Money, The Price Level and Inflation

Chapter 26

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Main ideas
After studying this chapter, you will be able to:

• Define money and describe its functions

• 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

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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
• The notes and coins held by individuals and businesses

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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:
o M1 – consists of currency plus cheque deposits owned by individuals and
businesses
o M2 – consists of M1 plus short- and medium-term deposits, such as savings
deposits and money market funds
o 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

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Depository Institutions
• This is a firm that takes deposits from households and firms and makes loans to
other households. 3 types of depository institutional licenses in South Africa:
• 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
• Co-operative banks – promotes a culture of saving 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

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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

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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

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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
• 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:
o Formulate and implement monetary policy
o Issue banknotes and coins
o Supervise the banking sector
o Ensure the effective functioning of the payment system in South Africa
o Act as banker for the government
o Act as lender of the last resort

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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. It is
made up of 5 members including the Governor
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
• 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

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 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

FIGURE 26.1 FIGURE 26.2

FIGURE 31.8

FIGURE 32.8

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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
o The desired reserve ratio is the ratio of reserves to deposits that a bank wants to
hold

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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

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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

FIGURE 26.3 How the banking system creates money by making loans

Increase in
monetary
base

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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: Adjusted for
The Price Level inflation
• If the price level rises by 10 per cent, people hold 10 per cent more nominal money
than before
Not adjusted for
The Nominal Interest Rate inflation
• 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

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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

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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 by the Reserve Bank) and
the money multiplier (depends on the
desired reserve ratio and currency
drain ratio)

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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

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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)

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