Chapter 3
THE BASIC MODEL II: FINANCIAL
INSTITUTIONS, MONEY AND INTEREST RATES
Outcome
Understand and explain the everyday, practical operation of financial
markets.
Explain the way interest rates are determined by money supply and
demand.
Explain movements in nominal and real interest rates and compare the
different roles of nominal and real interest rates in economic behaviour.
Compose chain reactions that show how monetary disturbances impact
on interest rates and the real economy, and vice versa, and evaluate
these with appropriate graphical aids.
Asses the role of monetary policy and the Reserve Bank in the
determination of real income.
Introduction
Elaborate on interest rates, which was left unexplained in previous
chapter.
This chapter integrates the analysis of the monetary sector and improve
the understanding of short-run fluctuations in expenditure.
Real activities like consumption, lending, borrowing, investing, saving,
and trading require the effectiveness of financial institutions, as
illustrated in the following graph.
Chapter 3: The basic model II: financial institutions, money and
interests rates
Page 70 A
4
3.1 The monetary sector and
interest rates
Nominal interest rates – interest rates at which banks charge the
customer, like the prime rate or the rate earned on a savings account.
Real interest rates – interest rates earned in effect after the eroding
effect of inflation has been removed from the nominal value.
r≈i-π
3.1 The monetary sector and interest rates (continue)
The practical determination of nominal interest rates in the
money market
◦ Financial market can be divided into the money market and the
capital market.
◦ The money market – handles instruments/assets with a term to
maturity of up to 1 year (short-run).
◦ The capital market - handles instruments/assets with a term to
maturity of more than 1year (long-run).
◦ No physical location / building
◦ Banks, pension funds, insurers in contact with each other via
telephone, video, computer links
The practical determination of nominal interest rates
in the money market
 Financial institutions
 Commercial banks
 Investment banks
 Pension funds
 Insurers
 Trades take place in the money market, where lenders / financial investors
(with surplus funds) and borrowers (with shortage funds) connects.
The practical determination of nominal interest rates in the
money market
◦ Financial instruments
◦ Various kinds of money market financial papers exists, each with its own
nominal interest rate.
◦ Each paper has a price, which implies a certain nominal interest rate for a
transaction.
◦ The main interest rates are those determined in the money market.
The practical determination of nominal interest rates
in the money market
Financial paper (financial instrument)
Bank /
Government
(borrower)
TREASURY BILL / NCD / BA
Face value: R 100 000
Maturity date: 20 May 2011 (91 days)
Funds / money
Primary market
◦ Issued by the government / bank at a price, e.g. R97 000
◦ Receive R100 000 at maturity
◦ Nominal interest rate:
◦ (R 3000 / R97 000) x (365 /91) x 100 = 12.45%
Secondary market
◦ Sold by the holder before maturity (e.g. 18 April2011) at R98 200
◦ The new holder will receive R 100 000 on 20 May 2011
◦ Nominal interest rate:
◦ (R 1800 / R98200) x (365/61) x 100 = 10.97%
◦ PRICE INCREASE, NOMINAL INTEREST RATE DECREASES
Public ( lender /
investor)
3.1 The monetary sector and interest rates (continue)
◦ Main types of money market paper:
◦ Treasury Bills (TB’s) – Issued by the Treasury/government when
it borrows from the private sector during the course of the year
in order to finance the budget deficit.
◦ Negotiable certificates of deposit (NCD’s) – Arise when shortterm financial investments are made at banks. Are issued/sold
by banks in order to get hold of cash when they experience a
liquidity/cash shortage.
◦ Banker’s acceptance (BA’s) – Is a bill of exchange that is
guaranteed by a bank. (Instead of buying inputs on account can
the BA be used as a measure of payment).
3.1 The monetary sector and interest rates (continue)
◦ Characteristics of financial instruments:
◦ There is a inverse relationship between the price and the
nominal interest rate.
◦ The price and nominal interest rate is determined by the
buying and selling of the paper (supply/demand).
◦ However, what cause the nominal interest rate to change
(supply/demand to change)?
◦ A better understanding can be reached by examining the
supply (MS) and demand of money (MD) – The role of money
in the economy.
3.1 The monetary sector and interest rates (continue)
◦ How supply and demand of money influences i
◦ Individuals/portfolio managers want a certain level of
cash (money) in their portfolio.
◦ If too much cash in portfolio (money supply > money
demand = surplus)– want to buy financial papers –
demand increase – price increase of papers – nominal
interest rate decrease (inverse relationship).
◦ If shortage in portfolio (money supply < money demand)
–want to sell their financial papers – supply of financial
papers increase – price decrease – nominal interest rate
increase (inverse relationship).
3.1 The monetary sector and interest rates (continue)
◦ Money:
◦ Definition:
◦ Medium of exchange / means of payment
◦ E.g. cash (coins & notes) and money in cheque
account.
◦ Can be used immediately to pay for transactions
◦ If you want to pay for something, you need to
convert other financial assets into cash / money…
3.1 The monetary sector and interest rates (continue)
◦ Demand for money (MD)
◦ Definition:
◦ The amount of money people require for transactions.
◦ Depends on the volume of goods exchanged
3.1 The monetary sector and interest rates (continue)
◦ Demand for money (MD)
◦ Determinants:
◦ 1. Income:
◦ If Y increase – will do more transactions – need more money demand for money increase (positive relationship).
◦ 2. Price:
◦ If average price level increase – need more money to pay for
the same transactions - demand for money increase
(positive relationship).
◦ 3. Nominal interest rates
◦ Higher nominal interest rate earned on financial instruments –
less willing to hold money / cash – decrease demand for money
(negative relationship)
3.1 The monetary sector and interest rates (continue)
◦ Three types of demand for money
◦ Transactions demand – the need for money to use in ‘active’
form in transactions.
◦ Precautionary demand – holding money in ‘ready’ form,
because one cannot foresee all transactions at all times.
◦ Speculative demand – depending on the interest rates, will
determine the amount of cash that will be held in one’s asset
portfolio.
◦ Asset portfolio consist of money and other financial assets
(e.g. bonds / financial papers…).
◦ If interest earn on other financial assets increase - hold less
cash and buy assets – money demand decrease.
◦ Low interest rates => incentive for greater demand of money.
3.1 The monetary sector and interest rates (continue)
In nominal terms: MD = f(i ; Y ; P)
- + +
In real terms: MD÷P = f(i ; Y)
Can also rewrite as: MD÷P = kY – li
◦ With k as the responsiveness real money demand is to changes in real
income.
◦ With l as the responsiveness real money demand is to changes in the
nominal interest rate.
◦ If average price level (P) increases, the money required increases, in
order to have the same real amount of money to conduct
transactions.
3.1 The monetary sector and interest rates (continue)
What will shift the curve:
Changes in Y
◦ Y increase, shift right
◦ Y decrease, shift left
Changes in P
◦ P increase, shift left
◦ P decrease, shift right
(changes in i will result in
moves ALONG the curve)
3.1 The monetary sector and interest rates (continue)
The money supply (MS)
◦ Definition:
◦ The nominal stock of money (money supply) is the amount of money that is
present in the economy at a particular moment
◦ The amount of money that the monetary system (Reserve Bank and financial
institutions) is supplying at a particular moment.
◦ There are four different money supply definitions:
◦ M1A – Sum of coins and bank notes in circulation, plus cheque and transmission deposits
of the domestic private sector at monetary institutions.
◦ M1 – M1A plus other demand deposits held by the domestic private sector at monetary
institutions.
◦ M2 – M1 plus other short-term deposits and all medium-term deposits at monetary
institutions (including savings deposits).
◦ M3 – M2 plus all long-term deposits held by the domestic private sector.
3.1 The monetary sector and interest rates (continue)
Determinants of Money supply
◦ The nominal quantity of money available (Ms) is the result of
the money creation process:
◦ Money creation process (by extension of credit/loans) occurs
via:
◦ The lending by the commercial banking system (using
deposits of clients).
◦ The deliberate actions of the Reserve Bank as part of
monetary policy.
3.1 The monetary sector and interest rates (continue)
Individual /firm
The money creation process via lending by commercial
banks:
Deposit
Cash reserve requirement
Commercial Bank
borrower
Loan
Buys goods / services
supplier
Cash reserve requirement
Deposit
Commercial Bank
Loan
borrower
supplier
Deposit
Commercial Bank
3.1 The monetary sector and interest rates (continue)
The money creation process via lending by commercial banks:
◦ Lending and relending takes place for a number of times – causing that the
eventual effect on the money stock to be greater than the initial injection – called
the credit multiplier process.
◦ The amount of money that each round in the credit multiplier is limited by means
of bank liquidity requirements / cash reserve requirements (leakage) – banks must
hold a certain percentage of money – must be 2.5% of total liabilities.
◦ Credit multiplier = 1 / R
◦ R = cash reserve requirement
◦ South Africa: 1 / 0.025 = 40
◦ Banks can also decide to hold excess reserves (higher than 2.5%), which will lower
the amount that can be relent during the credit multiplier process – restraining the
money creation process.
3.1 The monetary sector and interest rates (continue)
Why banks hold excess reserves?
◦ In periods of uncertainty excess reserves provide security.
◦ Provide buffer to protect bank against unexpected large withdrawals of cash
by clients.
◦ Excess reserves have an opportunity cost, because could earn interest by
using the money in providing loans.
◦ Higher interest rates will discourage the holding of excess reserves and
encourage maximum lending – increase money creation (Ms).
◦ Implies that there are a positive relationship between the interest rate and
money creation.
3.1 The monetary sector and interest rates (continue)
Role of the Reserve Bank in the money supply process
◦ Recap: three factors that determine supply of money:
1. Injections (Ms increases) of money into and withdrawals
(Ms decreases) from the banking system.
2. Banks voluntarily holding excess reserves (MS decreases).
3. Changes in the minimum reserve requirements.
◦ increase => decrease in Ms
◦ decrease => increase in Ms
◦ The last factor is under the control of the Reserve Bank.
◦ Two other ways the Reserve Bank can influence Ms…
3.1 The monetary sector and interest rates (continue)
◦ The Reserve Bank can also use the following instruments to influence the money supply:
4. Repo rate (repurchase rate)
DEF: the nominal rate that commercial banks have to pay when they borrow from
the Reserve Bank– function as ‘lender of last resort’.
◦ Increase repo rate => discourage loans from the SARB and restrain money
creation process => Ms decreases.
◦ Repo rate is formally announced by the governor of the SARB after the regularly
scheduled meetings of the Monetary Policy Committee.
5. Open market operations (OMO’s)
DEF: The SARB’s buying and selling of government bonds in the secondary market
(issued for first time in primary market by Treasury).
◦ Selling bonds withdraw money from circulation and decrease Ms
◦ Buying bonds bring money into circulation and increase Ms
SEE SUMMARY ON PAGE 88
3.1 The monetary sector and interest rates (continue)
The money supply function
◦ The nominal money supply (MS) is mainly a function of exogenous policy
factors under the control of the monetary authorities.
◦ VERTICAL money supply curve that shifts left or right by changes in Ms due to
MONETARY POLICY steps.
◦ In real terms: MS÷P
◦ BUT As already discussed: Due to excess reserves held by banks, there is a
positive relationship between interest rates and MS, which implies a positive
slope.
◦ However, the positive relationship is valid until point where banks are fully
loaned up – at this point the MS becomes vertical.
◦ See figure on the following slide.
◦ We use the simple vertical Ms/P curve in our analyses.
3.1 The monetary sector and interest rates (continue)
3.1 The monetary sector and interest rates (continue)
Equilibrium in the monetary
market:
Money supply = Money
demand
◦ MS÷P = MD÷P
◦ MS÷P = kY – li
3.1 The monetary sector and interest rates (continue)
◦ A shift in either or both of the curves will lead to a new
interest rate level.
◦ Increase in money demand, due to increase in Y, will lead
to a higher interest rate level.
◦ Increase in money supply will cause the interest rate level
to decrease.
◦ More in detail:
◦ For example – increase in Y cause the real demand for
money
30
3.1 The monetary sector and interest rates (continue)
CHAIN REACTION:
Y increases =>> MD/P increases
At the initial interest rate – there is an excess demand for money.
Require more money than currently in their portfolio.
Sell financial instruments/assets to get more money.
Causes downward pressure on prices of financial instruments/assets.
Due to inverse relationship between prices and interest rates – interest
rates will increase to new level, because the price level decrease.
This is why in increase in real demand for money cause the nominal
interest rate to increase.
3.1 The monetary sector and interest rates (continue)
There is also a relationship between short-term and long-term interest
rates - term structure of interest rates (yield curve).
Positive yield curve – short-term interest rates are lower than long-term
interest rates – indicates that interest rates are expected to increase in
the future.
Negative yield curve – short-term interest rates are higher than longterm interest rates – indicates that interest rates are expected to
decrease in the future.
WE WILL CONTINUE ON WEDNESDAY