THE ROLE OF MONEY

After studying this chapter, you should be

able to:
• explain the origin and functions of money
• discuss the requirements of money
• discuss the instruments of monetary policy
• discuss the transmission mechanism
• discuss the various financial intermediaries
active in the South African economy
 The Evolution of Money

The idea or concept of money has been around for a

long time.

 many things have been used as "money". From eggs,

to feathers, ivory, jade, kettles, leather, mats, nails, oxen,
pigs, quartz, tea, spices, rice, thimbles, and many more,
to dollars and coins.

The thing of value that is traded can also be a service.

 Evolution of Money

Barter trade
Commodity money
Paper money
E-Money
 BARTER TRADE
 Barter Economy-moneyless economy that relies
on trade or barter
With barter, an individual possessing a material
object of value, such as a measure of grain, could
directly exchange that object for another object
perceived to have equivalent value, such as a small
animal, a clay pot or a tool.
 The capacity to carry out transactions is severely
limited since it depends on a coincidence of wants.
 Barter Trade
 Problems-
products some people offer are not always acceptable or easy
to divide for payment
 In a barter economy, transaction costs are high because people
have to satisfy a “double coincidence of wants”
 It is very difficult to find another individual who has what
you want, and wants what you have.
 There is no common medium of exchange into which both
seller and buyer could convert their tradable commodities.
 There is no standard which could be applied to measure the
relative value of various goods and services.
 Benefits-
“mutual coincidence of wants” when two people
want exactly what the other has and are willing to
trade what they have for it
 COMMODITY MONEY
Commodity money is money whose value comes
from a commodity out of which it is made.
 It is objects that have value in themselves as well
as for use as money.
 money that has an alternative use as an
economic good, or commodity

Examples of commodities that have been used as

mediums of exchange
Examples of commodities that have been used
as mediums of exchange
gold
silver
copper
peppercorns,
large stones (such as Rai stones),
decorated belts,
shells,
alcohol,
cigarettes,
cannabis,
candy, barley etc.
 Paper Currency

Paper currency refers to pieces of paper that function as

a medium of exchange.
 Originally, paper currency carried a guarantee that it
was convertible into a fixed quantity of precious
metal.
 PAPER CURRENCY
When the public deposited gold with gold smiths, for
security reasons the gold smith issued receipts to the
depositors which were to be handed over when they
demanded their gold.

These receipts became a means of exchange as trust

in them grew.

They began to be circulated as money because of the

knowledge that they were backed up by gold.
 E- Money
All types of money which people deal with it
electronically, far from traditional ways of payment
like banks, cheques, paper money and coins.

e-Money allow users through internet or wireless

devices to pay the charges of their purchases directly
from their bank accounts electronically in ways such
as Smart cards, Digital wallets and micropayments.
 What is Money?
Money is any object or record that is generally accepted
as payment for goods and services and repayment of
debts in a given country.
 In other words money is any commodity or token that
is generally acceptable as means of payment
NB:Money should not be confused with income or
wealth.
Distinction between money and income:
- Money is a stock concept
- Income a flow concept
 Functions of Money

 Medium of exchange
 Standard of value/unit of account
 Store of value
 Standard of deferred payment
 Functions of Money

• Medium of Exchange- any object that is generally

accepted in exchange for goods and services.
• Money facilitates the exchange of goods and services.
• It eliminates the need for ‘double coincidence of
wants’ in barter trade.
• It also reduces transactions costs.
• The person who owned a cow can now simply sell it to
the person who offers the most money for it and then
buy the bullock cart from another person who offers
him the best bargain.
 Medium of exchange
• Money can be used for buying and selling goods
and services. If there were no money, goods would
have to be exchanged through the process of barter
(goods would be traded for other goods in
transactions arranged on the basis of mutual need).
For example: If I raise chickens and want to buy
cows, I would have to find a person who is willing
to sell his cows for my chickens. Such arrangements
are often difficult. But Money eliminates the need
of the double coincidence of wants.
 Money as a Unit of Account
• A function of money that allows it to serve as a common
way to express value ex. Price Tags
• A unit of account is a way of placing a specific value on
economic goods and services.
• As a unit of account the monetary unit is used to
measure the value of goods and services relative to
other goods and services.
• The unit of money becomes the measuring stick of
value, or what economists call the standard of value.
With a standard of value, computing the costs and
benefits of various options, that is, making choices,
becomes easier.
 Unit of Account
• An effective unit of account is to be:
• Divisible into small units without destroying its value; precious
metals can be coined from bars, or melted down into bars
again.
• Fungible: that is, one unit or piece must be exactly equivalent
to another, which is why diamonds, works of art or real estate
are not suitable as money.
• A specific weight, or measure, or size to be verifiably
countable. For instance, coins are often made with ridges
around the edges, so that any removal of material from the
coin (lowering its commodity value) will be easy to detect
 Store of Value
• To act as a store of value, a commodity, a form of
money, or financial capital must be able to be
reliably saved, stored, and retrieved - and be
predictably useful when it is so retrieved
• Put differently, money is a store of value in the
sense that it can be held and exchanged later for
goods and services. If it could not store value, it
could not serve as a means of payment
• Money can be a useful means of holding wealth
 Store of Value
• Money is not the only means of holding
wealth -Land, stocks and bonds, old
paintings, factories, and jewellery, house, car
are just some of the other ways people can
hold wealth.
– These alternatives have advantages over money-
they often pay higher interest rate, experience
price appreciation and deliver services
Uniqueness of money as store of value
• What makes money unique as a store of
value?
– attribute of liquidity: money alone has the unique
characteristic that it is a medium of exchange. It
does not have to be converted into anything else
to make purchases.
• How good is money as a store of value?
– Depends on the price level. In a hyperinflation, the
value of money is destroyed.
 Store of value
• Holding money as a store of value may involve
some cost-opportunity cost of holding money
is the interest income foregone.
 Money in South Africa
Other definitions of money
• So far we have defined money by what it
does
Definitions in practice
 It is easy to define but difficult to measure.
 SARB uses three measures of the quantity
of money. Labelled as M1, M2 and M3
 Other definitions of money (Cont…)
• M1: This is the narrowest measure of money,
and consists of all cash as well as demand
deposits with monetary institutions.
• it includes coins and notes (in circulation
outside the monetary sector) as well as
demand deposits of the domestic private sector
with monetary institutions
• component of the money supply relating to
money’s role as a medium of exchange
 Other definitions of money (Cont…)
• M2: This consists of M1 plus other short and medium term
deposits of the domestic private sector with the monetary
institutions.
• component of the money supply relating to money’s role as
a store of value
• Medium and short term deposits includes all deposits
invested for a certain period (less than 30 days for short
tesm and less than 6mnths for medium term deposits)
– Savings (savings deposit & money market deposit
account)
– Small time deposits (6 mo. CD)
– Money market funds (mutual fund)
 Other definitions of money (Cont…)
• M3: This consists of M2 plus long term
deposits of the domestic private sector with
monetary institutions.
• The most comprehensive measure of money
• The maturity of long term deposits is 6 mnths
and above
• It is regarded as the most reliable measure of
money supply
END OF LESSON 1
 Money creation
• Simplest way is to print more notes
and mint more coins – this will fuel
inflation
• Individual banks are not allowed to print their
own money. But, banks may create money by
creating checkable deposits, which are a part of
the money supply.
• More common is money creation by
commercial banks through granting of
overdrafts or loans to clients
Money and banking 28
 Money creation
• To understand the process of money creation today, let us
create a hypothetical system of banks. We assume 3 banks in
this system: Standard Bank, FNB Bank, and NedBank. Assume
that all banks are required to hold reserves equal to 10% of
their checkable deposits.
• The quantity of reserves banks are required to hold is called
required reserves.
• The reserve requirement is expressed as a required reserve
ratio; it specifies the ratio of reserves to checkable deposits a
bank must maintain.
• Banks may hold reserves in excess of the required level; such
reserves are called excess reserves. Excess reserves plus
required reserves equal total reserves.
 Money Creation
• Because banks earn relatively little interest on
their reserves held on deposit with the Central
Bank, we shall assume that they seek to hold
no excess reserves.
• We shall ignore assets other than reserves and
loans and deposits other than checkable
deposits.
 Money creation (eg)
• Suppose Noku deposit a R1000 in Standard
Bank. Standard bank sets aside a portion of that
R1000 that is required reserves say 10%.
• The remaining 90%, R900 becomes excess
reserves. Standard Bank can lend that R900 to
Sizo, who deposits into her account in FNB Bank.
At this step, the original R1000 remains in the
system, and we can now add Customer Sizo’s
R900. FNB sets aside 10%, and lends out the
rest. This process continues until no new excess
reserves can be created.
 Money creation (eg)
• Actual and Required Reserves
• Reserve Bank requires a bank to hold certain reserves (with the SARB)
• Banks could hold additional (excess) reserves
• Money creation:
• Assume:
• Fixed reserve ratio
• The process:
• Assume cash reserve requirement of 25%
• Assume a new deposit of R100 at Bank A
• Bank A hold R25 in reserve, and lends R 75 to Jacqui for home
improvements
• Jacqui pays her contractor who deposits R75 at Bank B
• Bank B keeps R18,75 in reserve, and lends R56,25 to Jacques for
a car
• Jacques pays the car dealer, who deposits R56,25 at Bank C,
• ETC.
 Money Creation.
• How much money can such a new deposit
create?
• Value of the new deposit x 1/reserve ratio
• In the example:
• R100 x 1/0.25
• = R400
• Therefore:
• ΔD=D x 1/b, where D=deposit money,
and b is the reserve ratio.
• Called the credit multiplier
• Effect of:
• Excess reserves
• Cash drains
 FINANCIAL INTERMEDIARIES
• Financial intermediaries are institutions that borrow
funds from people who have saved and make loans to
other people.
• They engage in process of indirect finance.
• At any particular time there are units (eg Households
and Firms which saved some of their income) that
have surplus funds and other units (eg Government,
firms and households) who are in search of funds.
• They can engage in either direct or indirect financing
 Direct and indirect finance
• Direct finance:
– through trading securities (financial instruments)
in financial markets.
– Whereby surplus units and deficit units can
contact each other directly
• Indirect finance:
– transfer funds via financial intermediaries.
– involves financial asset transformation

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 Financial Intermediaries
Indirect finance

Money Financial Intermediaries Money

(e.g. bank)
Financial Security Financial Security
Savers Borrower
Or Or
Surplus Financial Security (e.g. bond, stock) Deficit
units units

Money

Direct finance

36
 The South African Reserve Bank

• The Reserve bank is the most important financial

institution in any monetary economy
• FUNCTIONS OF THE SARB
• Formulation and implementation of monetary policy
 Repo rate system- main instrument through which
monetary policy is conducted in SA
 Other instruments includes open market operations
(OMO)
• Service to the government
– Banker and advisor
– Custodian of gold and foreign exchange
reserves
 The South African Reserve Bank

• Provision of economic and statistical

services
• Maintaining financial stability
– Bank supervision
– The National Payment
System
– Banker to other banks
– Banknotes and coins
END OF LESSON