An Overview of the Financial System
 Financial Markets transfer funds from those who have saved to those who have
shortages of funds.
 This can be done through
 Direct Finance: borrowers borrow funds directly from lenders in financial
markets by selling securities.
 Indirect Finance: Financial intermediaries borrow funds and then lend them out
 In South Africa, this is found in the SARB Quarterly bulletin
 Financial markets also promote economic efficiency by producing an efficient
allocation of capital, which increases production.
 Directly improve the well-being of consumers by allowing them to time purchases
better.
o For example, you can get a loan today and pay it later
Financial markets are structured according to:
 Debt and Equity Markets
 Debt instruments (maturity) for example - the bond market
 Equities (Dividends) for example – the stock market
 Primary and secondary markets
 Investment banks underwrite securities in the primary markets
 Brokers and dealers work in secondary markets
 Brokers match buyers and sellers
 Dealers buy and sell securities (Market making)
 Exchanges and over-the-counter Markets
o Exchanges
 These are formalized markets, with a central location
 NYSE, Chicago Board of Trade, JSE
o OTC Markets
 More of informal markets, trading is done using a computer from any
location.
 Foreign Exchange, Federal Funds or interbank markets.
 Money and Capital Markets
o Money markets deal in short-term debt instruments
o Capital markets deal in longer-term debt and equity instruments
Financial Markets Instruments
1. Money Market Instruments
 US Treasury bills
 Short-term loans borrowed by governments.
 Negotiable bank certificates of deposit (NCDs)
 Deposits in certificate form, which can be traded.
 This means that it can be sold when the bank wants to borrow funds
 Commercial Paper
 Also called CP
 These are IoUs issued by well-established companies
o
 In South Africa, this is called a promissory note.
Federal funds and security repurchase
 Reserves: These are funds that commercial banks have deposited with
the reserve bank.
 These reserves are borrowed overnight using the:
 Interbank rate,
 SABOR or
 Zaronia
Repo rate
Interbank Rate
Repo rate has a period of 7 days
The interbank rate has a period of 1 day
When banks borrow using the repo
rate they need security
When they borrow from each other in the
overnight markets they do not need
security

It is cheaper for banks to borrow from each other because there is no security required in the overnight
markets and also the interbank rate is less than the repo rate most of the time.
2. Principal Money Market instruments
o Corporate stocks
 In South Africa this is equity
o Residential mortgages
 Also known as home bonds or residential bonds
o Corporate bonds
 This is used by companies borrowing funds for a long time.
o Long-term loans for U.S Government
 U.S government agency securities
 State and local government bonds
 U.s government securities
o Bank commercial loans
 Loans that banks obtain
o Consumer loans
 Loans that consumers obtain from banks.
o Commercial and farm mortgages
 Loans that farmers obtain
Internationalization of Financial Markets


Foreign Bonds:
o Bonds sold in a foreign country and denominated by that country's currency.
o Example: Borrow in another country in that country's currency
 South African companies like SASOL sell bonds in the US to raise U.S.
dollars, they can do this if they want to expand in the US.
Eurobond:
o A bond denominated in a currency other than the country in which it is sold
 Example: South African company selling bonds in Australia to raise U.S.
dollars.

Eurocurrencies
o Foreign currencies are deposited in banks outside the home country.
 Eurodollars: these are US dollars deposited in banks outside the United
States.
 EuroZar: these are ZARs deposited in London for example.
The function of Financial Intermediaries
 The basic function of financial markets is to channel funds from savers who have excess
funds to spenders who have a shortage of funds.
1. Transaction Costs / Liquidity services
 Time and money spent in carrying out financial transactions.
 Intermediaries can reduce transaction costs because they benefit from
economies of scale due to expertise and size.
 Intermediaries provide liquidity services that make it easier for customers to
conduct transactions. [Customers can withdraw their deposits anytime]
 e.g. Checking accounts to pay bills.
2. Risk sharing
 They sell less risky investments and then use the funds to purchase more
risky investments.
 They earn a profit on the difference between the returns on risky assets they
bought and the payments made on assets they sold. Also called asset
transformation.
 They help individuals to diversify and thereby lower the amount of risk
through low costs and asset pooling.
3. Asymmetric information
This is when one party (lenders) does not know enough about the other party
(borrowers) to make accurate decisions.
Intermediaries are better equipped and can alleviate asymmetric information
problems.
This leads to two specific problems called adverse selection and moral hazard.
Two forms
1) Adverse selection [Bad selection]
→ Occurs before the transaction
→ Borrowers who are most risky are more likely to be selected by lenders
→ Results in fewer loans to all as lenders hesitate to lend at all.
2) Moral hazard
→ Occurs after the transaction.
→ the risk that the borrower will engage in activities undesirable to the lender
hence increase in the chance of default.
→ Reduces loans for all due hesitation to lend.
→ If there were no asymmetric information there could still be a moral hazard
problem because the lender knows there might be a default and reducing such
risk is too costly, therefore still a moral hazard.
Types of Financial Intermediaries
1. Depository institutions (banks)
o
Largest and most diversified
2. Thrift institutions
o
Savings and loan associations → Not large in South Africa
o
Mutual savings banks → Not large in South Africa
o
Credit Unions
o
Smaller Financial Intermediaries & Societies in SA

Stokvel → is the biggest in SA, however, they are more informal.

Savings and loan association

Co-operative Financial institutions → These are more formal forms of
stokvels.
3. Contractual Savings institutions
o
Life insurance companies
o
Fire and casualty insurance companies → called short-term insurance in SA
o
Pension Funds, government retirement funds
4. Investment intermediaries
o
Finance companies → smaller finance companies
o
Mutual Funds → Called collective investment or unit trust in SA. This is a saving
mechanism
o
Money market mutual funds → money market unit trusts
o
Hedge funds → collective (private) investments with a high risk
What is Money?
 Money is an asset that allows you to get what you want.
 Money is anything that is generally accepted as payment of goods or services, or in the
repayment of debts.
 Cheques are not money, because they are an instruction to the bank to transfer
funds
 However, traveller's cheques are counted as money. Why?
 Savings deposits are an asset, that belongs to the depositor so they are money.
 Credit cards are not considered as money. Why?
 The money in the credit card does not belong to the depositor but to the bank.
 So when credit card holders use their cards, they create an obligation for themselves.
Money is different from:
Wealth
 Wealth is a total collection of items of property that serve to store value, including
cash.
 Examples: Bonds, Cars, House, art, land etc.
 Money is a stock variable, meaning that it is an item in the balance sheet.
Income
 Income refers to the flow of earnings per unit of time.
 This means that you earn it over time.
Functions of Money [attributes of money]
1. Medium of exchange
 means that it is used as a means of payments
 eliminates the double coincidence of needs
 encourages specialization
Conditions for Medium of exchange:
 Be easily standardized to ascertain the value
 Be widely accepted
 Must not deteriorate quickly
 Be divisible
 Must be easy to carry
2. Unit of account
 Allows us to be able to price things
 Money is used to measure value in the economy.
 Also reduces transaction costs
3. Store of Value
 Money is used to save purchasing power over time.
 However, other assets can serve this function with better returns as well.
 But money is still used to store value because it is the most liquid of all the stores
of value.
 Even though money is used to store value, it does lose value over time
due to inflation.
Evolution of the Payment Systems
1. Commodity Money
 Example Gold
 Valuable, easily standardized, and divisible commodities
2.
Fiat money
 Legal tender, by government decree.
 Based on trust
3. Checks
 An instruction to your bank to transfer money from your account
 Phased out or discontinued in South Africa.
4. Electronic payment
 Enables you to pay bills online.
 Saves time and cost
 Example EFT,
5.
E-Money
Substitute for cheques and paper money.
Backed by Fiat currency, this is why it is different from crypto.
 Debit card
 Stored Value Card
 Smart cared
 E-Cash→ internet purchases
 E-Money: Potential Problem:
 Double spending, which is a risk that a cryptocurrency may be used twice or
even more.
 However, this is solved by using cryptography and blockchain.
 Digital Currency
 Regulated or unregulated currency available only in electronic form



6. Virtual Currency
 Unregulated digital currency that is controlled by its developers or the founding
organization
Crypto currency




Virtual currency that uses cryptography
To secure and verify transactions and also,
Facilitates the creation and control of new currency units.
Not controlled by the government.
Blockchain
 This is what makes crypto currencies secure.
 Blocks chained together via hashing
 To form a long historical record
 In a digital ledger called the "blockchain"
Blocks
 This is where transactions that were made at a certain period are recorded.
 These blocks are then chained in a ledger to form what is called "blockchain"
Hashing
 This is a way of using cryptography to secure transactions.
 This is a cryptography process that is used to
 Encode data of any length
 And then,
 convert it into a series of alphanumeric characters of fixed length.
Mining
 This is the process of verifying and recording new Bitcoin transactions
 Miners verify transactions by solving a computational math problem
 And then the computer that solves the problem first, will earn the right to create a new
block by submitting "proof of work".
Advantages of Blockchain/Bitcoin
 Peer-to-peer- this means that there is no single person or group can control it.
 Immutable- this means that data entered in a blockchain is irreversible.
 No middleman- bitcoin does not need a third party such as banks to ensure the
validity of transactions.
 Transparent- each node of the network(computer) has a copy of the distributed
ledger to ensure the validity and accuracy of information.
 Transactions are permanently recorded, and the network's entire history is viewable
to anyone.
Will Bitcoin become money of the future?
 No, because as much as it functions well as a medium of exchange, it is a not a
good store of value and unit of account because of its high fluctuation.
Measuring Money
 Defined as currency plus deposits. Hence M = C + D
 In SA, Currency = paper money and coins in circulation – (less) cash-held bank
vaults.
 Deposits = domestic, private non-bank deposits in banks exclude:
 Govt deposits held at commercial banks
 Foreign deposits held at commercial banks
 Vault cash
 The amount of currency in circulation is therefore known since it is currency is issued by
the reserve bank.
 Also, since deposits are held by commercial banks, banks know the exact amount of
deposits held by the nonbank private sector.
Monetary Authorities in SA
 SARB and CPD(Corporation for public deposits)
 Depository institutions
 Registered commercial banks
 Mutual banks
 Landbank &
 Postbank
Monetary aggregates
Remember that money is a stock variable that can be measured.
1. M1A
 M1A = Cash(banknotes & coins) in circulation + Cheque and transmission
deposits.
 Cheque & transmission deposits → no interest deposits mainly used to
make payments e.g. my bank account with Capitec.
 In SA M1A counts for a small portion of M3.
1. M1 (Narrow definition of money)
 M1A + other demand deposits
 Other demand deposits → monetary deposits other than transaction and
cash deposits.
 Other demand deposits→ are convertible into cash on demand and
normally carry a payment facility.
 Example my TymeBank Goal Save Account
 In SA M1 constitutes a large portion of M3
3. M2(Broader definition of money)
 M1 + Deposits
 Deposits→ Short term deposits (1 - 31 days)
 Deposits→ Medium term deposits(32 - 180 days)
 Examples:
 Savings deposits, savings bank certificates, share investments and
promissory notes amongst others.
 Cannot be converted into cash on demand, but only after a certain period of time.
 In SA M2 constitutes a large portion of M3
4. M3(A most comprehensive measure of money
 M2 + Long term deposits
 Much more stable than its components
 A better indicator of domestic spending
Quantity theory, inflation and demand for money
Quantity Theory of Money
 This is the theory of demand for money,
 It suggests that interest rates have no effect on the demand for money.
Velocity and Money Equation
 The velocity of money: the average number of times per year that a dollar is spent
buying the total amount of goods and services produced.
𝑃×𝑌
 𝑣=
, where 𝑃 × 𝑌 is the total spending
𝑀
 The equation of exchange: 𝑀 × 𝑉 = 𝑃 × 𝑌, means that the quantity of money multiplied
by the velocity of money gives you the total money spent in the economy/total income.
Determinants of velocity
 Assumed to be constant in the short run
 Institutional and technological features would only affect velocity slowly over time.
 Credit cards mean less money and therefore a higher velocity.
Demand for money
1
 𝑀𝑑 = 𝑘 × 𝑃𝑌 where 𝑘 = 𝑣
 This equation then suggests that the demand for money is a function of income and
interest rates do not affect money demand.
Quantity Theory of Money
 𝑃 × 𝑌 = 𝑀 × 𝑉, suggests that the quantity of money leads to a proportional change in
the price level.
Quantity theory and inflation
 𝜋 = ∆%𝑀 − %∆𝑌
 Suggests that the inflation rate equals the growth of the money supply minus the growth
of aggregate output.
 This theory is a good theory for explaining inflation in the long run but not in the short
run.
Governement budget constraint
 𝐷𝐸𝐺 = 𝐺 − 𝑇 = ∆𝑀𝐵 + ∆𝐵
 If the government deficit is financed by selling bonds, then there is not effect on MB or
money supply.
 However, the deficit will increase if financed by high-powered money.
 Lastly, financing persistent deficits through high-powered money will lead to sustained
inflation or hyperinflation like in Zimbabwe.
Liquidity Preference Theory
 Shows the relationship between interest rate and the quantity of money the public is
willing to hold.
 The theory states that interest rates are the price for money.
 According to Keynes, there are three reasons for the demand for money
 Transaction motive
 Precautionary motive
 Speculative motive
𝑃𝑌
 Liquidity Preference Function: 𝑉 = 𝑓(𝑖,𝑌)
 This equation suggests that velocity is not constant, and that means changes in interest
rates will affect velocity. Thus money supply is sensitive to interest rates.
Factors that determine the demand for money
Liquidity Trap
 It is when conventional monetary policy has no direct effect on aggregate spending
because a change in money supply has no effect on interest rates.
 This happens when the nominal interest rates are zero and the demand for money is flat.
 In such a case, the 𝑀𝑑 line is flat and not sensitive at all to changes in money supply.
 This happened in Europe and the U.S after the financial crisis of 2008
 This requires unconventional monetary tools to stimulate the economy.
The behaviour of interest rates
Chapter objective
We understand how the overall level of nominal interest rates is determined and which factors
influence their behaviour.
Determinants of assets demand
 Wealth: total resources owned by an individual, including all assets.
 Expected Return: the return expected over the next period on one asset relative to
another.
 Risk: the degree of uncertainty associated with the return on an asset relative to
alternatives.
 Liquidity: the ease and speed with which an asset can be turned into cash relative to
other assets.
Theory of Portfolio Choice
 Tells us ukuthi how much of an asset would people hold in their portfolio. Holding all
the other factors constants it states that:
 The quantity demanded of an asset is positively related to wealth
 The quantity demand of an asset is positively related to the expected return
relative to other asset classes.
 The quantity demand of an asset is negatively related to the risk of its returns
relative to other assets
 The quantity demanded of an asset is positively related to its liquidity relative to
other assets.
How nominal interest rates are determined?
(1) The supply and demand for bonds
 Demand
 At lower prices (high-interest rates), the quantity demand for bonds will be
higher, holding all the other factors constant.
 There is an inverse relation between bond prices and quantity demand for bonds
 Supply
 At the lower price (high-interest rates), the quantity supplied for bonds will be
lower, holding all the other factors constant.
 There is a positive relationship between bond price and quantity supplied.
 Market equilibrium
 Bd = Bs defines the equilibrium (or market clearing) price and interest rate.
Shifts in the demand for bonds
 Wealth
 An increase in the business cycle or Marginal propensity to save will shift bond
demand to the left.
 Expected interest rate
 A higher expected interest rate lowers the expected return and hence the
demand.
 Higher expected return on other assets lowers the demand for bonds
 Expected inflation
 Higher expected inflation leads to higher returns from other assets and lowers
relative returns from bonds.
Shifts in bond supply
 Expected inflation
 When inflation increases the real cost of borrowing falls.
Changes in interest rates due to expected inflation, the Fisher effect
 When expected inflation rises, interest rates will also rise, this is called the Fisher effect.
 We do not know ukuthi by how much the bond quantity change, but interest rates will
change by a certain amount.
Changes in interest rates due to a business cycle expansion
 Amounts of goods and services rise with a corresponding increase in national income
and business has more opportunities to expand, therefore they increase the supply of
bonds.
 An increase in wealth will, via the theory of portfolio choice, increase the demand for
bonds.
 Ambiguous change in interest rate but certain increase in quantity
(2) Liquidity Preference Framework
 This is an alternative method of determining interest rates and was
developed by John Maynard Keynes.
 This theory uses the demand and supply of money to determine the
prevailing interest rate.
 This theory assumes that there are two types of assets in an economy, that is
money and bonds which then equals the total wealth in the economy.
 The demand curve for money
 As interest rates rise the expected return of money falls relative to
bonds and the demand for bonds increases.
 The supply curve: determined by the central bank
Changes in Equilibrium Interest Rates in the Liquidity Preference Framework
The money demand curve shifts because of:
a. Income effect
A higher level of income causes the demand for money at each interest rate to
increase and the demand to shift to the right.
b. Price level effect(inflation)
A rise in the price level causes the demand for money to increase and the
demand curve to shift to the right.
Money supply shifts because of:
Changes in money supply as determined by the central reserve.
The response over Time to an Increase in Money Supply Growth
The following graphs show how interest rates respond over time to an increase of
the money supply.
(a) The liquidity Effect is larger than other effects



The liquidity effect dominates other effects, so the liquidity effect operates quickly to
reduce interest rates.
But as time goes the other effects kick in and start reversing the decrease, but not up
to the initial level.
Increase money supply to reduce interest rates.
b) The liquidity effect is smaller than other effects and slow adjustment to
expected inflation


The inflation expectation effect is slow to adjust interest rates upwards, and then as
time goes income, the inflation and price level effect also kick in.
The result is that we see interest rates rising above the initial level over time.
c) The liquidity effect is smaller than other effects and fast adjustment to
inflation expectations



Expected inflation kicks in immediately and overpowers the liquidity effect.
This then results in an immediate rise in interest rates, which climb even further
when income and price level effect kick in.
Reduce money supply to reduce interest rates
The Risk Term and Term Structure of Interest Rates
Chapter Objective:
 To understand the sources and causes of interest rates fluctuations relative to one
another
 Explain these fluctuations using the theories.
1. Risk Structure of interest rates
Bonds with the same maturity have different interest rates due to:
 Default risk
 Liquidity
 Tax considerations
2. The term structure of interest rates
 Bonds with identical risk, liquidity and tax characteristics have different interest rates
because the time remaining to maturity is different.
 When we plot these bonds with differing terms to maturity on a yield curve we get the
following types of Yield Curves
i.
Upward sloping: long term rates are above short-term rates
ii.
Downward sloping: long term rates are below short-term rates
iii.
Flat: long term rates are the same as short-term rates
 We also see that(through empirical evidence):[Highly Testable]
i.
Interest rates on bonds of different maturities move together over time. This is
explained by the expectations theory
ii.
When short-term rates are low, yield curves are more likely to have an upward
slope, when short-term rates are high, yield curves are more likely to have a
downward slope and be inverted. This is explained by the expectations theory
iii.
Yield curves are almost always upward-sloping. This is explained by the
segmented markets theory
Theories to explain the empirical evidence: [Highly Testable]
a. Expectations theory
 The interest rate on a long-term bond will equal an average of short-term
interest rates that people expect to occur over the life of the long-term bond.
 The key assumption is that buyers of bonds do not prefer one maturity over
another, so they will not hold any quantity of a bond if its expected return is
less than that of another bond with a different maturity.
 Treats bond with different maturities as perfect substitutes and thus have the
same expected return.
b. Segmented markets theory
 The interest for each bond with a different maturity is determined by the
demand for and supply of that bond.
 Investors have preferences for bonds of one maturity over another.
 Bonds of different maturities are not substitutes at all
c. Liquidity Premium & preferred habitat theory
 A mixture of expectations and market segments theory.
 The interest rate on a long-term bond will equal an average of short-term
interest rates expected to occur over the life of the long-term bond plus
the liquidity premium that responds to the supply and demand
conditions of that bond.
 Bonds with different maturities are partial substitutes.
 Investors tend to prefer short-term bonds as they have lower interest rate
risk.
 Investors must be offered a positive liquidity premium to induce them to
hold longer-term bonds.
 Preferred habitat Theory
 Investors have a preference for bonds of one maturity over
another
 They will be willing to buy bonds of different maturities only if
they earn a somewhat higher expected return.
 Investors are likely to prefer short-term bonds over long-term
bonds.
Figure 5 The Relationship Between the Liquidity Premium (Preferred Habitat)
and Expectations Theory
Figure 6 Yield Curves and the Market’s Expectations of Future Short-Term
Interest Rates According to the Liquidity Premium (Preferred Habitat) Theory