lOMoARcPSD|17558210 Notes 5 FINANCIAL ECONOMICS (University of Namibia) StuDocu is not sponsored or endorsed by any college or university Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 Money, The Price Level and Inflation Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 Main ideas After studying this chapter, you will be able to: • Define money and describe its functions • Explain the economic functions of banks and other depository institutions • Describe the structure and functions of the South African Reserve Bank (SARB) • Explain how the banking system creates money • Explain what determines the demand for money, the supply of money and the nominal interest rate • Explain how the quantity of money influences the price level and the inflation rate in the long run • Show the demand for money, the supply of money and money market equilibrium graphically • Calculate changes in the monetary base by using the money multiplier • Discuss and show graphically the factors that influence the demand for money • Use the quantity theory of money to calculate inflation and money growth in the long run 2 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 What is Money? • A means of payment is a method of settling a debt • Money serves three other functions: Medium of Exchange • A medium of exchange is any object that is generally accepted in exchange for goods and services Unit of Account • A unit of account is an agreed measure for stating the prices of goods and services Store of Value • Money is a store of value in the sense that it can be held and exchanged later for goods and services Money in South Africa Today • In South Africa today, money consists of: Currency • 3 The notes and coins held by individuals and businesses Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 What is Money? Deposits • Deposits of individuals and businesses at banks and other depository institutions, such as the Postbank, are also counted as money Official Measures of Money • The three main measures of money in South Africa today are known as: • M1 – consists of currency plus cheque deposits owned by individuals and businesses • M2 – consists of M1 plus short- and medium-term deposits, such as savings deposits and money market funds • M3 – M2 plus money that is deposited for longer time horizons, such as pension funds Deposits Are Money but Debit Cards and Cheques Are Not • Money is merely transferred from one place to another – the debit card itself was never money Credit Cards Are Not Money • You use a credit card when you buy something, but the credit card is not the means of payment and it is not money 4 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 Depository Institutions • This is a firm that takes deposits from households and firms and makes loans to other households. 4 types of depository institutions: • Commercial banks – act as intermediaries between people with excess money (surplus units) and those that are in need of money (deficit units) • Mutual banks – operates like a commercial bank, but with limited assets • The Postbank – promotes a culture of saving in South Africa • The Land and Agricultural Bank – provides financing for agricultural activities in South Africa Profit and Prudence: A Balancing Act • The aim of a bank is to maximise the net worth of its shareholders therefore the interest rate at which a bank lends exceeds the interest rate it pays out to its depositors • A bank must be prudent in the way it uses its deposits, balancing security for the depositors against profit for its shareholders What Depository Institutions Do • Depository institutions provide services such as cheque clearing, account management, credit cards and internet banking, all of which provide an income from service fees 5 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 Depository Institutions • • But depository institutions earn most of their income by using the funds they receive from depositors to make loans and to buy securities that earn a higher interest rate than that paid to depositors A commercial bank places the funds it receives from depositors and other funds that it borrows into four types of assets: 1. A bank’s reserves are notes and coins in the bank’s vault or in a deposit account at the South African Reserve Bank 2. Liquid assets are Treasury bills issued by government to finance current spending, as well as commercial paper 3. Investment securities are longer-term bonds (including government) 4. Loans are commitments of fixed amounts of money for agreed-upon periods of time Economic Benefits Provided by Depository Institutions Create Liquidity • By borrowing short and lending long Pool Risk • A loan might not be repaid – a default 6 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 Depository Institutions Lower the Cost of Borrowing • Depository institutions lower the cost of the search for an institution to borrow from Lower the Cost of Monitoring Borrowers • By monitoring borrowers, a lender can encourage good decisions that prevent defaults How Depository Institutions Are Regulated • Failure can have damaging effects on the entire financial system and economy so depository institutions are required to hold levels of reserves and owners’ capital that equal or surpass ratios laid down by regulation to minimise risk Financial Innovation • In the pursuit of larger profit, depository institutions are constantly seeking ways to improve their products • E.g. credit cards, internet payments and cellphone banking 7 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 The South African Reserve Bank A central bank is a bank’s bank that regulates a nation’s depository institutions and controls the quantity of money The Reserve Bank’s Goals and Targets 8 • Adjusts the quantity of money in circulation • Primary goal is to achieve and maintain price stability in South Africa’s economic system • The Reserve Bank takes responsibility, among others, to: • Formulate and implement monetary policy • Issue banknotes and coins • Supervise the banking sector • Ensure the effective functioning of the payment system in South Africa • Act as banker for the government • Act as lender of the last resort Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 The South African Reserve Bank The Structure of the Reserve Bank • Not owned by government, but is accountable to Parliament • Board of Directors with 15 members The Monetary Policy Committee • The MPC is the main policy-making organ of the South African Reserve Bank The Reserve Bank’s Policy Tools • The single most important responsibility is influencing the amount of money in circulation in South Africa in order to create price stability • The Reserve Bank uses three main policy tools to achieve its objectives: Required Reserve Ratios • All depository institutions are required to hold a minimum % of deposits as reserves – known as a required reserve ratio Repo Rate • 9 The main mechanism that the Reserve Bank uses to implement monetary policy, is the refinancing system – the Reserve Bank provides finance to banks to meet their requirements, at an interest rate, called the repo rate Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 The South African Reserve Bank Open Market Operations • This is the purchase or sale of Treasury bills issued by government and government bonds, as well as Reserve Bank debentures, by the Reserve Bank in the open market 10 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 How Banks Create Money • Most money is deposits, not cash – what banks create are deposits and they do so by making loans Creating Deposits by Making Loans • Swiping a credit card, for example, creates a bank deposit (seller) and a bank loan (buyer) • 3 factors limit the quantity of deposits that the banking system can create: The Monetary Base • The sum of banknotes and coins in circulation in the economy as well as deposits that banks keep at the Reserve Bank • The size of the monetary base limits the total quantity of money that the banking system can create because banks have a desired level of reserves, and households and firms have a desired level of cash holding Desired Reserves • A bank’s actual reserves consist of the banknotes and coins in its vaults and its deposit at the Reserve Bank • The desired reserve ratio is the ratio of reserves to deposits that a bank wants to hold 11 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 How Banks Create Money Desired Cash Holdings • We hold money in the form of cash and bank deposits • The proportion of money held as cash is not constant but at any given time, people have a definite view as to how much they want to hold in each form of cash • Because households and firms want to hold some proportion of their money in the form of cash, when the total quantity of bank deposits increases, so does the quantity of cash that they want to hold – thus, a portion of the monetary base is in the hands of ordinary citizens and not in the banking system • Because desired cash holding increases when deposits increase, there is always cash that leaves the banking system when loans are made and deposits increase – we call the leakage of cash from the banking system the currency drain. And we call the ratio of currency to deposits the currency drain ratio 12 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 How Banks Create Money The Money Creation Process • When the Reserve Bank buys securities from a bank, the bank’s reserves increase but its deposits do not change – so the bank has excess reserves 13 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 The Demand For Money • The quantity of money demanded is the inventory of money that people plan to hold on any given day • The quantity of money held must equal the quantity supplied The Influences on Money Holding • The quantity of money that people plan to hold depends on four factors: The Price Level • If the price level rises by 10 per cent, people hold 10 per cent more nominal money than before The Nominal Interest Rate • The higher the opportunity cost of holding money, the smaller the quantity of real money demanded Real GDP • The quantity of money that households and firms plan to hold depends on the amount they are spending • The quantity of money demanded in the economy as a whole depends on aggregate expenditure – real GDP 14 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 The Demand For Money Financial Innovation • Technological change and the arrival of new financial products influence the quantity of money held • Financial innovations include daily interest cheque deposits, automatic transfers between cheque and saving deposits, ATMs, credit cards and debit cards, Internet banking and bill paying The Demand for Money Curve • The demand for money is the relationship between the quantity of real money demanded and the nominal interest rate when all other influences on the amount of money that people wish to hold remain the same Shifts in the Demand for Money Curve • A change in real GDP or financial innovation changes the demand for money and shifts the demand for money curve 15 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 The Demand For Money Interest Rate Determination • Just like the market for goods and services, the interaction between the demand for and supply of money determines the equilibrium price for money • The price of money is the interest rate, since it represents the opportunity cost for holding money The Supply of Money • The quantity of money that can be created by the banking system depends on the monetary base (influenced b The Reserve Bank) and the money multiplier (depends on the desired reserve ratio and currency drain ratio) 16 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 The Money Market • The market where demand and supply interact to determine the interest rate Money Market Equilibrium • Occurs when the quantity of money demanded equals the quantity of money supplied The Effect of Monetary Policy • With a surplus of money holding, people enter the loanable funds market and buy bonds in an attempt to get rid of the extra money they are holding – raises the price of a bond and lowers the interest rate What Happens in the Long Run? • When the inflation rate equals the expected inflation rate and when real GDP equals potential GDP, the money market, the loanable funds market, the goods market and the labour market are in long-run equilibrium – the economy is in long-run equilibrium 17 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 The Quantity Theory of Money • In the long run, the price level adjusts to make the quantity of real money demanded equal the quantity supplied • The quantity theory of money is a special theory of the price level and inflation that explains this long-run adjustment of the price level • This proposes that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level • The velocity of circulation is the average number of times a specific rand is used annually to buy the goods and services that make up GDP • But GDP equals the price level (P) multiplied by real GDP (Y) 18 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 The Exchange Rate and the Balance of Payments Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 Main ideas After studying this chapter, you will be able to: • Describe the foreign exchange market and define the exchange rate • Explain how the exchange rate is determined day by day • Explain the factors that influenced the demand for and supply of rand • Show the demand for and supply of rand graphically and indicate the equilibrium in the foreign exchange market • Evaluate the effect of a change in the demand for and supply of rand on the equilibrium exchange rate and show it graphically • Distinguish between the nominal exchange rate and the real exchange rate • Calculate the real exchange rate • Explain the trends and fluctuations in the exchange rate and explain interest rate parity and purchasing power parity • Describe the alternative exchange rate policies and explain their effects • Discuss the balance of payments accounts and explain what causes an international deficit • Calculate the various balances of the balance of payments 20 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 The Foreign Exchange Market • Whenever people buy things from another country, they use the currency of that country to make the transaction Trading Currencies • The currency of one country is exchanged for the currency of another in the foreign exchange market Exchange Rates • An exchange rate is the price at which one currency exchanges for another currency in the foreign exchange market • A strengthening of the exchange rate is called an appreciation and a weakening is called a depreciation An Exchange Rate is a Price • An exchange rate is a price – the price of one currency in terms of another • The foreign exchange market is a competitive market – demand and supply determine the price 21 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 The Foreign Exchange Market The Demand for One Money is the Supply of Another Money • When people who are holding the money of some other country want to exchange it for South African rand, they demand South African rand and supply that other country’s money Demand in the Foreign Exchange Market • People buy South African rand in the foreign exchange market so that they can buy South African exports • They also buy South African rand so that they can buy South African assets such as bonds, shares, businesses and property or so that they can keep part of their money holding in a South African rand bank account • The quantity demanded depends on many factors, but the main ones are: 1. 2. 3. 4. The exchange rate World demand for South African exports Interest rates in South Africa and other countries The expected future exchange rate 22 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 The Foreign Exchange Market The Law of Demand for Foreign Exchange • The higher the exchange rate, the smaller is the quantity of South African rand demanded in the foreign exchange market • The exchange rate influences the quantity of rand demanded for 2 reasons: Exports Effect • The larger the value of South African exports, the larger is the quantity of South African rand demanded in the foreign exchange market • The value of South African exports depends on the prices of locally – produced goods and services expressed in the currency of the foreign buyer – these prices depend on the exchange rate Expected Profit Effect • The larger the expected profit from holding South African rand, the greater is the quantity of South African rand demanded in the foreign exchange market – expected profit depends on the exchange rate. 23 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 The Foreign Exchange Market Demand Curve for South African Rand • A change in the exchange rate, brings a change in the quantity of South African rand demanded and a movement along the demand curve Supply in the Foreign Exchange Market • The quantity of South African rand supplied in the foreign exchange market depends on many factors, but the main ones are: 1. The exchange rate 2. South African demand for imports 3. Interest rates in South Africa and other countries 4. The expected future exchange rate 24 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 The Foreign Exchange Market The Law of Supply of Foreign Exchange • The higher the exchange rate, the greater is the quantity of South African rand supplied in the foreign exchange market • The exchange rate influences the quantity of rand supplied for two reasons: Imports Effect • The larger the value of South African imports, the larger is the quantity of South African rand supplied in the foreign exchange market • The value of South African imports depends on the prices of foreignproduced goods and services expressed in South African rand – these prices depend on the exchange rate Expected Profit Effect • The stronger the exchange rate today, the larger is the expected profit from selling South African rand today and holding foreign currencies, so the greater is the quantity of South African rand supplied 25 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 The Foreign Exchange Market Supply Curve for South African Rand • A change in the exchange rate, brings a change in the quantity of South African rand supplied and a movement along the supply curve Market Equilibrium • At the equilibrium exchange rate, there is neither a shortage nor a surplus – the quantity supplied equals the quantity demanded 26 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 Exchange Rate Fluctuations Changes in the Demand for South African Rand The demand for the rand in the foreign exchange market changes when there is a change in: World Demand for South African Exports • An increase in world demand for SA exports increases the demand for the rand SA’s Interest Rate Relative to the Foreign Interest Rate • The higher the interest rate that people can make on South African assets compared with foreign assets, the more South African assets they buy • South African interest rate differential – South African interest rate minus the foreign interest rate The Expected Future Exchange Rate • A rise in the expected future exchange rate increases the profit that people expect to make and the demand for South African rand increases today 27 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 Exchange Rate Fluctuations Changes in the Supply of South African Rand Changes in the Supply of South African rand This occurs when there is a change in: South African Demand for Imports • An increase in the South African demand for imports increases the supply of South African rand in the foreign exchange market South Africa’s Interest Rate Relative to the Foreign Interest Rate • The larger the South African interest rate differential, the smaller the supply of SA rand in the foreign exchange market The Expected Future Exchange Rate • A fall in the expected future exchange rate decreases the profit that can be made by holding South African rand and decreases the quantity of South African rand that people want to hold – the supply of South African rand in the foreign exchange market then increases 28 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 Exchange Rate Fluctuations Changes in the Exchange Rate • If the demand for South African rand increases and the supply does not change, the exchange rate strengthens (the currency appreciates) – if it decreases the exchange rate weakens (the currency depreciates) • This works similarly for the supply of the South African rand Fundamentals, Expectations and Arbitrage • New information or expectations about the fundamental influences on the exchange rate – the world demand for South African exports, South African demand for imports and the South African interest rate relative to the foreign interest rate – makes the expected exchange rate change • Profiting by trading in the foreign exchange market often involves arbitrage: The practice of buying in one market and selling for a higher price in another related market • Arbitrage also removes profit from borrowing in one currency and lending in another and buying goods in one currency and selling them in another 29 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 Exchange Rate Fluctuations • These arbitrage activities bring about: Interest Rate Parity • Equal rates of return Purchasing Power Parity • Equal value of money The Real Exchange Rate • This is the relative price of foreign produced-goods and services to South African-produced goods and services The Short Run • If the nominal exchange rate changes, the real exchange rate also changes The Long Run • The nominal exchange rate and the price level are determined together and the real exchange rate does not change when the nominal exchange rate changes 30 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 Exchange Rate Policy Three possible exchange rate policies are: 1. Flexible Exchange Rate • Determined by demand and supply in the foreign exchange market with no direct intervention by the central bank 2. Fixed Exchange Rate • Determined by a decision of the government or the central bank and is achieved by central bank intervention in the foreign exchange market to block the unregulated forces of demand and supply 3. Crawling Peg • Follows a path determined by a decision of the government or the central bank and is achieved in a similar way to a fixed exchange rate by central bank intervention in the foreign exchange market 31 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 Financing International Trade Balance of Payments Accounts • A country’s balance of payments accounts record its international trading, borrowing and lending in four accounts: 1. Current account –receipts from exports of goods and services sold abroad, payments for imports of goods and services from abroad, net interest income paid abroad and net transfers abroad 2. Capital transfer account – capital transfers and the acquisition or disposal of non-produced, non-financial assets 3. Financial account – foreign investment in South Africa minus South African investment abroad 4. Change in net gold and other foreign reserves – change in South Africa’s official reserves, which are the government’s holdings of foreign currency and gold An Individual’s Balance of Payments Accounts • Records the income from supplying the services of factors of production and the expenditure on goods and services 32 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 Financing International Trade Borrowers and Lenders • A country that is borrowing more from the rest of the world than it is lending is called a net borrower • A net lender is a country that is lending more to the rest of the world than it is borrowing Debtors and Creditors • A debtor nation is a country that during its entire history has borrowed more from the rest of the world than it has lent to it • A creditor nation is a country that during its entire history has invested more in the rest of the world than other countries have invested in it Current Account Balance • CAB = NX + Net interest income + Net transfers Net Exports • Exports of goods and services minus imports of goods and services 33 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz) lOMoARcPSD|17558210 Financing International Trade • The government sector balance is equal to net taxes minus government expenditures on goods and services • The private sector balance is saving minus investment Where is the Exchange Rate? • In the short run, a fall in the rand lowers the real exchange rate, which makes South African imports more costly and South African exports more competitive • In the long run, a change in the nominal exchange rate leaves the real exchange rate unchanged and plays no role in influencing the current account balance 34 Economics 2ed: Global and Southern African Perspectives © 2013 Downloaded by Blessing Koomalo (smkhumalo@uniswa.sz)
