Chapter 3 Notes: Financial Institutions, Money, and Interest Rates

Chapter 3: The Basic Model II: Financial Institutions, Money and Interest Rates

Outcome

• Understand and explain the practical operation of financial markets.
• Explain how interest rates are determined by money supply and demand.
• Explain movements in nominal and real interest rates and compare their roles in economic behavior.
• Compose chain reactions to show how monetary disturbances impact interest rates and the real economy, and vice versa.
• Assess the role of monetary policy and the Reserve Bank in determining real income.

Introduction

• Elaboration on interest rates.
• Integration of the monetary sector analysis to understand short-run fluctuations in expenditure.
• Real activities such as consumption, lending, borrowing, investing, saving, and trading rely on the effectiveness of financial institutions.

The Monetary Sector and Interest Rates

• Nominal interest rates: Interest rates at which banks charge customers (e.g., prime rate, savings account rate).
• Real interest rates: Interest rates after adjusting for inflation.
• Approximation: $r ≈ i - π$ where:
  • $r$ = real interest rate
  • $i$ = nominal interest rate
  • $π$ = inflation rate

Practical Determination of Nominal Interest Rates in the Money Market

• Financial market divided into:
  • Money market: Instruments/assets with maturity up to 1 year (short-run).
  • Capital market: Instruments/assets with maturity of more than 1 year (long-run).
• No physical location; banks, pension funds, insurers communicate via telephone, video, computer links.

Financial Institutions

• Commercial banks
• Investment banks
• Pension funds
• Insurers
• Trades occur in the money market, connecting lenders/financial investors (surplus funds) and borrowers (shortage of funds).

Financial Instruments

• Various money market financial papers exist, each with its own nominal interest rate.
• Each paper has a price, implying a certain nominal interest rate for a transaction.
• Main interest rates are determined in the money market.

Financial Paper (Financial Instrument)

Primary Market

• Issued by the government/bank at a price (e.g., R97,000).
• Receive R100,000 at maturity.
• Nominal interest rate calculation example:
  $(\frac{R\ 3000}{R\ 97\ 000}) \times (\frac{365}{91}) \times 100 = 12.45\%$

Secondary Market

• Sold by the holder before maturity (e.g., 18 April 2011) at R98,200.
• The new holder receives R100,000 on 20 May 2011.
• Nominal interest rate calculation example:
  $(\frac{R\ 1800}{R\ 98200}) \times (\frac{365}{61}) \times 100 = 10.97\%$
• Price increase leads to a decrease in the nominal interest rate (inverse relationship)

Main Types of Money Market Paper

• Treasury Bills (TB’s): Issued by the Treasury/government when borrowing from the private sector to finance the budget deficit.
• Negotiable Certificates of Deposit (NCD’s): Issued/sold by banks to obtain cash when experiencing a liquidity/cash shortage.
• Banker’s Acceptance (BA’s): A bill of exchange guaranteed by a bank, used as a payment measure instead of buying inputs on account.

Characteristics of Financial Instruments

• Inverse relationship between the price and the nominal interest rate.
• Price and nominal interest rate are determined by the buying and selling of the paper (supply/demand).
• Changes in nominal interest rate are influenced by money supply (MS) and money demand (MD).

How Supply and Demand of Money Influences i (Nominal Interest Rate)

• Individuals/portfolio managers desire a specific level of cash (money) in their portfolio.
• Surplus: Money supply > Money demand => Want to buy financial papers => Demand increases => Price increases => Nominal interest rate decreases.
• Shortage: Money supply < Money demand => Want to sell financial papers => Supply increases => Price decreases => Nominal interest rate increases.

Money

• Definition: Medium of exchange / means of payment.
• Examples: Cash (coins & notes) and money in cheque accounts.
• Usable immediately for transactions.
• Other financial assets must be converted into cash/money to pay for transactions.

Demand for Money (MD)

• Definition: The amount of money people require for transactions.
• Depends on the volume of goods exchanged.

Determinants

• Income (Y): If Y increases => more transactions => increased money demand (positive relationship).
• Price (P): If the average price level increases => more money is needed for the same transactions => increased money demand (positive relationship).
• Nominal Interest Rates (i): Higher nominal interest rates => less willingness to hold money/cash => decreased money demand (negative relationship).

Three Types of Demand for Money

• Transactions demand: Money needed for active transactions.
• Precautionary demand: Holding money in ready form for unforeseen transactions.
• Speculative demand: Determined by interest rates, influencing the amount of cash held in an asset portfolio.
• Asset portfolio: Consists of money and other financial assets (e.g., bonds/financial papers).
• If interest earned on other financial assets increases => hold less cash and buy assets => money demand decreases.
• Low-interest rates => incentive for greater demand for money.

Money Demand Equations

• In nominal terms: $MD = f(i ; Y ; P)$
  • '-' represents a negative relationship with i.
  • '+' represents a positive relationship with Y and P
• In real terms: $MD/P = f(i ; Y)$
• Can also be rewritten as: $MD/P = kY – li$
  • $k$ = responsiveness of real money demand to changes in real income.
  • $l$ = responsiveness of real money demand to changes in the nominal interest rate.
• If the average price level (P) increases, the money required increases to maintain the same real amount of money for transactions.

Shifts in the Money Demand Curve

• Changes in Y:
  • Y increases => shift right.
  • Y decreases => shift left.
• Changes in P:
  • P increases => shift left.
  • P decreases => shift right.
  • Changes in i result in moves ALONG the curve.

The Money Supply (MS)

• Definition:
  • Nominal stock of money present in the economy at a particular moment.
  • Amount of money the monetary system (Reserve Bank and financial institutions) is supplying.

Money Supply Definitions

• M1A: Coins and banknotes in circulation + cheque and transmission deposits of the domestic private sector at monetary institutions.
• M1: M1A + other demand deposits held by the domestic private sector at monetary institutions.
• M2: M1 + other short-term deposits and all medium-term deposits at monetary institutions (including savings deposits).
• M3: M2 + all long-term deposits held by the domestic private sector.

Determinants of Money Supply

• Nominal quantity of money available (Ms) results from the money creation process.
• Money creation process (by extension of credit/loans) occurs via:
  • Lending by the commercial banking system (using deposits of clients).
  • Deliberate actions of the Reserve Bank as part of monetary policy.

The Money Creation Process via Lending by Commercial Banks

• Lending and relending take place multiple times, causing the eventual effect on the money stock to be greater than the initial injection.
• Credit multiplier process:
  • Limited by bank liquidity requirements / cash reserve requirements (leakage).
  • Banks must hold a certain percentage of money (e.g., 2.5% of total liabilities).
• Credit multiplier = $1 / R$
  • $R$ = cash reserve requirement.
  • South Africa: $1 / 0.025 = 40$
• Banks may hold excess reserves (higher than 2.5%), which will lower the amount that can be relent during the credit multiplier process, restraining money creation.

Why Banks Hold Excess Reserves

• Security during periods of uncertainty.
• Buffer against unexpected large withdrawals of cash by clients.
• Opportunity cost, as interest could be earned by providing loans.
• Higher interest rates will discourage the holding of excess reserves and encourage maximum lending => increase money creation (Ms).
• Implies a positive relationship between the interest rate and money creation.

Role of the Reserve Bank in the Money Supply Process

Recap: Factors that Determine the 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.

The Reserve Bank can also use the following instruments to influence the money supply:

1. Repo rate (repurchase rate):
   • Nominal rate commercial banks pay when borrowing from the Reserve Bank.
   • Functions as ‘lender of last resort’.
   • Increase repo rate => discourage loans from the SARB and restrain the money creation process => Ms decreases.
   • Repo rate is formally announced by the governor of the SARB after Monetary Policy Committee meetings.
2. Open market operations (OMO’s):
   • The SARB’s buying and selling of government bonds in the secondary market.
   • Selling bonds withdraws money from circulation and decreases Ms.
   • Buying bonds bring money into circulation and increases Ms.

The Money Supply Function

• 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: $MS/P$
• Due to excess reserves held by banks, there is a positive relationship between interest rates and MS, implying a positive slope.
• However, the positive relationship is valid until banks are fully loaned up – at this point, the MS becomes vertical.
• We use the simple vertical Ms/P curve in our analyses.

Equilibrium in the Monetary Market

• Money supply = Money demand
• $MS/P = MD/P$
• $MS/P = kY – li$

Shifts in Money Supply and Demand Curves

• A shift in either or both curves will lead to a new interest rate level.
• Increase in money demand, due to an increase in Y, will lead to a higher interest rate level.
• An increase in money supply will cause the interest rate level to decrease.

Chain Reaction: Increase in Y

• 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 a new level, because the price level decreases.
• This is why an increase in real demand for money causes the nominal interest rate to increase.

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, indicating that interest rates are expected to increase in the future.
• Negative yield curve: Short-term interest rates are higher than long-term interest rates, indicating that interest rates are expected to decrease in the future.