LEARNING UNIT 2

THE MONETARY SECTOR

1. FUNCTIONS OF MONEY
 Medium of Exchange
- A barter economy functions without money as goods are exchanged for other goods.
- A barter economy is inefficient as it requires a double coincidence of wants between parties and many unnecessary
exchange transactions may be needed
- Money serves as an intermediary to smooth exchange process and make it more efficient, ie. money functions as a
Medium of exchange.
- This function is unique to money
 Define money
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 Unit of Account
- Prices of g and s are expressed in monetary terms
- It is a common measure of cost that enables us to determine what we can afford
- It also measures total value of all g and s produced in the economy
- Other commodities can serve as a unit of account
 Why does money lose some of its usefulness as a unit of account during inflation?
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 Store of Value
- Wealth can be held in many forms, including money
- Money can always be exchanged for other goods and services at a later date
- Money is convenient and can be used immediately in exchange, ie. money is the most liquid form in which wealth can
be kept
- Money is not a good store of value during times of high inflation as it loses its purchasing value.
- Money also serves as a standard or deferred payment as it is a measure of value for future payments
- Money is also the means whereby credit is granted

 What Money is Not

- Money is not income or wealth
 Define income.
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 Define wealth and give some examples.
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2. DIFFERENT KINDS OF MONEY
- In the past commodities served as money, such as ___________________________________________________
- The intrinsic value of the commodity was equal to its exchange value
 List the properties of commodities required for suitability as money.
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- Coins were then used as money but became inconvenient for larger transactions
- Paper money was then used to make payments and was initially fully backed by a commodity eg gold or silver
- The replacement of paper money was the next step in the evolution of money
- This was a fractional reserve system as the notes were only partially covered by a commodity
- Fiduciary or credit money means that the total value of the paper money in issue is greater than the value of gold backing
it
- The value of modern bank notes is based only on confidence in government/monetary authorities maintaining their
purchasing power by controlling supply of notes as well as by declaring notes and coins as legal tender by law (cannot be
refused if tendered as payment)
- Nowadays _________________________ are the largest part of the money stock
 Explain why cheques, EFTs, debit cards as well as credit cards are not regarded as money.

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3. MONEY IN SOUTH AFRICA

- The SARB uses 3 different measures of the quantity of money
 M1
- Relates only to money’s function as a _______________________________________
- Includes notes and coins (in circulation outside the monetary sector) as well as all demand deposits (including
Cheques and transmission deposits) of the domestic private sector with monetary institutions
- The monetary sector includes the SARB, the Corporation for Public Deposits, the Land Bank, Postbank, private
banks and mutual building societies
- M=C +D
where M = quantity of money
C = cash (notes and coins)
D = demand deposits (deposits that can be withdrawn immediately by way of a cheque or EFT)
- D is the largest component of M1 (more than 90%)

 M2
- Consists of M1 + _________________________________________________________________________
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 Explain what is meant by short-term and medium-term deposits.
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- Known as quasi / near money since maturity is short

 M3
- Consists of M2 + __________________________________________________________________________
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- Relates more to money’s function as a ____________________________
- Most reliable indicator of developments in monetary sector

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4. THE SOUTH AFRICAN RESERVE BANK
- The main monetary authority in SA, ie. the central bank
- Has 4 main functions:

 Formulation and implementation of monetary policy

- The repo rate tender system is the main instrument through which monetary policy is conducted
- Uses it to meet daily liquidity needs of banks
- As it influences interest rates, the Bank has to force banks to borrow substantial amounts from it
- Open market operations are used to drain excess liquidity from money market and ensure that there is always a
liquidity shortage

 Service to the government

o Banker and advisor
- Main banker for govt but nowadays govt has tax and loan accounts with private banks
 Name the banking services that the SARB provides to govt.
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o Custodian of gold and foreign exchange reserves
- Keeps all gold and foreign exchange reserves of the country
- Level of reserves is an important indicator of state of economy and prospects for future growth
- Also formulates exchange rate policy
o Administration of exchange control
- Restricts movement of foreign exchange so as to protect economy from disruptive flows of capital and
international economic shocks

 Provision of economic and statistical services

- Makes statistics and information available for use by policymakers, analysts and researchers

 Maintaining financial stability

- Main objective, especially price stability
o Bank supervision
- Regulates and supervises banks to ensure a sound, efficient banking system
- Issues bank licences and monitors banking activities
o The National Payment System
- Purpose is to reduce interbank settlement risk and thereby reduce possibility of a systemic risk crisis
originating from settlement default by one or more settlement banks
o Banker to other banks
- Custodian of minimum cash reserves that banks are legally required to hold
- SARB controls the level and composition of minimum cash reserves since they partly affect the quantity of
money and banks use them to clear their mutual claims and obligations to one another
- May provide liquidity to banks experiencing liquidity problems (known as lender of last resort)
o Banknotes and coins
- Has sole right to make, issue and destroy notes and coins
- When the Bank buys financial assets cash comes into general circulation

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5. SUPPLY OF MONEY
- The quantity of money is a stock as it can only be measured at a point in time
- Banks accept deposits and lend funds to borrowers in the form of overdrafts
- Loans are assets for banks whereas deposits are liabilities
- Money is mainly created by banks
- They create money by creating deposits by making loans
 Describe the 2 ways in which demand deposits can be created.
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- Money creation is limited by the public’s demand for loans, credit worthiness of prospective borrowers and actions of
central bank
- The interest rate is one of the main factors that determines the quantity of loans demanded
- In order to grow the economy needs a growing money stock but money growth should not be excessive since it can cause
inflation
- The central bank therefore regulates the money creation process
- SARB uses interest rate to affect the demand for loans to influence the rate of growth of money creation
- The stock of money (money supply) is determined by the interaction of the demand for money and the interest rate which
is mainly determined by the central bank (through monetary policy) ie. there is no independent money supply curve
 Draw a diagram to illustrate the determination of the quantity of money.

- At io the quantity of money = M0

- A ↓ in the repo rate → a ↓in i from i0 to i1 → an ↑in quantity of money from M0 to M1, ceteris paribus
- The money stock is demand-determined, ie. it is endogenous money?!?!

6. DEMAND FOR MONEY

- Wealth can be held in various forms (people have a wealth portfolio)
- Wealth can include real assets, such as fixed property, oriental carpets, paintings, rare postage stamps, antiques
and financial assets
- Financial assets consist of money and interest-bearing assets referred to as bonds
- People must decide how to allocate their wealth between money and bonds
- The demand for money is the amount of money that participants plan to hold in the form of money balances, not the
amount of money that they want
- No interest is earned on cash and the interest on demand deposits is very low
- Interest paid on bonds is much higher therefore there is a cost to holding money
- The opportunity cost of holding money balances is the interest that could have been earned had the money been used to
purchase bonds instead
- Money will only be held if it provides a service that is valued at least as highly as the opportunity cost of holding it, ie.
demand for money is directly related to the functions that it performs

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- There are 2 components of the demand for money which relate to the 2 motives for holding money:
 Transactions motive → transactions demand for money which arises from the medium of exchange function
 Speculative motive → demand for money as an asset which arises from the store of value function

KEYNESIAN LIQUIDITY PREFERENCE THEORY

 Transactions Motive
- Relates to medium of exchange function of money
- Need to hold money to enter into transactions as payments and receipts of money do not coincide
- Amount of money required for transactions purposes depends mainly on the total value of the transactions
concerned, which depends on the level of income
ie. transactions demand for money is a function of total or national income
- It is drawn as a vertical line since it is independent of the interest rate
- It is drawn for a given level of income
- The demand for transactions balances determines the height of the curve
- There is a direct relationship between the demand for transactions balances and the level of income
o An ↑ in Y → increase in the demand for transactions balances
The curve will shift to the right
o A ↓ in Y → decrease in demand for transactions balances
The curve will shift to the left
 Draw a diagram illustrating the transactions demand for money.

 Speculative Motive
- Relates to the store of value function of money
- Wealth holders must decide whether to hold financial assets in the form of money or bonds
- Choice depends on the interest rate
- The opportunity cost of holding money is the interest that is foregone by not holding bonds
- There is an inverse relationship between the quantity of money demanded for speculative purposes and the level
of the interest rate:
o An ↑ in i → decrease in the quantity of money demanded for speculative purposes
There is a upward movement along the curve
o A ↓ in i → increase in the quantity of money demanded for speculative purposes
There is a downward movement along the curve
- The demand for speculative balances curve is downward sloping

 Draw a diagram illustrating the speculative demand for money.

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- At a certain interest rate level (i1) the quantity of money demanded for speculative purposes is zero as the interest
rate is so high that people only hold bonds as part of their wealth
- The transactions demand for money is known as the demand for active balances since the purpose is to actively
use it by spending it
- The speculative demand for money is known as the demand for passive balances (idle balances) since the purpose
is to hold it passively as a store of value
- The total demand for money consists of the demand for active balances plus the demand for passive balances and
is a function of the income level and the interest rate level
 Write down the equation for the demand for money.
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- The total money demand curve is obtained by horizontally adding the 2 individual demand curves
 Draw the liquidity preference curve (LL).

- LL is downward sloping and its slope is determined by the interest rate

- The position of LL depends on the income level
- Shifts of LL are caused by changes in income level
- Movements along LL are caused by changes in interest rate

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7. EQUILIBRIUM IN THE MONEY MARKET
- As there is no independent money supply curve, the interaction of the demand for money and the interest rate level
determines the supply of money

 Draw a diagram illustrating equilibrium in the money market if there is a demand-determined money supply.

- Equilibrium will change if there is a change in either the interest rate or the level of national income

8. RELATIONSHIP BETWEEN INTEREST RATES AND BOND PRICES

- Bonds pay the holder a fixed amount of interest every year = coupon payment = fixed percentage of value
- Bonds can be traded in the bond market and this causes bond prices to change
- The yield / interest rate on the bond is the annual interest payment as a % of its current value
Current Value Interest Payment Interest Rate
R2 000 R100 5%
R1 000 R100 10%
R800 R100 12.5%
R500 R100 20%
- There is an inverse relationship between prices of bonds and the interest rate:
 the higher the interest rate, the lower the price of the bond
 the lower the interest rate, the higher the price of the bond

9. MONETARY POLICY
- Formulated and implemented by the SARB
- The Monetary Policy Committee (MPC) takes decisions on the appropriate monetary policy stance
 Define monetary policy.
• the measures taken by the monetary authorities to influence the quantity of money or the rate of interest with a view to
achieving stable prices, full employment and economic growth

- Inflation targeting is the current monetary policy framework

- The inflation target is between 3% and 6%
- The 4 main features of the monetary policy framework are:
 the ultimate objective is balanced and sustainable economic growth
 the intermediate objective is a pre-announced inflation target
 the operational variable is short term interest rates, which are governed by changes in the repo rate
 the monetary control system is a classical cash reserve system

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  Instruments of Monetary Policy
- Market-oriented instruments are mainly used
o Accommodation Policy
- options available to banks experiencing a shortage of cash reserves are:
change other financial assets into cash
borrow funds on the interbank market
obtain funds from SARB via the repo system
- when banks apply for refinancing from SARB they tender for funds at weekly auctions of repos with 7-day
maturities
 Name the assets that are eligible for use in repos.
Government bonds, Treasury bills, land bank bills and reserve bank debentures of all maturities.
- The interest (repo) rate that banks have to pay for required reserves is fixed by the SARB
- Accommodation policy consists mainly of changes in the repo rate and other conditions on which cash is
made available to banks.
- The SARB uses it to regulate the quantity of money by cost of credit
 Explain how the monetary transmission mechanism works.
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o Open-market Policy
- Open-market transactions influence cash reserves of banks and consist of the sale or purchase of domestic
financial assets by the central bank to exert a specific influence on interest rates and the quantity of money,
via their effect on cash reserves of banks
- Open market transactions are used to make accommodation policy effective, ie. to ensure that banks always
experience a liquidity shortage
 The sale of government bonds will increase the money market shortage as it reduces cash reserves of banks
and forces them to make use of central bank financing facilities through repos
- Banks can create demand deposits and the money stock will increase
- To encourage investors to buy bonds, the central bank offers them at lower prices
- Falling bond prices → an increase in interest rates
- This is known as restrictive monetary policy
 When the central bank buys government bonds the cash reserves of banks increase and the money market
shortage decreases
- Banks can create ______________ deposits and the money stock will _____________
- Central bank will offer higher prices to encourage bondholders to sell their bonds
- Rising bond prices → a decrease in interest rates
- This is known as expansionary monetary policy or quantitative easing
o Other instruments
- Non-market-oriented measures such as credit ceilings and deposit rate control
- Changes in exchange control regulations
- Intervention in foreign exchange markets
- Public debt management

Mohr, P & Associates. 2014. Economics for South African Students. 5th ed. Pretoria: Van Schaik Publishers, pp 255 - 273
Mohr, P & Associates. 2020. Economics for South African Students. 6th ed. Pretoria: Van Schaik Publishers, pp 281 - 298

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