Money, The Price Level and Inflation — Chapter 26 Notes (SA context)

What is Money?

  • Money is a means of payment (a method of settling a debt).

  • It serves three broad functions:

    • Medium of Exchange: a generally accepted instrument for buying goods and services.
    • Unit of Account: an agreed measure for stating prices of goods and services.
    • Store of Value: money can be held today and exchanged later for goods and services.

  • Money in South Africa today comprises:

    • Currency: the notes and coins held by individuals and businesses.
    • Deposits: deposits of individuals and businesses at banks and other depository institutions (e.g., Postbank).

Money in South Africa Today

  • Official measures of money in SA today are three broad aggregates:

    • M1: currency + cheque deposits owned by individuals and businesses.
    • M2: M1 + short- and medium-term deposits (e.g., savings deposits and money market funds).
    • M3: M2 + money deposited for longer time horizons (e.g., pension funds).

  • Important distinctions:

    • Deposits are money, but debit cards and cheques are not money (money is transferred via mechanisms, not the plastic or paper).
    • Credit cards are not money (the card itself is not the means of payment).

  • These definitions reflect the degree of liquidity and the types of instruments that can be readily used as money.

Deposits and Depository Institutions

  • A depository institution is a firm that takes deposits from households and firms and makes loans to other households.

  • Three types of depository licenses in South Africa:

    • Commercial banks: act as intermediaries between surplus units and deficit units.
    • Mutual banks: operate like commercial banks but with limited assets.
    • Co-operative banks: promote saving in SA.

  • Profit and Prudence: a balancing act

    • Banks aim to maximise the net worth of shareholders; typically, the interest rate charged on loans exceeds the rate paid to depositors.
    • Banks must be prudent, balancing security for depositors with profit for shareholders.

  • What depository institutions do:

    • Provide cheque clearing, account management, credit cards, and internet banking.
    • Income mainly comes from lending and from buying securities that earn higher interest than the rate paid to depositors.

  • Asset classification for a commercial bank:
    1) Reserves: notes and coins in the bank’s vault or in a deposit account at the SA Reserve Bank.
    2) Liquid assets: government Treasury bills and other short-term instruments (e.g., commercial paper).
    3) Investment securities: longer-term bonds (including government bonds).
    4) Loans: fixed amounts lent for agreed periods.

  • Economic benefits provided by depository institutions:

    • Create liquidity by transforming short-term liabilities into longer-term assets.
    • Pool risk: a loan might default; diversification helps manage this risk.

  • Why depository institutions lower costs:

    • Lower the cost of searching for a borrower and monitoring borrowers, reducing information and enforcement costs.

  • Regulation and financial safety:

    • Bank failures can damage the entire financial system; therefore, institutions are regulated to hold adequate reserves and capital.
    • Regulation aims to minimise systemic risk and protect depositors.

  • Financial innovation:

    • Ongoing innovations to improve products and services (examples): credit cards, internet payments, cellphone banking, online transfers, etc.

The South African Reserve Bank (SARB)

  • The SARB is the central bank of South Africa; it acts as the banks’ bank and regulates depository institutions.

  • Primary goal: price stability in SA’s economic system; also responsible for formulating and implementing monetary policy and ensuring financial stability.

  • The Reserve Bank’s responsibilities include:

    • Formulating and implementing monetary policy.
    • Issuing banknotes and coins.
    • Supervising the banking sector.
    • Ensuring the effective functioning of the payment system.
    • Acting as banker to the government.
    • Acting as lender of last resort.

The Structure of the Reserve Bank

  • The SARB is not owned by the government, but it is accountable to Parliament.

  • Governance: Board of Directors (15 members).

  • The Monetary Policy Committee (MPC): the main policy-making body; composed of 5 members including the Governor.

  • Policy tools to influence money in circulation and price stability:

    • Required Reserve Ratios: banks must hold a minimum percentage of deposits as reserves.
    • Repo Rate: the rate at which the SARB provides finance to banks to meet reserve requirements.
    • Open Market Operations (OMO): the purchase or sale of government securities and SARB debentures in the open market to influence the monetary base.

The South African Reserve Bank – Policy Tools in Detail

  • Required Reserve Ratios
    • All depository institutions must hold a minimum percentage of deposits as reserves.
  • Repo Rate
    • The primary mechanism for implementing monetary policy; the SARB lends to banks at the repo rate to meet reserve requirements.
  • Open Market Operations (OMO)
    • Involves the purchase or sale of Treasury bills, government bonds, and SARB debentures in the open market to influence the quantity of money.

How Banks Create Money

  • The majority of money is in the form of deposits, not cash; banks create deposits when they make loans.

  • Creating deposits by making loans:

    • Example: When you swipe a credit card, the seller receives a bank deposit (credit to seller) and the buyer obtains a bank loan (debt of the buyer).

  • Three factors limit the quantity of deposits the banking system can create:

    • The Monetary Base (MB): the total of banknotes and coins in circulation plus deposits that banks hold at the central bank.
    • The Desired Reserves: the reserve ratio that banks wish to hold relative to deposits.
    • The Desired Cash Holdings: the public’s preference for holding cash, i.e., currency held by the non-bank sector.

  • The Monetary Base (MB) in South Africa, in the context of this framework, is the sum of currency in circulation plus bank reserves held at the central bank.

  • The currency drain (or currency drain ratio) is the portion of money that the public holds as currency rather than as deposits; it represents leakage from the banking system.

  • What happens when the central bank changes the MB:

    • When the central bank buys securities from banks, the banks’ reserves increase, but their deposits do not necessarily change immediately; this creates excess reserves that can be lent out, expanding deposits.

  • The money creation process is thus a cycle of lending and deposit creation conditioned by reserve requirements and currency holdings.

The Demand for Money

  • Definition: The quantity of money that people plan to hold on any given day (the money they want to hold as liquid assets).

  • Money demanded must equal money supplied in equilibrium.

  • Influences on money holding include four factors:

    • The Price Level: If the price level rises by 10%, people hold 10% more nominal money than before.
    • The Nominal Interest Rate: Higher opportunity cost of holding money reduces the quantity of real money demanded.
    • Real GDP: The amount of money households and firms plan to hold depends on how much is being spent; higher GDP generally raises money demand.
    • Financial Innovation: Technological changes and new financial products influence the quantity of money held (e.g., daily interest cheque deposits, automatic transfers, ATMs, credit/debit cards, internet banking, bill paying).

  • The Demand for Money Curve:

    • It is the relationship between the quantity of real money demanded and the nominal interest rate, holding other influences constant.
    • Shifts in this curve occur due to changes in real GDP or financial innovation (which alter how much money people wish to hold).

The Supply of Money and the Money Market

  • The money market is the arena where money demand and money supply interact to determine the interest rate (the price of money).

  • Money market equilibrium: Occurs when the quantity of money demanded equals the quantity of money supplied.

  • The price of money is the interest rate, representing the opportunity cost of holding money.

  • The supply of money depends on two components:

    • The Monetary Base (MB), which is influenced by the central bank.
    • The Money Multiplier (the factor by which the base money is expanded into broad money).
    • The money multiplier depends on the desired reserve ratio (rr) and the currency drain ratio (c).

  • Key relationships (summary):

    • MB = C + R, where C is currency in circulation and R are reserves held by banks at the central bank.
    • The broad money supply M is related to MB via the Money Multiplier: M = m \, MB\quad\text{where}\quad m = \frac{1}{rr + c}.
    • The monetary base can be expanded or contracted by the central bank through tools like open market operations.

  • The effect of monetary policy on the money market:

    • If there is a surplus of money (money demand > money supply), people buy bonds in the loanable funds market, raising the price of bonds and lowering the interest rate.

  • Long-run equilibrium considerations:

    • When inflation equals expected inflation and real GDP equals potential GDP, the money market, loanable funds market, the goods market, and the labor market are in long-run equilibrium.

The Quantity Theory of Money

  • Core idea: In the long run, the price level adjusts so that the quantity of real money demanded equals the quantity supplied.

  • Key proposition: An increase in the quantity of money leads to a proportional increase in the price level (inflation) in the long run, assuming the velocity of money is relatively stable.

  • Important definitions:

    • Velocity of circulation (V): The average number of times a unit of currency is used in a year to purchase the goods and services that make up GDP.
    • Real GDP (Y): The quantity of goods and services produced, adjusted for inflation (or in some expositions, at current prices depending on context).
    • The quantity theory is often written as the identity: M \cdot V = P \cdot Y.

  • From the identity, velocity can be expressed as: V = \frac{P\cdot Y}{M}.

  • The Theory’s implication for inflation: If the money supply grows faster than real output (and if velocity is stable), the price level rises, producing inflation. Conversely, if money grows slowly, inflation is low or even negative (deflation) if real output grows faster.

  • In the context of the long-run framework in this chapter, the velocity is treated as a factor that influences, but does not by itself negate, the relationship between money growth and inflation.

Key Relationships and Formulas (Summary)

  • Money demand and supply relationships:
    • Demand for money: the real money demand M^d depends on price level, nominal interest rate, real GDP, and financial innovation.
    • Supply of money: M^s = m \cdot MB, \quad m = \frac{1}{rr + c}, \quad MB = C + R.
  • Quantity theory identity:
    • M \cdot V = P \cdot Y.
    • In the long run, growth in the money supply translates into inflation proportional to the money growth rate, assuming velocity is stable.
  • Money market equilibrium and policy effects:
    • Equilibrium when money demanded equals money supplied.
    • Monetary expansion (increase MB) tends to lower interest rates in the short run (if demand is relatively inelastic) and raises deposits and money in the system, while in the long run it affects the price level via the money growth channel.

Practical Implications and Real-World Relevance

  • The central bank (SARB) uses monetary policy to influence the money supply and the price level with the aim of price stability, which supports sustainable economic growth and employment.
  • Financial innovation changes how people hold money, which can shift the demand for money and alter the effectiveness of monetary policy.
  • The money multiplier concept shows how the base money created by the central bank can be amplified through the banking system, but the extent of amplification depends on bank reserve habits and public currency preferences.
  • Understanding the long-run relationship between money growth and inflation helps explain why persistent money supply growth without proportionate real output growth can lead to inflationary pressures.