding economic structure in this

chapter, as well as financial crises in Chapters 9 and 10, and principles of bank credit risk

management in Chapter 11.



36

2 Economics in action

After studying this chapter you should now appreciate that information plays a significant role in the

financial world and how it explains the important role of financial intermediaries. Statement (3)

refers to the free rider problem.

D Activities

Which of the following is the correct option?

1 Marketable equities include

a nonbank loans

b bonds

c stocks

2 Direct finance includea nonbank loans

b bonds

c stocks

3 Financial intermediaries deal with

a nonbank loans

b bank loans

c bonds



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37

Complete the table by providing a concise description/reason within the applicable cells.

Phenomena to be explained

Factors which explain it or help to explain it

Transaction costs

(TC)

Adverse

selection (AS)

Moral hazard

(MH)Basic facts about financial structure throughout the world

1

Stocks are not the main source of

external financing

2

Marketable securities are not the

primary source of finance

3

Indirect finance is more important than

direct finance

4

Banks are the principal source of

external funds

5The financial system is heavilyregulated

6

Only large, well-established firms have

access to securities markets

7 Collateral is prevalent in debt contracts

8

Debt contracts have numerous

restrictive covenants

Other

a

An underdeveloped financial system

(as in developing countries) is

detrimental to economic growth

bThe role of banks will probably decline

in future

Answers:

1 Marketable equities include

b√ bonds

c√ stocks

2 Direct finance includeb√ bonds

c√ stock

3 Financial intermediaries deal with

a√ nonbank loans

b√ bank loans



38

Complete the table by providing a concise description/reason where applicable.

Phenomena to be explained

Factors which explain it or help to explain it

Transaction costs

(TC)

Adverse

selection (AS)

Moral hazard

(MH)

Basic facts about financial structure throughout the world

1Stocks are not the main source of

external financing

p 209

Lemons problem

p 214 Debt

contracts;

Principal agent

problem

2Marketable securities are not the

primary source of finance

3Indirect finance is more important than

direct finance

p 208 Financial

intermediaries'

economies ofscale and

expertise

p 212 Expertise

to evaluate risks;

No free rider

problem

p 1215 Principal

agent problem

p214 Venture

capital

4Banks are the principal source of

external funds

p 218 Private

loans reduce

MH problem

5The financial system is heavily

regulated

p 211

Information

p 214

Accounting

standards and

law enforcement

6Only large, well-established firms have

access to securities markets

p 213

Information

p 218 Easier to

monitor

7 Collateral is prevalent in debt contractsp 213 reduceconsequen-ces

of AS

p 217 Incentives

8Debt contracts have numerous

restrictive covenants

p 218 Affect

behaviour

Other

a

An underdeveloped financial system

(as in developing countries) is

detrimental to economic growth

p 213

Information

difficulties

p 221 Property

rights, legal and

political

systems,

Corruption

bBank's role will probably decline in

future

p 213

+Information

technology



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8.1 List eight basic facts about financial structure throughout the world. (8)

8.2 Explain the role of financial intermediaries by referring to the problem of high transaction costs in

financial transactions and the role of financial expertise. (10)

8.3 Explain why marketable securities (debt and equity) are not the primary source of financing for

businesses and how financial intermediaries and government regulation can partly overcome the

problem of asymmetric information (adverse selection). (10)

8.4 Explain, in general, why indirect financing is more important than direct financing and, in particular,

why banks are the most important source of external finance for financing businesses. Then

comment on the two statements: "The role of banks in lending will probably decline in future" and

"The more established a firm is, the more likely it will issue securities to raise funds". (10)

8.5 Explain why the presence of adverse selection in credit markets explains the fact that collateral (or

net worth) is important in debt contracts. (4)

8.6 Explain why moral hazard explains why stocks are not the most important source of financing forbusinesses and why debt contracts may be preferable. (Hint: In your answer, amongst others, refer

to the principal agent problem.) (12)

8.7 Explain the meaning of the concept of moral hazard and why it explains that debt contracts are

complicated legal documents that place substantial restrictions on the behaviour of the borrower

(also list the four types of restrictive covenants). Are monitoring and restrictive covenants

necessarily effective? Can you explain why financial intermediaries play a more important role in

channelling funds from lenders → borrowers than marketable securities? (12)

8.8a Explain the meaning of conflicts of interest (a type of moral hazard), and why they may arise in

financial institutions. (5)

8.8b Explain why conflicts of interest arise in underwriting and research in investment banking. (6)8.9 Explain why underdeveloped financial systems in developing and transitional economies face

several difficulties that restrict their efficiency, and why certain practices in developing and

transitional countries reduce economic efficiency. (6)



40

Chapter 9: Financial crises in Advanced Economies


The financial sector is vulnerable. A financial crisis causes financial markets to fail, and has

disastrous effects on the economy.

• What is a financial crisis?

• Dynamics of financial crises in advanced economies


Financial crises are inherently interesting because they are dramatic. The impact of a financial

crisis on an economy may be severe, and with the increased internationalisation of financial

markets, the impact may be widespread. There are many examples of their impact.

1 Defaults in the Subprime market (2007-) caused Wall street firms and commercial banks hundredsof millions of losses … As the crisis spread to other countries, it slowed down the global

economy... causing a decline in international commodity prices ... and a weakening of South

African exports.

2 Zimbabwe is a recent example of the devasting effects of hyperinflation (2000-2009). This arose

both because of the government’s inability to finance budget deficits a sharp depreciation of the

currency. Zimbabwe's economy has consistently shrunk since 2000. Agriculture and industry have

been destroyed.


What is a financial crisis?

Dynamics of financial crises in Advanced economies

Stage One: Initiation of financial crisis

Stage Two: Banking crisis

Stage Three: Debt deflation

Application: The Mother of all Financial Crises: The Great depression

Application: The Global Financial Crisis of 2007 – 2009.



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1 This chapter is an application of agency theory, the economic analysis of the effects of asymmetric

information (adverse selection and moral hazard), that was covered in the previous chapter.

Agency theory is used to outline the six factors that play key roles in financial crises.

2 Figure 1: Sequence of events in financial crises in advanced economies, is especially helpful in

explaining, in broad terms, the dynamics of a financial crises.

D Activities

Which of the following is correct?

1 When an asset-price bubble bursts and asset prices realign with fundamental economic values,

there is a resulting decline in the net worth of firms and firms have incentives to take on risk at thelender's expense.

2 A lower net worth of a firm means there is less collateral, so adverse selection increases.

3 An unanticipated decline in the price level leads to firms' real burden of indebtedness increasing.

The resulting decline in a firm's net worth increases adverse selection and moral hazard problems

facing lenders.

4 When a domestic firm's debt contracts are denominated in foreign currency, and when there is an

unanticipated decline in the value of the domestic currency, then the debt burden of the firm

increases.

5 A lower net worth means there is less collateral and so adverse selection increases.

6 When there are simultaneous failures of financial institutions, there is a loss of informationproduction in financial markets and a direct loss of banks' financial intermediation.

7 A failure of a major financial institution, which leads to a dramatic increase in uncertainty in

financial markets, makes it hard for lenders to screen good from bad credit risks. The resulting

inability of lenders to solve the adverse selection problem makes them less willing to lend.

8 Individuals and firms with the riskiest investment projects are those who are willing to pay the

highest interest rates. If increased demand for credit drives up interest rates sufficiently, good

credit risks are less likely to want to borrow while bad credit risks are still willing to borrow.

9 When there is weak bank regulation and supervision, then financial institutions will take on

excessive risk because market discipline is weakened by the existence of a government safety net.

Answers:

All of 1-9 are correct.


9.1 Explain six factors that may cause financial crises and explain why financial crises lead to

contractions in economic activity. (30)

9.2 Explain the dynamics of past financial crises in the US as they progressed along three stages.

Focus on financial institutions. (15)



42

Chapter 10: Financial crises in Emerging Market Economies


To explain the movement in financial crises in different emerging market economies over the three

stages

• Dynamics of financial crises in emerging market economies


In the great depression (1929-1933) in the US, more than 30% of banks went under … loans fell by 50%

… investment declined by 90% … the general price level fell by 25% .... unemployment rose by 25%.

Why do financial crises occur? Can they be prevented?


Dynamics of financial crises in emerging market economies

Stage One: Initiation of financial crisis

Stage Two: Currency crisis

Stage Three: Full-fledged financial crisis

## Application: Crisis in South Korea, 1997 - 1998; and The Argentine Financial Crisis, 2001

– 2002: Not prescribed, but can be read for interest.

## Preventing Emerging Market financial crises: Not prescribed, but can be read for interest.


1 The financial crises in emerging market economies have relevance for South Africa. South Africa

was to some degree shielded from the 2007-2009 Subprime crisis because of strict and effective

banking regulation. However, South Africa remains a small open economy which has experienced

currency crises in the past.

E Examination question

10.3 Explain the dynamics of a financial crisis in emerging market economies. (15)



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Chapter 11: Banking and the management of financial institutions


To explain the functioning of banksHow and why banks make loans; how they acquire funds and make profits

The bank balance sheet

Basic banking

The general principles of bank management

Managing credit risk

Managing interest rate risk

Off-balance-sheet activities


Banks are large business and when these businesses are well run, they make healthy profits. –

http://www.bankers.asn.au/


The bank balance sheet

Liabilities; assets

Basic banking

General principles of bank management

Liquidity management; Asset management; Liability management; Capital adequacy management

Applications:

Strategies for managing bank capital

How a capital crunch caused a credit crunch during the Global Financial Crisis

Managing credit risk

Screening and monitoring; Long-term customer relationships; Loan commitments; Collateral and

compensating balances; Credit rationing

Managing interest rate risk

Gap and duration analysis; Application: strategies for managing interest rate risk

Off-balance-sheet activities

Loan sales; Generation of fee income; Trading activities and risk management techniques## Global Barings, Daiwa, Sumitomo, and Societe Generale: rogue traders and the principal agent

problem (not prescribed).



44


1 The goals of this chapter are twofold. The first is to understand how banks manage their assets

and liabilities to make a profit. Banks are essentially profit driven which explains much of their

behaviour. Secondly, it introduces T-accounts. This technique allows one to better understand

banks. In Part 4: Central banking and the conduct of monetary policy, T-accounts will also be used

to explain the links between the central and the commercial banks and the basics of the control of

the money stock.

2 The business of banks is to accept deposits and to convert them into higher yielding assets. These

activities are reflected in the balance sheets of banks. Table 11.1 provides the main categories of

assets and liabilities of South African commercial banks.

Table 11.1: Consolidated balance sheet of South African commercial banks, as on 31 Dec 20095

Assets R1 000million

Share Liabilities R1 000million

Share

Reserves 65 2,2% Deposits total

Cheque and transmission

deposits

Other demand deposits

Savings deposits

Short-term deposits

Medium-term deposits

Long-term deposits

2 181

397

440

120

289

483

452

73,6%

Securities 646 21,8% Borrowings of banks 265 8,9%

Loans 2 252 76,0% Capital 517 17,5%

Total 2 963 100,0% Total 2 963 100,0%

a Deposits form the largest part of banks' liabilities while loans form the bulk of banks' assets. In

principle, the bank makes a profit because the revenue earned by interest on loans and the yield of

securities, exceeds the interest paid on deposits.

b By far the greatest proportion of the new deposits that banks issue are to borrowers. For example,

when you borrow money from a bank, the bank issues you with an increased deposit accountbalance.

c Most loan assets are banks' provision of finance to the private sector.

d Banks hold reserves (which are only about 2% of their assets) amongst others in order to provide

for the possibility of deposit withdrawals. Withdrawals are, however, typically ofset by deposits –

unless there is a run on the banks. Thus the main reason why reserves are held is that the central

bank requires banks to hold a certain minimum of reserves as a percentage of their deposit

liabilities. The cash reserve requirement is 2,5 per cent in South Africa. In practice it is slightly

less, due to certain technical adjustments. Because reserves do not earn interest, banks hold as

few reserves as possible.

5 Quarterly Bulletin of SARB. June 2010. Tables S-6, S-7, S-8 and S-9.



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e Borrowings of banks (liabilities of banks) are mainly borrowings by banks from the South African

Reserve Bank.

2. T-accounts provide a logically consistent framework to demonstrate the impact of typical

transactions of banks. All the basic transactions are dealt with in section D: Activities, of this study

guide. T-accounts will also be extensively used in Part 4: Central banking and the conduct of

monetary policy.

3 The increased interest rate volatility (also in South Africa) has created the need for banks to deal

with interest rate risk.

4 Banks' traditional activities (acquiring deposits and converting them to higher yield assets) are

recorded in balance sheets. Off-balance-sheet activities (e.g. trading financial instruments and

generating income from fees and loan sales) do not appear in balance sheets but in income

statements. You must understand the meaning of loan sales and the generation of fee income.

Trading activities and risk management techniques involve trading in financial futures and optionsand interest rate swaps. These are often highly technical instruments which can be used to reduce

interest rate risk. Some of these activities are subject tot risk.

D Activities

Evaluate the following statements (correct/incorrect):

1 Bank A experiences a shortfall of capital. Because this increases the likelihood of a bank failure,

bank A is likely to reduce its issue of new loans.

2 The purpose of screening and collecting information about a prospective lender is to gain relevant

information to evaluate the risk of default of the loan. The process to gain this relevant information

is called adverse selection.

3 A loan commitment arrangement reduces a bank's cost for screening and information collection.

4 Compensating balances function as a form of collateral for loans.

5 Loan sales occur when, say Bank A, sells a future income stream of certain categories of its loans,

or part of its loans, to outside investors, at a price slightly above the original loan amount, whichcreates a profit in Bank A's income account. In terms of balance sheet entries, this reduces the

amount of loans of bank A, while simultaneously increasing the amount of securities held by bank

A.

6 Generation of fee income occurs when banks perform specialised services for clients, e.g.

provision of foreign exchange, servicing of a security, providing a guarantee of debt securities (e.g.

BAs), provision of backup lines of credit, etc. Some of this exposes the bank to risk. If the issuer of

the security fails then the bank has to pay.



46

Answers:

1a The increase in deposits of +10 gives rise to excess reserves of +9 which do not earn interest.

These excess reserves are converted to new loans (+9) which are interest bearing and thus

increase profits.

a-f Entries in bank's balance sheet

Assets Rm Liabilities Rm

Reserves

(a)

(b)

(c)

Stocks (d)

Profits (g)

Dividends (g)

+10

-9

+2

-1

+6

-5

Deposits

(a)

Borrowings of banks (c)

+10

+2

Securities

(d)

(e)

+1

-3

Capital

(f)

Profits (g)

Dividends (g)

-4

+6

-5

Loans

(b)

Issue new loans (e)

Write off loans (f)

+9

+3

-4

Total +9 Total +9

1 Correct .

2 Incorrect . The purpose is correctly stated. However, this process itself is not called adverse

selection. The purpose of this process to gain information is to avoid adverse

selection due to lack of information.

3 Correct .

4 Correct .

5 Correct . The gap of First National Bank is -$30m. One percent of this is $0.3m.

6 Correct .

E Exam questions

11.1 Present the major assets and liabilities of a commercial bank in balance sheet format. (6)

11.2 Demonstrate (make appropriate entries in this balance sheet, only changes are required) of the

following transactions. (Hint: Each of the transactions requires two entries in the balance sheet.)

(a) New deposits of R10m arise. (2)

(b) The bank uses asset transformation (into loans) arising from (a). Explain why this gives rise

to profits. Assume the required reserve ratio is 10% of deposits. (3)

(c) The bank borrows R2m from the central bank in order to increase its excess reserves. (2)

(d) The bank buys R1m of government stock. (2)



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(e) The bank sells R3m of securities in order to finance a new loan of R3m. (2)

(f) The bank writes off R4m of bad loans. (2)

(g) The bank makes a profit of R6m. Thus the bank pays a dividend of R5m to its share holders.

(3)

11.3 Explain the primary concerns banks have in managing their assets and liabilities. (10)

11.4 Explain the meaning of credit risk and how banks can manage their credit risk. (7)

11.5 Explain briefly the meaning of interest rate risk and how banks may deal with this problem. (5)

11.6 Briefly explain the meaning of off-balance-sheet activities and the forms in which they occur. What

type of risks do they hold for banks? (8)



48

PART 4: CENTRAL BANKING AND THE CONDUCT OF MONETARY POLICY

Chapter Goal

14 Central banks: A global perspective

15 The money supply process

16 Tools of monetary policy

17 The conduct of monetary policy: Strategy and

tactics

The role of the central bank in the banking system

The money supply process and the derivation of

two simple formulas

∆D = (1/r)∆R

( ) MBcer

c M

++

+=

1

Three instruments of monetary policy

• open-market operations• changes in the borrowed reserves

• changes in the reserve requirement

Two approaches to monetary policy

• Monetary targeting

• Inflation targeting



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Chapter 14: Central banks: a global perspective


To explain

• the goals of monetary policy

• the role of the central bank (SARB) in the South African banking system

• the case for central bank independence

Economics in action

Can monetary policy help to alleviate the unemployment problem in South Africa? Below we refer

to two diverging views on unemployment in South Africa. Which of the two do you think is more

relevant?

Firstly, COSATU calls for a review of the inflation targeting policy framework.

...propose that the minister, together with the monetary authority, adopt a more multi-faceted

monetary policy where all of the macro-economic policy objectives such as employment,

sustainable economic growth, price stability, financial stability are equally prioritized and dealt with.

Inflation targeting as a primary objective of our monetary policy has failed ordinary South Africans;

hence, equally, if not, more contentious issues such as relentless unemployment, low economic

growth have subjected most of us into deepening levels of poverty never witnessed before, and as

such I propose for immediate review of inflation targeting as a primary goal of the central bank.

Source:http://www.unorth.ac.za/application/downloads/Wef%20Fchief-Masemola%20Leshoka.pdf

Secondly, the official statistics agency in South Africa reports:

South Africa's Bureau of Statistics estimates that between 1 million and 1.6 million people in

skilled, professional, and managerial occupations have emigrated since 1994 and that, for every

emigrant, 10 unskilled people lose their jobs.

Source: Benno J. Ndulu; Human Capital Flight: Stratification, Globalization, and the Challenges to

Tertiary Education in Africa; JHEA/RESA Vol. 2, No. 1, 2004, pp. 57–91. Referred to in

http://en.wikipedia.org/wiki/Economy_of_South_Africa.

B Prescribed section

The following sections are not prescribed## because they refer to the US Federal Reserve

System and other foreign banks. Section C provides some notes on the South African

situation which replaces these sections.

• Origins of the Federal Reserve System

##

• Structure of the Federal Reserve System##

• How independent is the Fed?##



50

• Should the Fed be Independent?

• Structure and independence of the European Central Bank##

• Central Banks round the world##

Explaining central bank behaviour

Additional for South Africa

C3 Can monetary policy help to alleviate South Africa's unemployment problem?

C4 The South African Reserve Bank (SARB)


1 The focus of this chapter is: What should the goal of monetary policy be? Because the central bank

implements and applies monetary policy it is also important to know what motivates the central

bank and who controls it.

2 In most countries, the goal of price stability (low inflation) is increasingly seen as the primary goal

of monetary policy. This differs from the post-World War II Keynesian view that expansionary

monetary policy may be used to stimulate growth, but which, in practice, led to high inflation and a

decreased long-term growth.

3 Can monetary policy help to alleviate South Africa's unemployment problem?

In South Africa, the goals of employment and economic growth appear particularly important. The

reason of course is the present high unemployment rate, and the prevalence of poverty among

large sections of the population. A figure sometimes quoted is that the unemployment rate in South Africa could be as high as 30%-40%, which means that unemployment is a serious problem.

The SARB is under pressure to lower interest rates, particularly from the trade unions. South

African interest rates have historically been high and people often the question whether interest

rates are not too high. Many believe that the advantages of a low interest rate (perceived as higher

employment) far outweigh the problems of a low interest rate (a higher rate of inflation).

Can monetary policy, in the form of lower interest rates, help to alleviate South Africa's

unemployment problem? The short answer is no. Monetary policy is an ineffective tool to achieve

this goal. Several reasons can be put forward in support of this view.

a South Africa's high level of unemployment is mainly a structural problem. Structural unemployment

occurs when there is a mismatch between the supply of worker skills and the demand for skill

required. In South Africa most unemployed are unskilled workers. In a modern economy, business

and industry demand skilled workers and it is typically also a skilled person who is in a better

position to start a business. Raising the skill level of workers calls for structural solutions, such as a

good school system and the development of worker skills and entrepreneurship through education

and training. Structural problems of a long term nature are best solved by long term structural

solutions. Short-term solutions like lowering interest rates to solve the structural unemployment

problem are generally ineffective and often not sustainable.



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b Monetary policy is often criticised because interest rates are perceived to be too high. The policy

solution is then to lower interest rates. The case for lower interest rates rests on the assumption

that lower interest rates will lead to a higher level of economic activity and employment.

This is, however, not necessarily the case, at least not in the long term. The problem is that lower

interest rates may lead to price inflation, and that the lack of price stability has negative effects on

long term growth. Although it is generally accepted that low interest rates do boost production in

the short term, Mishkin (2009) notes that in the long term, price stability actually supports the other

goals like economic growth (see p.319). Thus, in the long term, there is no trade-off between price

stability and growth. This has been confirmed by empirical studies which involve many different

countries worldwide. The economies of countries that have a lower inflation rate generally perform

better.

The impact of lower interest rates on aggregate demand is also much more certain than its impact

on employment. Theoretically lower interest rates increase disposable income of households andincreases borrowing. This increases aggregate demand, that is, the capacity of consumers and

firms to spend. The first problem is, however, that when the increased spending is on imported

goods (for example luxury goods and machinery), then there is very little impact on the domestic

economy, that is, on its level of production. Secondly, analysts point out that the South African

production structure – which ultimately affects employment, is not very sensitive to interest rates.

Some industries sell in fixed price markets (e.g. exports of mining goods) which are not affected by

interest rates.

Thirdly, even if lower interest rates increase production, then it will not necessarily affect

employment. This is particularly applicable to unskilled and low skilled jobs which is where theproblem lies.

Fourthly, monetary policy controls the repo rate which is a short-term interest rate. It is more likely

that output and employment will react to medium and long term interest rates. There are

meaningful lags before a lower interest rate impacts on the domestic economy. This could be

anything from 3 to 24 months. It takes time, both for the consumer, and the producer to react. This

makes it more difficult to measure the impact of lower interest rates.

c Low interest rates can also have adverse affects on the economy which have to be taken into

account. Because higher interest rates are likely to lead to lower inflation, this implies that lowerinterest rates might lead to higher inflation. Another problem is that lower interest rates might lead

to a depreciation of the value of the Rand.

Higher inflation has a number of adverse affects on the economy. It increases uncertainty which

complicates planning, it corrupts information which disrupts markets, it leads to all sorts of

unproductive activities trying to escape the adverse affects of inflation, it causes an unfavourable

redistribution of income, it reduces social cohesion and leads to social unrest (see chapter 24 for

more on the costs of inflation). Everybody can gain by low inflation, particularly the mass of

workers who are more likely to be adversely affected by inflation.

Lower interest rates are also likely to cause a depreciation of the value of the Rand on the foreign

exchange market. Lower interest rates may reduce the inflow of foreign currency which may cause

the value of the Rand to fall. This makes imports more expensive and adds fuel to the inflation

process.



52

d How does one judge that interest rates are high? The best way to judge interest rates is to use the

real interest rate (nominal interest rate minus the inflation rate) because this is what motivates

most economic agents. A high nominal interest rate does not necessarily imply that the real

interest rate is also high.

The best contribution the SARB's monetary policy can make is to maintain price stability and

contain cyclical variation in production employment levels. This creates favourable conditions for

sustainable growth in income and employment.

4 The South African Reserve Bank (SARB)

The SARB is the central bank of South Africa and was established in December 1920. The SARB

regulates banks but also directs and executes monetary policy. The inflation-targeting framework is

the current monetary policy framework in use in South Africa which replaced the previous system

of monetary targeting. These frameworks will be dealt with in more detail in chapter 16.

South Africa has a well-developed financial system, particularly by emerging market or developing

country standards. The South African banking system comprises a central bank (SARB), a few

large commercial banks and investment institutions, and a number of smaller banks. Many foreign

banks and investment institutions have set up operations in South Africa over the past decade. The

Banks Act in South Africa is primarily based on similar legislation in the UK, Australia and Canada.

South Africa's banking industry is dominated by four major commercial banking groups: ABSA,

First National Bank, Standard Bank and Nedcor. These provide retail and investment banking

services in competition with a wide range of niche investment banks.

Functions of the SARB

The Reserve Bank has six main functions. In relation to the payment system, the central bank has

two main functions:

1. The SARB has the sole right to issue cash or currency (banknotes and coins). The SARB controls

the South African Mint Company which issues coins, and owns the South African Bank Note

Company which prints banknotes. New currency is printed to serve the needs of the public. The

net income originating from the printing of currency does not accrue to the SARB but to the

government. Because notes and coins are a small part of the money stock (about 4%), the issue ofnew currency only provides a relatively small amount of revenue to government. Because the

printing of new currency generates revenue for the government, it calls for care and restraint. The

printing of currency on an excessive scale inevitably leads to hyperinflation, the collapse of the

financial system and ultimately the collapse of the economy.

2. The SARB provides facilities for clearing and the settlement of interbank obligations. An interbank

obligation arises, for example, when deposit holder A, who banks at bank AA, writes a cheque to

pay person B, who banks at bank BB. The cheque is simply an instruction to bank AA to transfer

an amount from the account of person A to the account of person B held at bank BB. Cheques and

electronic payments are cleared centrally by the SARB (through the Automated Clearing Bureau).



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When a customer of bank A withdraws or deposits cash by using an Automated Teller Machine

(ATM) which belongs to bank A, then the transaction will be performed entirely through the

system/s of bank A. There are also ATM's operated by SASWITCH, the interbank operator. Most

bank accounts of individuals in South Africa are or can be linked to the SASWITCH system

enabling fund withdrawals or deposits at ATMs across the country and from/to any bank. The

SASWITCH system is also used for transactions between banks.

Because a large number of cheques and electronic transfers occur daily, the clearing of payments

on a daily basis involves the calculation of net claims between the banks, as well as between the

banks and the Reserve Bank. Settlement is the final discharge of an obligation of one bank in

favour of another, by means of the accounts the banks hold with the SARB. The SARB provides for

final real-time electronic settlement of interbank obligations, emanating from all noncash payments

made in the economy, via the South African Multiple Option Settlement (SAMOS) system.

The SARB also oversees the safety and soundness of the payment system through theintroduction of settlement risk reduction measures.

When it comes to supervising commercial banks, the central bank has the following function:

3. The SARB acts as a banker for and supervisor of other banks, and as a lender of last resort. The

SARB acts as a banker for other banks in the sense that it provides accommodation to banks on a

daily basis when they experience liquidity shortages – which is a normal phenomenon in South

Africa. The SARB also holds the statutory cash reserves which all registered banks are required to

maintain; as mentioned earlier, banks keep their cash reserves with the central bank in the form of

deposits.

The purpose of bank supervision is to maintain sound and effective banking practices in the

interest of depositors of banks and ultimately of the economy as a whole.

In terms of the SARB's function as a lender of last resort, in exceptional circumstances, it provides

liquidity (that is, cash) assistance to, say, a bank experiencing exceptional liquidity shortages

through unexpectedly large cash drains, which could otherwise have caused the bank to fail.

In relation to the conduct of monetary policy, the central bank performs the following critical

function:

4. The primary function of the SARB, but also politically, the most sensitive one, is the formulation

and implementation of monetary (and exchange rate) policy. Monetary policy works through

several levels.

The first level involves the SARB and the banks by means of the refinancing or accommodation

system. This system currently operates as follows: The SARB sets the repo rate (the SARB's

policy instrument) which is the price (interest rate) at which the central bank provides

accommodation to banks in the case of liquidity shortages. Liquidity shortages of banks are normal

and are in fact actively maintained by the SARB. This forces banks to borrow from the SARB at the

repo rate. In the banking system – the next level – the repo rate influences the level of all interest

rates. If the repo rate increases, then all interest rates increase.



54

Lastly, interest rates affect the behaviour of all participants in the economy. An increase in interest

rates, for example, implies that consumers have less income to spend, which tends to make them

more price conscious. Changes in interest rates seek to achieve a low inflation rate through the

interest rate transmission mechanism which affects the economy through several channels. These

channels or mechanisms will be explained in later chapters.

The following two functions of the central bank relate to services rendered to the government:

5. The SARB acts as banker for government. The main services provided are administering the

auctions of government bonds and treasury bills, participating in the National Treasury's debt

management meetings and managing the flow of government funds in the money market.

6 The SARB is the custodian of the greater part of South Africa's gold and other foreign exchange

reserves. Although banks also hold foreign reserves, they might not necessarily hold sufficient

reserves, given the fact that banks are guided by the profit motive. The SARB manages these

reserves prudently, against the background of international uncertainty, the possibility of externalshocks and exchange rate volatility. The availability of reserves also adds credibility to the

exchange rate policy.

d Is the SARB independent?

South Africa currently uses an inflation targeting policy framework in which monetary policy seeks

to keep the inflation rate within a predefined target range (3-6%). This inflation target is set in

consultation between the Governor of the SARB and the Minister of Finance. This means that the

SARB does not have goal independence, that is, the SARB cannot set objectives on its own. This

is not necessarily bad. Inflation can only be beaten when it has the support of all of government,firms and labour. If the Minister of Finance agrees to the goal then government actions in support

of reaching this goal are more likely.

The SARB does, however, have operational (instrument) independence, that is, the choice of

instruments and the autonomy to adjust such instruments in monetary policy decisions aimed at

achieving the target. The SARB's decision-making process, as far as the execution of monetary

policy is concerned, is independent of political interference. This independence of the SARB is

legally established in terms of the Constitution Act 108 of 1996:

The South African Reserve Bank, in pursuit of its primary object, must perform its functionsindependently and without fear, favour or prejudice, but there must be regular consultation

between the Bank and the Cabinet minister responsible for national financial matters.

However, the SARB is accountable to Parliament via the Minister of Finance. In terms of section 32

of the South African Reserve Bank Act 90 of 1989:

The Bank must submit a monthly statement of its assets and liabilities and an annual report to

Parliament.



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The Governor of the SARB holds regular discussions with the Minister of Finance and, from time to

time, appears before the parliamentary Portfolio and Select Committees on Finance. This ensures

transparency in policy decisions. The SARB also publishes monetary policy reviews biannually,

while regular regional Monetary Policy Forums are also arranged to provide a platform for

discussions of monetary policy with the community. The governor of the SARB also frequently

explains the SARB's policy stance in the media.

The SARB is managed by a board of 14 directors representing commerce, finance, industry and

agriculture. The President of South Africa appoints the governor and three deputy governors for

five-year terms. This practice implies that the SARB may not be completely isolated from political

influences.

In the SARB, the Governor of the SARB, in consultation with the Monetary Policy Committee

(MPC), makes monetary policy decisions. The MPC consists of the governor, deputy governors

and a few senior officials of the SARB. The MPC currently meets six times per year.

Because the SARB is financially independent of government, this contributes to the SARB's

independence. The SARB accrues a large amount of net interest income, which comfortably

exceeds its operating costs. The surplus of the SARB's earnings is paid to government. Its

operations are not profit driven nor financially constrained by government.

5 Comments on Economics in action:

As far as the role of monetary policy is concerned, please refer to point C3.

With regard to the second statement: Firstly, if it is true then it implies that if 1 million skilled

persons emigrated, then 10 million unskilled jobs were lost. Secondly, this emphasises theimportance of skills development. Skills development not only has advantages for the persons

concerned, but also for the country at large.

D Activities

Evaluate each of the following statements (correct/incorrect):

1 A nominal anchor is a nominal variable that monetary policymakers use as an intermediate target

to achieve an ultimate goal such as price stability. The nominal anchor affects people's price

expectations.

2 Monetary policy is considered time-inconsistent because of the lags associated with theimplementation of monetary policy and its effect on the economy.

3 If the central bank promotes price stability in the long term, then the other goals of monetary policy

such as high employment, economic growth, stability of financial markets, interest rate stability and

stability in foreign exchange markets are also achieved in the long term.

4 High employment and price level stability can, at times, conflict in the short run.

5 Either a dual or hierarchical mandate is acceptable as long as price stability is the primary goal in

the long run.

6 A potential problem of a dual mandate (price stability and employment) is that the central bank

emphasises inflation control rather than reducing business-cycle variations.

7 A potential problem of a hierarchical mandate is that the central bank may focus too much on

short-term objectives.



56

8 Monetary policy in South Africa is an ineffective tool to achieve higher employment because

monetary policy does not address the root of the unemployment problem and lower interest rates

do not necessarily increase employment over the long term.

9 The Minister of Finance and parliament can, in principle, overrule the execution of monetary policy

decisions of the SARB.

10 The ability of a central bank to set its monetary policy instruments is called goal independence.

11 The SARB is not goal independent.

12 The theory of bureaucratic behaviour suggests that the objective of a bureaucracy is to maximise

the public's welfare.

13 Recent research indicates that low inflation has been found to be best in countries with the most

independent central banks.

14 The case for central bank independence rests on the idea that monetary policy is performed better

by professional experts such as the SARB.

Answers:

1 Correct 2 Incorrect . Monetary policy is considered time-inconsistent not because of lags but because

policymakers are tempted to pursue discretionary policy that is more expansionary

in the short run.

3-5 Correct

6 Incorrect . A potential problem of a dual mandate (price stability and employment) is that the

central bank emphasises inflation control rather than reducing business-cycle.

7 Incorrect . A potential problem of a hierarchical mandate is that the central bank may focus too

much on price stability.

8 Correct

9 Incorrect . The SARB is independent in executing monetary policy.10 Incorrect . The ability of a central bank to set its monetary policy instruments is called

instrument independence.

11 Correct . The inflation target is set in consultation between the Governor of the SARB and the

Minister of Finance.

12 Incorrect . The theory of bureaucratic behaviour suggests that the objective of a bureaucracy is

to maximise its own interests.

13 Correct

14 Incorrect . The case for central bank independence rests on the idea that an independentSARB would be more concerned with long-run objectives and would thus defend a

stable price level.



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E Exam questions

14.1 Should price stability be the primary goal of monetary policy? Also explain the meaning of

hierarchical and dual mandates and how they can be used. (12)

14.2 Briefly explain the nature of the time-inconsistency problem and the role of the nominal anchor.

(5)

14.3 Briefly explain why the price stability goal in SA is desirable in spite of other pressing economic

problems. (15)

14.4 List and briefly explain the six main functions of the SARB. (6x3=18)

14.5 Explain

(a) the advantages and disadvantages of the independence of a central bank (10)

(b) and whether the SARB is in fact independent (9)



58

Chapter 15: The money supply process


This chapter explains the money supply process, that is, how money is created.

• It explains the behaviour of the three players in the money creation process

• It first derives a simple formula for multiple deposit creation: ∆D = (1/r)∆R

• and then derives a more complex version of the money multiplier

( ) MBcer

c M

++

+=

1

• It explains the money supply process in South Africa and its causal direction.

The material presented in this and the next chapter is fundamental to a sound understanding of

monetary policy.


John Kenneth Galbraith is famous for once saying:

"The process by which money is created is so simple that the mind is repelled."

Money creation is a bizarre thing to ponder. It is actually a very simple process, but it's really

difficult to accept. Money is loaned into existence. Conversely, when loans are paid back, money

'disappears'.

Source: http://www.chrismartenson.com/crashcourse/chapter-7-money-creation


Three players in the money supply process

The Fed's (SARB's) balance sheet

Liabilities; Assets

Control of the monetary base

Federal Reserve Open market operations; Shifts from deposits into currency; Discount loans;

Other factors that affect the monetary base; Overview of the Fed's ability to control the monetary

base

Multiple deposit creation: A simple model

Deposit creation: The single bank; Deposit creation: The banking system; Deriving the formula for

multiple deposit creation; Critique of the simple model

Factors that detemine the money supply

Changes in the nonborrowed monetary base; Changes in the borrowed reserves; Changes in therequired reserve ratio; Changes in the currency holdings; Changes in excess reserves

Overview of the money supply process



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The money multiplier

Deriving the money multiplier; Intuition behind the money multiplier; Money supply response to

changes in the factors

Application: The great depression bank panics, 1930-1933, and the money supply##

not prescribed

Monetary policy in South Africa: Additional material

C7 Tax and loan accounts in South Africa

C8 Money supply in South Africa

C9 The causal direction of the money supply process in SA


1 This chapter explains the money supply process, that is, the supply side of how the money stock isdetermined. The supply side of money supply points to the actions of the central bank. An

assumption is that the central bank controls the monetary base (MB) where MB=C+R and

R=MBn+BR (C=currency, R=reserves, MBn= nonborrowed monetary base, BR=borrowed

reserves). It will be explained in later chapters that in the case of South Africa, the BR is in fact not

controlled by the SARB. But even when we assume that MB is controlled by the central bank, then

the money supply is not determined solely by the central bank as the behaviour of banks and

depositors also counts. See summary table 1, p 395.

2 The purpose of the simple model of multiple deposit creation is primarily to illustrate the basic

processes involved in money creation. These steps are fundamental and underlie all the models ofmoney creation.

The formula for multiple deposit creation: ∆D = (1/r)∆R can also be derived by simple

mathematical means which, however, hide the underlying processes involved. If we assume that

RR=R (required reserves = actual reserves)

then R is a fixed fraction of D. Thus, in equilibrium

R=r.D, D=(1/r)R and ∆D=(1/r)∆R. See p 392.

The advantage of the mathematical derivation is that it is concise. The problem, however, is that it

only provides a static equation – the final equilibrium outcome over time. It ignores the steps overtime of the deposit creation process. These steps refer to the increase in the reserves of banks

which causes banks to increase their loans, which again lead to an increase in deposits (as well as

reserves), a process which repeats itself over time until a stable equilibrium is reached.

A further shortcoming of ∆D = (1/r)∆R is that only the required reserve ratio is accounted for (r=R/D

as required by the central bank) and that the preference of banks to hold a variable excess

reserves-ratio (e=ER/D) and of depositors to hold a variable cash to deposits-ratio (c=C/D) is

ignored.



60

The variability of all three factors (r, c and e) are incorporated in the money multiplier equation (see

p.363-364) which is mathematically derived as follows:

( ) MBcer

c M

++

+=

1

3 The balance sheet of the SARB, the first player in the money supply process, is reproduced below.

Table 15.1 The balance sheet of the SARB as on 31 Dec 20096

Assets R billion Liabilities R billion

Foreign assets (mainly

foreign currency) plus

investments (e.g. bonds)

293Currency in circulation (C), that is,

currency held by the nonbank public78

Loans to banks (liquidity

provided to banks plus

advances to banks)

21

Bank reserves (R)

Central government and other deposits

Other liabilities

49

109

78

Total 314 314

The SARB balance sheet shows the following

• Securities (assets) include a relatively large amount of foreign currency assets which are

held because South Africa is a small open economy.

• The central government holds a relatively large amount of deposits with the SARB. This item

is not shown in the stylised Federal Reserve System's balance sheet in the USA.

• Other liabilities include SARB debentures which are securities issued by the SARB and sold

to the banks to reduce their liquidity.

• Currency (C) plus reserves (R) are called the monetary base (MB = C + R). Both of these

appear as liabilities in the SARB balance sheet.

• The SARB earns interest on its investments and on loans to banks. The SARB does not pay

interest on the banks' reserves and on government's deposits.

4 The second player: The banks

Table 15.2: Balance sheet of South African commercial banks, as on 31 December 20097

Assets R billion Liabilities R billionDeposits with the SARB (Reserves: R)*

Bank notes and coins

49

16

Deposits (D) 2 181

Securities 646 Borrowings of banks

(includes repos)

265

Loans 2 252 Capital 516

Total 2 963 Total 2 963

*Deposits with the SARB (Reserves=R49b, assets) appears as a liability in the SARB balance

sheet (table 15.1).

6 South African Reserve Bank Bulletin. June 2010. Derived from tables S-2 and S-3.

7 South African Reserve Bank Bulletin (June 2010. Derived from tables S-6 to S-9.



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5 The third player is the nonbank public which includes depositors and borrowers. To be logically

consistent, we could also show the balance sheet of the nonbank public sector as shown in the

prescribed book. However, because our main interest lies with the banking sector, the changes in

the balance sheet of the nonbank public sector are not indicated.

6 T-account entries facilitate a good understanding of the money creation process. You must

understand how financial transactions between any pair of the three players are recorded. This

requires a good understanding of these balance sheets plus common sense.

You need to master two aspects of T-account transactions. The first is the technical issue of

recording transactions with the proper balance sheet categories. The second aspect you must

understand is that the banks' reserves directly affect the banks' ability to create money. To

summarise, the banks' holding of reserves increases (assuming all other factors remain constant)

when

(a) the central bank buys assets (securities, debentures or foreign exchange) from banks

(b) the central bank buys assets (securities, debentures or foreign exchange) from the nonbankprivate sector

(c) the central bank makes loans to banks

(d) the private nonbank sector deposits cash with banks

(e) the government transfers money from its deposit account with the central bank into its deposit

account with commercial banks, or the government makes payments to private parties by

transferring funds out of its account with the central bank and into the accounts of these private

parties

Mishkin (2009) does not mention the case of the central bank buying foreign exchange (forex) from

the banks, which will also increase banks' cash reserves. This consideration is fairly significant inSouth Africa. A surplus on the balance of payments causes not only an increase in the local money

supply (M1) but an increase in the local amount of bank reserves (R) too – assuming banks sell

their forex to the central bank.

When the nonbank private sector increases its preference for keeping its money in deposits (D)

instead of in cash (C), the private nonbank sector deposits additional cash with banks (case d), so

that banks' reserves (R) increase - although the monetary base (C + R) remains the same.

7 Tax and loan accounts in South Africa

In South Africa, the government keeps a deposit account with both the central bank and with the

four large commercial banks. The government accounts held at the (commercial) banks are called

tax and loan accounts. The deposits in these accounts do count as reserves of the banks although

government deposits are excluded from the definition of money. When the government transfers

funds out of its account with the central bank and puts its funds into a tax and loan account, then

the cash reserves of the banks will increase. Alternatively, when the government makes payments

to the private sector by transferring funds out of its account with the central bank and into the tax

and loan account, then the reserves held by the commercial banks will increase.



62

The reverse of these transactions leads to decreases in reserves (assuming all other factors

remain the same). For example, when the central bank sells securities, debentures or forex to

banks or the nonbank sector, banks' reserves decrease. Or when the public develops an increased

preference for keeping its money in cash rather than deposits, it will withdraw cash from banks and

they will lose reserves. Or when the government transfers funds from its account with commercial

banks into its account with the central bank, banks' cash reserves will decline. Incidentally, shifting

funds between the government's deposit accounts with the commercial banks and the central bank

is one of the important ways in which the monetary authorities manipulate the reserves of banks in

South Africa.

8 Money supply in South Africa

In principle, the money supply (defined as cash and deposits in possession of the nonbank public)

increases when banks issue more deposits to the nonbank public. Mishkin assumes that the

money supply only increases as a result of the banks granting additional credit to the nonbank

public. We can, however, distinguish more reasons why banks issue deposits to the nonbankpublic. The complete list in South Africa is as follows:

1. There is a net increase in the loans the banks grant to the nonbank public.

2. There is a net increase in assets (mostly securities) that banks buy from the nonbank public.

3. There is a net increase in the payments the central bank makes to the nonbank public via the

latter's accounts with commercial banks. This figure roughly corresponds with the net amount of

open-market purchases by the central bank from the nonbank public.

4. There is a net increase in the payments the government makes to the nonbank public. This figure

roughly corresponds with the size of the government budget deficit (government spending minus

tax income minus net borrowing from the nonbank public).

5. There is a net increase in the amount of foreign exchange the nonbank public sells to the banks.This figure roughly corresponds with the size of the surplus on the balance of payments.

The relative importance of the factors underlying the growth in the South African money stock is

provided in table 15.3. Because private sector loans are by far the largest contributor to M3, it is

usually also the most dominant item to explain changes in M3. Clearly 2009 was an abnormal year

for monetary changes.

Table 15.3: Contribution to the change in M3 in SA for 2009 by sector 8

At end of year Total M3

Net foreign

sector 9

Net loans to the

government

Loans to the

private sector Net otherMoney stock: R million

31 December 2008 1 914 200 239 196 44 728 1 981 049 -350 775

31 December 2009 1 947 911 271 641 85 685 1 978 368 -387 783

Change Rm +33 711 +32 445 40 957 -2 681 -37 008

Table 15.3 is derived from the consolidated balance sheet of the monetary sector (see the next

table 15.4).

8 Quarterly Bulletin of the South African Reserve Bank. Jun 2010. Table S-24.



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Table 15.4: Consolidated balance sheet of the monetary sector

Assets Liabilities

Claims on the private sector

Claims on the foreign sector

Claims on the government sector

Interbank claims

Other assets

Money supply deposits

Foreign deposits (deposits by non-residents with SA

banks)Government deposits

Interbank deposits and loans

Capital and reserves and other liabilities

The purpose of the monetary analysis provided in table 15.3 is to explain changes in money

supply. Table 15.3 is based on table 15.4. The consolidated balance sheet (table 15.4) has a

liability item called Money Supply Deposits (M3) which consists of Banknotes (C) plus Private

Sector Deposits (D). The idea is to move all the other liability items to the asset side. These

liabilities are subtracted, first from the liabilities side, and secondly from their corresponding asset

items. In addition, a number of detail adjustments are made to these net items. These operationsleave only M3 items as liabilities and something referred to as the counterparts of change in M3, as

assets. This statistically explains changes in money supply via the counterparts of money supply.

The counterparts consist of changes in

a net foreign assets (claims on the foreign sector minus foreign deposits)\

b net claims of government sector(claims on the government sector minus government

deposits)

c claims on the private sector

d net other assets (interbank claims minus interbank deposits and loans plus all other assets

and minus all other liabilities)

9 The causal direction of the money supply process in SA

Mishkin's (2009) analysis implicitly assumes that the causal direction in the money supply process

is that "reserve holding leads to deposit creation", thus R → D (or MB → M). However, this

assumption is not uncontroversial. Prominent economists argue that the reversed causal direction

"deposit creation leads to reserve holding" (D → R) better describes what really happens. This

section briefly sets out the arguments for a reversed causality and explains some of its

implications.

a Under a modern money system, cash reserves consist of money issued by the central bank ,

mostly in the form of deposits which commercial banks keep at the central bank. This is not to say

the central bank is the only place where banks can obtain cash reserves. Banks can also borrow

from abroad or sell their holdings of forex for cash to the central bank. Even so, there is a limit to

how much and how quickly banks can obtain cash reserves from abroad10. Hence, for all practical

purposes, commercial banks are dependent on the central bank for their cash reserves.

10 Note that interbank borrowing/lending does not increase the total amount of cash available for the bankingsector as a whole; what one bank gains the other loses. Nonetheless, interbank lending/borrowing willdistribute available cash more effectively to the places where it is needed.



64

b Because of this reliance and because it would be unreasonable for the central bank not to enable

the banking system to meet its reserve requirements, the central bank has no choice but to issue

the banking system with the cash reserves it needs. The central bank functions not only as the

"lender of last resort", which provides emergency cash reserves to banks in distress, but more

importantly, it also supplies the banking system with its normal cash reserves requirements.

c The central bank can choose between two strategies to supply the banking system with cash

reserves. The first strategy is to control the amount of cash reserves it provides and allow the cash

fund rate (the Fed funds rate in the US or the repo rate in SA) to find its own level as determined

by the demand for cash reserves as exercised by the banking system. Alternatively, it can fix the

cash funds rate and allow the amount of cash reserves it makes available to the banking system to

find its own level, as determined by the demand for cash as exercised by the banking system.

d Given this second strategy, there is only a price constraint (cash fund rate) and no quantity

constraint on the amount of cash the central bank offers to the banking system. If the central bank

wishes to set the cash funds rate at a target level, it has no choice but to accommodate fully andunconditionally the banking sector's total demand for cash reserves at that target level, irrespective

of whether the cash reserves are provided through OMOs or through accommodation loans.

Individual banks that require a disproportionate amount of cash because they have been

disproportionately irresponsible, may be refused and allowed to go bankrupt – that is, if these

banks are small enough (if they are too big, they will be rescued in order to prevent a contagion;

see the section "Too big to fail" in chapter 11, which is not prescribed). However, the banking

system as a whole will never be denied the cash reserves it needs.

Hence an individual bank that is averagely prudent by growing its deposit issue at a rate which is

more or less in line with the average of the banking system as a whole, is for all practical purposesassured of its cash reserves – at the prevailing cash funds rate (repo rate in SA). In addition, if

banks are roughly equally competitive, they are in any event likely to face roughly the same growth

in the demand for credit. They can therefore more or less grant all that credit and issue all the

deposits in the process, and subsequently seek to obtain the necessary cash reserves to meet the

reserve requirements. If this is a fair representation of what happens in practice, the reversed

causal direction ("deposits lead to cash holdings") is predominant and D → R or M → MB.

e This, however, implies that changes in r , c and e do not cause a change in the impact of R on D.

The converse is true – they will cause a change in the impact of D on R. For instance, if the

required reserve ratio (r=R/D) is increased, the result is not that there will be less money creationbut that banks need more reserves for the deposits they have already created, which the central

bank will normally provide. Or the effect of an increase in the currency ratio (c=C/D) is not that

there will be less deposit money creation, but that the central bank needs to pump more cash (MB)

into the system to enable the banks to obtain the reserves necessary to sustain the deposits that

have been created. Similarly, when the value of the excess reserve ratio (e=ER/D) is increased,

more MB is required.



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f Because banks hold few excess reserves (ER), this would seem to confirm the reversed causal

direction view ("deposits lead to cash holdings"). If an average prudent bank is assured of

obtaining all the cash reserves it needs, there is no reason to keep additional excess cash

reserves. Because it faces little risk of being short of cash reserves, the rationale for keeping much

excess cash reserves falls away. If it has any excess cash reserves it would immediately lend it in

the interbank market to other banks that are temporarily short.

g There is another reason for banks to hold few excess cash reserves. In South Africa, banks do not

need to comply with the cash reserve requirements on a day-to-day basis. Instead, they only need

to keep the required cash reserves as an average over a month period. Banks can therefore afford

to fall below their required cash reserves during some days, as long as they keep more than the

required reserves at other days during the month. This system removes the rationale for holding

large excess reserves on a daily basis. Instead of holding excess cash reserves as a buffer against

erratic cash withdrawals and interbank payments, banks can now allow their cash reserves to fall

temporarily below their required level.

D Activities

1 Derive the money stock (M3), as on 31 December 2007, based on tables 15.1 and 15.2.

2 Record the (direct) changes arising from the following transactions in both the balance sheets of

the SARB and those of banks (copy the required lines from the framework below, and enter the

amount of change into the Rm columns). In each case derive the effect of the transaction/s on the

MB. (Also enter the transaction, for example (a), (b), etc at the top, where each transaction

requires a new set copied from the framework below.)

Transaction =

Institution Assets Rm Liabilities Rm Affect on MB

SARB (S)ecurities and FX (C)urrency

(L)oans to banks (R)eserves

(G)ov deposits

Banks (R)eserves (D)eposits

(S)ecurities and FX (B)orrowings

(L)oans to priv (C)apital

FX: Foreign exchange; Priv: Private sector (households and firms)

(a) The SARB, using open market transactions, buys R1m of securities from banks.

(b) The SARB, in an open market transaction, buys R2m of bonds from a private sector firm. The firm

deposits the revenue with the banks.

(c) The SARB, in an open market transaction, buys R3m of bonds from private households. The

households are paid in cash.

(d) The SARB makes a R4m loan to banks.

(e) The SARB sells R5m of bonds to a firm and the firm pays in cash.

(f) The private nonbank sector deposits R6m cash with banks – cash that the banks hold with the

SARB.(g) The government transfers R8m from its deposit account with the SARB to its deposit account with

banks.



66

(h) The SARB buys R9m of foreign exchange from the banks.

(j) The nonbank private sector increases its preference for holding its money in deposits (D) instead

of in cash (C) by +R10m.

Try the following one which refers to C9 of chapter 3.

(k) The Zimbabwean government forces the central bank to buy an issue of (government) securities of

Z$100. This causes an increase in government deposits at the central bank of Z$100. Government

spends Z$80 of its newly acquired deposits on paying its government employees. This causes the

private sector deposits (and money stock) to increase by Z$80.

Enter these transactions into the balance sheets of the central bank and the banks.

Answers:

1 M3 = C + D = 68 + 1 862 = 1 930.

2 Balance sheet entries

(a) The SARB, using open market transactions, buys R1m of securities from banks.

Institution Assets Rm Liabilities Rm MB=C+R

SARB (S)ecurities and FX +1 (R)eserves +1 +1

Banks (R)eserves +1

(S)ecurities -1

(b) The SARB, in an open market transaction, buys R2m of bonds from a private sector firm. The firm

deposits the revenue with the banks.


Banks (R)eserves +2 (D)eposits +2

(c) The SARB, in an open market transaction, buys R3m of bonds from private households. The

households are paid in cash.

SARB (S)ecurities and FX +3 (C)urrency +3 +3

(d) The SARB makes a R4m loan to banks.

SARB (L)oans to banks +4 (R)eserves +4 +4

Banks (R)eserves +4 (B)orrowings +4

(e) The SARB sells R5m of bonds to a firm and the firm pays in cash.

SARB (S)ecurities and FX -5 (C)urrency -5 -5



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(f) The private nonbank sector deposits R6m cash with banks – cash that the banks hold with the

SARB.

SARB (C)urrency -6

(R)eserves +6 0= -6+6Banks (R)eserves +6 (D)eposits +6

(g) The government transfers R8m from its deposit account with the SARB to its deposit account with

banks.

SARB (R)eserves +7 +7

(G)ov deposits -7


(h) The SARB buys R9m of foreign exchange from the banks.


Banks (R)eserves +9

(S)ecurities and FX -9

(j) The nonbank private sector increases its preference for holding its money in deposits (D) instead

of in cash (C) by +R10m.

SARB (C)urrency -10(R)eserves +10 +0


(k) The Zimbabwean government forces the central bank to buy an issue of (government) securities of

Z$100. This causes an increase in government deposits at the central bank of Z$100. Government

spends Z$80 of its newly acquired deposits on paying its government employees. This causes the

private sector deposits (and money stock) to increase by Z$80.

Zimbabwe (S)ecurities and FX +100 (C)urrency MB=C+R+80central (L)oans to banks (R)eserves +80

bank (G)ov deposits +100

-80


This method of financing government deficits where government issues new bonds and sells them

to the central bank is called monetising the debt. This action increases the monetary base through

the money creation process. If it is continuously used over a long period it can lead to

hyperinflation, as in Zimbabwe in 2001-2008.



68

E Exam questions

15.1 You must be able to record the (direct) changes arising from any of the transactions in section D

question 2, in both the balance sheets of the SARB and that of banks.

15.2 Derive the simple multiple deposit creation model (formula: ∆D = (1/r)∆R). Explain its meaning, the

underlying behaviour of the three players of the money creation process, its simplifying

assumptions and its critique. (20)

15.3 Explain how each of the following factors change money supply: changes in the nonborrowed

monetary base; changes in the borrowed reserves; changes in the required reserve ratio; changes

in the currency holdings; and changes in excess reserves. (Hint: Make use of appropriate formulas

which you do not have to derive.) (9)

15.4 Derive the money multiplier equation mathematically:

( ) MBcer

c M

++

+=

1 .

Explain the meaning of the variables (M and MB; and r , e and c ) and the effect on the multiplier of

an increase in each of r , e and c . (12)

15.5 Briefly explain the arguments for a reversed causality in South Africa, that is, "deposit creation

leads to reserve holding" (D → R) could be more realistic. (15)



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Chapter 16: Tools of monetary policy


To explain how the tools (instruments) of monetary policy can be applied.

1. First, we develop a framework of analysis which is the market for reserves.

2. We use this framework to discuss the three instruments of monetary policy (in the USA):

(a) open-market operations (OMOs) which affect the supply of reserves (R) and the monetary

base (MB = C + R)

(b) changes in the borrowed reserves (BR) which affect the monetary base

(MB = MBn + BR)

(c) changes in the reserve requirement (r) which affect the money multiplier:

MBcer

c M ×

++

+=

1

Because the monetary system in South Africa differs from that in the USA, we need to review each of the

elements of monetary policy.

C3. A framework for monetary policy in South Africa

C4. How monetary policy is applied in South Africa

(a) open-market operations

(b) accommodation policy

(c) reserve requirements


The market for reserves and the federal funds rate (in the USA)

Demand and supply in the market for reserves; How changes in the tools of monetary policy affect

the federal funds rate

## Application: How the Fed reserve's operating procedures limit fluctuations in the Federal

funds rate

Conventional Monetary Policy Tools

Open-market operations; Discount policy and the lender of last resort; Reserve

requirements; Interest on Reserves; Relative Advantages of the Different Tools.



70

## Nonconventional Monetary Policy Tools during the global financial crisis.

## Monetary policy tools of the European bank: Not prescribed

Additional material for South Africa

C3 A framework for monetary policy in South Africa

C4 How monetary policy is applied in South Africa

(a) open-market operations

(b) accommodation policy

(c) reserve requirements


1 The supply and demand framework in the market for reserves provides an elegant framework for

the analysis of monetary policy, based on the material developed in previous chapters. This

framework can accommodate all three types of instruments of monetary policy (MBn(OMOs), BRand r). A sound understanding of figure 1 (p.410) is essential.

2 In the USA, the amount of BR is extremely small (BR is frowned upon), and the equilibrium point

typically occurs on the vertical part of the Rs curve. The US monetary authorities decide on a target

Fed funds rate and execute their OMO accordingly – which is directed at managing their supply of

MBn to the banks.

3 A framework for monetary policy in South Africa

The system in South Africa works differently from that of the USA. In the USA, the Fed uses open-market operations (OMOs) to manipulate the scarcity of funds in the interbank market as a way of

targeting the interest rate in that market (the fed funds rate). Virtually all the normal reserve needs

of the US banking system are met through OMOs at the prevailing fed funds rate. Banks seek

discount loans only when they have exceptional cash needs, presumably because they have been

somewhat less than averagely prudent. For that reason, the Fed charges an interest rate on

discount loans, which is usually about 100 basis points higher than the current federal funds rate.

The refinancing system in South Africa is based on that of Europe and the UK. Initially the idea

was to also have an active interbank market where banks lend cash reserves to each other.

However, in South Africa this market is simply too small to function effectively. The small numberof large banks prevents free competition in the interbank market and thwarts the possibility of

maintaining a target cash funds rate by manipulating the scarcity of cash. Consequently, the SARB

had to change to system where the cash funds rate is not determined in the interbank market but is

fixed by the SARB.

In South Africa, the SARB conducts its OMOs in such a way that it ensures that the banks do NOT

obtain all the reserves they need to meet their reserve requirements. The aim is to force the banks

to supplement their reserves by seeking accommodation loans from the central bank. Because the

SARB meets all these accommodation loan requests unconditionally, the interest rate it sets there

(the "repo rate") becomes the pivotal rate that dominates the interbank cash funds rate and

ultimately the rate banks charge their borrowers. Since the volume of accommodation loans that



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banks seek from the SARB (their borrowed reserves) is largely manipulated by the central bank

(through its OMOs), it reveals less about the behaviour of banks and more about the behaviour of

the central bank.

Graph 16.1 displays the market for reserves in South Africa. In the USA, while the Rd curve

intersects the Rs curve in its vertical section, in South Africa the Rd curve intersects the Rs curve in

its horizontal section (point C).

Graph 16.1: The South African market for reserves

C a s h fu n d s ra t e

r d B C D

R s = M B n + B R

R d = R R + E R

0 A Q u a n t i t y o f r e s e r ve s

M B n

E

The vertical axis shows the cash funds rate. Unlike the situation in the USA, the cash funds rate is

not determined by the market but is fixed by the SARB at level r d. The supply of reserves curve

(Rs) is denoted by ABD. The vertical section (AB) shows that the supply of nonborrowed reserves

(MBn) is independent of the cash funds rate. The horizontal section BD shows the amount of

borrowed reserves (BR) that the SARB is willing to supply at the fixed repo rate r d.

The demand for reserves (Rd) curve is downward sloping. Rd consists of the sum of required

reserves (RR=r.D) plus excess reserves (ER). Excess reserves are kept at a minimum as it inhibits

a bank's ability to generate profits The inverse relation between the cash funds rate and R d in the

USA is explained by Mishkin in terms of the fact that the cash funds rate is an opportunity cost of

excess reserve (ER) holding. Hence, the higher (lower) i, the lower (higher) the demand for ER will

be.

The Rd and Rs curves intersect at point C which shows the equilibrium quantity of reserves are 0E

at the interest rate r d. The total quantity of reserves 0E consists of 0A of nonborrowed reserves

plus AE of borrowed reserves. In South Africa, the SARB ensures that the banks always have a

liquidity shortage which forces them to borrow reserves from the SARB. The amount of borrowed

reserves in SA is about ¼ of total reserves.



72

Because the SARB fixes the cash funds (repo) rate, the exact location of 0A (the amount of

nonborrowed reserves) is not as critical in South Africa as it is in the USA. In the USA, the Fed

supplies just enough cash (nonborrowed reserves) to the interbank market, so that the fed funds

rate equates with its target level. Put differently, in the US system, the Fed seeks to steer the cash

funds rate towards its target level by manipulating the supply of nonborrowed reserves (MBn)

through the volume of its open-market operations. In South Africa, the cash funds rate (repo rate)

is fixed and the model only determines the total amount of borrowed reserves (and consequently

also total the total reserves) and not the interest rate.

4 How monetary policy is applied in South Africa

The previous section provides the broad framework of monetary policy in South Africa. In

summary

• The SARB uses OMOs to ensure that the supply of nonborrowed reserves (MBn) always falls short

of the total liquidity requirement.

• Banks are thus required to borrow reserves (BR) from the SARB at the repo rate. The SARB setsthe repo rate at its target level and subsequently accommodates any demand for cash reserves by

the banks.

• The SARB does not rely on changes in the required reserve ratio (r) in its day-to-day management

of the money market.

This section provides more detail on how the instruments of monetary policy are used in South

Africa.

a Open-market operations (OMOs)

(i) In South Africa, the SARB actively maintains a liquidity requirement by means of open-marketoperations which compel banks to borrow a substantial amount from the SARB (BR) at the repo

rate (ie the SARB maintains a money market shortage).The SARB is constantly active in the

money market to drain excess liquidity in order to force a liquidity shortage.

(ii) The SARB carefully estimates the banks' overall liquidity requirement on a daily, weekly and

monthly basis and takes account of all factors that may affect the liquidity shortage. A relatively

large amount of liquidity requirements arises from maturing short-term repo transactions. Once

estimates have been made, the SARB offers a number of securities on auction at varying interest

rates. The SARB offers various securities and maturities in its open-market operations.

Banks estimate their liquidity shortage for the coming week and tender for the amounts andinterest rates, which are then allocated in ascending order of the interest rates bid (the higher price

bids are allocated first). The securities are auctioned weekly, normally on Wednesdays. The

interest rate on bids is generally below that of the repo rate.

(iii) To drain liquidity from the market, the SARB also sells longer-term reverse repos from its monetary

policy portfolio. Reverse repo transactions are transactions in which financial assets are sold, say,

today, and then repurchased at a later date, and where the interest rate is fixed on the date of the

initial sale. The SARB also conducts outright sales of securities.



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(iv) The SARB also uses foreign exchange swap transactions (e.g. swapping US dollars for rand) to

temporarily drain rand liquidity from the market. These swaps are short term and are used to

smooth intramonth fluctuations in liquidity.

(v) Another instrument that supplements open-market operations is the tax and loan accounts of the

government held with private banks, instead of at the SARB. Their operation is best explained in

terms of an example. Assume a private company pays its tax bill to the government. If the tax is

deposited into the government's account at the SARB, it then causes a destruction of the reserves

of banks. However, should this amount be deposited into a tax and loan account held at a private

bank, the banks' reserves remain unaffected. The SARB can also transfer deposits from its tax and

loan accounts to the government's account held at the SARB, which will then cause a reduction in

bank reserves. The tax and loan accounts serve to alleviate large fluctuations in liquidity arising out

of the tax flows from the private sector to the government. They also have the advantage of

earning interest revenue for the government.

b Accommodation Policy

(i) The purpose of accommodation policy in South Africa is that the SARB provides liquidity (borrowed

cash reserves: BR) to banks. Because the SARB uses repurchase agreements (repo's) and the

USA mainly uses discount instruments for this purpose, it is called discount policy in the USA and

accommodation policy in SA. The intention of both is to provide BR to banks. In the USA, the

amount of discount lending is very small, in contrast to the situation in SA where accommodation is

quite large.

In the USA the name discount policy arises because the central bank, to provide liquidity, buys

securities from the bank at a discount (at the discount rate) in exchange for reserves.

The SARB does not use discount instruments for this purpose. The SARB provides liquidity to thebanks by means of repurchase agreements (repos) whereby the SARB "buys" government

securities. When these repos mature (usually after a week), the banks repay the central bank the

original amount provided a week ago plus interest at the repo rate. Because the central bank

thereby accommodates the liquidity requirements of banks, this is called accommodation in SA.

(ii) In South Africa, the cash funds rate is called the repo rate. A change in the repo rate amounts to a

change in monetary policy because the repo rate affects interest rates in general. To ensure that

the repo rate remains effective, the SARB compels the banks to borrow a substantial amount of the

liquidity requirement from the SARB.

(iii) The liquidity requirement of banks is met at the main refinancing repo auctions that occur weekly.

At these auctions, the SARB provides liquidity to the banks by means of repurchase agreements

(repos) involving mainly government bonds, treasury bills, SARB debentures and Land Bank bills.

Banks sell their securities to the SARB for a period of one week, in return for cash reserves. Banks

pay the repo interest rate on these reserves. The ownership of securities formally remains with the

banks, and banks also retain the right to interest income earned on these securities.

On Wednesdays, the SARB invites tenders from banks for its refinancing auction. Because the

repo rate is fixed, banks tender only for the amounts of refinancing they need (for open-market

transactions, banks tender both quantities and interest rates). The transaction is reversed at

maturity. If the daily liquidity requirement of banks is different from the amount allotted at the main

repo auction, banks can utilise a number of facilities to square their positions at the end of day. The

need to finance these deviations stems from changes in the amount of currency in circulation,



74

government spending and foreign exchange transactions, which are all difficult to forecast. In the

case of a daily shortage, further refinancing is provided either through a supplementary repo

auction or a standing facility repo. Surplus liquidity is absorbed by means of a supplementary

reverse repo auction or a standing facility reverse repo.

(iv) As in the USA, if individual banks in South Africa or the banking sector as a whole face a severe

cash reserve shortage that threatens to undermine the stability of the banking system, the central

bank may have to act as lender of last resort. It will then provide emergency loans to banks at a

rate higher than the repo rate. Additionally, the SARB may also render special assistance to banks

by providing liquidity against a broader range of collateralised assets. The type and conditions of

this assistance vary on a case-by-case basis. This facility is not regarded as part of the SARB's

monetary policy framework, but relates more to the SARB's responsibility to promote financial

stability.

c Reserve requirements

(i) Formally, banks are required to hold 2,5% of their total liabilities to the public as required reserves.In practice this is somewhat less because banks are allowed to exclude certain liabilities as

required reserves.

(ii) Banks are required to adhere to the reserve requirement on an average daily basis over a full

month period. This implies that if a bank falls below its required reserves for a few days, it has to

hold additional reserves during the remainder of the month. The reserve requirement per bank is

determined once a month and is based on an average of deposit holdings of the previous month.

The bank's holdings of vault cash to service daily withdrawals of currency also do not qualify as

part of the required reserves, and the required reserves held at the SARB are thus in addition to

banks' holdings of vault cash.

(iii) In principle, the SARB can change the required reserve ratio whenever the need arises. In practice

it does not do so. The variation of the required reserve ratio is a slow, unwieldy and crude

instrument. Changes in the reserve requirements have to be announced through a notice in the

Government Gazette, which is a slow process. It is crude because small changes in the reserve

requirement may lead to relatively large changes in required reserves. As in the USA, a fluctuating

reserve requirement would increase the uncertainty for banks and make their management of

liquidity more difficult. It amounts to a tax on the banking system, which should rather be avoided.

D Activities

1 Derive the value of the money multiplier (M=m.MB) in South Africa. Assume that c=C/D=4%,

r=R/D=2% and e=ER/D=0%.

2 Assume that the SARB increases the repo rate. Further assume that the repo rate affects all other

interest rates, which then affects the amount of bank lending. Explain how the supply and demand

curves in the market for reserves (as applicable to SA) will be affected assuming that all other

factors remain constant. Illustrate graphically by using the equilibrium in graph 16.1 as your starting

position. Also predict the new equilibrium position.



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3 The SARB purchases R10m of bonds from the private sector in an open market operation. Explain

how the supply and demand curves in the market for reserves (as applicable to SA) will be

affected, assuming that all other factors remain constant. Illustrate graphically by using the

equilibrium in graph 16.1 as your starting position. Predict what will happen to total reserves and

the money supply.

4 Based on activity (3), comment on the following: In the 2nd year macroeconomics course you were

taught that the SARB can increase the money supply by purchasing bonds from the private sector.

The mechanism is as follows: When the SARB purchases bonds from the private sector, then the

amount of reserves increases, which allows the banks to extend more loans.

5 What is the implication of the answer to activity (4) with respect to the control of the money supply

in South Africa?

6 Explain whether the formula M=m.MB applies to South Africa.

Answers:

1 The multiplier is m=(1+c)/(r+e+c) where c=0,04, r=0,02 and e=0.

Thus m = 1,04/(0,02+0+0,04) = 1,04/0,06) = 17,33.

2 The increase in the repo rate (r d) will move the supply curve (Rs) upwards. The position of A,

however, will be unchanged because the amount of MBn is unaffected. The supply curve will be

say AB'D' where B'D' lies horisontally above BD.

The increase in the repo rate (r d) will also affect the demand curve (Rd). The amount of banklending will decrease because the increase in the repo rate will increase the interest rate paid on

loans. Deposits (D) will decrease and the Rd curve (RR+ER = r.D+ER) will shift to the left. The

new equilibrium position E' will be to the left of E.

3 When the SARB purchases bonds from the private sector then the supply of reserves increases,

which will shift position A of the Rs curve to the right, but which leaves r d unchanged. Thus section

AB of Rs shifts to the right. Because the repo rate remains the same, section BD will remain at its

level r d.

Curve Rd will not be affected. Because banks will then experience a surplus of BR over the shortterm, they will quickly reduce their amount of accommodation so that total reserves remain at C.

If we assume that point C lies to the right of point B (which is most likely because the open market

transaction is relatively small) then there will be no change in total reserves and no change in

money supply.

4 Based on the answer to activity (2) we can say that the increase in nonborrowed reserves will be

matched by a decrease in borrowed reserves which will leave total reserves and the money stock

unchanged.

The 2nd year macroeconomics course assumes that reserves consist exclusively of nonborrowed

reserves. This is incorrect in practice. Reserves include both nonborrowed and borrowed reserves.



76

5 The implication of this is that the money stock is not controlled by the SARB. Only the interest rate

is controlled as in activity (2). Money is endogenous: The money stock is determined at a point

where the interest rate intersects the demand for money curve.

6 There are two aspects to this question.

(1) If we assume that c, r and e are constant over time then the formula M=m.MB explains how MB

and M are related. Of course, c, r and e are, in practice, not constant over time which causes the

relationship between MB and M to be less than perfect (meaning a constant ratio over time).

(2) The formula appears to imply that MB is controlled by the central bank and that changes in MB

causes changes in M (MB → M). In SA, the MB is not controlled by the central bank as indicated in

the answer to activity (5). The central bank only controls the supply of nonborrowed reserves while

the banks are accommodated by the central bank with as much supply of borrowed reserves

(BR=R-MBn) as needed to meet their total reserve requirement (R=RR+ER = r.D+ER). Because

BR automatically adjusts to other variables, and reserves are not controlled (fixed) by the centralbank, the causality does not run from MB → M but rather from M → M.B. Thus reverse causality

applies.

E Exam questions

16.1 Explain and graphically illustrate a model of the supply and demand in the market for reserves (as

applicable to the US) which explains how the federal funds rate is determined. Also explain how

changes in the tools of monetary policy (OMOs, changes in the discount lending rate, and changes

in the reserve requirements) affect the federal funds rate. (15)

16.2 Explain and graphically illustrate how the market for reserves operates in SA. Also explain inprinciple how the tools of monetary policy (OMOs, BRs and the required reserve ratio) fit into this

framework. (15)

16.3 Explain in more detail how monetary policy is conducted in South Africa. Explain the manner in

which

(i) OMOs are used by the SARB as well as the operation of other tools used to supplement

OMOs (10)

(ii) accommodation policy is applied (5)

(iii) the discount rate is used (5)

16.4 Comment on the following statement: "The formula M=(1+c)/(r+e+c).MB implies in the case ofSouth Africa the central bank can accurately predict M given MB". Also comment on the question

of causality between MB and M. (Hint: This matter is dealt with in the Activities section: D2-D6.)

(10)



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Chapter 17: The conduct of monetary policy: Strategy and tactics


To explain two major monetary policy strategies:Monetary targeting and inflation targeting

1 Monetary targeting uses the instrument of controlling the money supply.

This instrument was used in many countries from the 1970s up to the 1990s.

It was used in South Africa from 1985 onwards but was discarded in 1999.

It was displaced by

2 inflation targeting which uses the instrument of controlling the interest rate.


Nobel Memorial Prize winning economist Professor Joseph Stiglitz added grist to the mill of the

anti-inflation-targeting lobby last week when he reiterated his stance that the "rigid" application of

inflation targeting by central bankers had contributed to the onset of the current economic crisis.

He added that containing inflation needed to be balanced with other concerns, such as sustaining

growth and maintaining financial stability. He asserted that many central banks had made the

"mistake" of "acting as if low consumer-price inflation was necessary and almost sufficient for

economic stability".

Source: http://www.engineeringnews.co.za/article/inflation-targeting-debate-flares-2009-07-17


The price stability goal and the nominal anchor

The role of the nominal anchor; The time-inconsistency problem

Other goals of monetary policy

High employment; Economic growth; Stability of financial markets; Interest rate stability; Stability in

foreign exchange markets

Should price stability be the primary goal of monetary policy?

Hierarchical versus dual mandates; Price stability as the primary, long-run goal of monetary policy.



78

Inflation targeting

## Inflation targeting in New Zealand, Canada and the UK (not prescribed);

The advantages of inflation targeting; The disadvantages of inflation targeting

## The Federal Reserve’s monetary policy strategy

## Lessons for monetary policy strategy from the global financial crisi

Tactics: Choosing the policy instrument

Criteria for choosing the policy instrument

## Tactics: The Taylor rule (not prescribed)


C2 Monetary targeting in South Africa


1 Monetary targeting was used in many countries during the period 1975 to 1995. A number of major

lessons were learnt from the application of monetary targeting in the USA, Japan and Germany:

● It is difficult to hit a monetary target and monetary targets were not strictly adhered to, or not

seriously pursued. In the USA, for example from 1975 onwards, targets were often missed. After

1982 the Fed decreased its emphasis on monetary targets, and in 1993 discarded monetary

targets as a guide for monetary policy.

● Monetary targets are not a reliable guide for monetary policy.● It could be interest rate movements, rather than the targeting of monetary aggregates itself that

would lower inflation.

● The success of monetary targets depends on the stable relationship between monetary aggregates

and the aggregate price level, which was not the case in many countries.

● Transparent communication of the long-term intention of monetary targets could be more important

than the target itself.

2 Monetary targeting in South Africa (additional material)

This section provides a brief overview of monetary policy in South Africa after the 1970s. Itspecifically deals with South African experience of monetary targeting during this period. To

facilitate the discussion, see chart 16.1 for the South Africa inflation rate and the growth in M3.



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Chart 17.1: The inflation rate (growth in CPI) and the growth in M3 in South Africa (1976-

2009)11

High inflation emerged in South Africa during the 1970s. It was initiated by the 1973 oil crisis and

remained high up to the early 1990s. The SARB's initial response involved attempts to constrain

the growth of the money stock. The SARB used direct controls to influence the banks' capacity to

create credit. During the period under Reserve Bank Governor De Jongh (1967-1980), there was

mainly nonmarket-related administrative intervention – that is, direct quantitative restrictions on the

extension of bank credit as well as direct quantitative controls on interest rates. None of these

measures were particularly successful in reducing the inflation rate.

Table 17.1: Evolution of South Africa's monetary policy framework

Period Monetary policy framework

1960 -1981

1971-1976

Liquid asset ratio-based system with quantitative controls over interest rates and

credit; that is, direct control

Credit ceilings

1981-1985 Mixed system during transition

1986-1999

1986-1990

1990-1998

1998-1999

Discretionary policy or eclectic approach :

Monetary targets (M3)

Cost of accommodation-based system with pre-announced guidelines for growth in M3Daily tenders of liquidity through repurchase transactions (repo system), plus pre-

announced M3 targets and informal targets for core inflation

2000- Formal inflation targeting

11 Source: Quarterly Bulletin of the South African Reserve Bank . Various editions (based on table S-23: 1374M(M3) and table S-137: 7032N (CPI) in older editions and 7170N (CPI urban) in more recent editions)



80

In the early 1980s, the De Kock Commission of Inquiry into the Monetary System and Monetary

Policy in South Africa laid the foundation for the implementation of monetary policy during the

1980s. The report's approach was that the economy is best served by domestic price stability

through market-oriented measures which was pretty much in line with the approach adopted in

most developed countries at the time. In contrast to the previous nonmarket (or direct) approach,

monetary policy was transformed into a more market-oriented one. Most of the direct control

measures (credit ceilings, interest rate control, etc), which were selectively used in the 1960s and

1970s, were abolished in favour of a policy in which financial markets played a more active role.

Market-oriented measures seek to create incentives (price incentives in particular, through

changes in the interest rate) for financial institutions to voluntarily react in desirable ways.

In the 1980s, during the era of Reserve Bank Governor Gerhard de Kock (1980-1990), monetary

policy may be described as a market-oriented blend of conservative Keynesian demand

management and monetarism. In March 1986, pre-announced, flexible monetary target ranges

were used with the main policy emphasis being on the central bank's accommodation interest rate

to influence the cost of overnight collateralised lending and hence market interest rates. Thereremained a strong emphasis on discretionary demand management. Money supply growth targets

were used, but they were not strictly adhered to. Other national objectives such as economic

growth and employment also played a role. In practice, this led to lower real interest rates and

higher rates of growth in the money supply. Ultimately, however, this produced higher inflation

without any sustained increase in long-term growth.

After the early 1980s, the SARB used an intermediate objective to control the growth in M3. The

bank rate (a short-term interest rate the Reserve Bank charges for its loans to banks) was adopted

as the operational variable. In practical terms, this meant that the Reserve Bank influenced short-

term interest rates in the financial markets through its accommodation policy (also referred to asrefinancing policy). This policy was supplemented by the use of other monetary policy instruments

to influence the money supply. During this period, the most popular intermediate targets worldwide

were those relating to monetary aggregates. In South Africa, the M3 money supply aggregate was

used as an intermediate target. Statistical studies had shown (at the time) that there was a

satisfactory correlation between the growth in M3 and the growth in nominal GDP. Nominal GDP

represents the value of the GDP before correcting for inflation. Despite these measures, inflation

remained high, and with hindsight, one could say that monetary policy was not strict enough.

In the 1990s, under Reserve Bank Governor Chris Stals (1990-1999), monetary policy was tighter

and less erratic. Stals was less inclined to tolerate trade-offs between the perceived short-rungrowth and the longer-term objective of permanently reducing the inflation rate. This led to the

relatively restrained monetary policies of the 1990s. The result was that the inflation rate of the

1980s of around and above 15% was reduced to a level below 10% (see chart 17.1).

From 1988 onwards, the SARB consistently applied guideline ranges in the growth of money

supply. These money supply guidelines served as the intermediate objective of the SARB, the

ultimate objective being to bring down the inflation rate. The SARB set a guideline growth range for

M3 and because of the close correlation between the growth of M3 and nominal GDP, this also

reduced inflation. For example, in 1997, the guideline range of M3 at the end of the first quarter of

each year, was set at between 6% (the lower limit) and 10% (the upper limit). These measures

successfully reduced the rate of inflation over the longer term.



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During this period, the SARB adopted a more medium- to long-term approach and the use of

monetary supply guidelines was accordingly changed. The guideline for the growth in money

supply was initially changed to the quarterly average growth of M3 between the fourth quarter of a

specific year to the fourth quarter of the next year. In 1998, the guideline was changed to the

average rate of increase in M3 over the next three years, measured over successive 12-month

periods.

Monetary targeting abandoned

The successful application of monetary guidelines as an intermediate instrument of monetary

policy is based on two assumptions. The first is that there is a stable relationship between nominal

income (Y) and money stock (M). The second is that the causality runs from M (the policy

instrument) to Y. After the 1980s, these assumptions were increasingly questioned, internationally

and in South Africa, both on theoretical and empirical grounds.

Empirical evidence in the case of South Africa increasingly confirmed that the previous directrelationship between aggregate spending and the money supply had changed. For example, from

1995 onwards, the M3 money supply increased at rates consistently higher than the guidelines

from M3 growth while inflation declined, contradicting previous experience. One possible

explanation for this was that the relationship between money and income was significantly

changed by the growing integration of global financial markets and the liberalisation of the South

African capital market. Another view is that the relationship between money and inflation changes

with decreasing inflation, and that more money is held when inflation is low. The experience in

South Africa in this regard was not unique because other countries experienced similar problems

with their money-to-aggregate income ratios. The current consensus is that the monetary

transmission mechanism works through various channels, complicating the previously simplerelationship between money and the price level.

Up to that time, it was widely believed that the money supply is exogenously determined, that is,

determined by parties other than the private nonbank sector, the central bank in particular. There

was, however, a growing consensus that money is mainly endogenous – in other words, it is

determined by the private nonbank sector. What this means is that, as the economy grows, it

causes the demand for bank loans on the part of the nonbank public to grow, which will have the

effect of raising the supply of money too (you will recall how banks create deposit money when

they extend credit to the public). Thus the public itself largely determines the supply of money

through the demand for bank loans which it exercises, although the central bank can influence thatdemand by changing the level of the interest rate. Such is the idea of endogenous money, which is

indeed valid insofar as the money stock changes as a result of changes in the demand for bank

loans by the public.

The analytical implication of endogenous money is that the causal direction runs from changes in

(planned) nominal output (∆PY) to changes in the money stock (∆M). By contrast, exogenous

money means that the causal direction runs in the opposite direction, from changes in the money

stock (∆M) to changes in nominal output (∆PY). Exogenous money presupposes that the money

stock can be directly influenced by agents other than the private nonbank sector, the central bank

in particular. Hence the money stock is determined by parties that are exogenous to (outside of)

the private nonbank sector. The exogenous money view is valid insofar as the money supply grows

as a result of (1) the central bank conducting open-market purchases with the nonbank public, (2)



82

the government deliberately running a budget deficit, or (3) a surplus on the balance of payments.

Sources of growth (1) and (2) can be controlled by the monetary authorities (the central bank and

the treasury), while source (3) is predominantly driven by forces outside the local economy.

Because most of the growth in the money supply can be explained by growth in the demand for

credit (bank loans) on the part of the nonbank public, the money supply is indeed predominantly

endogenous, although not entirely so. As noted several times earlier, the above-mentioned

sources (1), (2) and (3) can play a significant role too.

Monetary targeting as a policy approach can be largely associated with the monetarist school of

thought, that is, those economists who agree with and advocate the ideas put forward by the well-

known American economist, Milton Friedman in the 1950s.1 The basic theoretical foundation is

quite simple. Consider the basic version of the equation of exchange MV = PQ, where M is the

money stock, V is the velocity of circulation of money, and PQ represents total spending. PQ can

also be interpreted as nominal income or nominal GDP. Note that nominal GDP consists of a price

component P and a quantity or real component Q. The equation of exchange based on M1 is then

written as M1V1 = PQ.

The fact that the money stock grows mainly as a result of growth in the public's demand for bank

credit does not, however, convince economists like Mishkin (2007) about its predominant

endogeneity. On the basis of the money multiplier formula, M = m.MB, they would argue that the

central bank, by controlling MB, can exercise significant control over M – even when it is primarily

determined by the public's demand for bank credit. However, if it is accepted that the causal

direction in M = m.MB runs in the opposite direction (from MB to M), M would not be determined by

MB, but the other way around. In the reversed-causal-direction, endogenous-money view, it is not

the central bank's control over MB (or R) that allows it to influence M, but the central bank's control

over the interest rate. Hence, in this view, the only way in which the central bank can influence M is

by manipulating the demand for bank loans through changes in the interest rate – which is whathappens in reality. Nonetheless, some sources of exogenous growth in the money supply remain

important, as indicated by sources (1), (2) and (3) above.

In the course of the 1990s, it became apparent that the growth in the money stock had become a

less reliable indicator of underlying inflation, and therefore also a less reliable anchor for monetary

policy. The SARB accordingly started to move away from formally targeting the money stock and

began using a broader range of economic indicators to guide its policy actions. This was called the

eclectic approach. The wider range of indicators included in this approach consisted of changes in

bank credit extension, the overall liquidity in the banking system, the level of the yield curve,

changes in the foreign reserves and in the exchange rate of the rand and actual and expectedmovements in the rate of inflation.

Under Reserve Bank Governor Tito Mboweni (1999 - 2010) the SARB continued to pursue its

policy of domestic price stability. In the February 2000 budget speech, the Minister of Finance

announced that inflation targeting would be the new monetary policy framework in South Africa.

This meant that the monetary authorities would now target the rate of inflation directly instead of

following the previously applied "eclectic" monetary policy approach in which intermediate

objectives (like the growth in M3) played a prominent role. The primary objective of monetary policy

1The so-called monetarist counter-revolution (against the theories of JM Keynes which prevailed in the post GreatDepression era) was started by Milton Friedman in 1956 with a publication entitled “The Quantity Theory of Money - ARestatement”.



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would remain low domestic inflation in order to obtain balanced and sustainable long-term

economic growth.

3 Why does monetary targeting affect the inflation rate?

In the previous section you learnt that the application of strict monetary guidelines (constraints of

the growth of money supply) reduces the inflation rate. There appears to be a link between

monetary policy and the aggregate price level. Why does this occur?

According to the normal causal direction view (exogenous money), the central bank can control the

supply of money via its control over MB, which is derived from M = m.MB. According to this view,

the central bank effectively controls the money stock (M) by its control over the monetary base

(MB). Because the growth in M mainly originates from the issue of net new loans by banks, this

implies that the control of the monetary base mainly impacts on the issue of net new loans by

banks.

Moreover, the central bank does not directly control the aggregate price level. Production in a

market economy is mainly determined by the private sector. Although the prices of some goods

and services, which are produced by semi-government institutions (eg electricity in South Africa),

are simply fixed by the relevant authorities (so-called "administered prices"), the prices of most

goods and services are determined in the market by demand and supply. In the market, producers

actively compete for their share of consumer spending by using both price and non-price

(advertising, better quality goods, etc) competition.

Is there a link between the issue of net new loans by banks and the aggregate price level? Yes,

there is. The issue of net new loans by banks affects the level of spending. When, for example,new loans are more difficult to obtain, or when interest rates are high, consumers simply have less

to spend and are more price sensitive. The ability of producers to increase prices is thus

constrained. The application of monetary policy is thus simply an indirect means of influencing the

pricing behaviour of producers. This matter will be discussed more fully in the next part, which,

amongst others, deals with the transmission mechanism of monetary policy.

4 Comment on the Economics in action statement:

Joseph Stiglitz's criticism is essentially that within inflation targeting the goal of fighting inflation

needs to be balanced with other goals such as growth and financial stability. The statement is of ageneral nature and the question is whether it also applies to South Africa. Many South African

economists would argue that the SARB had not been overly rigid in its application of inflation

targeting. However, the nature of South African's economic problems should also not be ignored.

Refer to chapter 14: section C3. South Africa's high level of unemployment is a structural problem.

Monetary policy is ill-suited to solve structural problems.



84

D Activities

Evaluate each of the following statements:

1 Monetary targeting means that the central bank targets a growth rate of some monetary aggregate

(for example M2) or interest rate to counter high inflation.

2 Monetary targeting can only work well when there is a reliable and stable relationship between the

growth of the monetary aggregate and the inflation rate.

3 Monetary targeting worked quite well in South Africa when it was strictly applied and succeeded in

reducing the inflation rate to a level below 10% per year for most of the 1990s.

4 The advantages of monetary targeting are that data on the instrument and the goal become

available without a long delay, and that the central bank can be held accountable for executing

monetary policy.

5 Monetary targeting was abandoned in South Africa after 1994 when the ANC came into power.

6 The advantages of inflation targeting are that is highly transparant and that inflation can be readily

controlled by the central bank.

7 The central bank cannot simultaneously set both a monetary aggregate instrument and an interestrate instrument.

8 Endogenous money means that the level of the money stock changes mainly as a result of

changes in the demand for bank loans.

Answers:

1 Incorrect . Monetary targeting means that only a growth rate of some monetary aggregate is

targeted. The goal is indeed to counter inflation.

2 Correct .

3 Correct .

4 Correct .5 Incorrect . Monetary targeting was abandoned when it became apparent that the growth in

the money stock had become a less reliable indicator of underlying inflation.

6 Incorrect . Although inflation targeting is highly transparant, inflation itself cannot be readily

controlled by the central bank.

7 Correct .

8 Correct .

E Exam questions

17.1 Briefly explain the meaning of monetary targeting and its main advantages and disadvantages.Then briefly explain the major lessons that were learnt from the application of monetary targeting in

the US, Japan and Germany as it was applied from the 1970s to the 1990s. (15)

17.2 Explain the five elements of inflation targeting. Also explain the advantages and disadvantages of

inflation targeting (15)

17.3 Explain and illustrate graphically why the central bank (in the USA) cannot target both the NBR and

the cash funds rate simultaneously. (Hint: Use a supply and demand for reserves framework.)

(10)

17.4 Explain which monetary policy instrument/s may be used by the central bank and which criteria

apply when choosing a monetary policy instrument. (10)



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PART 6: MONETARY THEORY

Chapter Goal

20 Quantity Theory, Inflation and the demand

for money

21 The IS Curve

22 The Monetary policy and the aggregate

demand curves##

23 Aggregate Demand and Supply Analysis##

24 Monetary Policy Theory

25 The Role of Expectations in Monetary Policy

26 Transmission Mechanisms of Monetary

Policy

To explain which factors affect the demand for

money

To explain what is wrong with the ISLM model

Not prescribed

Not prescribed

To explain the role of monetary policy to prevent

inflation

Explain the role of monetary policy in time-

inconsistency and nominal anchor

To describe the way in which the instruments of

monetary policy affect the economy



86

Chapter 20: Quantity Theory, Inflation and the demand for money


To explain which factors determine the demand for money, which is the remaining part of the

supply of and the demand for money story.

The supply of money was dealt with in section 4: Central banking and the conduct of monetary

policy.

An important factor is whether interest rates affect the demand for money.


You would think that the demand for money would be infinite. Who doesn't want more money? The

key thing to remember is that wealth is not money. The collective demand for wealth is infinite asthere is never enough to satisfy everyones desires. Money is a narrowly defined term which

includes things like paper currency, travellers checks, and savings accounts. It doesn't include

things like stocks and bonds, or forms of wealth like homes, paintings, and cars.

Source: http://economics.about.com/cs/money/a/money_demand.htm


Quantity theory of money

Velocity of money and equation of exchange; From the equation of exchange to the Quantitytheory of money; Quantity theory and the price level; Quantity theory and Inflation.

Budget Deficits and Inflation

Keynesian theories of money demand

Transaction motive; Precautionary motive; Speculative motive; Putting the three motives together

Portfolio Theories of Money Demand

Empirical evidence for the demand for money



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1 Why do we focus on the demand for money?

We are interested in the demand for money because it forms part of a greater story. We are, in

fact, primarily interested in the impact of monetary policy changes on the real economy. The real

economy includes real and nominal income, but also the general price level, and variables

covering related phenomena like consumption, employment and imports. In general we refer to the

impact of monetary policy changes on the real economy as the monetary transmission mechanism.

Our interest in the demand for money arises because it is part of the greater story of the monetary

transmission mechanism.

The next chapter looks at both macroeconomic demand and supply – the well known ISLM model.

Money is an important element of ISLM analysis. Disequilibrium may occur between the demand

for and the supply of money. Disequilibrium in ISLM implies that people hold less or more moneythan they desire. The question arises, what in the economy should change in order to re-establish

equilibrium between demand and supply? Our current interest lies with the variables which affect

the demand for money. These are mainly income and interest rates.

Chapter 19 starts with the very simple quantity theory of money. It states that nominal income is

solely determined by the quantity of money. In the case of the quantity theory of money the

following model applies:

Equation of exchange: MV=PY.

It is assumed that V and Y are constants within the model and that the causality runs from M

(exogenous variable) to P (endogenous variable). If the money supply increases then adisequilibrium arises which is only restored if the price level increases by the same magnitude. E.g.

if M increases by 20% then equilibrium is restored when P also increases by 20%.

2 Is velocity constant?

In the USA, empirical data show that the velocity of money (V=M/Y) is not constant. The same

applies in South Africa (see chart 20.1).



88

Chart 20.1: Income velocity of circulation in South Africa (V=PY/M: Left-hand axis) and how V

changes from year to year (right-hand axis)12

Note that Mishkin (2009) determines V as it appears in the Equation of exchange in the form of MV

= PY. Hence it is defined as V = PY/M (nominal income/money stock). Hence this version of V is

often referred to as the "income velocity of circulation".

3 The overall conclusion is that the demand for money is unstable, and that the setting of rigid

money supply targets to control aggregate spending may thus be ineffective. Chart 20.1 supports

this conclusion for South Africa. It indicates that the income velocity of circulation in South Africa

shows considerable variation.

D Activities

1 Derive each of the variables of the Fisher quantity equation MV = PY for South Africa for 2009

given the following data for South Africa (all in units of R billion13):

Money stock (M3) nominal, at the end of 2009 1995

Gross domestic product, at current prices, 2009 2 423

Gross domestic product, at constant 2005 prices, 2009 1 782

12 Source: Quarterly Bulletin of the South African Reserve Bank (June 2008). YP (nominal income) is series

6006J in table S-103, while M (M3) is series 1374M in table S-23.

13 R1 billion is R1000 million



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2 Compile a table which summarises the model and approach of each of the theories of the demand

for money (Md). Also list which factors affect Md in each case.

a Quantity theory of money demand

b Keynes's liquidity preference theory

c Further developments of the Keynesian demand for money

Answers:

1 MV = PY:

1995 x V = P x 1782 where M: 1995 and Y: 1782. The GDP deflator can be used as a proxy for P =

(Nominal GDP)/(Real GDP) = 2 423/1 782 = 1.3597.

V = PY/M = nominal GDP / Money stock = 2 423/1 995 = 1.2145.

Thus MV=PY: 1 995 x 1,2 145 = 1,3597 x 1 782.

2 Compile a table which summarises the model and approach of each of the theories of the demandfor money (Md). Also explain which factors affect Md in each case.

Theory Model and its approach What determines Md?

Quantity theory of

money demand

Md=k.PY explains what affects the demand for M: Y=

real income and P = general price level. V is assumed

constant.

Md depends on nominal

income (PY) only, not on

interest rates

Keynes's liquidity

preference theory

Md/P=f(i,Y). V=PY/M is not constant because the

demand for M is negatively related to interest rates.

The theory assumes that people hold money becauseof 3 motives.

Real Md is affected by

interest rates and real

income

Developments of

the Keynesian

demand for M

Transactions and precautions demand for M is also

negatively related to i. Tobin uses a risk diversification

approach which better explains speculative demand.

Confirms that Md is

affected by interest rates.

Friedman's

modern quantity

theory of money

Md/P=f(Yp, r b-r m,r e-r m,πe-r m). Uses 3 types of assets:

bonds, equity and goods.

Changes in interest rates

have little effect on Md,

only Yp affects Md

E Exam questions

20.1 Briefly explain the quantity theory of money (QT), that is, its assumptions and predictions.

Demonstrate that the QT can be transformed into the quantity theory of money demand. Does the

assumption regarding V agree with the empirical findings? (10)

20.2 Explain why Keynes's liquidity preference theory predicts that both nominal income and interest

rates affect the demand for money. (10)

20.3 Explain the major findings of empirical evidence on the demand for money function and its

implication for monetary policy. (5)



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Chapter 21: The IS Curve


To critically evaluate the IS model. Since you dealt with this model in your second-year

studies in macroeconomics, this should not be too difficult.


One myth which we are not going to perpetuate is that the cause of changes in the quantity of

money occurs if, and only if the central bank changes the size of the monetary base. In the United

Kingdom money is endogenous. The (central) bank supplies money on demand at its prevailing

interest rate.

Source: Howells, P and Bain, K. 2008. The economics of money, banking and finance. 4 th edition.

p 256. Pearson Education.


The ISLM approach to aggregate output and interest rates should just be a refresher of

second-year macroeconomics. Make sure that you understand the foundations of the ISLM

model before moving on to the prescribed sections.

Planned expenditure and aggregate demand

The components of aggregate demand

Goods Market equilibrium

Understanding the IS curve

Factors that shift the IS curve

Additional material

Is the ISLM model realistic?

Note: There is only one possible exam question on this chapter which refers to the realism of the

ISLM model. But in order to evaluate the realism of the ISLM model, you must understand what

ISLM is all about.



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1 The ISLM model is an economic model which is based on Keynesian principles and which

describes the relationships between macroeconomic variables and their causality (which variable

affects which others). By its nature an economic model is always a gross simplification of reality. It

focuses on essential variables only and for simplicity, ignores the others. The advantage of this

approach is that it allows us to perform simulations (what if-scenario's) and generate forecasts of

variables relatively easy without the burden of excessive complexity.

Within the context of a model, we distinguish between two types of variables: Exogenous and

endogenous variables. It is important to understand their meaning and use. The causality always

runs from exogenous to endogenous variables. Exogenous variables affect other variables but are

never themselves affected by the other variables. Endogenous variables are affected by other

variables, firstly by the exogenous variables but also by other endogenous variables within themodel. Exogenous variables can be used as instrument variables (used by policy makers) to

induce changes in the endogenous variables.

Example:

In the ISLM model, government expenditure (G) is an exogenous variable. Government budgets to

spend a certain amount and then proceeds to do so. So G is fixed. G is exogenous – it affects

other variables, for example Y (income) but Y does not, in turn, affect G. Y is an endogenous

variable. It is affected both by exogenous variables in the model and by other endogenous

variables.

2 The heart of ISLM consists of a number of simple mathematical equations. Its derivation starts with

the simple Keynesian model (Y=C+I) for the determination of aggregate output (Y) and then adds

the government and international trade sectors to it (Y=C+I+G+NX). Of course, each of the

variables at the right hand side of the last equation are expanded into separate equations. The

monetary sector is added by the inclusion of an equation for the demand for money (M) which

depends on income (Y) and interest rates (i). The critical assumption is that M is defined as an

exogenous variable. M is assumed to be fully controlled by the central bank. If M increases it leads

to increases in Y and in the demand for money (Md). But because M is fixed, this leads to an

increase in interest rates which, in turn, affects the real sector of the economy.

3. The ISLM model is used for the simultaneous determination of aggregate output and interest rates.

Equilibrium is attained where the IS curve (the real economy) intersects the LM curve (the money

market). Note that the interest rate is endogenous because it adjusts to other variables within the

model.

Additional material



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4 Is the ISLM model realistic?

Many economists have noted that the ISLM model is unrealistic. First, a quote:14

ISLM analysis is actually misleading because you tell students that the interest rate is determined

endogenously but they read in the newspaper that a group of good wise men are setting an

interest rate.

Some perspective is required in this context. Since any economic model is a simplification or

stylisation of reality, strictly speaking, all models will be unrealistic. A model is like a road map,

which is not meant to accurately show all the detail but focuses on the intended purpose of the

map. In the case of a road map it shows locations, roads and distances. It merely shows what is

relevant, and purposefully excludes all irrelevant things. A road map, if used within the limits of its

intended purpose, can provide valuable and useful information.

What is the intended purpose of the ISLM model? Its purpose is to show the links between the

major macroeconomic variables. It shows how the real components of Y, (Y = C + I + G + NX) arerelated to each other. For example, it shows that C depends on Y. It also indicates how the real

variables are related to the monetary variables M and i. It provides an elegant framework to

determine how changes in one variable (called exogenous variables) impact on the other

(endogenous) variables.

To determine whether the ISLM model is generally realistic, it is necessary to consider which

variables are exogenous and which are endogenous. Exogenous variables affect other variables in

the model but are not affected by the model's other variables, while endogenous variables are

affected by other variables within the model. Which variables are exogenous and which are

endogenous in the ISLM model? A major assumption of the ISLM model is that M is an exogenousvariable which is controlled by the central bank and that both Y and i are endogenous variables.

The realism of a model is also a matter of judgment. The ISLM model, for example, assumes that

the aggregate price level is constant because there is no variable within the model that represents

the aggregate price level. This is a simplifying assumption that does not agree with reality. We can,

however, live with that unrealism if we apply the ISLM model only in a short-term situation and if

inflation is low. Thus, under given conditions, we can accept the unrealistic assumption of a

constant aggregate price level.

However, the assumption of ISLM that the interest rate is endogenous (in the sense of beingdetermined within the model by the supply of and demand for money) and that money is

exogenous (in the sense of being determined outside the model by the central bank) is one that

creates serious difficulties. In many countries, including South Africa, the interest rate is controlled

by the central bank while M (insofar as it is determined by the demand for bank loans and is free to

find its own level as influenced by that interest rate). The central bank does not control money,

even if it can somewhat influence it through exogenous sources of money creation as previously

mentioned.

14 Chatterji (2005)



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Also refer to D1 in this chapter which explains why the money supply in South Africa is

endogenous due to the nature of the supply of reserves.

What this means in terms of the ISLM model is that the LM curve is horizontal at the interest rate

fixed by the central bank. While we can live with an ISLM approach in which the LM curve is taken

to be horizontal (the central bank sets the interest rate and not money supply), some of its

elegance is lost. For example, the ISLM model does not anymore determine the interest rate, but

only the level of income.

Most economists see the ISLM model as being at best a first approximation for understanding the

links between the monetary and the real world. In spite of its unrealistic assumptions, ISLM is still

the dominant paradigm in undergraduate macro- and monetary economics.

D Activities

1 Explain why the money supply is endogenous in South Africa and not exogenous.

Answer:

Refer to

Chapter 15: C9 The causal direction of the money supply process in SA

Chapter 16: C3 A framework for monetary policy in South Africa

In chapter 15 the formula ( ) MB

cer

c M

++

+=

1

was derived which shows the relationship between

the money stock (M) and the monetary base (MB=Cash plus Reserves). However, the causality in

South Africa is not that MB → M but rather the other way round that M (deposit creation) leads to

reserve holding (MB). The money stock is endogenous because it "automatically" adjusts to the

reserve requirements of the banks which, in turn, depend on the amount of money the private

sector wishes to borrow. Exogenous money would apply if the central bank fixes the amount of

reserves (and the MB) – which then determines M. But the central bank does not fix the monetary

base.

The endogenous nature of M arises because the commercial banks are dependent on the central

bank for their cash reserves and the central bank accommodates the banking system with the cash

reserves it requires. There is no constraint on the supply of reserves. The supply of reserves

(Rs=MBn+BR) consists of non-borrowed reserves (MBn) plus borrowed reserves (BR). In South

Africa, the SARB conducts its open market operations (which determine MBn) in such a way that it

forces the banks to supplement their reserves by seeking accommodation loans (BR) from the

central bank at the repo rate. In SA, the stock of borrowed reserves are substantial and amount to

about ¼ of the total supply of reserves.

Does this "elastic" supply of reserves imply that there is no constraint on money creation by

banks? The answer is no. Money creation is constrained by the demand side, and not from thesupply side by limiting the supply of reserves and the monetary base. The SARB sets the repo

rate, and this effectively impacts on all interest rates. This level of interest rates determines (or

limits) how much the private sector wishes to borrow.



94

E Exam question

21.1 Briefly explain why the assumptions/predictions of the ISLM model are unrealistic in the case of

South Africa. Explain the meaning of endogenous and exogenous variables and explain why the

money supply is endogenous/exogenous in South Africa. Which additional assumption can be

made to make ISLM more realistic? (12)



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Chapter 24: Monetary Policy Theory


To explain the role of monetary policy to prevent inflation.

A comprehensive South African perspective is provided in section C3.

• Inflation: an overview of the main issues


Vigorous anti-inflationary monetary policies are not only economically sound, but also morally essential.

•

Inflation is the depreciation of a currency's purchasing power. This once occurred throughgovernments debasing their currencies. When such policies were implemented by the sixteenth-

century Spanish monarchy, they were condemned as fraud by Spanish theologians.

• Those who suffer the most from inflation are those who live off accumulated savings or those on

fixed incomes, such as pensioners, the elderly, and the poor. Inflation redistributes income from

these people to others who are better off.

• Inflation undermines economic liberty by impairing the ability of entrepreneurs, businesses, and

consumers to make sound economic decisions.

Inflation is more than an economic phenomenon. It strikes at the economy's ability to assist people to

achieve their full human potential.

Source: http://www.acton.org/commentary/commentary_349.php (shortened)

Before reading the prescribed sections in this chapter, read the “Appendix to Chapter 13 – The

Phillips curve and the short-run aggregate supply curve” from page 616 of the prescribed

textbook. (This is for information purpose only)


Response of monetary policy to shocks

Application: Quantitative (Credit) Easing in response to the global financial crisis (for

information purpose).

How actively should policymakers try to stabilize economic activity?

Inflation: Always and everywhere a monetary phenomenon

Causes of inflationary monetary policy

Application: The Great Inflation



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C3: Inflation: an overview of the main issues15

C3.1. Definition and measurement of inflation

C3.2. Impulses versus spirals

C3.3. Money and inflation

C3.4. Social conflict and inflation proneness

C3.5. Combating inflation

C3.6. The cost of inflation


1 What is the cause of inflation and, consequently, how do we prevent inflation? Milton Friedman's

answer to this question lies in his famous proposition that inflation is always and everywhere a

monetary phenomenon. This is correct in the sense that a high rate of money growth is a

necessary condition for sustained inflation. Inflation, in the sense of a sustained increase in the

general price level, must necessarily be supported by a continuous increase in money growth. Ifthe money growth is limited or blocked, then the inflation process cannot continue. Read section

C3.3 which explains why the money stock needs to increase in order to sustain an inflationary

process.

Note that Mishkin qualifies Milton Friedman's statement to be valid in the case where there is a

persistent and rapid rise in inflation. In this case, the increase in the money stock is an exogenous

event, and money alone is to blame for inflation.

The problem with Milton Friedman's statement is, however, that it assumes that inflation is always

a demand-pull phenomenon facilitated by increases in the money stock ("too much money chasingtoo few goods"). In section C3 of this chapter, the view is put forward that inflation is essentially a

symptom of social conflict over income distribution. It is driven by the desire of agents to protect (or

even increase) their real incomes by continually imposing the burden of cost increases on other

parties/sectors of the economy. According to this view, the cause of inflation can lie with any or all

of business, government and labour as the three main sectors of the economy that contribute to

make claims on the social product. See section D, 1a-1c for some numerical examples thereof.

In contrast, Mishkin puts the blame of inflation one-sidedly on government, that is, when its

attempts to hit (too) high employment targets or when it runs a (too) large budget deficit. This is

applicable to the US where competition limits the power of individual sectors of the economy toimpose their will on others.

2 Inflation in Zimbabwe

Zimbabwe experienced hyperinflation during the period 2001-2008. Even before this period, during

the 1990s inflation was already high with the average inflation rate at about 36% per year. But from

2001 onwards the general price level more than doubled each year. From 2006 onwards it became

progressively worse. During 2006 prices just about doubled every month. What was the underlying

cause?

15 By Piet-Hein van Eeghen, Unisa Department of Economics



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The following passages come from a report written in 200516 on the Zimbabwean economy. It

describes the broader picture of what happened in Zimbabwe "once a vibrant and diversified

economy, and a hope for Africa's future."

Zimbabwe has experienced a precipitous collapse in its economy over the past five years. The

government blames its economic problems on external forces and drought. We assess these

claims, but find that economic misrule is the only plausible cause of Zimbabwe's economic

regression and the decline in welfare.

The list of misgovernance is long. The policy of land seizures and the chaotic disruption on the

farms is likely the main reason the staple maize production fell by three-quarters. This impacted

rural incomes, exports, and food security. Indeed, Zimbabwe once exported food, but now requires

massive food aid. In addition to the frontal attacks on agriculture, the rest of the economy suffered

from the undermining of property rights and macroeconomic mismanagement. The government

has run huge budget deficits (22% of GDP in 2000) and printed money to cover the gaps—with the

predictable results of high inflation. Overall, manufacturing has shrunk by 51% since 1997 andexports have fallen by half in the past four years. Political troubles combined with the abandonment

of sensible economic policy also closed off most of the aid tap, scared away most foreign

investment, and chased much of the talented workforce out of the country.

Of particular interest to us, is the Zimbabwean hyperinflation. A report17 states the following:

Zimbabwe's central bank (instructed by the Mugabe government) has printed trillions of new

Zimbabwean dollars (Z$) to keep ministries functioning and to shield the salaries of key supporters

against further erosion.

Zimbabwe fell into hyperinflation after a flight of foreign capital, shortages and a steep increase in

the money supply. Foreign investors fled, manufacturing ground to a halt, goods and foreign

currency needed to buy imports fell into short supply and prices shot up.

The 100 trillion Zimbabwean dollar

banknote which was issued

in 2008. A 100 trillion is 100

x 1012 = 1 x 1014 or a one

with 14 zeros:

100 000 000 000 000.

The high inflation rate destroyed the value of the Zimbabwe dollar 18.

16 Michael Clemens and Todd Moss of the Center for Global Development. July 2005. Costs and causes ofZimbabwe’s crisis.

17 www.nytimes.com/2006/05/02/world/africa/02zimbabwe.html

18 Wikipedia, Zimbabwean dollar



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Political turmoil and hyperinflation rapidly eroded the value of the Zimbabwe dollar. The use of the

dollar as an official currency was effectively abandoned as a result of the Reserve Bank of

Zimbabwe legalising the use of foreign currencies for transactions in January 2009. Currently,

foreign currencies such as the South African Rand, Botswana Pula, Pound Sterling and the United

States Dollar are widely used instead for nearly all transactions in Zimbabwe.

Hyperfinflation in Zimbabwe was caused by an excessive and continuous growth in the money

supply. In Mishkin's terms, the growth in money supply was an exogenous event. In Zimbabwe the

government forced the central bank to continuously buy government securities to finance its debt.

Because the central bank was not independent enough to withstand the wishes of government, this

caused a continuous increase in government deposits at the central bank. When the government

spent these newly acquired deposits, say by paying its government employees, it caused the

private sector deposits (and money stock) to continuously increase.

To better understand how the Zimbabwe government misused the monetary system see chapter 3:

What is money? Section C9: Can government "print" money? Also see chapter 14: The money

supply process, section D2 (k). The answer to question (k) explains the impact of a governmentsale to the central bank of an issue of (government) securities to finance government deficit.

3 Inflation: an overview of the main issues (additional material)19

This section gives you an alternative view on inflation applicable to South Africa.

3.1 Definition and measurement of inflation

Inflation is defined as a continuous and considerable rise in the general (or aggregate) price level.

The term "continuous" means that inflation is a process which occurs over a time period. The

general price level is customarily expressed as an index relative to a base year, and the inflationrate is then calculated as the percentage increase in this index, usually expressed at an annual

rate. Inflation is measured as the annual rate of increase in the price of a basket of goods over a

time period. Baskets can differ according to the goods included in them as well as to the relative

weights assigned to the goods in the basket. Baskets are obviously compiled in order to capture

the spending pattern of the average consumer or producer in the country and are updated every

few years to keep track of changes in consumption patterns.

There are various price indices which reflect the general price level. The main ones are the

consumer price index (CPI), and the production price index (PPI). The PPI is a measure of prices

of manufactured goods at the factory door and values imports at the price importers pay. The aimof the PPI is to measure the cost of production.

The CPI measures the cost of consumption. Separate CPI figures are provided for urban and rural

areas. Economists sometimes speak of "core inflation", which is the CPI net of those prices that

are highly volatile in the short term or set by government itself, such as the price of fresh fruit and

vegetables, the mortgage bond rate and the VAT rate. The aim of the core inflation rate is to

measure the more sustained inflationary tendencies in the economy. In South Africa, the CPI is the

most commonly used measure of the inflation rate, also because the South African Reserve Bank

uses it for the purpose of its inflation targeting policy framework.

19 By Piet-Hein van Eeghen, Unisa Department of Economics



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3.2 Impulses versus spirals

Inflation can be defined as a continuation of price increases whereby these increases feed on

themselves – price increases leading to price increase. Hence inflation is a process rather than an

event; it does not refer to a momentary, once-off increase in prices but to a spiral of sustained price

increases.

To explain this process, let us track an increase in the price of a single good. Given that a market

price is an agreement between a supplier and a demander on the amount of money to be paid for

a certain good, underlying any single market price increase lies a decision by the supplier to

increase his or her money income by raising the price instead of the real volume of his or her

sales, as well as a decision by the demanders to continue buying the good at the higher price.

This initial single price rise can occur at the initiative of the supplier and is then commonly referred

to as cost-push, because suppliers raise their prices to compensate for cost increases of inputs tokeep their profits unchanged. But it is also possible that suppliers increase their prices in order to

increase their profits which should then more aptly be labelled profit-push. In addition to cost/profit

push, the price of a good can also increase in reaction to higher demand for the good, which is

commonly referred to as demand-pull inflation. Demand-pull inflation normally requires fairly high

levels of capacity utilisation. Only when firms start to reach the limit of their current production

capacity, will they tend to increase their price in reaction to increased demand for their goods.

A once-off rise in the price of a good may be called an inflationary impulse, or more commonly

referred to as a "first-generation inflation effect". But an inflationary impulse does not yet constitute

inflation. After all, we did not define inflation as a single once-off rise in the price of goods, but as asustained spiral of price increases. Whether inflation ensues depends on the reaction to this initial

price rise by the other agents, starting with the demanders of the good whose price has increased.

After having paid a higher price for the good concerned, the demanders may decide to maintain

their real spending on other goods, which means that their nominal spending has to increase, thus

raising their financial needs. If these demanders, in their subsequent role of suppliers, decide to

obtain the necessary extra finance by raising the price of their own goods or services rather than

drawing on their monetary reserves or producing and selling more, price increases start to feed on

themselves – and that is when inflation sets in. Inflation proper thus refers to the spiral of second-,

third-, and umptieth-generation effects, which follow from the first-generation impulse.

The inflation process can be summed up as follows: When a market price increases, suppliers

raise their claims on real wealth at the expense of demanders (first-generation effect). If

demanders subsequently react to these losses, not by simply accepting them or by compensating

for them through increasing their real wealth creation (produce and sell more), but by playing the

same trick on other demanders when acting as supplier themselves, price increases feed on

themselves and total income claims keep on running ahead of total real wealth creation at existing

prices (second-, third-, umptieth-generation effect). In order to achieve ex post equality between

total income claims and real wealth creation, the nominal value of the latter is then inflated.



100

Traditional theory, like that of Mishkin (2009), explains inflation with the aid of aggregate demand

and supply curves, whereby the vertical axis measures the aggregate price level and the horizontal

axis measures income. An upward shift of the aggregate demand curve then depicts demand-pull

inflation and an upward shift in the aggregate supply curve reflects cost-push inflation. The

weakness of this portrayal is that the dynamic nature of the inflationary process becomes invisible.

No distinction is made between an inflationary impulse (a single momentary price rise) and inflation

proper (a dynamic process of sustained price rises feeding on themselves). Moreover, the

distinction between cost-push and demand-pull is relevant only for inflationary impulses (first-

generation effects), but no longer plays a role once such impulses have turned into an inflationary

spiral (further-generation effects). In other words: While the distinction between cost-push and

demand-pull may be useful in explaining a once-off increase in the aggregate price level, it is not

helpful in explaining a sustained increase in the aggregate price level whereby price increases feed

on themselves, which is what inflation is all about. Such inflationary spirals are driven by the desire

of agents to protect their real incomes by continually carrying forward their cost increases into

higher prices, which is a matter of cost-push only. Hence, while inflationary impulses can be a

matter of either cost-push or demand-pull, inflationary spirals are a matter of cost-push only .

3.3 Money and inflation

The monetary sphere plays a vital role in sustaining the inflationary process.

An inflationary impulse of the cost/profit push variety is initiated by suppliers. Once such an

impulse turns into an inflationary spiral, with demanders buying the good at the higher price and

making up for the loss by increasing their own prices when acting as suppliers themselves, there

are monetary implications, because demanders require extra finance to buy the same number of

goods at higher prices. For the same reason, an inflationary impulse of the demand-pull varietyrequires a prior increase in the financial resources of demanders.

To obtain the necessary extra money, agents can dishoard, that is, use previous saving (which has

a limit), sell real or financial assets (which does not help the economy as a whole), or borrow more

from the banking sector, which soon becomes the only option (recall how bank borrowing amounts

to money creation). That is essentially why the money stock needs to increase during an

inflationary process. The causal direction can go from P↑ to M↑, since P↑ raises the financial needs

of buyers (goods cost more) which inclines them to borrow more from the banking system, thus

causing M↑.

If the money stock does not increase (or does not increase sufficiently), a contraction in sales

volume is inevitable, demanders reacting to increased prices by reducing their real purchases,

which, if it goes on for too long, could lead to job losses. Prices can rise without an increase in the

money stock for a little while, but the economy will eventually and inevitably run out of finance to

buy up the same amount of goods. That is why central banks often allow the money stock to

increase in accordance with the inflation rate, although they are careful not to let the money stock

increase beyond the inflation rate and thus fan the inflationary flames by way of an additional

demand-pull impulse.



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The well-known dictum of Milton Friedman that inflation is always and everywhere a monetary

phenomenon is correct insofar as it points to the fact that persistent price increases require an

increase in the total money stock if the volume of transactions is not to shrink. However, it is

incorrect insofar as it suggests that inflation is always and everywhere a demand-pull phenomenon

facilitated by increases in the money stock ("too much money chasing too few goods"). Cost/profit

push factors also play a role as inflationary impulses, while inflationary spirals are propelled by

cost-push factors only – that is, by the desire to protect real wage rates and profit margins by

consistently carrying forward cost increases into higher prices.

3.4 Social conflict and inflation proneness

Social conflict and inflation proneness, by definition, presuppose imperfectly competitive markets.

In imperfectly competitive markets, market prices not only reflect relative scarcities as determined

by the market mechanism but also reflect the relative bargaining power of the market participants.

If markets were fully competitive and nobody could influence prices, market prices would reflect

relative scarcities only. Inflationary spirals, however, presuppose that suppliers (of goods or labour)are able to carry forward their cost increases into higher prices, which implies that they have the

bargaining power to do so. If suppliers would not be able to carry forward cost increases, then no

inflationary spiral could occur.

Asssume a rise in the price of a good. If demanders accept the loss due to a rise in the price of the

good, keep on buying the good and do not raise the price of the goods (including labour) they

supply themselves, then the initial inflationary impulse is stopped in its tracks and no inflationary

spiral is set in motion. At worst, there is only a slight once-off increase in the aggregate price level

because of the price rise of the good concerned. But even that is unlikely. In a dynamic economy

where tastes and technologies continually change, both price increases and decreases are likely tooccur. These price changes have a good chance of more or less cancelling out each other over a

period, so that the aggregate price level remains unchanged. However, when demanders do not

accept the loss due to a rise in the price of a good they wish to buy, but compensate for that loss

by raising the price of the goods (including labour) they supply themselves, an inflationary spiral is

set in motion. Inflation is thus essentially a symptom of conflict over income distribution, which is

not settled by relative price/wage movements. In light of this insight, we can determine what makes

an economy inflation prone. Three factors play a role here.

First, an economy is prone to inflationary spirals when it regularly faces sudden significant

increases in the price of goods or services which are an important input into the production processor of the cost of living. The point is that smaller increases in goods prices tend to be absorbed by

demanders, without them wishing to carry the resultant cost increases forward into higher

price/wage demands. After all, smaller price increases of some goods tend, over the long haul, to

be compensated for by smaller price decreases in other goods, so that no major shocks in the real

value of income need be experienced. But as soon as there is a sudden significant increase in the

price of a good which is a major determinant of the cost of production of producers or the cost of

living of consumers, the effects on real income can no longer be ignored. That is when producers

and consumers raise their price and wage demands to compensate for the loss in real income and

that is when inflationary spirals are set in motion. For example, a sudden, significant increase in

the wage rate or the oil price or a significant drop in the exchange rate, all of which substantially

affect the cost of production, will cause producers to make good these losses by passing them on

to buyers in the form of higher prices. And these higher prices will then give rise to cost of living



102

increases for consumers, who will in turn increase their wages demands to protect their real wage

rates. The conclusion is that the primary prices in an economy, such as the price of staple food

(maize or bread), the price of fuel, the wage rate and the exchange rate, need to display stability if

inflationary impulses are to be avoided.

Second, an economy is prone to inflationary spirals when its major sectors namely business,

government and labour, are all large and powerful enough to protect the real value of their income

by increasing their own prices when faced with cost increases. In other words, the inflation

proneness of an economy is affected by the competitiveness of both its goods and labour markets.

When business has the bargaining power to increase its prices without fear of losing sales volume,

unions have the bargaining power to secure higher wages without fear of compromising

employment levels, and government has the power to increase taxes without fear of incurring a tax

revolt, what incentive do they have to resist each other's price increases? The answer is: very little.

In these circumstances, they will be inclined to pass on cost increases rather than absorb them by

accepting lower real profit margins, wages rates and tax rates, which perpetuates the inflationary

spiral and prevents inflation from ever coming down. Only when firms are major exporters and in

danger of compromising their international competitiveness if they give in to overly high wagedemands at home, will there be an incentive to resist such demands.

Third, an economy is prone to inflationary spirals if the money stock is highly elastic , as it is under

a modern fiat money system. When the money stock is highly elastic, demand-pull impulses are

more easily facilitated by increases in credit demand and inflationary spirals are more easily

accommodated by similar increases in credit demand. When the money stock can increase

quickly, nominal income claims can quickly run ahead of real productive contributions, which is

what spells inflation. If the money supply were more inelastic, firms would be more hesitant to pass

on cost increases to their customers in the form of higher prices for fear of losing sales volume. As

we will see below, the precise aim of tight monetary policy as a counter-inflationary measure is tosimulate a more inelastic money system by restricting money creation through high interest rates.

When there is less money and the demand for goods is scarcer, firms are encouraged to absorb

more cost increases and accept lower profit margins.

Business, government and labour are the three main sectors of the economy that contribute to and

make claims on the social product. However, in a small open economy like South Africa the foreign

sector is also a vital claimant on the social product. An increase in the rand price of imported

goods (for an unchanged volume) raises foreign claims on the local social product . The rand price

of imported goods rises either when their dollar price increases or when the value of the rand

relative to the dollar falls (a weakening of the exchange rate), or a bit of both. We simply pay morerands for our imports, which affects our incomes. The effect on local incomes is all the more

dramatic in South Africa since on average about 25% (very rough figure) of the cost of production

of local manufacturing consists of the cost of imported inputs (mainly tools and machinery). By the

same token, when the rand strengthens (and volumes remain unchanged), the foreign sector

claims less of our social product.

Given that most import and export prices are determined in the international market and set in

dollar terms, a weakening of the exchange rate (a fall in the value of the rand) will cause a rise in

the rand price of both imported and exported goods. A strengthening of the rand will have the

opposite effect of lowering the rand price of both imports and exports. When the rand weakens, the

asymmetric situation arises in which South African importers lose money on higher import costs

but foreigners do not gain money in the process; after all, they receive the same amount of dollars



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they always had (assuming the $ price did not also change). Similarly, a weakening of the rand

causes South African exporters to increase their rand income without foreign buyers necessarily

experiencing a loss of income (again, they pay the same amount of dollars they always had,

assuming the price did not also change). A strengthening of the rand will have the opposite effect

of making South African buyers of imported goods richer in rand terms without making foreign

sellers of these goods poorer in dollar terms, and of making South African sellers of exported

goods poorer in rand terms without making foreign buyers of these goods richer in dollar terms.

Another incongruency is that, while domestic prices of imported goods tend to rise sharply when

the exchange rate falls, they are inclined to decrease much more slowly and hesitantly when the

exchange rate strengthens again, which is another indication of the strong competitive position of

firms. Businesses are quick to increase their prices when import costs have increased because of

a fall in the value of the rand, but they are much slower to reduce their prices when imports costs

have fallen owing to a strengthening of the rand, in which case firms would enjoy increases in their

profit margins. Bear in mind that, if profit margins are to remain the same, there should be price

decreases in absolute terms when the cost of imports falls, not only smaller and slower priceincreases.

The greater openness of the South African economy since our reintegration into the international

economy, and hence the greater extent to which prices of tradables are determined internationally

rather than on the local market, has had another significant effect on local inflation. It has caused

some prices of locally produced goods to have increasingly become dollar denominated . When

local producers are always able to export their products rather than sell them locally, local

consumers must compete with foreign consumers for locally produced goods. Hence when foreign

consumers are prepared to pay a certain dollar price for goods, local consumers must be prepared

to pay the same price (dollar parity pricing ). A fall in the value of the rand then means that thedollar price of the good translates into a higher rand price – something that obviously benefits local

producers at the expense of local consumers. However, when the rand strengthens, and the

international dollar price translates into a lower rand price, local consumers gain at the expense of

local producers. In other words, the principle can work both ways, provided that local producers do

actually drop their prices in absolute terms when the rand strengthens. Agriculture and steel

production are examples of sectors in which dollar parity pricing is now widely practised. Local

maize prices rose sharply during 2002 after the dramatic fall in the rand and fell just as sharply

when the rand strengthened in the next two years, in spite of the fact that the cost of maize

production did not change that much. Similarly, since Iscor has been sold to Mittal, local steel

prices have also become dollar parity prices – hence an increase in the international dollar price ora weakening of the rand raises the local rand price of steel. Hopefully (it must still show) the local

rand price of steel will come down again when the international dollar price falls or the rand

strengthens.

In conclusion, whenever the internationally determined $ price of an imported good with a

significant effect on the cost of local production, say oil, increases or whenever the value of the

rand falls, the foreign sector increases its claims on the real wealth produced in this country.

Having to pay more dollars for say oil and having to pay more rand for the dollars in which we need

to pay foreigners, South Africans have no choice but to give up some of their real income. This

necessary and unavoidable real income sacrifice could be extremely painful.



104

There are three ways in which South Africans can bear that pain – the noninflationary scenario, the

fully inflationary scenario and the partially inflationary scenario. In the noninflationary scenario,

local producers and retailers keep their rand prices unchanged – hence no inflation. The increased

cost due to the rise in the rand price of imports is entirely financed out of profits, which means that

the pain is entirely borne by local business (producers and retailers) in the form of lower profit

margins. In the fully inflationary scenario, local businesses carry their import cost increases forward

into higher prices in full, in order to maintain their real profit margins, and consumers subsequently

carry their living cost increases forward into higher wage demands in full in order to protect their

real wage rates, etc. An inflationary spiral is thus set in motion. The question then presents itself: if

both business and households (and government) have protected themselves against all pain, who

suffers the pain in this scenario? The answer is: everybody who holds ready money (in cash or in a

bank account), since inflation reduces the purchasing power of money. If people subsequently also

refuse to carry this purchasing power loss on their money holdings by further raising their prices

and wages to compensate for this loss, accelerated inflation sets in. In the partially inflationary

scenario, business, labour and government each absorb some of the pain by carrying forward only

part of their cost increases in higher prices/wages, thereby accepting some decrease in profit

margins and some compromise in real wages claims.

Given the presence of inflationary spirals, an anti-inflationary policy is to try to convince business,

labour and government to keep on absorbing some of their inflationary cost increases and

accepting some reduction in real profit margins, wage rates and tax rates, so that inflation can

gradually be squeezed out of the system. This is covered in the next section.

3.5 Combating inflation

First, it is important to note that because productivity increases can lead to lower unit costs of

production, these can lower inflation. These are called supply-side measures of combatinginflation. The better and increased use of technology is part of this strategy. Although this course

does not specifically deal with these in great detail, these measures remain important, irrespective

of other causes of inflation.

In the presence of inflationary spirals, a structural solution to inflation would entail a reduction in

the inflation proneness of an economy. This requires greater stability in the most important input

prices (especially the exchange rate, the wage rate and the oil price), more competition in goods

and labour markets, and a less elastic money supply. Major institutional changes are necessary to

bring this about.

But given the present institutional set-up, what can be done to get rid of inflation once the spiral

has already set in? In this situation, the monetary authorities can apply various counter-inflationary

measures.

However, before we discuss these, it is necessary to reiterate the bad news, namely that inflation

cannot come down unless real income sacrifices are made, although productivity gains (real

growth) will lessen the necessary sacrifice. If business, labour and government consistently carry

their cost increases forward into higher prices, wages and taxes, inflation cannot come down.

Inflation can only come down if the nominal profit rate, wage rate and taxes increase by less than

the inflation rate, that is, if real income sacrifices are made, although real growth in production

creates some space for nominal income growth without causing inflation. Of course, nobody likes

to make income sacrifices or limit their nominal income increases to the real growth in production,



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which is exactly why inflationary impulses tend to turn into inflationary spirals and why it is so

difficult to break these spirals in an effort to squeeze inflation out of the system.

The good news, however, is that a reduction in the inflation rate does not require a reduction in

prices in absolute terms (say from R7,50 per litre of milk to R6,80 per litre of milk). It suffices for

prices to rise more slowly (instead of rising from R6,80 to R7,50 last year, the price only rose from

R7,50 to R7,70 per litre of milk this year). Because, in the present social climate, it is impossible for

nominal wages to come down in absolute terms, the prices of local, labour-intensively produced

goods are unlikely to decrease in absolute terms as well.

However, the price of imported inputs, such as raw material and equipment, comes down in

absolute terms when the value of the rand increases (the exchange rate strengthens). That is why

it may still be possible for the price of locally produced goods to decrease in absolute terms when a

large part of the total cost of production consists of the cost of imported inputs. An absolute

reduction in the price of goods will obviously have a strong downward influence on the inflation

rate, which is why a strengthening of the value of the currency is such an effective and powerfulway of reducing inflation and why a weakening of the rand is such a strong inflationary impulse.

Unfortunately, this effectiveness works both ways.

The following counter-inflationary measures are possible:

3.5.1 Price controls

The first possible policy option is for the authorities to institute price controls, whereby they fix

prices by law. However, experience all over the world has shown that such a policy does not work

and has serious detrimental side effects. It leads to the development of black markets, reducessupply if the fixed price does not allow sufficient cost recovery (all the shops go empty, as

happened in Zimbabwe), stifles competition and cannot do anything about the prices of imported

goods. Moreover, its inflation-dampening effect tends to be short-lived, nullified by accelerated

inflation once the price controls are lifted again.

3.5.2 A voluntary social contract between business, labour and government

This counter-inflationary policy option is potentially highly effective. Business, labour and

government could sit around a table and work out a compromise on allowable price/wage/tax

increases, in an effort to equitably share the necessary sacrifices to squeeze out inflation, which ispartially how many European countries got rid of their inflation in the 1980s.

Such a strategy would, however, require a degree of willingness to sacrifice own interest for the

sake of the interest of the country as a whole, which may not be present in South Africa. The

antagonism and mutual distrust between business, labour and government are probably too strong

in South Africa for such a cooperation to materialise.



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3.5.3 Tight monetary policy: increasing the scarcity of demand

A third policy option is the one adopted by most central banks in their fight against inflation, and

probably the only feasible one for South Africa at present: tight monetary policy by way of high

interest rates.

As already mentioned, the only operational variable of monetary policy is the interest rate on bank

loans. By increasing that interest rate, the central bank seeks to raise the cost of bank credit, which

is meant to reduce the net demand for credit. This, in turn, dampens the total amount of money in

circulation, which is supposed to rein in total demand for goods.

Faced with this lower demand for goods and the resultant threat of not being able to sell their

goods at a higher price, businesses are then encouraged to absorb more of their cost increases

and accept lower profit margins. Generally speaking, a greater scarcity of demand increases

competition between businesses. Apart from encouraging firms to accept lower profit margins, this

greater competition also strengthens their resolve to withstand wage demands by labour. Byforcing business and labour to accept reduced real profit and wage rates, it is envisaged that

inflation can be gradually squeezed out of the system. It is thus incorrect to suggest, as is

sometimes done, that interest rate increases that work mainly on the demand side of the economy

cannot be effective in reducing an inflation caused by cost-push factors on the supply side.

For a number of reasons, however, tight monetary policy by way of high interest rates is far from

reliable.

First, increases in the cost of credit need not immediately lead to lower credit demand. A higher

interest rate dampens credit demand only with a long and variable lag – from six months to twoyears. In the interim, the total money stock and total demand for goods could hardly be restrained

at all. Nonetheless, there is also a direct effect of raised interest rates on people's disposable

incomes, even if it has not been effective in reining in the demand for credit and has not reduced

growth in the money stock. Increased interest rates raise the interest payments on a given amount

of debt, which leaves people with less money to buy goods.

Second, an increase in the interest rate not only works on the demand side by lowering demand for

goods, but also on the supply side by increasing cost. This cost can be especially significant for

small businesses which often have significant overdrafts. When these interest cost increases are

passed on to buyers, which is not unthinkable, a rise in the interest rate can also have aninflationary effect!

Third, the success of tight monetary policy in combating inflation requires the cooperation of

business and labour, which the central bank does not always enjoy. In South Africa in particular,

business has tended to increase its prices by more than what is justified in terms of their raised

cost and has not always lowered its prices when cost comes down again. Unions in South Africa

have also tended to claim wage increases exceeding the inflation target, and sometimes even

exceeding the current inflation rate. By resisting any real profit margin and real wage rate sacrifices

and, even worse, by seeking to gain from the general inflationary climate, business and labour are

effectively sabotaging the Reserve Bank's policies. Government itself, awkwardly enough, does not

always cooperate that well with its own counter-inflationary policies. In the past it has allowed

many administered prices (eg the price of electricity and telephone calls) and civil servant salaries



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to increase by more than the inflation target and even by more than the inflation rate. Government

seems to forget that if everybody keeps on increasing their prices along with the inflation rate, then

inflation will never come down. A reduction in the inflation rate can only materialise when people

accept that their incomes rise by less than the inflation rate, that is, when they make real income

sacrifices.

When business, labour and government do not cooperate by restraining their price, wage and tax

rate demands, a tight monetary policy could lead to a recession although productivity increases

can neutralise the inflationary effect of increased income demands, to some extent. The monetary

authorities will then be under pressure to let go of tight policy and allow interest rates to drop in

order to stimulate credit demand and total spending again. Of course, the interesting point is that

such a recession will then have been caused as much by the tight monetary policy as by the

refusal of business, labour and government to simultaneously restrain their price and wage

demands. Even so, in all likelihood, public opinion will put all the blame on tight monetary policy,

which will increase the pressure on central banks to relax their tight monetary policy. Alternatively,

they could maintain high interest rates and use fiscal stimulation to achieve the same end, whichhas the advantage of appearing not to give in to public pressure.

3.5.4 The role of the foreign sector again

When business, labour and government refuse to make real income sacrifices and insist on

increasing their income by at least as much as the inflation rate, the only remaining sector able to

make the necessary sacrifice for inflation reduction is the foreign sector. And this is precisely what

happened when the rand strengthened during the period between 2004 and 2007. The success in

bringing down inflation during that period can be attributed almost entirely to the reduced import

cost following the strengthening of the rand, rather than to restrictive demand management. As youknow, the foreign sector can make real income sacrifices in rand (which is what matters for local

inflation) without making any such sacrifices in dollars (assuming that import prices are dollar

determined, as they normally are), which is why an increase in the value of the currency is such a

painless and effective way of reducing inflation, apart from the fact that it reduces the rand income

of local exporters.

However, a weakening of the rand, coupled with an increase in the dollar price of imported goods

has the opposite effect of significantly increasing the foreign sector's claims on our social product.

Foreigners now demand significantly more of our wealth. If inflation is subsequently to be

contained, South Africans (business, labour and government) must collectively accept acommensurate reduction of their share in the wealth they create. South Africans will need to allow

their nominal incomes to increase by less than the inflation rate, although real growth in output

(normally between 2% to 5% annually) may somewhat temper this bad news. If the inflationary

effect of the increased rand price of imported goods is to be contained, and assuming low real

growth, South Africans must accept to be worse off in real terms, which may be difficult for middle-

class people but even harder for the poor.



108

On the other hand, a strengthening of the rand makes it possible for South Africans to achieve a

lower inflation rate without having to make real income sacrifices. The problem with strengthening

the rand as a counter-inflationary measure is, of course, that the exchange rate cannot be

permanently pushed upwards by the authorities. It cannot be controlled. The lowering of the

inflation rate due to a rise in the value of the rand must be regarded as a windfall gain just as a rise

in inflation due to falls in the value of the rand is a windfall loss.

If the rand does not strengthen, and in the absence of increases in productivity, then the only way

to bring down inflation is when South Africans as a nation (labour, business and government)

temper their nominal income claims in such a way that they accept lower real incomes. This

unpleasant fact seems insufficiently understood. Only by accepting the pain of real income

sacrifice can the inflation rate come done, even if real growth may somewhat reduce this sacrifice.

Since everybody (labour, business and government) seems intent on at least maintaining the real

value of their incomes, nobody seems to realise that they are actually preventing inflation from

coming down.

3.5.5 The self-reinforcing nature of lower inflation: the role of inflationary expectations

Trying to influence the public's inflationary expectations plays a significant role in any counter-

inflation policy , of which the inflation targeting framework adopted by the South African government

affords a clear example. Widely publicising an inflation target and emphasising the government's

resolve to reach that target is, to a significant degree, an exercise in persuasion. By these means

the authorities wish to convince the public to revise its inflationary expectations downwards, which

is essential because inflationary expectations are a main determinant of future inflation and thus

become self-fulfilling: people factor their inflationary expectations into their current income

demands, which is then exactly what makes these inflationary expectations come true in the future.

While wage demands by labour are predominantly retroactive, seeking to compensate the worker

for past purchasing power losses on income, pricing decisions by business are normally more

proactive, raising prices in anticipation of future cost increases. To the extent that the monetary

authorities manage to persuade business to revise their inflationary expectations downwards,

business will be inclined to raise its prices by less, which would, in turn, incline labour to temper

wage demands, thus reducing inflation. When inflationary expectations are subsequently revised

downwards, a downward inflationary spiral is set in motion. After all, just as rising inflationary

expectations set in motion an upward inflationary spiral, so too do falling inflationary expectations

set in motion a downward inflationary spiral. By creating a great deal of hype around inflationtargets and by suggesting (falsely) that the central bank has it within its power to reach that target

by sheer will power, it is hoped that people believe the target and revise their expectations

downwards in an effort to set the economy on to such a downward spiral, which is probably what

inflation targeting is mainly about.

In the current climate of rising inflation and pessimistic forecasts, the central bank's ability to

influence people's inflation expectations is severely tested.



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3.6 The costs of inflation

Inflation damages real productivity when it turns economic agents away from productive activity

and productive investment, which can happen for three reasons.

First, productive investment of money and effort is discouraged because inflation adds an extra

source of uncertainty to estimates of future profitability underlying investment decisions. Generally

speaking, it contributes towards a general climate of instability and pessimism which is always bad

for investment.

Second, inflation means that changes in nominal prices no longer reflect changes in relative prices,

which are the prices that agents need in order to make decisions about what to buy or sell.

Relative prices can be obtained by deducting the inflation rate from nominal price increases, which

is difficult precisely because the inflation rate is normally only known after the fact. Inflation thus

tends to distort relative prices, adding to an atmosphere of instability and pessimism whichdiscourages investment.

Third, inflation causes people to divert their effort and capital away from productive enterprise

towards nonproductive investment merely to protect the real value of their wealth, such as

collecting stamps or antiques.

Inflation also has adverse effects on income distribution, which is important in South Africa. There

are four main categories of people whose real income is negatively affected by inflation.

The first category are those who lack the bargaining power to increase their nominal incomes inaccordance with the inflation rate or, even worse, who are on contractually fixed incomes – the

unemployed, the ununionised, pensioners, and small business owners. Inflation therefore tends to

hit the weakest in society hardest, which is one of the reasons why governments and central banks

are keen to get rid of inflation.

The second category consists of those people who hold money because inflation reduces the

purchasing power of that money. This category includes all those with money in their purses or

their bank accounts, which is all of us. But again, it is the poorest in society who are worst hit by

this effect, because the greatest proportion of their wealth lies in the money they receive as weekly

or monthly wages. By contrast, a significant proportion of the wealth of richer people is in goodsand assets (homes, land, shares, etc), the nominal value of which normally keeps pace with

inflation. In that way, the wealth of richer people is better protected against inflation.

The third category consists of creditors – people who have lent money to others. Because inflation

means that the purchasing power of money steadily declines over time, creditors are repaid in

money units of lower purchasing power. This effect, however, happens only if interest rates are not

adjusted upwards to compensate for this loss, as they often are. Only when inflation causes a

decline in the real interest rate on debt (roughly determined as the nominal interest rate minus the

inflation rate) do creditors lose as a result of inflation or, for that matter, do debtors gain from

inflation. Because the Reserve Bank makes sure that it keeps the real interest rates at a

reasonable positive level, creditors do not suffer much loss because of inflation; nor do debtors

gain much from inflation.



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The fourth category of people includes all of us, to the extent that inflation causes us to fall into a

higher income tax bracket. South Africa, like most countries in the world, has a progressive income

tax system, meaning that on successive additions to income (called brackets) a higher percentage

of income tax is levied. Because inflation raises the nominal value of our income, it can force us

into higher tax brackets even while the real value of our income remains the same (this is known

as the "bracket creep"). As a result, people are required to pay more tax without necessarily

increasing the real value of their income, which causes a redistribution of income from the average

citizen to the government, unless the government adapts the tax brackets upwards in order to

compensate for this effect. In the past, the South African government has benefited considerably

from bracket creep, although it also regularly changes the brackets in an effort to compensate for

inflation.

An inflation rate higher than that of our main trading partners can also discourage foreign

investment , because the exchange rate will then fall steadily, which means that foreigners, after

having invested in South Africa, can only withdraw their money again at a lower pound, euro or

dollar exchange rate. The return on investment in rand must make up for this loss, which does notalways happen. The damage of inflation to foreign investment also has a purely psychological

element: a high inflation rate simply does not look good to foreign investors, especially in a global

environment that places a high premium on macroeconomic stability. However, one is not always

so sure about the contribution that foreign investment makes to our economy, especially because it

consists for over 90% of highly volatile short-term investments in securities markets, with very little

long-term FDI (foreign direct investment) taking place at all. In principle, foreign investment can

contribute to the overall productivity of the economy, which, by raising real growth, creates more

space for non-inflationary, nominal wage/profit/tax increases.

D Activities

1 Section C1 states that the cause of inflation can lie with the behaviour of any of business, labour

and government as the three main sectors of the economy that contribute to and make claims on

the social product. Assume there is an initial price shock - the price of energy increases. Use

tables A, B and C below to explain which actions (compile scenario's) of each of (a) business, (b)

labour and (c) government would cause a continuation of the inflation process; and which actions

of each would terminate the inflation process.

A Income and expenditure of the business sector

Item Base

value

Increase

in cost

Cost of intermediate goods (materials) and

services (which includes the cost of energy)

1 100 1200

Labour cost 400

Gross profit 500

Total inputs/output 2 000



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B Income and expenditure of the household sector

Item Base

value

Increase

in energy

costSalaries and wages 700

Income from property (dividends, profits etc.) 300

Total revenue/expenditure of households 1 000

Household expenditure 900 930

Household saving 100

C Income and expenditure of government

Item Base

value

Increase

in energycost

Taxes paid by households and business 460

Loans 40

Total revenue / expenditure of government 500 520

2 Hyperinflation in Zimbabwe during 2001- was caused by an excessive growth in the money supply

when government forced the central bank to continuously buy government securities. Government

deposits were continuously created and spent, which caused the money stock to increase

continuously.

Determine who carries the burden of government spending in this case.

Answers:

1a Business

Assume the income and expenditure of the business sector is as follows:

Item Base

value

Increase

in cost

A1 A2 A3

Cost of intermediate goods

(materials) and services (whichincludes the cost of energy)

1 100 1 200 1 200 1 200 1 200

Labour cost 400 400 400 400

Gross profit 500 500 400 450

Total inputs / output 2 000 2 100 2 000 2 050

The "Base value" column indicates the position before the price increase of energy, and the

"Increase in cost" the position after the price increase of energy. The increase in the cost of energy

increases the cost of intermediate inputs.

Business has the option of simply passing on the higher cost of energy. In this case scenario A1

could result, assuming that the volumes of inputs and output are not affected. Business couldincrease the price of its output by 5% (2 000 to 2 100) and the burden would be passed on to the

purchasers of the goods. This would sustain the inflation process.



112

Business also has the option of absorbing the higher cost of energy. In the case of scenario A2,

business absorbs the increase in the cost of energy by accepting lower profits and the price of

output is not affected. The burden is not passed on to other sectors and the inflation process is

terminated.

Business may also select scenario A3 whereby it partially carries the burden itself and partially

passes on the burden to its consumers.

If energy is fully imported, then the increase in the energy cost represents an increase in the claims

of the foreign sector on the domestic product. This burden must be carried by the domestic sector.

If nobody within the domestic sector carries this burden, then inflation would be sustained

indefinitely.

1b Households

Assume the income and expenditure of the household sector is as follows:

Item Base

value

After

increa

se inenerg

y cost

B1 B2

Salaries and wages 700 730 700

Income from property (dividends, profits etc.) 300 300 300

Total revenue/expenditure of households 1000 1 030 1 000

Household expenditure 900 930 930 930

Household saving 100 100 70

The "Base value" column indicates the position before the price increase of energy. The increase

in the cost of energy increases the cost of household expenditure.Households have the option of simply passing on the higher cost of energy. In the case of scenario

B1, households demand higher salaries and wages and the burden would be passed on to

employers. This would sustain the inflation process.

Households can also absorb the higher cost of energy. In the case of scenario B2, households

decrease their savings and because salaries and wages remain constant, the inflation process is

terminated.

1c Government

Assume the income and expenditure of government is as follows:

Item Base

value

After

increase

in energy

cost

C1 C2

Taxes paid by households and business 460 480 460

Loans 40 40 60

Total revenue/expenditure of overnment 500 520 520 520

The "Base value" column indicates the position before the price increase of energy. The increase

in the cost of energy increases the cost of government expenditure.



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Government has the option of simply passing on the higher cost of energy. In the case of option

C1, government raises higher taxes which would pass the burden on to the business and

households sectors. This would sustain the inflation process.

Government can also absorb the higher cost of energy. In the case of option C2, Government

increases its loans and because taxes remain constant, the inflation process is terminated. There

might, however, be an increase in the burden on the rest of the economy in the long term because

loans require future repayments which might necessitate higher taxes in future.

2 Hyperinflation in Zimbabwe was caused by an continuous growth in the money supply. Determine

who carries the burden of government spending.

Normally governments finance their expenditure through taxes. In this case, the burden of

government expenditure is borne by taxpayers, that is, by business and households.

In the case of Zimbabwe, the government itself is unlikely to carry much of a burden. Because

government sells securities, these must be repaid over a time period. However, because therepayment is in nominal terms, the ensuing high inflation rate drastically decreases the real value

of repayments which grossly reduces the burden on government.

Because the value of the currency is reduced each time new money is created, the burden is

carried by those who hold money, that is, by business and households.

E Exam questions

24.1 Provide a perspective on Friedman's proposition that inflation is always and everywhere a

monetary phenomenon. Firstly evaluate the empirical evidence in this regard (you may refer to the

experience of any country), then explain whether inflation is always and everywhere a demand-pullphenomenon. Lastly explain why money plays a vital role in sustaining the inflationary process.

(15)

24.2 Define inflation and explain how inflation is measured in South Africa. Refer to the CPI, PPI and

core inflation. (10)

24.3 Provide a definition of inflation. Specifically refer to the difference between an inflationary impulse

and an inflationary spiral initiated by an initial increase in the price of a good. (8)

24.4 Comment on the statement: "Inflation is essentially a symptom of conflict over income distribution,

which cannot be settled by relative price/wage movements". Then discuss three factors which

make an economy more inflation prone. (18)

24.5(a) Explain the importance of the foreign sector in the SA economy and explain the effect which

changes in the R/$ exchange rate have on the revenue earned by SA and the foreign sector

and the speed at which R-prices change in SA. (12)

(b) Also explain the effects of the increase in dollar parity pricing in SA and the real income

gains and sacrifices to be made in SA due to changes in the R/$ exchange rate. (8)

24.6 Briefly discuss solutions to inflation problem in South Africa.

(a) Explain the essence of any anti-inflationary policy and briefly discuss a structural solution to

inflation. (9)

(b) Explain the effect of a stronger and weaker exchange rate (R/$) on the domestic inflation

rate. (6)



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24.7 Briefly discuss the following counter-inflationary policy measures:

(a) Price controls (6)

(b) A voluntary social contract between business, labour and government (4)

(c) Tight monetary policy (8)

In each case, explain its meaning, whether it is likely to be successful, and if applicable, its

advantages and disadvantages.

24.8 Briefly explain how inflation was contained in SA during the 2004-2007 period, how this situation

was reversed in August 2008 and the implications of this for the SA economy. (7)

24.9 Explain the self-reinforcing nature of lower inflation, that is, the role of inflationary expectations.

(6)

24.10 Explain the costs of inflation, that is, on productivity, income distribution and foreign investment.

(18)



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Chapter 25: The role of expectations in Monetary Policy


To explain the role of monetary policy in time-inconsistency situations and benefits of a credible

nominal anchor.


Policy conduct: Rules or Discretion

Only section “Discretion and the Time-Inconsistency Problem”

The role of credibility and a nominal anchor

Only section “Benefits of a Credible Nominal Anchor”

Application: A tale of three oil price shocks (for information purpose)



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Chapter 26: Transmission mechanisms of monetary policy


To describe the transmission mechanisms of monetary policy, that is, the way in which the

instruments of monetary policy affect the economy.

Mishkin (2009) examines the problems of using empirical evidence to evaluate monetary policy.

Mishkin then applies this to evaluate the early Keynesian/monetarist debate that was about the

importance of monetary policy to economic fluctuations.

In South Africa we distinguish between three major channels of how monetary policy affects the

economy:

• Interest rate channel

• Prices of other financial assets (prices of foreign exchange and equity prices)

• Credit channel


The transmission mechanism of monetary policy explains how monetary policy works - which

variables respond to interest rate changes, when, why, how, how much and how predictably. It is

vital that central banks and their observers, worldwide, understand the transmission mechanism so

that they know what monetary policy can do and what it should do to stabilise inflation and output.

Source: Mahadeva, L & Sinclair, P (editors). 2002. Monetary transmission in diverse economies.

Cambridge University Press.


Transmission mechanisms of monetary policy

Traditional interest rate channels

Other asset price channels

Credit view

Why are credit channels likely to be important?

## Application: The great recession

Lessons for monetary policy: You can read this for information purposes.

## Application: Applying the Monetary Policy Lessons to Japan



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Additional materials (South Africa)

C2: Transmission mechanisms of Monetary Policy

C3: The transmission mechanism of monetary policy in South Africa20


1 Approach

The earlier approaches to the transmission mechanism of monetary policy were based on relatively

simplistic models which stressed the role of a single variable.

The earlier Keynesian models, as well as ISLM, focussed on the interest rate as the primary

mechanism to transmit monetary effects. The basic mechanism is embodied in the causality chain:

∆M→∆i→∆I→∆Y. According to this view the monetary sector impacts largely on the volume ofoutput (Y), and one can use the M instrument to affect changes in Y. It must be added, however,

that because of uncertainty in the two links in the causality chain: ∆M→∆i and ∆i→∆I→∆Y the

Keynesians preferred fiscal to monetary policy.

The early monetarist evidence on the importance of money focused on reduced form evidence on

the nature of ∆M→∆P. The monetarist prescription is: To fight inflation you must contain the growth

of M.

This structuralist approach of the monetary transmission mechanism focuses on the many

channels through which monetary policy operates. This approach has largely replaced the earlierapproaches which stressed the role of a single variable.

2 Transmission mechanisms of monetary policy

The transmission mechanism originally depicts the relationship between the change in the money

supply and the real sector of the economy. Developments in the structuralist approach have led to

a better understanding of the various channels or transmission mechanisms of monetary policy

which are likely to be important. Applied to South Africa, the treatment of these channels in Mishkin

(2012) involves three problems.

a The causal direction between M and i is reversed: M↑ does not cause i↓, but i↓ causes M↑ (wherethe effect on Md is more immediate than the effect on Ms). Monetary policy seeks to affect the

demand for credit and thus the money stock by changing the interest rate. The central bank cannot

control the money supply directly, but can control the interest rate directly, via which it seeks to

manipulate the money supply by influencing the demand for credit (i↓ → demand for bank credit↑ → deposits↑ and M↑).

b In Mishkin (2012), most of these channels ultimately appear to influence real income (Y) only. For

example, an expansionary monetary policy ultimately affects Y: i↓ → Y↑. This may create the

perception that monetary policy only impacts on real variables like real consumption and

employment. This is incorrect. The change in Y also impacts on the aggregate price level, and the

complete impact of a contractory monetary policy may be depicted as: i↓ → ↓∆Y → ↓∆YP (nominal

20 Based on Smal & De Jager (2001)



118

income) → ↓∆P. In the case of South Africa, the effect of monetary policy is directed to contain

inflation – that is, it ultimately affects the aggregate price level.

c The other asset price channel (through the exchange rate) has a direct impact on P. Mishkin

(2009) ignores this crucial effect on the aggregate price level.

In view of these difficulties, the relevant sections in Mishkin (2012) are not prescribed but are

replaced by the next section. In this section an adjustment is made in respect of (a) and (c) above,

and that effect (b) is implied and can be added to these channels (see diagram 26.1).

3 The transmission mechanism of monetary policy in South Africa21

When the SARB changes the repo rate, it sets in motion a chain of economic events. Economists

refer to this chain of developments as the "transmission mechanism of monetary policy". The main

links in the transmission mechanism of monetary policy, depicted in the flow chart in diagram 26.1,

can be briefly described as follows:

● The operational instrument of monetary policy is the repo rate. The repo rate has direct effects on

other variables in the economy, such as other interest rates, the exchange rate, money and credit,other asset prices and decisions on spending and investment. Hence changes in the repo rate

affect the demand for and supply of goods and services.

● The pressure of demand relative to the supply capacity of the economy is a key factor influencing

domestic inflationary pressures. Inflation is, among others, the result of pressures originating in the

labour market and/or the market for goods and services as well as of imported inflation, which is

influenced by exchange rate movements.

● If market interest rates, the exchange rate of the rand, credit or other asset prices do not respond

meaningfully to changes in the repo rate, monetary policy will have little effect on the economy –

that is, the channels will be blocked or not fully functional.

In South Africa, the repo rate affects the economy through a number of channels. Various channels

have been developed to better understand how monetary policy affects aggregate demand and

inflation. The complexity of these channels give rise to lags in the transmission mechanism, that is,

the time period between the policy action taking place and its ultimate effect on the economy. In

South Africa, these lags vary between 12 to 24 months. This section briefly describes some of the

channels of monetary influence.

21 Based on Smal & De Jager (2001)



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Diagram 26.1: Channels of influence emanating from the monetary transmission mechanism in

South Africa

Other interestrates

Nominalexchange rate

Relative pricesMoney and

credit

Other assetprices (equity,land, property)

Import pricesInflation

expectationsNet wealth

Expenditureand

investment

Imports andexports

Expenditureand

investmentWages

Expenditureand

investment

Demand and

supply ofgoods andservices

Demand and

supply ofgoods and

services

Inflation rate

Repo rate

Demand and supply of goods andservices

(1) The interest rate channel can be presented as follows:

↑repo rate → ↑interest rates → (↓Investment, ↓C) → ↓Ywhere Y is real income, C: real consumption and Inv: real fixed capital formation.

Changes in the repo rate initially influence the interest rates on retail financial products. Soon after

the repo rate is changed, domestic banks are inclined to adjust their lending rates, usually, but not

necessarily, by the same amount as the policy change. In South Africa, the Reserve Bank repo

rate, the prime overdraft rate of commercial banks and the interest rate on fixed deposits generally

move in tandem.

Firms and individuals respond to the change in interest rates by altering their investment and

spending patterns. As a result, consumer spending (C), fixed capital formation (Inv) and real output

(Y) start to respond. It is through this channel that demand pressures feed through changes in the

output gap to inflation.

(2) Other financial asset prices

Other relative asset prices can transmit monetary effects through the economy. There are two

other asset prices that act as channels for the transmission of monetary effects:

• prices of foreign exchange

• equities prices



120

(2.1) Prices of foreign exchange (in the current SA floating exchange rate regime)

The prices of foreign exchange act as a channel for the transmission of monetary effects. The

schematic illustration of the exchange rate channel is as follows:

↓repo rate → ↓interest rates → ↓ER → ↑NX → ↑Y

When South African real interest rates fall, deposits denominated in rand become less attractive

than deposits denominated in foreign currencies, and the rand depreciates. The lower value of the

rand (ER) makes foreign goods more expensive than domestic goods, causing a rise in net exports

(NX), and hence in aggregate output. In South Africa, there is a strong inverse relationship

between net exports (its share of GDP) and the real prime rate.

A further significant consequence of the depreciation of the rand (ER) is that it directly increases

the cost of imported goods and therefore leads to increases in the domestic aggregate price level,

and hence increases inflation.

↓ER → ↑Cost of imports → ↑P

(2.2) Equity prices

Combining higher equity prices with higher fixed capital formation leads to the following schematic

transmission of monetary policy:

↓repo rate → ↑equity prices → ↑Inv → ↑Y

Monetary policy can affect the economy through its effect on equity prices. As monetary policy is

relaxed, the public finds that it has more money to spend, and one potential place for spending this

money is the stock market. The higher demand for stocks leads to an increase in its prices.

Household wealth is another asset that operates as a channel for transmitting monetary effects.

Schematically, this transmission channel is as follows:

↓repo rate → ↑(prices on equity, property, land) → ↑C → ↑Y

For households, wealth is a vital component of their lifetime financial resources. Portfolios

consisting of common stocks and property form a major part of an individual's wealth. Monetary

policy has the ability to influence consumers' balance sheets (ie their wealth). Relaxing monetary

policy will result in an increase in equity and property prices, thereby increasing consumers'

financial resources and consequently raising their consumption. This can be a powerful channelthat adds substantially to the potency of monetary policy.



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(3) Credit

The monetary policy effect is represented as:

↓repo rate → ↑bank deposits → ↑bank loans → (↑Inv, ↑C) → ↑Y

This channel operates, firstly, through bank lending. Certain borrowers will not have access to

credit markets unless they borrow from banks. Expansionary monetary policy increases bank

reserves and bank deposits, thus increasing the amount of loans available. This increase in loans

will cause fixed capital formation and consumer spending to rise.

A significant implication is that monetary policy through this channel will have a greater effect on

those more reliant on bank loans, such as smaller firms, since larger firms have recourse to

obtaining funds by issuing new share capital. As circumstances and restrictive regulatory

frameworks change to allow banks greater ability to raise funds, the potency of this channel will be

reduced.

Secondly, credit affects the balance sheets of households and firms and also arises from

asymmetric information in credit markets.

↓repo rate → ↑price expectations → ↑cash flow → ↓adverse selection →

→ ↓moral hazard → ↑lending → (↑Inv, ↑C) → ↑Y

The higher net worth of firms and households leads to an increase in collateral available for loans

and the banks' potential losses from adverse selection decreases. This is coupled with the

improvement in the cash-flow situation of firms and individuals.

D Activity

1 The SARB decreases the repo rate which causes interest rates to decrease. This causes the rand

to depreciate and, in turn, leads to an increase in net exports and an increase in Y. It also leads to

increases in the domestic aggregate price level. Explain in detail why these effects occur. Use a

Rand/$ exchange rate (R8/$ and R10/$) in your explanations.

Answer:

1 The exchange rate channel is as follows:↓repo rate → ↓interest rates → ↓ER → ↑NX → ↑Y

Changes in the repo rate causes most other interest rates to follow in the same direction because

this is the way in which banks behave. The fall in interest rates also reduces an inflow of capital

into South Africa simply because it increases the prices of domestic stocks and securities –

lowering their future return. This causes the rand exchange rate to fall, say from R8/$ to R10/$.

The rand depreciates – its value is less - because it now requires more rand to purchase one $.

Foreign goods are now relatively more expensive in SA than domestic goods and SA imports will

decrease. At the same time, SA export goods – assuming their rand cost within SA remains the

same - are now less expensive to foreigners – it costs them less $. Thus net exports (NX=X-M)

increase. The increase in exports leads to an increase in aggregate output (Y).

The impact on inflation is provided by:

↓ER → ↑Cost of imports → ↑P



122

The depreciation of the rand (ER) increases the rand cost of imported goods which leads to

increases in the domestic aggregate price level (P). This effect may be significant because about

¼ of SA's domestic product is exported in exchange for import goods.

E Exam questions

26.1 Explain the meaning of the transmission mechanism of monetary policy in South Africa in general,

describe its main links, explain how it influences domestic inflation and why monetary policy is

subject to lags. (12)

26.2 Explain how the interest rate channel of monetary policy operates. (6)

26.3 Explain how the other financial asset prices channel of monetary policy operates. (9)

26.4 Explain how the credit channel of monetary policy operates. (9)



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