ECS 1601

Study Unit 2
The Monetary Sector
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 Content
In this study unit you will learn more about:
– The functions of money
– Different kinds of money
– Money in South Africa
– Financial intermediaries
– The South African Reserve Bank (SARB)
– The demand for money
– The stock of money and how money is created
– Instruments of monetary policy
Read section 2.1

2.1 Functions of money

in textbook pp.
22-25

• Alternative to an economy with money is a barter

system where people would exchange goods for other
goods. For example, you can exchange apples for milk.
• For example if David has a lot of apples from the tree
in his garden, but he needs milk, he can trade his
apples for milk.
• The problem is that he needs to find someone that has
a lot of milk and NEEDS or WANTS apples.
– This is called double coincidence of wants
 2.1 Continued
Due to the inefficiency and high transaction costs of a barter
system, people started to use different forms of money.
Money is anything that is generally accepted as payment for
goods and services or that is accepted in settlement of debt.
Money is:
… a unit of account Watch 1601 DVD, for more
on money as unit of account
… a store of value and store of value. And
discuss with your e-tutor
… not income or wealth
Read section 2.2 pp

2.2 Different kinds of money

25-26, Box 2-1 and
Box 2-2 in textbook

• Various things have been used as money in the past: cattle,

seashells and even cigarettes.
• Not all forms of money were practical, it was difficult to carry
cattle around and it could not be split into a thousand pieces
(money should be divisible). Seashells differ from one
another (money should be uniform). Cigarettes could break
or even be smoked (money should be durable).
• Eventually people started using metals
such as copper, iron, silver and gold coins.
• Coins are heavy and due to large
transactions paper money were
introduced.
Study box 2-1 on
p 26
Box 2-1: .
• A cheque is not money; a cheque simply transfers
a demand deposit from one person to another.
• A Debit card also simply transfers a demand
deposit from one person to another.
• A Credit card is a fast way to acquire a small loan
from the bank, in order to make a purchase. But
you have to pay the bank back later.
– With a credit card you do not pay immediately, the
bank does, but you will have to repay the bank,
eventually. You are postponing the payment.
Read section 2.3
in textbook pp Watch 1601

2.3 Money in South Africa

27-28 DVD, for more
on M1, M2 and
M3.

To measure money, three groups are used:

M1 – The conventional measure
Coins and notes that is used by the public PLUS demand
deposits (cheque and transmission deposits). M= C+ D
M2 – A broader definition of money
M1 PLUS short- and medium-term deposits
M3 – The most comprehensive measure of money
M2 PLUS all long-term deposits
Puts emphasis on ‘store of value’ function of money
Read section 2.4
pp 28-30 and Box
2-3 in textbook
2.4 Financial intermediaries
• An economy has a real and financial sector with
real and financial transactions.
• A financial transaction is when no goods or
services are exchanged.
• Financial intermediaries act as middle man
between surplus units (people that save) and
deficit unit (people that borrow).
• If you lend money to a institution or person you
get ‘paid’ for the money (interest rate).
Read section 2.5 pp 30 – Watch 1601
35, figures 2-1 and 2-2, DVD for more on
Table 2-1 and Box 2-4 in
textbook 2.5 Demand for money the demand for
money

What can make a person wealthy?

• Real assets such as property
• Valuable assets such as paintings
and jewelry
• Financial assets; money and bonds
• However:
The demand for money is the amount that
people want to hold in the form of money.
Why do we have a demand for cash? If we
invested all our money, we can earn maximum
interest. Cash earns NO INTEREST.
For example:
David has R1 000 in his wallet. If David invested
the R1 000 (at an interest rate of 10% for a year)
he would have had R1 100. But he did not invest
it; he kept it in his wallet.
Thus, David foregone the R100 interest and that
is why we say, the opportunity costs of holding
money in your wallet is the interest rate.
If David could have earned an extra R100, why did he choose to hold the R1
000 in cash and not to invest it? John Maynard Keynes has three reasons:
These are Active balances
1. He has a transaction demand for money: meaning, he wants to buy
goods and services. David can only buy goods and services with money
and not with a bond or an investment.
2. David is unsure of the future, he therefore has a precautionary demand
for money. If his car breaks down or he cellphone is stolen he has to
have money for unforeseen transactions.
These are Passive balances
3. The speculative motive to hold money has to do with the opportunity
cost of holding money. Let’s say David would like to invest some money
every month. The first month, there is interest rate of 1%. David realises
that if he invests at such a low interest rate, he will have almost no
return (it is a weak investment) and the opportunity cost of having cash
is very low!
The next year, however, the interest rate is 20% and David rushes to
invest all the money he can because this is a great investment. He does
not want to have money in his wallet with such high opportunity costs.
• On the vertical axis we show the interest
We are
rate i. now going
• It is important that this is NOT the interest to show the
demand for
rate on money but the interest rate on money on a
other assets that you can hold instead of graph
money – we call these bonds.
• Thus, i is the interest rate on bonds.
• If you hold money instead of bonds, you It is also important to
will not receive this interest. Thus the note that interest rates

Interest Rate (i)

interest that you loose when you hold in the economy usually
money instead of bonds is the move in harmony with
opportunity cost of holding money. each other. Therefore,
• On the horizontal axis we show the we can say that this is
amount of money that you would like to the general interest rate
hold (L) and also the amount of money level in the economy.
that will be created (M).
• We use L because the demand for money is
the same as the demand for liquidity.
Money is the asset that you can use
immediately to buy something – it is the 0
most liquid asset. Quantity of money (L,M)
 Active balances
Remember: this
is only your
Meaning, if your ACTIVE demand
income is Y , for money, not
The amount of cash you would your demand for
1

L1(Y1) the passive

like to hold for transaction money will be L1 demand!
purposes (L1) is determined by
The active quantity
your income, NOT the interest of money demanded
rate!

Interest Rate (i)

Interest rate is on is a straight line
the y-axis! because it is not
The interest rate has no
ALWAYS influenced by the
influence on youremember
active demand
to interest rate
to hold cash. name you axis! Quantity of
The graph shows your active money is on the
demand to hold cash. As it is not x-axis! ALWAYS
remember to
influenced by the interest rate, name you axis!
it will be the same quantity of
money demanded at ANY 0
interest rate. Quantity of money (L,M)
 Passive balances (speculative motive) Remember: this
is only your
PASSIVE demand
for money, not
Remember the opportunity cost of the active
The passive demand demand!
holding money? That influences the
for money is a
speculative motive to hold money.
negative sloping
Unlike the active demandline forbecause
money,it is

Interest Rate (i)

the passive demand for inversely
money (or influence
by the interest
speculative motive) is determined byrate .
the interest rate!
At a high interest rate people will
rather hold bonds on which they can
earn high interest, thus low demand
for money.
At a low interest rate there is little L2
reason to hold bonds, as not a lot of
interest is lost, this results in a 0
higher demand for money Quantity of money (L,M)
 L1(Y1)
Active + Passive = Total demand
for money
Interest Rate (i)

Do you also
wonder
what will
D
happen
when the
income level
increases?

Interest Rate (i)

0
Interest Rate (i)

L=L1+L2

L2 0
0 Quantity of money (L,M)
Quantity of money (L,M)
 When income increases to
Y2 the active demand for
Active
L (Y )
1 1+ Passive = Total demand for money
L1(Y2) money increases and thus
Interest Rate (i)

the L1 curve shift to the Do you also

right. wonder what
will happen
whenD the
income level
increases?

Interest Rate (i)

0
The passive demand for
money L2 is not affected by
the increase in income.
The total demand for money
Interest Rate (i)

curve L will shift to the right

by the same amount that L’
the active demand increases
by. L=L1+L2

L2 0
0 Quantity of money (L,M)
Quantity of money (L,M)
Read section 2.6 pp 38- Watch 1601
40, Box 2-7 and figure DVD for more on
2-3 in textbook
2.6 How money is created? banks that create
money.

• Banks create money. But how?

• Banks create money by making loans.
• When a bank provide a loan to a customer, it
creates a deposit for that customer for the
amount of the loan.
• That deposit that is created increases the money
supply.
• Remember: Money = Cash + Deposits
• Thus, when deposits increase, money supply also
increases.
• Banks can create money as long
The money supply M is
as there is a demand for loans The interest rate is also the
determined by the
cost of borrowing.
from creditworthy borrowers. demand for money L.
We say money supply
• Thus, the amount of money

Interest Rate (i)

is demand
created will depend on the determined.
i1
demand for loans at the current
interest rate.
• At a higher interest rate (i1) it is
more expensive to borrow,
i
thus less money will be created 2
(M1). L
• At a lower interest rate (i2) it is 0
M1 M2
less expensive to borrow, thus
Quantity of money (L,M)
more money will be created
(M2).
Thus, the demand for money (L) at the current interest rate
determines the supply of money (M).
 The money supply M is
determined by the
When money supply is demand for money L.
determined by demand, We say money supply

Interest Rate (i)

we say that it is is demand
endogenous money. determined.
i1
Traditionally it was
assumed that the money
supply was exogenously
determined by the
monetary authorities.
i2
L

0
M1 M2
Quantity of money (L,M)
 The money supply M is
determined by the
The monetary authorities
demand for money L.
determine the level of the
We say money supply

Interest Rate (i)

interest rate.
is demand
They do this by influencing
determined.
the repo rate. i1
By influencing the interest
rate level, the monetary
authorities influence the
amount of money that is
created.
i2
L

0
M1 M2
Quantity of money (L,M)
Read section 2.7 in
textbook pp 40-42
2.7 The role of the SARB
• What is the primary objective of the SARB?
– See first paragraph of section 2.5 of text book
• What are the four major areas of responsibility
of the SARB?
1) Formulation and implementation of monetary
policy
2) Service to the government
3) Provision of economic and
statistical services
4) Maintaining financial stability
(1) SARB: formulation and implementation
of monetary policy
• Main instrument of implementing monetary policy is the
repo rate (accommodation policy/refinancing system).
• Financial intermediaries lend money to the public at
interest rates.
• But the financial intermediaries sometimes need to borrow
money from someone…
• Financial intermediaries borrow from the SARB at the repo
rate
• Thus the repo rate influences the interest rate.
• The SARB can also change cash reserve requirements or use
open Repo
market
Rate transactions. Interest Rate
 (2) SARB: service to the government
The SARB helps the government in 3 ways:
– Banker and advisor: the government keeps
accounts with the SARB. The SARB can also give
the government financial advice.
– Custodian of gold and foreign exchange reserves:
the SARB stores all the country’s gold and foreign
exchange reserves. It also formulates exchange
rate policies.
– Administration of exchange
control: the SARB keeps an
eye on the amount of
foreign exchange that
 (3) SARB: provision of economic and
statistical services
The SARB collects, processes,
interprets and publishes
economic statistics and other
information. The data these
publications contain is a
major source of information
for policymakers, analysts
and researchers.
Go check it out on the SARB
website; you will see a lot of
this:
(4) The SARB: maintaining financial stability
The SARB is dedicated to financial and price stability. They do
this by…
• supervising banks in order to ensure a healthy banking
system,
• overseeing the National Payment System (NPS) in order to
manage risks in the banking system,
• being the only institution that can make or destroy currency.
• serving as a bank for other banks:
– It also sets the cash reserve requirements (the is the legal
amount of money that a bank has to hold against deposits).
– It settles obligations that one bank has towards another, thus,
they act as a clearing bank.
– The SARB is a lender-of-last-resort. If a bank is in trouble, it can
borrow from the SARB.
 Why does the SARB want to influence
money creation?
• The SARB is responsible for maintaining the
increases in the price level at a low level (between 3
and 6 percent).
• When there is more money available in the
economy, it is easier for producers and retailers to
increase prices.
• Therefore, the SARB will try to limit the growth in
the money supply when the inflation rate is too
high.
• The way in which they do this is by increasing the
interest rate level.
When the interest rate is higher (e.g. i1)

The demand for credit is less

And the increase in the money supply is i1

Interest Rate (i)

smaller

When there is less money available, it is

more difficult for producers and retailers
to put up prices.
i2
L
Thus, the inflation rate comes down.
0
M1 M 2
Quantity of money (L,M)
Monetary policy in South Africa refers to the measures taken by
the monetary authorities to influence the interest rate level to
achieve stable prices, full employment and economic growth.
Next we look at monetary policy.
 Read section 2.8 pp

2.7 Monetary policy

42-44, Box 2-8, and
section 2.9 pp 424-45
in textbook.

• Monetary policy can refer to steps 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.
• In South Africa, monetary
Who arepolicy
the monetaryrefers to
authorities?
The SARB formulates and implements
decisions concerning the repo
monetary policyrate,
in South which
Africa. The
Monetary Policy Committee (MPC) of the
determines the interest rate
SARB takes level.
decisions on the repo rate level.
The MPC consists of the governor and
deputy governor of the SARB and a few
senior officials.
 The monetary policy framework in South
Africa
• The ultimate objective is balanced and
sustainable economic growth.
• The intermediate objective is a pre-announced
inflation target (currently between 3 and 6 %).
• The operational variable is the short-term
interest rate level, which is determined by the
level of the repo rate.
• The monetary control system is a classical cash
reserve system.
 What is a classical cash reserve system?
Banks have to hold 2,5% cash Repo rate determines the interest rate at
which banks will lend money to customers
reserves against all deposits.
and all other short-term rates in the
economy.

Can borrow from

Banks may not have enough
the SARB to finance
cash – liquidity deficit. Borrow from liquidity deficit.
SARB at repo rate

Why does the SARB create a liquidity deficit?

The SARB can also influence size of • To entice banks to borrow at the repo rate,
liquidity deficit by using open because this is the only way in which the
market operations. SARB can influence the interest rate level,
and thus money creation and inflation.
 Instruments of monetary policy
Banks have to hold 2,5% cash Determines the interest rate at which
reserves against all deposits. banks will lend money to customers and
all other short-term rates in the economy.

Can borrow from

Banks may not have enough
the SARB to finance
cash – liquidity deficit. Borrow from liquidity deficit.
SARB at repo rate
When the SARB lends money to
the banks to finance the liquidity
deficit, we call it accommodation
The SARB can also influence size of policy.
liquidity deficit by using open
market operations When the SARB uses open market
transactions to influence the size of the
liquidity deficit, we call it open market policy.
 Accommodation policy
• Accommodation policy refers to decisions
concerning the interest rate at which the SARB
will provide funds to the banks to finance their
daily liquidity deficit, which is called the repo
rate.
• Decisions concerning the repo rate are taken by
the Monetary Policy Committee (MPC).
• To take these decisions the MPC will take
various factors into account, but the most
important factor is the inflation rate.
 How does the SARB provide
accommodation to the banks?
Repurchase agreements (two legs)
Financial assets that can be used
include only:
•First leg • Government bonds
Bank with • Treasury bills
Bank sells financial assets to SARB
• Land Bank bills
liquidity
• SARB debentures
deficit SARB provides funds to
banks to finance liquidity
deficit
•Second leg (7 days later)
Bank buys back financial assets
from SARB
Banks pays back amount
borrowed in first leg plus interest MPC determines repo rate
at the repo rate
 How does accommodation policy influence
the economy?
Repo rate ↑

Interest rate at which banks lend

and all other interest rates in the Demand for loans ↓
economy ↑

Money creation ↓
Accommodation policy
involves decisions concerning Increases in prices ↓
the repo rate to affect the
cost of credit in the economy.
Inflation rate ↓
 Open market policy
• Open market policy refers to transactions
where the SARB buy or sell financial
instruments in the market to influence the size
of the liquidity deficit of the banks.
Banks
SARB sells financial assets to banks

Banks pay, thus rand flows to SARB

The SARB will increase cash
Banks’ financial deficit ↑ deficit of banks to entice
(less cash with the banks) them to borrow at the repo
rate
 Open market policy
• The SARB can also decrease size of liquidity
deficit of banks

Banks
SARB buys financial assets from banks

SARB pays, thus rand flows to banks

The SARB will provide more
Banks’ financial deficit ↓ cash to banks to entice
(more cash with the banks) them to lend more
(quantitative easing)
Other monetary policy instruments
• Non-market-oriented measures
Credit ceilings Not used in SA
Deposit rate control

• Exchange control regulations

• Central bank intervention in foreign
exchange market
• Public debt management
• Moral suasion
 Do you…
• understand a barter system?
• know what money is and is not?
• know different types of money?
• know a short history of money?
• know the difference between M1, M2 and M3?
• understand the role of financial intermediaries?
• understand the primary objectives of the SARB?
• know the major functions of the SARB?
• understand demand for money?
• understand how money is created?
• understand the instruments of monetary policy?
 Done and
dusted. Great
That is the end of study unit 2.
work! A quiz on this work will be
available soon; make sure you
do it and discuss it
with your e-tutor!