2

Table of Contents
Part 1- Introduction
Chapter 1: Why study money, banking and financial markets?
Chapter 2: An overview of the financial system
Chapter 3: What is money?
Part 2 - Financial Markets
Chapter 4: Understanding interest rates
Chapter 5: The behaviour of interest rates
Chapter 6: The risk and term structure of interest rates
Part 3 - Financial institutions
Chapter 8: An economic analysis of financial structure Chapter 9
: Financial crises in advanced economies Chapter 10: Financial
crises in emerging market economies Chapter 11: Banking and
the management of financial
institutions
Part 4 - Central banking and the conduct of monetary policy Chapter 14:
Central banks: a global perspective
Chapter 15: The money supply process
Chapter 16: Tools of monetary policy
Chapter 17: The conduct of monetary policy
Part 5 - Not Prescribed
Part 6 - Monetary theory
Chapter 20: Quantitative theory, Inflation and the demand for
money
Chapter 21: The IS curve
Chapter 24: Monetary policy theory
Chapter 25: The role of expectations in monetary policy
Chapter 26: Transmission mechanisms of monetary policy
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Part one: Introduction

(Textbook: Chapters 1, 2 and 3)

CHAPTER 1: WHY STUDY MONEY, BANKING AND FINANCIAL MARKETS

Why study financial markets?

Securities - a claim on the issuer’s future income or assets that is sold by a

borrower to a lender. Securities may also be referred to as financial
instruments. Financial instruments may be divided into two main categories:
money market instruments (e.g. Negotiable Certificate of Deposit (NCDs),
Commercial Papers; Retirement Annuity (RAs) and Bankers Acceptance
(Bas)) and capital market instruments (e.g. bonds and shares).

Bonds - a specific type of security, namely a debt security that promises to

make payments periodically for a specified period of time.

Interest rate - cost of borrowing or the price paid for the rental of funds. “The”
interest rate is made up of a number of different interest rates that exist in an
economy. E.g. mortgage, car loan etc

Bond Market is especially important to economic activity because it enables

corporations and governments to borrow to finance their activities and it is
where interest rates are determined.

Stock Market is the market in which claims on the earnings of corporations

(shares of stocks) are traded. In SA we refer to the trading of shares rather
than stocks.

Stock (share) - equity: a financial instruments representing part ownership of a

corporate entity. Sometimes referred to as common stock as compared to
the more specialized type of share, e.g. preference shares. Issuing shares is a
way in which a company can raise funds.

Importance of stock /stock market: the price (value) of shares affects the
amount of funds that can be raised by selling newly issued stock to finance
investment spending. The higher the price of a firm’s shares the more money
can be raised to buy, e.g. machinery and equipment to increase production.
Also, as per the study guide: the stock market creates a facility for financial
investors to invest their surplus funds and for firms to facilitate real investment.

Why study financial institutions and banking?

Structure of the Financial System:

The financial system is complex, comprising many different types of private
sector financial institutions (banks, insurance companies, mutual funds,
finance companies, investment banks) all of which are heavily regulated by
Government.
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Financial Intermediaries - institutions that borrow funds from people

(surplus units) who have saved and in turn make loans to others (deficit
units).

Financial Innovation - shows how creative thinking on the part of

financial institutions can lead to higher profits. To keep in touch with
what is happening within the financial systems of the world it is
necessary to study the changes that innovation has brought about.
One example is the way in which dramatic improvements in
information technology have brought about new means of delivering
financial services electronically (e-finance).

Why study money and monetary policy?

Definition of money: money is defined as anything that is generally accepted

in payment for goods and services (in terms of its function as a medium of
exchange). In this course, the term money generally refers to the money
supply.

Importance of Money: money is linked to changes in economic variables

and is important to the health of the economy. Money plays an important
role in generating business cycles: empirical data indicates that, in the USA,
the rate of growth in money supply has declined before every recession;
however, not every decline in money growth is followed by a recession.
Inflation is believed to be caused by continuing increases in money supply.
Money plays an important role in interest rate fluctuations.

Aggregate Output: gross domestic product (GDP) = the market (total) value
of all final goods and services produced in a country during the course of a
year.

Aggregate Income: total income received for the use of factors of

production (land, labour and capital) used to produce all the goods and
services in the economy during the course of the year.

Business Cycles: the upward and downward movement of aggregate

output produced in the economy.

Aggregate price level: the average price of goods and services in an

economy. Three commonly used measures are the GDP deflator (nominal
GDP divided by real GDP), the consumer price index (CPI) and the personal
consumption expenditure deflator (PCE).

Inflation: a continual increase in the aggregate price level in an economy.

The price level and money supply generally rise together.
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Monetary Policy: the management of money and interest rates by the

central monetary authorities. Because money can affect many economic
variables in the economy, politicians and policymakers care about the
conduct of monetary policy.

Real versus Nominal GDP: nominal GDP indicates that current prices are used
to measure GDP. Real GDP is nominal GDP adjusted to remove inflation and
using constant prices from an identified base year.

Don’t forget to study Appendix 1 at the end of the chapter!

Typical Examination questions

1.1 Explain briefly and in general terms what is the meaning of a security and
how it facilitates direct lending and borrowing. (5)
1.2 Explain briefly what is a common stock, what purpose it serves and how it
affects business investment decisions. (4)
1.3 List two ways in which the quantity of money may affect the economy. (2)
1.4 Explain the difference between nominal and real GDP and the purpose
for which each should be used. (4)
1.5 List and define three commonly used measures of the aggregate price
level. (6)

True or false review questions

Money:
1. Monetary economics primarily teaches students how to make money
quickly and effortlessly.
2. A decrease in the interest rate normally increases the money stock in
the economy.
3. Because money is complex, it is difficult to demonstrate the real
advantages of money within the economy.
4. The use of money introduces sources of instability in the economy.
5. When interest rates rise, then all households are worse off.

Securities:
6. A security is a financial instrument. In simple terms it is a "piece of
paper" which is sold by the issuer to investors in exchange for funds. The
security promises to repay these funds (plus interest) over the term of
the security by means of a number of (one or more) future payments
to the holder of the security.
7. A security is issued mostly by firms and government that wish to borrow
money.
8. The issuer of a security promises to make future payments to the holder
(purchaser) of the security.
9. The purchaser of a security provides cash to the issuer of a security.
10. The purchaser of a security is the lender (provider of funds).
11. The issuer of a security is the borrower of funds.
12. The holder (purchaser) of the security receives future payment/s from
the issuer of the security.
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13. Securities can be traded on the financial market. When holder A of a

security sells the security in the financial market at the going market
price to B then B pays cash to A and B receives the remaining
payments of the security.
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CHAPTER 2: AN OVERVIEW OF THE FINANCIAL SYSTEM

Function of financial markets.

Functions and advantages of financial markets in general: they allow funds

to flow from people who lack productive investment opportunities but have
surplus funds, to people who have such opportunities but do not have the
funds to make it happen

Direct financing: borrowers borrow funds directly from lenders in the financial
markets by selling them securities. Remember that both borrowers and/or
lenders can be households, businesses, government and foreigners.

Indirect financing: this refers to the activities of financial intermediaries such

as commercial banks in facilitating and reconciling the different requirements
of borrowers and lenders via the process of financial asset transformation.
[Example: banks accept deposits from savers and lend that money out to
borrowers.]

Financial markets are critical for producing an efficient allocation of capital.

Structure of financial markets

How does a debt instrument work? A debt instrument is a contractual

agreement by the borrower to pay the holder of the instrument fixed amounts
at regular intervals (interest and principal payment) until a specified date
when the final payment is made (maturity date).

Maturity of a debt instrument: number of years (term) until the instruments

expires or becomes paid up. It is short-term if it is less than a year and long-
term if it is ten years or longer with the intermediate-term being between one
and ten years. In South Africa however, any financial instrument with a
lifespan that is longer than a year is referred to as long-term and is traded in
the capital market.

An equity instrument: is a claim to share in the income and net assets of a

business. It is more commonly known as a stock or share. An advantage of
such an instrument is that the holder owns part of the business. You essentially
own a part of the business and are therefore awarded the right to vote on
important issues to the firm as well as elect the directors. You will also benefit
from an increase in the firms profitability or asset value. A disadvantage is that
the holder is a residual claimant. This means that the business must pay its
debt holders before it pays its equity holders. Such an instrument has no
maturity date.

The structure of the different financial markets relates to the type of functions
and the type of financial instruments that are found in each of them.

 Debt and Equity markets: Debt market is that market in which

debt instruments are traded, while an equity market is a market in
which equity instruments are traded, e.g. stock exchange.
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 Primary and Secondary markets: Primary market is the market

in which financial instruments are issued, while the secondary
market is the market in which financial instruments are traded.

o An important financial institution that assists in the initial sale of

securities in the primary market is the investment bank. It does
this by underwriting securities and guarantees a price for a
corporations securities and then sells them to the public.

 Exchanges and OTC Markets: Secondary markets can be

organised in two ways:

 Exchanges: a place specifically designed for the meeting of

buyers and sellers of securities.

 Over-the-counter-markets: dealers at different locations who

have an inventory of securities stand ready to buy and sell
securities “over the counter” to anyone who comes to buy
(e.g. US bond market).

 Money and Capital Markets: the money market is the market in

which short-term financial instruments are traded, such as TBs,
NCDs, CPs etc. The capital market is where longer-term financial
instruments are traded e.g. stocks and long-term bonds.

Financial (Money) Market Instruments

Treasury Bills (TBs): short-term (1, 3, 6 month) debt instrument issued by

government. It is a primary security. It represents a claim on the government
payable at some future date. TBs are fully secured and guaranteed by the
government in SA.

Negotiable Certificate of Deposit (NCD): a debt instrument sold by a bank to

depositors that pays annual interest of a given amount and at maturity pays
back the original purchase price. Negotiable NCDs are sold in the secondary
market.

Commercial Paper: a short-term debt instrument issued by large banks and

well-known corporations. In SA it is described as a short- or medium-term
security (securities) issued by corporations and other non-banking institutions
to acquire working capital.

Banker’s Acceptances (BAs): a bank draft (a promise of payment) issued by

a firm, payable at some future date, and guaranteed for a fee by the bank
that stamps it. The firm issuing the instrument is required to deposit the
required funds into its account with the bank to cover the draft.
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Repurchase agreements (Repos or RAs): short-term loans (normally less than

two weeks) for which TBs serve as collateral. Most notable lenders in this case
is large corporations.

Capital Market Instruments

Debt and equity instruments have maturities of greater than one year
(medium and long term) and are traded in the capital market. Prices of
these instruments fluctuate more than those of money market instruments.
Generally considered to be riskier investments.

Stocks: equity claims on the net income and assets of a corporation.

Mortgages: loans to households and/or firms to purchase housing, land or

other real structures where the structure or land serves as collateral for the
loans. The mortgage market is the largest debt market in the USA.

Corporate Bonds: long-term bonds issued by corporations with very strong

credit ratings. Typical corporate bond will grant the holder an interest
payment twice a year and pays off the face value when the bond matures
(on maturity date).

Convertible Bonds: Work in the same way as corporate bonds with the added
benefit of the holder being able to convert the bond into a specified number
of shares of stock at any time up to the maturity date.

Government Securities: long-term debt instruments issued by the Treasury to

finance deficits of the central government. They are the most widely traded
bonds in the USA (and in SA). They are also the most liquid of the securities
traded in the secondary market. Local government bonds are also referred
to as municipal bonds. The market for these bonds in South Africa is very
limited. In the US the income on these bonds is exempt from federal taxes
and state taxes.
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Function of financial intermediaries

The main function of financial intermediaries is moving funds between

borrowers and lenders in the economy. This process is referred to as financial
intermediation and is the primary way in which funds are moved from lenders
to borrowers. In order to understand the importance of this form of
“financing” it is necessary to consider the role of each of the following:

 transaction costs
 risk sharing
 information costs in financial markets

Transaction costs: financial intermediaries can substantially reduce

transaction costs because they can take advantage of economies of scale.
They can also provide customers with liquidity services which make it easier to
conduct transactions e.g. cheque accounts and providing interest on these
accounts.

Risk sharing: financial intermediaries can help reduce the exposure of

investors to risk through the process of risk sharing. They create and sell assets
with risk characteristics that people are comfortable with and then the
financial intermediaries can use these funds to buy and sell other assets that
are more risky. Costs are kept low by the fact that intermediaries are able to
earn a profit on the spread between the returns they earn on risky assets and
the payments they make on the assets they have sold. This may also be
referred to as asset transformation. Risk sharing is also made possible by
diversification which entails investing in a collection (portfolio) of assets, the
returns of which do not all move in the same direction.
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Information costs: this specifically refers to the problems that occur when the
parties involved in a transaction do not have the same level of information.
This is referred to as asymmetric information. Lack of information creates
problems before the transaction is entered into (adverse selection) and after
the transaction (moral hazard). [Ref page 41 TB]

Adverse Selection:
…………………………………………………………………………………………

…………………………………………………………………………………………………

……………….…………………………………………………………………………………

Moral Hazard:
…………………………………………………………………………………………………

…………………………………………………………………………………………………

…………………………………………………………………………………………………

Promoting efficiency in financial markets: financial intermediaries provide

liquidity services, promote risk sharing and solve information problems,
thereby also make it possible for small savers and borrowers to benefit from
the existence of the financial markets.

Types of Financial Intermediaries

Depository institutions: commonly referred to as banks. These are institutions

that accept deposits from individuals and other non-bank institutions and
make loans.
They include: commercial banks; savings and loan associations (S & L); mutual
savings banks, credit unions.

Contractual Savings institutions: financial intermediaries that acquire funds at

periodic intervals on a contractual basis. Liquidity of assets is not as important
to these institutions and they tend to invest their funds primarily in long-term
securities. They include life insurance companies; short-term insurers (fire and
casualty); pension and retirement funds.

Investment intermediaries: which include finance companies (raise funds by

selling commercial paper and stocks and bonds); mutual funds (sell shares to
individuals and use the funds to invest in a diversified portfolio of stocks and
bonds); money market mutual funds (characteristics of a mutual fund but also
function as a depository institution).
Investment banks: are not banks or financial intermediaries in the ordinary
sense. They do not lend out their deposits. Investment banks help corporations
issue securities by advising them on what securities are best to issue ie: stocks
or bonds and then helps sell (underwrite) the securities by buying them from
the corporations and reselling them in the market.
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Regulation of the financial system

The purpose of regulation is to:

(a) Increase information to investors, and
(b) To ensure the soundness of financial intermediaries and their different
forms, etc.

Typical Examination questions

2.1 Briefly explain the function of financial markets, the meaning of direct and
indirect financing and the meaning of a financial intermediary. (5)
2.2 Explain the differences between debt and equity markets, primary and
secondary markets, exchanges and OTC markets, and money and capital
markets. (10)
2.3 List and explain the operation of any three money market instruments.
(3x5=15)
2.4 List and explain the operation of any three capital market instruments.
(3x5=15)
2.5 Explain the functions performed by financial intermediaries and how and
why these promote economic efficiency in financial markets. (8)
2.6 Explain the broad purpose and methods used in government regulation of
the financial system. (6)

True or false review questions

1. If a firm borrows money from a bank to finance its debt, it is an

example of indirect finance.
2. If government sells treasury bills to investors to finance a deficit, then it
engages in direct financing.
3. If a firm issues a bond that repays the debt over a five-year period,
then the firm engages in indirect financing.
4. The term to maturity of a bond remains constant over the term of the
bond.
5. The existence of a well-functioning secondary market for a financial
instrument ensures the liquidity of the financial instrument.
6. Over-the counter-markets which simultaneously operate in different
locations, buy and sell at fixed prices and ignore market conditions.
7. US government securities are long-term debt instruments and are the
most liquid securities traded on the capital market.
8. Primary bond markets are more important than secondary bond
markets. New lending and borrowing occur in primary markets only,
and it is these new issues which are ultimately important. The
secondary market does not create new lending and borrowing.
9. In a world of no information and transaction costs, financial
intermediaries would not exist.
10. If there were no asymmetry in the information that a borrower and a
lender had, there could still be a moral hazard problem.
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CHAPTER 3: WHAT IS MONEY?

Meaning of money

Define money: economists define money as anything that is generally

accepted in payment for goods and services or in repayment of debts.
Money does not mean the same as wealth or income. In a modern economy
money consists of two major components: currency plus deposits (M = C + D)

Wealth: consists of money but also includes assets such as stocks, bonds,
houses, cars etc.

Income: is the flow of earnings per unit of time. Money on the other hand is a
stock at a given point in time.

Functions of money

Medium of Exchange: money serves as a medium of exchange allowing it to

be used as payment for goods and services. As such it promotes economic
efficiency by reducing the time taken for transactions to take place.

Money needs the following characteristics:

1. Standardised: simple for everyone to ascertain its value.
2. Widely accepted
3. Divisible: so that it is easy to make change.
4. Easy to carry
5. Not deteriorate quickly

Unit of Account: used to measure value of goods and services in an economy

and helps to reduce transaction costs by reducing the number of prices that
need to be considered.

Store of Value: serves as a store of purchasing power from the time the
income is earned to the time it is spent.

Wealth = total collection of pieces of property that serve to store value.

Income = Flow of earnings per unit of time.

Evolution in the payment system

The history of money is closely linked to the payment system. Several

hundred years ago, the payments system in all but the most primitive societies
was based primarily on precious metals. The introduction of paper currency
lowered the cost of transporting money. The next major advance was the
introduction of cheques which lowered the transaction costs still further.
Currently the move is towards an electronic payments system in which paper
is eliminated and transactions are handled by computers. This will likely lower
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transaction costs still further. The following table explains the different terms in
relation to the different types of payment systems and the related concepts:

Description Advantages Disadvantages

Commodity Money: money An early medium of This form of money is very

made up of precious metals exchange that was heavy and is hard to transport
or other valuable universally acceptable. from place to place.
commodities.

Fiat Money: paper currency Much lighter than precious Easily stolen. Can be
decreed by government as metals or even coins. expensive to transport in large
legal tender. Largely quantities.
dependent upon trust of the
value of currency.

Cheques: an instruction from Allow transactions to take Takes time to get cheques
you to your bank to transfer place without carrying from place to place.
money from your account to around large sums of money. The administration required to
someone else’s account. Improved the efficiency of support the use of cheques is
the payment system. Loss expensive.
from theft is greatly reduced.

Electronic payments: transmit It is quick and efficient. Problems of making errors in

payments via the internet. It is a cheap means of transmission do exist and are
“Money” moves directly from payment. really difficult to reverse.
one persons account to that While security is good, there is
of another. a risk of “hackers” being able
to intervene in transactions.

E-Money: substitute for cash Efficient and convenient. Expensive to set up.
and exists only in electronic Electronic means of payment
form. The debit card is a form raise security and privacy
of e-money. concerns.
Leaves an electronic trail
which contains personal
data.

NOTE: The following must be studied from the study guide:

C7 Measuring money in South Africa

The customary measures of money are M1, M2 and M3. Learn the
descriptions from Study Guide, pages 11 - 14. Note the following:
 The measures are all based on the relationship: M = C + D and
differ according to which types of deposits are included. Make
sure you can describe each of them (M1, M2, M3)
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C8 What causes money stock to increase?

 Net increases in bank loans to the private sector contribute, by far,

most of the increase in M3.
 M = C + D where D is deposits held by the private nonbank sector
with the banks. Only when D changes does the stock of money
change. These deposits change because of the following:
 Banks’ loans to firms and individuals
 Transactions in financial assets between banking sector,
central bank and private sector.
 Government transactions with the private nonbank
sector (pays for services or changes taxes).
 Foreign exchange transactions (exports +, imports -)

C9 Can government print money?

Make sure you are able to answer this question, specifically compare the two
ways in which the money supply is increased. Refer to pages 15 - 17 in the
study guide.

1. Printing banknotes and coins.

a. Only SARB has right to print money
b. SARB sells new money to the banks and pays proceeds to
government.
c. Banks use extra money to replace old worn notes or will issue it
to private sector when they need it in exchange for deposits.
Money stock has still not increased yet.
d. Only when government decides to spend extra money (build a
school) then deposits of private building contractor and
therefore money stock will increase.
This process can be dangerous if government is corrupt and misuses printing
press to create excessive money.
2. Forcing central bank to buy excessive issues of government securities
(government borrows excessively from central bank) – monetization of
government debt.
a. Government issues new government securities to central bank
b. Government spends newly acquired deposits, say by paying its
employees, then private sector deposits (money stock)
increases.
c. Consequences: MV = PY. If V and Y are constant then increases
in M cause increases in P
d. Hyperinflation occurs when this process is repeated many times
over. E.g. Zimbabwe

Typical Examination questions

3.1 Provide a formal definition of money. Then explain how the money stock is
measured in principle. (5)
3.2 Briefly distinguish between money and income, and money and wealth.
(4)
3.3 List and explain the three primary functions of money. (3x2=6)
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3.4 Explain the meaning of the following terms as well as the advantages/
disadvantages of each in facilitating payments: (5x3=15):
Commodity money, fiat money, cheques, electronic payment, e-money.
3.5 Define the following measures of aggregate money stock in South Africa:
M1A, M1, M2, M3.(4x2=8)
3.6 Explain the meaning and implications of the government "printing" money.
(10)

True or false review questions

1. In principle, economists are not exactly sure how to measure money.

2. The use of a credit card to purchase goods does not affect the money
stock.
3. The following transactions typically increase the money stock:
a. trade credit
b. payment of taxes
c. government expenditure
d. exports
e. imports
4. An increase in the interest rate will cause increases in M1A and M3.
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Part two: Financial markets

(Textbook: chapters 4, 5 and 6)

CHAPTER 4: UNDERSTANDING INTEREST RATES

Measuring interest rates (Calculations not included)

Interest rates are most accurately measured by the concept yield to maturity.

Present value (PV): is a concept used to compare one kind of debt

instrument with another. This is based on the notion that a rand (dollar) paid
to you one year from now is less valuable to you then, than a rand (dollar)
paid to you today. Also referred to as present discounted value.

Four types of credit market instruments: these are categorized according to

the timing of their cash flow payments:

1. Simple loan: the lender provides the borrower with an amount of funds
(the principal) which must be repaid to the lender at the maturity
date, along with an additional payment for interest. Money market
instruments are of this type. For simple loans the simple interest rate
equals the yield to maturity.

Formula (SG pg 21): PV = CF/ (1 + i)n

(where CF is cash flow at end of period n)

2. Fixed payment loan: lender provides the borrower with an amount of

funds, which must be repaid by making the same payment every
period, consisting of part of the principal and interest for a set number
of years. Example: mortgage payments on houses or cars.

In this case the fixed yearly payment and the number of years until
maturity are known quantities, only the yield to maturity is not. For
example, if you borrowed $1000, a fixed-payment loan might require
you to pay $126 every year for 25 years. (Refer textbook page 111).

Formula: (SG pg 21): LV = + + + …..+

( ) ( ) ( )

(where i is interest rate per period, LV is the Loan Value, FP is Fixed Payments)

3. Coupon bond: pays the owner of the bond a fixed interest payment
(coupon) every year until the maturity date, when a specified final
amount (face value/ par value) is repaid. Four pieces of information
are required for a coupon bond: 1) the issuing party (government or
corporation), 2) The maturity date of the bond 3) The coupon rate 4)
Face value of the bond.
 18

Three important facts relating to coupon bonds:

(i) When the coupon bond is priced at its face value, the
yield to maturity equals the coupon rate.
(ii) The price of a coupon bond and the yield to maturity are
negatively related (when the yield to maturity rises, the
price of the bond falls).
(iii) The yield to maturity is greater than the coupon rate
when the bond price is below its face value.

A higher interest rate implies that the future coupon payments and final
payment are worth less when discounted back to the present, therefore, the
price of the bond must be lower.

Formula (textbook pg 115): P = + + + …. + +

( ) ( ) ( ) ( ) ( )

Where C is coupon rate and F is final payment or face value of bond

C, F and n are fixed when the bond is issued. The current market price then
determines i: the yield to maturity of the coupon bond.

4. Discount bond (also called zero-coupon bond): bought at a price

below its face value (at a discount) and the face value is repaid at the
maturity date. A discount bond does not make interest payments, it
only pays the face value. The yield to maturity is negatively related to
the current bond price.

Formula (textbook pg 118): i = (where i is yield to maturity)

The borrower receives P (current price of discount bond at beginning of

period), he repays F (face value of bond) at end of period (one year’s time).

The concept of PV is used to compare these different types of instruments

based on their respective yield to maturity.

Yield to Maturity: of the several common ways to calculate interest rates, the
most important is the yield to maturity, the interest rate that equates the PV of
cash flow payments received from a debt instrument with its value today. This
is the most accurate measure of interest rates.

Distinction between interest rates and returns

The rate of return can be defined as payments to the owner plus the change
in its value, expressed as a fraction of its purchase price.
The return on a bond is not necessarily equal to the yield to maturity on a
bond. The return on a security shows how well you have done by holding this
 19

security over a stated period of time and it can differ substantially from the
interest rate measured by the yield to maturity.
Because of fluctuating interest rates, the capital gains and losses on long-
term bonds can be large. [When an investor sells a financial instrument before
its maturity date, the sale will be subject to market rates. These market rates
mean that the instrument might be sold at a profit or a loss depending on
whether prices have increased or decreased.]

E.g. With a $1000 face value coupon bond with a coupon rate of 10%
that is bought for $1000, held for one year and then sold for $1200.

The payments to owner are the yearly coupon payments of $100 and
the change in its value is $1200 - $1000 = $200. Adding these together
and expressing them as a fraction of the purchase price of $1000,
gives us the one-year holding-period return for this bond:

$ $ $
= = 0.30 = 30%
$ $

This demonstrates that the return on a bond will not necessarily equal the
yield to maturity on that bond.

Therefore, the return on a bond held from time t to time t + 1 is:

R=
Where C = coupon payment
Pt = price of bond at time t

The following factors are important:

(i) Rise in interest rates is associated with a fall in bond prices,
resulting in capital losses on bonds where the terms to maturity
are longer than the holding period.
(ii) The more distant a bond’s maturity, the greater the size of the
percentage price change associated with an interest-rate
change.
(iii) The more distant a bond’s maturity, the lower the rate of return
that occurs as a result of the increase in interest rate.
[P↓→i↑]
(iv) Even if a bond has a substantial initial interest rate, its return can
turn out to be negative if interest rates rise.

Maturity and volatility of bond returns: prices and returns for longer-term
bonds are more volatile than those for shorter-term bonds. The riskiness of an
asset’s return that results from interest rate changes is so important that it has
been given a special name: interest-rate risk.

Bonds that have a maturity that is longer than the holding period are subject
to interest-rate risk. The only time this risk is eliminated is when the holding
period and the maturity period are the same. This is because the price at the
 20

end of the holding period is already fixed at the face value. The change in
interest rates can then have no effect on the price at the end of the holding
period for these bonds, and the return will therefore be equal to the yield to
maturity known at the time the bond is purchased.

Distinction between nominal and real interest rates

Nominal interest rates: makes no allowance for inflation.

Real interest rates: interest rate is adjusted by subtracting expected
changes in price level.

When real interest rates are low there are greater incentives to borrow and
fewer incentives to lend.

Indexed Bonds: a bond whose interest and principal payments are adjusted
for changes in price levels and whose interest rate thus provides a direct
measure of real interest rates. These bonds are useful to policy makers,
because by subtracting their interest rate from a nominal interest rate on a
non-indexed bond, they generate more insight into expected inflation, a
valuable piece of information.

Typical Examination questions

4.1 Explain the meaning of the following four types of credit market
instruments (4x3=12)
Simple loan, fixed payment loan, coupon bond, discount bond.
4.2 Explain the meaning of the following concepts in the context of a coupon
bond: coupon rate, yield to maturity and the return on a bond. (7)
4.3 Distinguish between the nominal and the real interest rate. Which one is
more important and why?(5)

True or false review questions

1. The yield to maturity (i) of each of the four types of credit market
instruments and its price (P, PV or LV, whatever applies) are inversely
related.
2. Investors cannot ever be worse off when investing in bonds.
3. A negative real interest rate on coupon bonds implies that the interest
earned on the bond does not fully compensate for the loss of
purchasing power of money. Thus the investor is worse off.
 21

CHAPTER 5: THE BEHAVIOUR OF INTEREST RATES

The supply and demand analysis for bonds provides one theory of how
interest rates are determined. It predicts that interest rates will change when
there is a change in demand because of changes in income (or wealth),
expected returns, risk or liquidity, or when there is a change in supply. An
alternative theory of how interest rates are determined is provided by the
liquidity preference framework, which analyses the supply of and demand for
money. It shows that interest rates will change when there is a change in the
demand for money because of changes in income or the price level or when
there is a change in the supply of money.

Determinants of demand for assets and direction of effect of changes

Factors that determine the demand for assets: an asset is a piece of property
that is a store of value. These include, inter alia, money, bonds, stocks, art,
land, houses, farm equipment and manufacturing machinery. The following
are the factors that will influence a person’s demand for assets:

 Wealth: total resources owned by the individual, including all

assets. Holding everything else constant (ceteris paribus), an
increase in wealth raises the quantity demanded of an asset -
positively related.

 Expected return: on one asset relative to alternative assets. An

increase in an asset’s expected return relative to that of an
alternative asset, ceteris paribus, raises the quantity demanded of
that asset - positively related.

 Risk: (the degree of uncertainty associated with return) on one

asset relative to other assets. Ceteris paribus, if an asset’s risk rises
relative to that of alternative assets, the quantity demanded of that
asset will fall - negatively related.

 Liquidity: (the ease and speed whereby an asset can be turned

into cash) relative to alternative assets. The more liquid an asset is
relative to alternative assets, ceteris paribus, the more desirable it is
and the greater will be the quantity demanded - positively related.

The Theory of Portfolio Choice: therefore states that, ceteris paribus:

(1) the quantity demanded of an asset is positively related to
wealth
(2) the quantity demanded of an asset is positively related to its
expected return relative to alternative assets.
(3) the quantity demanded of an asset is negatively related to the
risk of its returns relative to alternative assets.
(4) the quantity demanded of an asset is positively related to its
liquidity relative to alternative assets.
 22

Supply and demand in the bond market

One approach to the determination of interest rates looks at the supply and
demand for bonds, to see how the price of bonds is determined.

The demand curve for bonds: at different points on the demand curve, the
price of a bond and its interest rate are inversely related. The demand curve
for bonds shows the relationship between the price of bonds (and interest
rate) and the quantity demanded. This is an inverse relationship and is
illustrated by a downward sloping (negative) demand curve.

The equation that would be used as a basis to the derivation of the demand
curve for bonds may be written as (refer textbook, 10th edition, pg 134; 9th
edition, pg 94):

i = Re =

Where i = interest rate = yield to maturity

Re = expected return
F = face value of discounted bond
P = initial purchase price of the discount bond

By substituting different prices, given a specific face value, it can be shown

that as the price of the bond decreases, the interest rate increases or vice
versa. This would enable one to plot the relevant demand curve for the
specific bond onto a set of axes. Refer Figure 1 pg 134 (chapter 5). Make
sure you can derive such a demand curve. NB: Pay careful attention to the
information on the vertical axis, namely price of the bond and interest rate.

Supply curve for bonds: in this case, when the price of bonds is low, fewer
bonds will be supplied, because these bonds will have a higher interest rate.
At a higher price more bonds will be supplied. There is a positive relationship
between the price of bonds and the quantity supplied. [This implies a
negative relationship between the interest rate and the quantity of bonds
supplied – as the interest rate decreases (price of bonds increases) it
becomes less costly to borrow by issuing bond.]

Market Equilibrium price and quantity of bonds: in the bond market this is
achieved when the quantity of bonds demanded is equal to the quantity of
bonds supplied at a specific price. If the price of the bonds is above the
equilibrium price, then the quantity of bonds supplied will exceed the
quantity demanded (excess supply). This will cause the price of bonds to fall
and force the price towards equilibrium price.

If the price of bonds is lower than the equilibrium price, then the quantity
demanded of bonds will be greater than the quantity supplied (excess
demand). This will cause the price of bonds to rise and force the price up
towards equilibrium price. This will continue until an equilibrium price is
 23

reached. NOTE: this can also be expressed in terms of changes in interest

rates because each price corresponds to a particular interest rate.

NOTE: supply and demand are always in terms of stocks (amounts at a given
point in time) of assets, not in terms of flows. This asset market approach is the
dominant methodology used by economists. Use the space below to draw a
supply and demand curve for bonds and show how equilibrium in the bond
market is reached.

Figure 1pg 134: Supply and demand for bonds

Changes in equilibrium interest rates

It is important to remember the difference between a movement along the

curve and a shifting of the curve. If the price of a bond or the interest rate
changes, the movement will be along the existing curve indicating a change
in quantity demanded. A shift of the demand or supply curve indicates that
the quantity demanded or supplied at each given price and interest rate has
changed by some other factor besides the bonds price or interest rate. When
this happens, there will be a new equilibrium for the interest rate.

Factors that cause a shift of the demand curve: refer to table 2 PG 138 and
record the effect of changes of each of the following determinants:

 Decrease in wealth: a decrease in the

demand for bonds

 A decrease in the expected interest rate:

increase in the demand for bonds
 24

[Remember in this case the interest rate

decreases, the price of the bonds increases and
the opportunity for making a profit on the sale of
the bonds increases]

 An increase in expected inflation: when

inflation is expected to increase, the
demand for bonds will decrease because
other assets become more attractive as a
hedge against inflation. [When expected
inflation rises, the supply curve shifts to the
right and the demand curve shifts to the left.
The result is that the equilibrium bond price
decreases and the equilibrium interest rate
rises. This in turn means that when expected
inflation rises then interest rates also rise ==
Fisher effect.]

 An increase in the riskiness of bonds relative

to other assets: the demand for bonds will
decrease.

 The liquidity of bonds increases (more

people traded bonds easier to sell bonds
quickly) relative to other assets: demand for
bonds will increase. Similarly, increased
liquidity of alternative assets lowers demand
for bonds.

Factors that cause a shift of the supply curve: the following factors will cause
a shift of the supply curve for bonds:
 Expected profitability of investment
opportunities: in a business cycle expansion,
firms are more willing to borrow, the supply
of bonds increases and the supply curve
shifts to the right. Likewise in a recession, the
supply of bonds decreases (fewer expected
profitable investment opportunities) and the
supply curve shifts to the left.

 Expected inflation: an increase in expected

inflation causes the supply of bonds to
increase and the supply curve to shift to the
right. When the expected inflation
increases, the real cost of borrowing,
measured by the real interest rate, falls.
 25

 Government budget: government issues

bonds to finance government deficits, when
the deficit is large, the government will issue
more bonds and the quantity of bonds
supplied at each price will increase.

APPLICATION:

(1) In a business cycle expansion, the amount

of goods and services produced increases and
so national income increases. Business will be
more willing to borrow and the supply of bonds
will increase. In addition the expansion is likely to
increase wealth and therefore the demand for
bonds will also increase. However, depending on
whether the supply or demand curve shifts more,
the new equilibrium interest rate is either higher
or lower. Data says that we normally see a higher
interest rate.

(2) If expected inflation rises, the expected

return on bonds relative to real assets falls for any
given bond price and interest rate. Demand for
bonds then falls and demand curve shifts left.
The rise in expected inflation also shifts the supply
curve right as the real cost of borrowing has
declined. Fisher effect: when expected inflation
rises, interest rates will rise.

The Liquidity Preference framework: supply and demand in the money

market for money

An alternative method for determining the equilibrium interest rate,

developed by John Maynard Keynes, is the liquidity preference framework.
This framework uses the demand and supply of money to determine the
prevailing interest rate.

Money is a special type of asset: Keynes based the liquidity preference

framework on the assumption that there are two main categories of assets
that people use to store wealth: money and bonds. Therefore the total
wealth in an economy must be equal to the sum of money and bonds. This
can be expressed as follows:

Bs + Ms = Bd + Md

Rewrite the equation to show how it is possible to illustrate that if the money
market is in equilibrium, then the bond market must also be in equilibrium:

Bs _ Bd = Ms _ Md
 26

Simplifications (assumptions) of the liquidity preference framework: the

demand and supply of bonds framework is easier to use when analyzing the
effects from changes in expected inflation, while the liquidity preference
framework is easier to use when analyzing the effects of changes in income,
price level and the supply of money.

This framework assumes the following:

 Wealth is stored in a combination of money and bonds. Real assets
are ignored.
 Money has a zero rate of return. Bonds have an expected return
equal to the interest rate (i). As the interest rate rises, ceteris
paribus, the expected return on money falls relative to the
expected return on bonds and so the quantity of money
demanded will fall.
 The concept of opportunity cost can also be used to explain why
the demand for money and interest rates are inversely related. At
a higher interest rate the opportunity cost of holding money is
greater than it would be at a lower interest rate.
 The supply of money is fixed by the central bank. The supply curve
is vertical.

Equilibrium in the money market implies equilibrium in the bond market: the
position where the quantity of money demanded equals the quantity of
money supplied occurs at the point of intersection of the demand and supply
curves for money.
If there is an excess supply of money (that is the interest rate is above the
equilibrium interest rate) then people are holding more money than they
desire and will want to buy bonds. They are therefore likely to bid up the
price of bonds and the interest rate will fall towards the equilibrium rate.

In the case of excess demand for money, people wish to hold more money
and will therefore wish to sell bonds. As a result the supply of bonds will
increase and the price will drop which will push the interest rate up towards
the equilibrium rate.
 27

Refer to Figure 8 pg 148 and use a graph to illustrate equilibrium in the money
market.

Interest Rate
Ms

25
excess
supply
15 = i

excess
5 demand Md

0
Quantity of Money

Changes in equilibrium interest rates in the liquidity preference framework

Money Demand curve shifts because of:

 Income effect: a higher level of income causes the demand for
money at each interest rate to increase and the demand curve to
shift to the right.

 Price-level effect: a rise in the price level causes the demand for
money to increase and the demand curve to shift to the right.
(people care about amount of money they hold in real terms)

Money Supply curve shifts because of:

 Changes in money supply: an increase in the money supply due to
expansionary monetary policy implies that the supply curve for
money will shift to the right. When the supply of money increases,
ceteris paribus, the interest rate will decline (liquidity effect). When
the supply of money decreases, ceteris paribus, the interest rate will
rise.

Assumption of all other factors being equal may not necessarily hold, given
an initial increase in money supply, why?

Refer to the section in the textbook, pg114. Milton Friedman acknowledged

that the liquidity preference analysis is correct and referred to the fact that
an increase in the money supply lowered the interest rate as the liquidity
effect. However, he also noted that an increase in the money supply might
nullify the ceteris paribus assumption.
 28

This may be summed up as follows: “there are four possible effects of an

increase in the money supply on interest rates: the liquidity effect, the income
effect, the price-level effect and the expected-inflation effect. The liquidity
effect indicates that a rise in money supply growth will lead to a decline in
interest rates, the other effects work in the opposite direction. The evidence
seems to indicate that the income, price-level, and the expected-inflation
effects dominate the liquidity effect such that an increase in money supply
growth leads to higher rather than lower interest rates” [Mishkin F, The
economics of Money, Banking and Financial Markets. 2007. Boston: Pearson
Education Inc.]

C5 How is the interest rate determined in South Africa?

Refer to the study guide and answer this question, pg 34.

A: As far as the bond market is concerned, the demand and supply of assets
that explained bond interest rates is a good approximation of reality in South
Africa.

However the liquidity preference theory does not apply in SA. The Reserve
Bank cannot and does not control the money supply but rather the interest
rate (repo). The level of the repo rate determines the demand for money –
the amount the private sector wishes to borrow.

Typical Examination questions

5.1 Briefly explain how four major factors affect the demand for an asset.
(4x2=8)
5.2 Derive a bond demand curve (price of bond versus its quantity
demanded) and a bond supply curve and explain how the equilibrium P and
Q for the bond is determined using the asset market approach. Explain which
curve may be associated with borrowers/lenders respectively. Illustrate
graphically. (10)
5.3 Briefly explain the demand/supply for assets framework and then use it to
predict (provide reasons) how the demand for and supply of bonds are
affected by each of the following:
a A business cycle expansion (also predict the equilibrium P,Q as well
as i) (5)
b An increase in the public's propensity to save (2)
c Higher expected future interest rates (maturity of bond n>1) (2)
d An increase in the expected inflation rate (also predict the
equilibrium P,Q) as well as i) (6)
e An increase in the riskiness of bonds relative to other assets (2)
f An increase in the government's budget deficit (2)

5.4 Explain Keynes' liquidity preference framework, that is, its simplifying
assumptions, the derivation of the demand and supply curve and how
equilibrium is determined. (8)
5.5 Explain how Keynes' liquidity preference framework can be used to
explain the effects of an increase in income, a rise in the price level and an
increase in the money supply (assume that all other economic variables
 29

remain constant). Then explain why an increase in money supply does not
necessarily lead to a decrease in interest rates over the longer term. (12)

True or false review questions

Bonds: Asset demand and supply

1. The demand curve for bonds indicates the willingness of lenders to buy
bonds. If a lender buys a bond then the lender supplies funds to the
borrower, which the borrower must repay over time. The price of bonds
in figure 1 (p 134 of the prescribed text book) is the discount price the
lender pays for the bond (the term discount bond applies in the case
of a simple one-year bond). The lower the price, the greater is the
discount, the higher is the interest rate (P=F/[1+i]) and the more willing
lenders are to purchase bonds – and to supply funds to the issuers of
bonds (the borrowers).
2. The supply curve for bonds indicates the willingness of borrowers to sell
bonds. When a bond is sold to an investor, then the investor provides
funds to the borrower. The price of a bond in figure 1 (p 134 of the
prescribed text book) is what the borrower receives for the bond. The
higher the price of bonds, the more the borrower receives and the
lower the interest rate which the borrower must pay.
3. If the interest rate is expected to increase, then the price of bonds can
be expected to fall. In the case of longer-term bonds, this may imply a
lower return on bonds than initially expected. This will shift the demand
curve for bonds to the left and the supply curve of bonds to the right.
4. A higher expected inflation rate will shift the demand curve for bonds
to the left and the supply curve of bonds to the right. The demand
curve will shift to the left because investors will be less willing to supply
funds. The supply curve will shift to the right because this allows
borrowers to obtain funds at a lower real cost.
5. The more liquid a bond, the more desirable it becomes for borrowers.
6. When a bond price increases, its yield also increases, because yield is
calculated as a fixed percentage of price.
7. The Fisher effect unambiguously states that when the inflation rate is
expected to increase, both the quantity and the price of bonds will
decrease.
8. A business cycle expansion is likely to lead to a decrease in the supply
of bonds because of a reduced need for bonds.

Liquidity preference

9. When the central bank increases the money supply, the initial short-
term effect is that the supply curve of money shifts to the right, so that
the interest rate falls. This is called the liquidity effect.
10. When the interest rate falls, then over time, this has an expansionary
effect on the economy. When income increases, then the demand
curve for money will shift to the right, which causes an increase in the
interest rate.
 30

11. When income increases then this might also cause an increase in the
general price level. The expected increase in inflation, according to
the liquidity preference model, leads to an increase in interest rates.
12. The short-term expansionary effect of an increase in the money supply
may thus be partly reduced or even completely overcome by longer-
term increases in the interest rate due to the income and expected-
inflation effects.
 31

CHAPTER 6: THE RISK AND TERM STRUCTURE OF INTEREST RATES

Risk structure of interest rates

Meaning of risk structure of interest rates: the relationship between interest

rates on bonds with the same maturity. Factors such as risk, liquidity and
income tax rules play a role in determining the risk structure of different bonds.

Consider the factors that influence the risk structure:

 Risk of defaulting: bonds that have no default risk are referred to as
default-free bonds. The spread between default-free bonds and
bonds with default risk is referred to as the risk premium. This refers
to how much additional interest a bond must earn in order to make
a person willing to hold it. A bond with default risk will always have
a positive risk premium, and an increase in its default risk will raise
the risk premium. [APPLICATION: refer to figure 2 on page 162 in
the textbook to understand an application that illustrates the
response to an increase in a default risk].

 Liquidity of bonds: the more liquid an asset is the more people will
wish to hold it. The greater the liquidity of a bond, the lower the
interest rate required. The spread between a bond with high
liquidity and one with low liquidity is also referred to as a risk
premium.

 Tax treatment: the fact that interest payments on municipal bonds

in the USA are tax free has the same effect on the demand for
these bonds as an increase in their expected returns. The demand
for municipal bonds tends to be higher than a Treasury bond, even
though they are riskier and less liquid, therefore prices are higher
and interest rates have been lower (implying lower risk) than the
Treasury bonds. Refer to figure 3 (9th pg 129, 10th ed. Pg 166).
32
 33

Credit rating agencies are important providers of information on risk premium.

Term Structure of interest rates

Another factor (aside from those considered above) that can influence
interest rates is a bond’s term to maturity.

Meaning of term structure: bonds with identical risk, liquidity and tax
characteristics may have different interest rates because of different times
remaining to maturity.

Characteristics of yield curves: a plot of the yields on bonds with differing

terms to maturity but the same risk, liquidity and tax considerations is called a
yield curve. See pg 168.

 When a yield curve slopes upwards (most common): long-term

interest rates are above short-term interest rates
 When a yield curve is flat: short- and long-term interest rates are
the same.
 34

 When a yield curve slopes downwards (inverted): long-term

interest rates are below short-term rates.

The following empirical facts relating to yield curves are also important:
1. Interest rates on bonds of differing maturities move together over time.
See figure 4pg 169
2. When short-term interest rates are low, yield curves are more likely to
have an upward slope; when short-term rate are high, yield curves are
more likely to slope downwards and be inverted.
3. Yield curves almost always slope upward.

Different theories: there are three theories that are used to explain the term
structure of interest rates:

1. Expectations theory: “the interest rate on a long-term bond will equal

an average of the short-term interest rates that people expect to
occur over the life of the long-term bond.”
The key assumption behind this theory is that buyers of bonds do not
prefer bonds of 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. Bonds that have this characteristic are
said to be perfect substitutes – if bonds with different maturities are
perfect substitutes, the expected return on these bonds must be equal.

To prove this consider two investment strategies:

 Purchase a 1-year bond and when it matures in one year,
purchase another 1-year bond.
 Purchase a 2-year bond and hold it until maturity
Because both strategies have the same expected return, the interest
rate on the 2-year bond must equal the average of the two 1-year
interest rates.
 35

The expectations theory is able to explain facts (1) and (2) above but is
unable to explain fact (3). When the yield curve is upward sloping, the
theory suggests that short-term interest rates are expected to rise in the
future.

2. Segmented market theory: markets for different-maturity bonds are

seen as completely separate and segmented. The interest rate for
each bond with a different maturity is determined by the supply and
demand for that bond, with no effects from expected returns on other
bonds with other maturities.
The key assumption in this case, is that bonds of different maturities are
not substitutes at all, so the expected return from holding a bond of
one maturity has no effect on the demand for a bond with another
maturity. Investors have strong preferences for the bonds of one
maturity but not for another, so they will be concerned only with the
expected returns for bonds of the maturity they prefer.

The segmented market theory is able to explain fact (3) above but is
unable to give an adequate explanation for (1) and (2) as it views the
market for bond of different maturities as completely segmented
therefore there is no reason that a rise in interest rates for one bond
would affect the rates of another maturity .

3. Liquidity premium theory (preferred): this theory states that 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 a liquidity premium that responds to supply and demand
conditions for that bond.”
The key assumption is that bonds of different maturities are substitutes,
which means that the expected return on one bond does influence
the expected return on a bond of a different maturity, but it allows
investors to prefer one bond maturity over another. Investors tend to
prefer shorter-term bonds because of less interest-rate risk and so
investors must be offered a liquidity premium to induce them to hold
longer-term bonds.

Closely related to this theory is the preferred habitat theory which

assumes that investors will have choice preferences and will only be
persuaded to move to another choice if they can expect higher
returns.

These two theories (liquidity premium and preferred habitat) combine the
features of the expectations theory and the segmented market theory and
are then able to explain all three facts relating to yield curves. They view
long-term interest rates as equaling the average of future short-term rates
expected to occur over the life of the bond plus a liquidity premium.

Note:
 please read over Application: Interpreting yield curves 1980-2011 on
pg 178
 from SG, go through additional explanation of SA yield curves on pg 30
 36

Typical Examination questions

6.1 Explain the meaning of the risk structure of interest rates. List and explain
the three factors which affect the risk structure of interest rates using a supply
of/demand for bonds-framework. (18)
6.2 Explain the meaning of the term structure of interest rates and the yield
curve. Draw a normal yield curve and explain why its shape applies. List three
empirical observations of the yield curve. (10)
6.3 Explain the assumptions and predictions of the expectations theory and
how well it explains the three empirical observations of the yield curve. (9)
6.4 Explain the assumptions and predictions of the segmented market theory
and how well it explains the three empirical observations of the yield curve.
(7)
6.5 Explain the assumptions and predictions of the liquidity premium theory of
the term structure and the preferred habitat theories of the term structure and
how well they explain the three empirical observations of the yield curve. (18)

True or false review questions

For each of the following questions, which one of the options is the most
correct?
1. The risk structure of interest rates explains why the interest rate on
bonds differs because the
(a) quality of bonds are different although their time to maturity is
similar
(b) time to maturity is different but their quality is similar

2. The R157 bond was issued during 2005 and it matures in September
2015. In March 2009, the term to maturity of the R157 bond was
approximately
(a) cannot be derived
(b) 10 years
(c) 6½ years
(d) 5¼ years

3. Which of each of the following is confirmed by chart 6.1 (SG pg 30)?

(a) the interest rates on bonds of different maturities tend to move
together
(b) the typical form of a yield curve is upward sloping
(c) when short-term interest rates are low, the yield curve is upward
sloping; and when short-term interest rates are high, yield curves
tend to be downward sloping

4. Which characteristics apply to the yield curve? In each case select the
most appropriate one of the two options which are underlined.

A yield curve shows the

(a) relationship / difference between
(b) the yield to maturity / current return
(c) measured in terms of percentage per year / a price index
 37

(d) and the remaining / original term to maturity

(e) of bonds / three bonds
(f) of similar quality / different quality
(g) on a specific date / over a specified period

Which of the following is true?

5. The yield curve can change significantly over time.

6. The expectations theory assumes that the yield on long term bonds is
related to the yields of short-term bonds.
7. An assumption of the segmented market theory is that the yield on
long term bonds is independent of the yield on short-term bonds.
8. The liquidity premium theory offers relatively better explanations than
the expectations and segmented market theorems.
 38

PART THREE: FINANCIAL INSTITUTIONS

(Textbook: Chapter 8, 9 and 10)

CHAPTER 8: AN ECONOMIC ANALYSIS OF FINANCIAL STRUCTURE

Basic facts about financial structure throughout the world

Mishkin highlights eight basic facts about financial structure (refer to study
guide). You must learn these:

1. Stocks are not the main source of external financing.

2. Marketable securities (stocks) are not the primary source of finance.
3. Indirect finance (using financial intermediaries) is more important than
direct finance.
4. Banks are the principal source of external funds (loans).
5. The financial system is heavily regulated
6. Only large, well-established firms have access to securities markets.
7. Collateral is prevalent in debt contracts
8. Debt contracts have numerous restrictive covenants.

A deeper understanding of the problems that are incorporated in these basic

facts can be obtained by considering each of the specific problems of
transaction costs, asymmetric information and the resulting adverse selection
and moral hazard problems in detail.

Transaction Costs

The costs of investing on an individual basis are high, for example the smallest
denomination for a bond investment in the USA is $10 000. When investing in
shares there are often minimum requirements by brokers. Even when there
are no minimum requirements, individuals with small amounts of savings to
invest, are limited in the number of shares they are able to purchase and thus
are unable to diversify.

Financial intermediaries can help to reduce transaction costs in two main

ways:
 Through economies of scale: bundle the funds of investors
together and reduce transaction costs e.g. mutual fund – financial
intermediary that sells shares to individuals and then invests the
proceeds in bonds or stocks.

 Expertise: for example expertise in computer technology enables

financial intermediaries to offer customers convenient services. E.g
toll free numbers for information on investments or ability to write
cheques on their accounts.
 39

Asymmetric Information

This occurs in situations where one party’s insufficient knowledge about the
other party involved in a transaction makes it impossible to make accurate
decisions when conducting transactions.

 Adverse selection is a problem arising from asymmetric information

and occurs before the transaction takes place. Potential bad
credit risks are the individuals that most actively seek out loans.
Adverse risk increases the chances that a loan might be made to a
bad credit risk and so lenders might decide not to make any loans.

 Moral hazard occurs after the transaction has taken place. Lender
runs the risk that the borrower will engage in undesirable or risky
behavior and make it less likely that the loan will be paid back

 The analysis of how the above asymmetric problems affect

economic behavior is referred to as agency theory.

The lemons problem: how adverse selection influences financial structure

Lemons in stock and bond markets: this problem is what prevents the
securities markets from being effective in channeling funds from savers to
borrowers.

Because an investor cannot necessarily tell which firms are good risks and
which are bad, he (or she) is likely to estimate his buying price based on an
average taking into account good and bad. Firms that know that they are
good will be unlikely to sell their securities to the investor at the average price
and will ask more. This will be higher than the investor is prepared to pay, and
only the securities from bad (poor) risk firms fall into his price range. If the
investor is sensible he will not wish to buy these securities and will end buying
none at all.

In the bond market, investors will wish to pay prices low enough to ensure
interest high enough to compensate for average default risk.
Knowledgeable owners of a good firm realize they will be paying a higher
interest than they wish to and so decide not to raise finance through bonds.

Tools to help solve adverse selection problems:

 Private production and sale of information: private companies

collect and publish information that helps to distinguish good firms
from bad. This info is then sold. However, another problem arises,
the free-rider problem. People who do not pay for the information
provided are able to benefit from it.
 Government regulation to increase information: government could
be responsible for releasing relevant information. However, this
could be a politically sensitive matter. Another way in which
 40

government may assist would be to regulate the securities markets

in ways that encourage participants to reveal honest information
about themselves. This would take the form of audits by reputable
auditing firms. However, such regulation did not prevent the Enron
scandal (pg 212).

 Financial intermediation by banks that become experts of

companies in various industries helps to solve the problem. Banks
can acquire deposits and lend the money to good firms by making
private loans. Such loans are not traded and therefore no-one else
will be able to interfere with the price/interest involved (no free-
rider problem). Banks hold mainly nontraded loans.

 Collateral, property promised to the lender if a borrower defaults,

reduces the consequence of adverse selection. Net worth (equity
capital) is the difference between a firm’s assets and its liabilities
and can perform a similar role to collateral.

How moral hazard affects the choice between debt and equity contracts

Moral hazard in equity contracts (the principal-agent problem): the

separation of ownership (shareholders) and management (do not own
shares) in companies gives rise to the principal-agent problem.
Managers (agents) may act in their own interests rather than the interests of
the shareholders (principals). The degree of the problem will be affected by
the level of integrity of the agents involved.
Internationally and even locally, managers have frequently been accused
(and found guilty) of diverting funds for their own private benefit. Managers
might also follow strategies that allow them to increase their own personal
power in a company, rather than for material benefit, or even in the interests
of the company itself.
 41

Tools to help solve the Principal-Agent problem:

 Production of information: the monitoring process and the

production of sufficient information to ensure the elimination of
moral hazard problem is costly in terms of money and time: costly
state verification.
The free-rider problem can decrease monitoring because if an
individual knows that other stockholders are paying to monitor the
activities of a company in which he holds shares, he can take a
free ride on their activities. But what if everyone does this?
 Government regulation to increase information: laws enforcing
companies to meet standard accounting principles make profit
verification easier. Strict criminal penalties on people committing
fraud.
 Financial intermediation through, e.g. a venture capital firm helps
to reduce the moral hazard problem. Venture capital firms pool
the resources of their partners and use the funds to help budding
entrepreneurs start new businesses. In exchange for the use of
capital, the firm receives an equity share in the new business.
Venture capital firms normally have some members of their own on
the board of directors and this protects the interests of the investors.
Because only the people involved know about the specific
companies and profits, etc. the free-rider problem is eliminated.
 Debt contracts: an equity contract is a claim on profits in all
situations. However, a debt contract is an agreement by the
borrower to pay the lender fixed amounts at periodic intervals. The
lender therefore, does not particularly worry as to whether the
company is making more or less profit, as long as it is able to meet
its commitment. It is only when the company is unable to meet its
payments that the investors would require verification. This involves
a lower cost of monitoring and verification. It explains why debt
contracts are used more frequently than equity contracts to raise
capital.

How moral hazard influences the financial structure in debt markets

Debt contracts are still subject to moral hazard. Because borrowers have an
incentive to make higher profits, there is the tendency to take on riskier
investment opportunities and this can result in unnecessary losses.

Tools to help solve moral hazard in debt contracts:

 Net worth and collateral: when borrowers have more at stake

because their net worth is high or the collateral they have pledged
to the lender is valuable, the risk of moral hazard is reduced.
 Monitoring and enforcement of restrictive covenants:
a. covenant to discourage undesirable behaviour;
 42

b. covenant to encourage desirable behaviour;

c. covenant to keep collateral valuable;

d. covenants to provide information.

Refer to Summary (Table 1) on page 220 in textbook. Complete the 2 tables

in SG on pg 37-38 to secure your understanding of this chapter!!

Typical Examination questions

8.1 List eight basic facts about financial structure throughout the world. (8)
8.2 Explain the role of financial intermediaries by referring to the problem of
high transaction costs in financial transactions and the role of financial
expertise. (10)
8.3 Explain why marketable securities (debt and equity) are not the primary
source of financing for businesses and how financial intermediaries and
government regulation can partly overcome the problem of asymmetric
information (adverse selection). (10)
8.4 Explain, in general, why indirect financing is more important than direct
financing and, in particular, why banks are the most important source of
external finance for financing businesses. Then comment on the two
statements: "The role of banks in lending will probably decline in future" and
"The more established a firm is, the more likely it will issue securities to raise
funds". (10)
8.5 Explain why the presence of adverse selection in credit markets explains
the fact that collateral (or net worth) is important in debt contracts. (4)
 43

8.6 Explain why moral hazard explains why stocks are not the most important
source of financing for businesses and why debt contracts may be
preferable. (Hint: In your answer, amongst others, refer
to the principal agent problem.) (12)
8.7 Explain the meaning of the concept of moral hazard and why it explains
that debt contracts are complicated legal documents that place substantial
restrictions on the behaviour of the borrower (also list the four types of
restrictive covenants). Are monitoring and restrictive covenants necessarily
effective? Can you explain why financial intermediaries play a more
important role in channeling funds from lenders → borrowers than marketable
securities? (12)
8.8a Explain the meaning of conflicts of interest (a type of moral hazard), and
why they may arise in financial institutions. (5)
8.8b Explain why conflicts of interest arise in underwriting and research in
investment banking. (6)
8.9 Explain why underdeveloped financial systems in developing and
transitional economies face several difficulties that restrict their efficiency,
and why certain practices in developing and transitional countries reduce
economic efficiency. (6)
 44

CHAPTER 9: FINANCIAL CRISES IN ADVANCED ECONOMIES

This section makes use of agency theory to see why financial crises occur and
why they have such devastating effects on the economy. [Agency theory =
the economic analysis of the effects of asymmetric information (adverse
selection and moral hazard) on financial markets and the economy].

What is a financial crisis?

A financial crisis occurs when an increase in asymmetric information from a

disruption in the financial system causes severe adverse selection and moral
hazard problems that render financial markets incapable of channeling funds
efficiently from savers to households and firms with productive investment
opportunities. These barriers to efficient allocation of capital are called
financial frictions. When financial markets fail to function efficiently, economic
activity contracts sharply.

Dynamics of Financial Crises in Advanced Economies See figure1 pg 229

Stage one: Initiation of financial crisis.

Several possible ways:

 Mismanagement of financial liberalization/innovation: the

elimination of restrictions on financial markets and institutions, or
when new innovations are introduced. Often there is a lack of
understanding of the changing situations which leads ultimately
to banks taking greater risks and then having to face the
consequences of bad debts arising from these risks. When this
occurs banks are forced to restrict lending (deleveraging) and
this puts pressure on the economy, leading to a severe
decrease in economic activity. Lending boom becomes a
lending crash

 Asset price booms and busts: “irrational expectations” tend to

drive asset prices above the real value of these assets. Asset-
price bubbles (tech stock market 1990s, house prices 2007) are
often driven by credit booms, where the large increase in credit
is used to fund purchases of assets, thereby driving up their
price. When “reality” eventually prevails, the assets are largely
devalued and the consequences for an economy can be
devastating.

 Increase in uncertainty: during periods of uncertainty (after a

recession, stock market crash or failure of major financial
institution) accurate information is harder to obtain and
consequently the problems of adverse selection and moral
hazard increase, financial frictions increase, lending declines
and economic activity decreases.
 45

Stage Two: Banking Crisis: deteriorating balance sheets and tougher

business conditions lead some financial institutions into insolvency. Depositors
begin to withdraw their funds from banks and a banking crisis or bank panic
ensues, in which multiple banks go out of business. This may force banks to
sell off assets quickly to raise the necessary funds – fire sales. The resulting
decline in the number of banks results in a loss of information capital
(creditworthiness), worsening adverse selection and moral hazard problems in
credit markets and a further downward spiral of the economy. Uncertainty in
the market declines when healthy and insolvent banks are sorted through.
Adverse selection and moral hazard problems subside and stage is set for an
economic recovery.

Stage Three: Debt Deflation: if however the downturn in the economy leads
to a general decrease in prices, this can lead to a decrease in the net value
of firms – debt deflation. In most advanced economies with debt contracts
with fixed long term interest rates, the unanticipated decline in price level
raises the value of borrowing firms’ debt in real terms but does not raise the
real value of borrowing firms’ assets. The borrowing firms’ net worth in real
terms thus declines. When this happens the adverse selection and moral
hazard problems can become so severe that lending, investment spending
and aggregate economic activity remain depressed for a long time. One of
the most famous of these types of financial crisis is the Great Depression in the
United States.

Application: The Great Depression pg 231

 Stock market crash

In 1928 and 1929, prices doubled in the U.S. stock market. Federal
Reserve officials viewed the boom as excessive speculation and to
curb it they pursued a tightening of monetary policy to raise interest
rates to limit the rise in stock prices. However the stock market crashed
in October 1929, falling by 40%.
 46

 Bank panics
By the middle of 1930, stocks had recovered almost half their losses
and credit markets conditions stabilized. However, when severe
droughts in the Midwest led to sharp declines in agricultural
production, the result was that farmers were unable to pay back their
bank loans. The mortgage defaults led to large loan losses on bank
balance sheets. The weakness of the economy and banks prompted
substantial withdrawals from banks, building to a full-fledged panic in
November 1930. By March 1933, more than one-third of U.S.
commercial banks had failed.

 Continuing decline in stock prices

Stock prices kept falling and the increase in uncertainty from the
unsettled business conditions created by the economic contraction
worsened adverse selection and moral hazard problems in financial
markets. A manifestation of the rise in financial frictions is that lenders
began charging businesses much higher interest rates to protect
themselves from credit losses.

 Debt deflation
The ongoing deflation that started in 1930 eventually led to a 25%
decline in price level. The resulting decline in net worth led to a
prolonged economic contraction in which unemployment rose to 25%
of the labour force.

 International dimensions
Bank panics in the US also spread to the rest of the world, and the
contraction of the U.S economy sharply decreased the demand for
foreign goods. The worldwide depression caused great hardship, with
millions upon millions of people out of work, and the resulting
discontent led to the rise of fascism and World War II.
 47

Application: The Global financial Crisis of 2007-2009 pg 234

Causes of the crisis:

 Financial innovation in the mortgage markets

Before 2000, only the most credit worthy (prime) borrowers could
obtain mortgages. However, with advances in computer technology
and statistical risk analysis techniques, banks (with the help of
securitization) were able to offer subprime mortgages to borrowers
with less than stellar credit records. See FYI box on pg 235

 Agency problems in the mortgage markets

Mortgage brokers did not make a strong effort to evaluate whether
the borrower could actually pay back the loan, since they would
simply sell (distribute) the loan to investors in the form of mortgage
backed securities. This originate-to-distribute model was exposed to
principal-agent problems where the mortgage brokers acted as
agents for the investors but did not have their best interest at heart.
Once the broker had earned his fee, why should he care if the
borrower keeps up to date on their payments? Compounding this
problem was lax regulation of originators, who weren’t required to
disclose info to borrowers that would’ve helped them assess whether
they could afford the loans.

 Asymmetric information and credit rating agencies

Credit rating agencies were subject to conflicts of interest because
they earned large fees from advising clients on how to structure
complex financial instruments like CDOs as well being responsible for
rating these same products on their probability of default. Therefore
they had no incentive to make sure their ratings were accurate.

Effects of the crisis:

 Residential housing prices: Boom and Bust
Aided by low interest rates, the asset price boom in housing helped
stimulate the growth of the subprime mortgage market. With housing
prices rising, subprime borrowers were also unlikely to default as they
could always sell the house to pay off the loan. Eventually the housing
price bubble burst. With housing prices falling drastically, the value of
many subprime borrowers’ houses fell below the amount of the
mortgage. Struggling homeowners had large incentives to walk away
from their homes.
 48

 Deterioration of Financial Institutions’ Balance Sheets

With rising defaults on mortgages, the value of mortgage-backed
securities and CDOs collapsed, leaving banks with a lower value of
assets and a decline in their net worth. This caused them to sell off
assets and restrict lending. Financial frictions then increased in financial
markets.

 Run on the shadow banking system

This is composed of hedge funds, investment banks and other non-
depository financial firms, which are not as tightly regulated as banks.
With the values of mortgage-backed securities falling, the same
amount of collateral would allow financial institutions to borrow only
half as much. Thus to raise funds, they needed to engage in fire sales
which further lowered asset prices. The decline in asset prices in stock
market (fell by over 50% from Oct 2007 – Mar 2009) and the more than
30% drop in house prices, along with fire sales, weakened both firms’
and households’ balance sheets

 Global financial markets

Although the problem originated in the US, a sign of how extensive the
globalization of financial markets had become was when the crisis hit
Europe.
 49

 Failure of high profile firms

The sale, failure and bail out of firms like Bear Sterns, Fannie Mae,
Freddie Mac, Lehman Brothers and AIG etc.

The 2007-2009 financial crisis did not lead to a depression because of

aggressive Federal Reserve actions and worldwide government intervention
through bailouts of financial institutions.
 50

Typical exam questions

9.1 Explain six factors that may cause financial crises and explain why
financial crises lead to contractions in economic activity. (30)

9.2 Explain the dynamics of past financial crises in the US as they progressed
along three stages.
Focus on financial institutions. (15)
 51

True or false Review Questions

1. When an asset-price bubble bursts and asset prices realign with
fundamental economic values, there is a resulting decline in the net
worth of firms and firms have incentives to take on risk at the lender's
expense.
2. A lower net worth of a firm means there is less collateral, so adverse
selection increases.
3. An unanticipated decline in the price level leads to firms' real burden
of indebtedness increasing. The resulting decline in a firm's net worth
increases adverse selection and moral hazard problems facing
lenders.
4. When a domestic firm's debt contracts are denominated in foreign
currency, and when there is an unanticipated decline in the value of
the domestic currency, then the debt burden of the firm increases.
5. A lower net worth means there is less collateral and so adverse
selection increases.
6. When there are simultaneous failures of financial institutions, there is a
loss of information production in financial markets and a direct loss of
banks' financial intermediation.
7. A failure of a major financial institution, which leads to a dramatic
increase in uncertainty in financial markets, makes it hard for lenders to
screen good from bad credit risks. The resulting inability of lenders to
solve the adverse selection problem makes them less willing to lend.
8. Individuals and firms with the riskiest investment projects are those who
are willing to pay the highest interest rates. If increased demand for
credit drives up interest rates sufficiently, good credit risks are less likely
to want to borrow while bad credit risks are still willing to borrow.
9. When there is weak bank regulation and supervision, then financial
institutions will take on excessive risk because market discipline is
weakened by the existence of a government safety net.
 52

Chapter 10: Dynamics of Financial Crises in Emerging Market Economies

Stage one: Initiation of financial crisis

 Mismanagement of financial liberalization/globalization. The

opening up of economies to flows of capital and financial firms
from other nations is called globalization. Problems arise when
institutional weakness (fiscal imbalances, ineffective screening
and monitoring of borrowers and lax government supervision of
banks) prevents a country from successfully handling the
liberalization or globalization process. Only when prudent
regulation and supervision are strong, the lending boom and
bust that often follows the opening up the emerging market
economies will not occur.

 Severe fiscal imbalances. Governments that run up high deficits

often persuade or even force the banks to purchase
government debt (bonds). When investors lose confidence in
the ability of the government to repay the bonds, the price of
the bonds plummets and this means that banks that are holding
such bonds have a serious decrease in the value of their assets.
With less capital, lending will decline and a worsening of
adverse selection and moral hazard problems will occur.

 Some additional factors: rise in interest rates from events

abroad which are most likely to be agreed to by riskier firms.
The loans that are made therefore become high risk.

Stage two: Currency crisis

As the effects in stage one build on each other, participants in the forex
market sense an opportunity: they can make huge profits if they speculate
with the currency and they bet on the currency depreciating. As a result the
currency is subject to speculative attack where speculators engage in
massive sales of the currency. The market is flooded with currency, supply far
outstrips demand, the value of the currency collapses and a currency crisis
occurs. Countries are unable to defend their currency when it becomes
impossible to raise interest rates or the central bank has exhausted all its forex
reserves. A currency crisis can also be triggered by government deficits that
spin out of control. Foreign investors start doubting the government’s ability to
honour its debt and start pulling their money out of the country and thus
selling the domestic currency.

Stage three: Full-fledged financial crisis

When debt contracts are denominated in foreign currency and then the
value of the domestic currency depreciates, the amounts owing on these
debt contracts increase. The debt burden of firms and government increases
substantially. The value of debt increases more than the value of assets and
firms’ net worth declines. The collapse of the currency can also lead to
higher inflation. Developing country CBs have less credibility as inflation
fighters, thus a sharp depreciation of the currency leads to immediate
upward pressure on import prices. A dramatic rise in both actual and
 53

expected inflation will follow. The resulting increase in interest payments

causes reductions in firms’ cash flow and this in turn leads to asymmetric
information problems. Banks also suffer from loss of value in terms of their
assets while their liabilities rise. The risk of a bank crisis is increased.

Note:

The financial crises in emerging market economies have relevance for South
Africa. South Africa was to some degree shielded from the 2007-2009
Subprime crisis because of strict and effective banking regulation. However,
South Africa remains a small open economy which has experienced currency
crises in the past.

Typical exam question:

Explain the dynamics of a financial crisis in emerging market economies. (15)
 54

CHAPTER 11: BANKING AND THE MANAGEMENT OF FINANCIAL INSTITUTIONS

The bank balance sheet

A bank’s balance sheet is also a list of its sources of bank funds (liabilities) and
uses to which these funds are put (assets). Banks obtain funds by borrowing
and by issuing other liabilities. They then use these funds to acquire assets
such as securities and loans. Banks make profits by charging a higher interest
rate on their assets (e.g. loans) than they pay on their liabilities (deposits they
hold).

Assets (uses) Liabilities (sources)

Reserves Checkable deposits
Deposits at other banks Nontransaction deposits
Securities Borrowings
loans Bank capital

Basic banking

In general banks make profits by selling liabilities with one set of

characteristics (a combination of liquidity, risk, size and return) and using the
proceeds to buy assets with a different set of characteristics. Often referred
to as asset transformation, e.g. savings deposit into a mortgage loan
(borrowing short and lending long).

 Deposits form the largest part of banks' liabilities while loans form the
bulk of banks' assets. In principle, the bank makes a profit because the
revenue earned by interest on loans and the yield of securities,
exceeds the interest paid on deposits.

 By far the greatest proportion of the new deposits that banks issue are
to borrowers. For example, when you borrow money from a bank, the
bank issues you with an increased deposit account balance.

 Most loan assets are banks' provision of finance to the private sector.

 Banks hold reserves (which are only 2.5% of their assets) amongst others
in order to provide for the possibility of deposit withdrawals.
Withdrawals are, however, typically offset by deposits – unless there is a
run on the banks. Thus the main reason why reserves are held is that
the central bank requires banks to hold a certain minimum of reserves
as a percentage of their deposit liabilities.

 T-accounts provide a logically consistent framework to demonstrate

the impact of typical transactions of banks.
 55

General principles of bank management

Banks have four primary concerns:

 Liquidity management: to keep enough cash or liquid assets on
hand. Note the role of excess reserves which is insurance
against the costs associated with deposit outflows. The higher
the costs associated with deposit outflows, the more excess
reserves banks will want to hold.

 Asset management: to maximize profits banks must

simultaneously seek the highest returns possible on assets,
reduce risk and make adequate provisions for liquidity by
holding liquid assets. They try and achieve this through:

o finding borrowers who will pay high interest rates and are
unlikely to default
o purchase securities with high returns and low risk
o attempt to lower risk through diversification
o satisfy the reserve requirements without suffering high costs.

 Liability management: concept of acquiring funds at a low cost.

How have banks become creative in their acquisition of funds?

______________________________________________________________

______________________________________________________________

______________________________________________________________

______________________________________________________________

______________________________________________________________

 Capital adequacy management: amount of capital required

and strategy to acquire this capital. Importance of bank
capital:
(i) helps prevent bank failure
(ii) it affects returns for the owners of the bank
(iii) a minimum amount of bank capital is required by
regulatory authorities.

How the amount of bank capital affects returns to equity

holders:
o Bank owners care most about how much the bank is earning
on their equity investment ROE
 56

o The Equity multiplier (EM) is the relationship between the

return on assets (how efficiently the bank is run) and the
return on equity (how well the owners are doing on their
investment).

EM = Assets/equity capital

o Banks have to face a trade-off between safety and returns

to equity holders. Bank capital has both benefits and costs.
It makes investment safer (reduces likelihood of bankruptcy)
but it is costly because the higher it is, the lower return on
equity for a given return on assets.
o Given the return on assets, the lower the bank capital, the
higher the return for the owners of the bank.

Application: Strategies for Managing Bank Capital

 As a manager of FNB you have to decide on the correct amount of

capital required. On analyzing the balance sheet of the bank you
discover that the large amount of capital is causing the return on
equity to be too low. You therefore conclude that the bank has a
surplus of capital.
 In order to lower the amount of capital relative to assets and to raise
the equity multiplier you can do any of three things: (1) reduce the
amount of bank capital by buying back some of the banks stocks; (2)
reduce the capital by paying higher dividends and thereby reducing
retained earnings; (3) keep bank capital constant but increase the
bank’s assets by acquiring new funds, e.g. issuing CDs and then
seeking out loan business or purchasing more securities with these
funds.
 Because you think it would enhance your position with the
stockholders, you decide on the 2nd option.
 Assume now, on the other hand that FNB has a ratio of bank capital to
assets of 4%. Now you are concerned that the bank does not have
enough capital to prevent a bank failure.
 To raise the amount of capital relative to assets, you have three
choices: (1) raise capital for the bank by a stock (equity) issue; (2) raise
capital by reducing dividend payments and increasing retained
earnings; (3) keep capital at the same level but reduce the bank’s
assets by making fewer loans, and so shrink the size of the bank.
 Note: a shortfall of bank capital is likely to lead to a bank reducing its
assets and therefore a contraction in lending.
 57

Application: How the capital crunch caused a credit crunch during the
Global Financial Crisis

 The slowdown in the growth of credit following the financial crisis,

which started in 2007, meant that credit was hard to obtain, the so
called credit crunch. This was caused, at least partly, by a shortage of
bank capital.
 The boom and bust in the housing market led to huge losses for banks
and they were forced to take back onto the balance sheet many of
the structured investment vehicles they had sponsored.
 Losses that had reduced capital together with the capital required to
support the assets coming back onto balance sheets meant that
banks were faced with shortages of capital
 As a consequence they were less inclined to lend and so credit was
not easily available.

Managing credit risk

To be profitable, financial institutions must overcome the adverse selection

and moral hazard problems that make loan default more likely. There are a
number of ways they can do this:

 Screening and monitoring: adverse selection in loan markets requires

that lenders screen out the bad credit risks from the goods ones so that
loans are profitable. Lenders must, therefore, collect reliable
information from prospective borrowers. Effective screening and
information collection together form an important principle of credit
risk management.
Banks often specialize in lending to firms in a particular industry. This
goes against the idea of diversification but at the same time makes
some sense. By concentrating on leading firms in a specific industry
the bank becomes knowledgeable about that specific industry and is
better able to make informed decisions.
Once a loan has been made there is still the risk of moral hazard. In
order to reduce the likelihood of this occurring, financial institutions
should adhere to the principle of managing credit risk and write
provisions (restrictive covenants) into loan contracts that restrict
borrowers from engaging in risky activities.

 Long-term customer relationships: such relationships reduce the costs

of collecting information and make it easier to screen out bad credit
risks. This has the added advantage of the customer wishing to ensure
that he/she can preserve a good relationship with the bank for future
loan requirements and so reduces the chances of the customer doing
anything to jeopardize the situation.

 Loan commitments: an agreement between the bank and a firm to

grant loan requirements up to an agreed amount at an interest rate
that is linked to a market rate. Majority of industrial and commercial
loans are made under the loan commitment arrangement. The
 58

advantage to the firm is a secure source of credit and to the bank a

long-term relationships which facilitates the collection of information.

 Collateral and compensating balance: collateral requirements are

important credit risk management tools. One particular form of
collateral required by a bank when it makes a commercial loan, is
called compensating balances: a firm receiving the loan must keep a
required minimum amount of funds in a cheque account with the
bank. This helps the bank to monitor the client and reduce the risk of
moral hazard.

 Credit rationing: refusing to make loans even though customers are

willing to pay the required interest rate. There are two forms: (i) refusal
to make any loan and (ii) restricting the size of the loans made.

Managing interest rate risk

The increased volatility of interest rates has caused banks to become more
concerned about their exposure to interest rate risk, i.e. the riskiness of
earnings and returns associated with changes in interest rates. If a bank has
more rate-sensitive liabilities than assets, a rise in interest rates will reduce the
bank’s profits and a decline in interest rates will raise bank profits.

Gap and Duration analysis: The sensitivity of a bank’s profits to changes in

interest rates can be measured using gap analysis. The amount of rate-
sensitive liabilities is subtracted from the amount of rate-sensitive assets.

[Example: rate sensitive assets – rate sensitive liabilities = $20m - $50m

= -$30m. This gap is multiplied by the change in interest rate, +5% and
equals -$1,5m. This means that profits will decline by $1,5m if interest
rates increase by 5%.]

An alternative method for measuring interest rate risk is called the duration
analysis and examines the sensitivity of the market value of the bank’s total
assets and liabilities to changes in interest rates. This is based on Macaulay’s
concept of duration, which measures the average lifetime of a security’s
stream of payments.
 59

Percent change in market value of security ≈ - percentage-

point change in interest rate x duration in years

Duration analysis involves using the average duration of assets and liabilities
to see how the net worth responds to a change in interest rates.

[Example: Suppose FNBs average duration of assets is 3 years and

liabilities is 2 years. If FNB has $100 million in assets, $90 million in liabilities
so bank capital is 10% of assets. With +5% in interest rates, the market
value of the bank’s assets fall by 15% (=-5% x 3 years) down to $85
million. However the market value of liabilities only fall by 10% (=-5% x 2
years) down to $81 million. The net result is that the net worth (assets
minus liabilities) has declined by $6 million (from an original net worth
value of $10 million down to only $4 million now) or 6% of the total
original asset value.

Application: Strategies for managing interest rate risk: read through the
application on page 287. The following is a summary:

Suppose that a duration and gap analysis for the bank has been done and
decisions have to be made on alternative strategies. If you believe that
interest rates will fall in the future, you may be willing to take no action
because you know that the bank has more rate-sensitive liabilities than rate-
sensitive assets and so will benefit from the expected interest rate decline.

[Explanation: the decrease in the amount banks have to pay on deposits

(liabilities) will be greater than the decrease in the interest they will receive on
their loans (assets)] What will happen though if the interest rates increase? It
is possible you could shorten the duration of the bank’s assets to increase their
rate-sensitivity, alternatively you could lengthen the duration of the liabilities.
New financial instruments such as derivatives (forwards, future, options and
swaps) can help the bank reduce its interest-rate risk exposure and do not
affect the balance sheet directly.

Off-balance sheet activities

The environment within which banks operate is becoming increasingly

competitive and as a result banks have been aggressively seeking out profits
by engaging in off-balance sheet activities. These involve trading financial
instruments and generating income from fees and loan sales, activities that
affect bank profits but do not appear on bank balance sheets.

 Loan Sales: a type of off-balance-sheet activity that has grown. Also

called Secondary loan participation and involves a contract that sells
all or part of the cash stream from a specific loan and thereby
removes the loan from the bank’s balance sheet. Banks earn profits by
selling loans for an amount slightly greater than the amount of the
 60

original loan. Because of the high interest rate on these loans it makes
them attractive, institutions buy them.

 Generation of Fee Income: banks obtain income for providing

specialized services to their customers, such as making foreign
exchange trades on a customer’s behalf, servicing a mortgage-
backed security by collecting interest and principal payments and
then paying them out, guaranteeing debt securities etc. Even though
a guaranteed security doesn’t appear on a bank’s balance sheet, it
still exposes it to default risk.

 Trading activities and risk management techniques: activities such as

trading in financial futures, options for debt instruments and interest-
rate swaps are off-balance-sheet activities. While these activities are
often undertaken to reduce risks, banks also engage in speculative
activities which can be very risky.
A particular problem for banks in the case of such trading activities is
that the principal-agent problem can be severe. The Barings Bank
failure is an example of how a trader was able to cause the collapse
of an initially healthy bank (pg 289).

To reduce the principal-agent problem, managers of financial

institutions must set up internal controls to prevent such severe
problems from arising. Such controls include the separation of the
people in charge of trading operations from those in charge of the
bookkeeping of such transactions. In addition, controls should be set
on the limits of the total amount of traders’ transactions and on the
institution’s exposure to risk.
 61

Typical Exam questions

11.1 Present the major assets and liabilities of a commercial bank in

balance sheet format. (6)
11.2 Demonstrate (make appropriate entries in this balance sheet, only
changes are required) of the following transactions. (Hint: Each of the
transactions requires two entries in the balance sheet.)
(a) New deposits of R10m arise. (2)
(b) The bank uses asset transformation (into loans) arising from
(a). Explain why this gives rise to profits. Assume the required
reserve ratio is 10% of deposits. (3)
 62

(c) The bank borrows R2m from the central bank in order to
increase its excess reserves. (2)
(d) The bank buys R1m of government stock. (2)
(e) The bank sells R3m of securities in order to finance a new
loan of R3m. (2)
(f) The bank writes off R4m of bad loans. (2)
(g) The bank makes a profit of R6m. Thus the bank pays a
dividend of R5m to its shareholders.(3)
11.3 Explain the primary concerns banks have in managing their assets
and liabilities. (10)
11.4 Explain the meaning of credit risk and how banks can manage
their credit risk. (7)
11.5 Explain briefly the meaning of interest rate risk and how banks may
deal with this problem. (5)
11.6 Briefly explain the meaning of off-balance-sheet activities and the
forms in which they occur. What type of risks do they hold for banks?
(8)

True or false review questions

1. Bank A experiences a shortfall of capital. Because this increases

the likelihood of a bank failure, bank A is likely to reduce its issue
of new loans.
2. The purpose of screening and collecting information about a
prospective lender is to gain relevant information to evaluate
the risk of default of the loan. The process to gain this relevant
information is called adverse selection.
3. A loan commitment arrangement reduces a bank's cost for
screening and information collection.
4. Compensating balances function as a form of collateral for
loans.
5. Loan sales occur when, say Bank A, sells a future income stream
of certain categories of its loans, or part of its loans, to outside
investors, at a price slightly above the original loan amount,
which creates a profit in Bank A's income account. In terms of
balance sheet entries, this reduces the amount of loans of bank
A, while simultaneously increasing the amount of securities held
by bank A.
6. Generation of fee income occurs when banks perform
specialised services for clients, e.g. provision of foreign
exchange, servicing of a security, providing a guarantee of
debt securities (e.g. BAs), provision of backup lines of credit, etc.
Some of this exposes the bank to risk. If the issuer of the security
fails then the bank has to pay.
 63

Part four: Central banking and the conduct of monetary policy

(Textbook: chapters 14, 15, 16 and 17)

CHAPTER 14: CENTRAL BANKS: A GLOBAL PERSPECTIVE

Central banks are important players in the financial markets around the
world. They are the monetary authority and their actions affect interest rates,
money supply and the supply of credit. All these factors have an effect on
financial markets, aggregate demand and inflation.

The study guide highlights three questions relating the central bank:
 The goals of monetary policy
 The role of the central bank (SARB) in the South African banking system
 The case for central bank independence

Explaining central bank behavior

C3 Can monetary policy help to alleviate SA’s unemployment problem?

In South Africa the goals of employment and economic growth are both
equally important. SARB has been under pressure to lower interest rates
particularly from trade unions.
Many believe that the advantages of a low interest rate (perceived as higher
employment) far outweigh the problems of a low interest rate (a higher rate
of inflation).

Refer to pages 50 - 52 in the study guide and complete this section. Note the
conclusion.
Can monetary policy in the form of low interest rates, help to alleviate South
Africa’s unemployment problem? The short answer to this question is no:

1. South Africa's high level of unemployment is mainly a structural

problem. In a modern economy, business and industry demand skilled
workers and it is typically also a skilled person who is in a better position
to start a business. Raising the skill level of workers calls for structural
solutions, such as a good school system and the development of
worker skills and entrepreneurship through education and training.
Structural problems of a long term nature are best solved by long term
structural solutions. Short-term solutions like lowering interest rates to
solve the structural unemployment problem are generally ineffective
and often not sustainable.

2. The case for lower interest rates rests on the assumption that lower
interest rates will lead to a higher level of economic activity and
employment. Not always the case however! Lower interest rates may
lead to price inflation, and the lack of price stability has negative
effects on long term growth. Theoretically lower interest rates increase
disposable income of households and increases borrowing. This
increases aggregate demand. What happens to imports? Lastly,
 64

monetary policy controls the repo rate which is a short-term interest

rate, and there are significant lags before a lower interest rate impacts
on the domestic economy.

3. Lower interest rates might lead to a depreciation of the value of the

Rand and higher inflation. High inflation increases uncertainty which
complicates planning, it corrupts information which disrupts markets, it
leads to all sorts of unproductive activities trying to escape the adverse
effects of inflation, it causes an unfavourable redistribution of income,
it reduces social cohesion and leads to social unrest. Depreciation of
the rand makes imports more expensive and adds fuel to the inflation
process.

C4 The South African Reserve Bank (SARB)

Functions of the SARB

The SARB has six main functions, study these in study guide (page 52).

1. Sole right to issue cash or currency.

2. Provides facilities for clearing and the settlement of interbank
obligations (cheques).
3. Acts as banker for and supervisor of other banks and as lender of last
resort.
4. Formulation and implementation of monetary policy.
5. Banker for government
6. Custodian of the greater part of SA gold and other foreign exchange
reserves.

Is the SARB independent? (Possible exam essay question!!)

Study in study guide. Pay particular attention to the following:

 South Africa uses an inflation targeting policy framework. The
inflation target range is 3% to 6%.
 This target is set in consultation between the Governor of the SARB
and the Minister of Finance.
 SARB has operational independence in monetary policy decisions
aimed at achieving the target.
 SARB is accountable to Parliament via the Minister of Finance.
 The Governor of the SARB frequently explains the SARB’s policy
stance in the media.
 SARB is financially independent of government.
 The President appoints the governor and three deputy governors 
implies SARB may not be completely isolated from political
influences.
 65

Should the Fed (SARB) be independent?

The following are points to consider supporting the case for independence:

 A strong argument that supports independence is that the

subjecting of Fed to political pressures would cause an inflationary
bias to monetary policy
 Because politicians tend to be motivated by self-interest (i.e.
election) they are inclined to be short-sighted in regard to
objectives. They are inclined to focus on finding short-term, popular
solutions which may not have good long-term outcomes.
o An example: high money growth in the short run might lead to
a drop in interest rates, but ultimately, as inflation heats up, will
cause interest rates to rise.
 It is believed that a politically insulated (independent) Fed is more
likely to be concerned with long-term objectives, such as a sound
currency and stable price level.
 The political business cycle is also a reason for keeping the Fed
independent. Expansionary policies are generally followed
immediately prior to elections, and the bad consequences are only
felt afterwards.
 If the Fed is put under the control of the president it would be
subject to influence by the Treasury.
 The control of monetary policy is too important to leave to
politicians. This can be stated in terms of the principal-agent
problem: both the Federal Reserve and the politicians are agents
of the public (the principals) and both have incentives to act in
their own self-interests. It is argued though that the principal –agent
problem is worse for politicians than for the Fed.
 An independent Fed can pursue policies that may not be popular,
but are in the public interest.

The following are the points to consider when arguing the case against
independence:

 Control of monetary policy by an elite group who is answerable to

no-one is considered undemocratic
 The current lack of accountability is a problem.
 In arguing for the independence of the Fed, it is then possible to
also argue for the independence of the Joint Chiefs and the IRS.
 The public holds the president and Congress responsible for the
economic well-being of the country but lacks the control over a
very important element in determining the health of the economy.
 In order to achieve economic stability, monetary policy must be
coordinated with fiscal policy.

Recent research seems to support the idea that the central bank should be
independent: when central banks are ranked from least independent to most
independent, inflation performance is found to be the best for countries with
the most independent central banks. In addition countries with independent
 66

central banks are no more likely to have high unemployment or greater

output fluctuations than those with less independent central banks.

Typical Exam questions

14.1 Should price stability be the primary goal of monetary policy? Also
explain the meaning of hierarchical and dual mandates and how they can
be used. (12)
14.2 Briefly explain the nature of the time-inconsistency problem and the role
of the nominal anchor.(5)
14.3 Briefly explain why the price stability goal in SA is desirable in spite of
other pressing economic problems. (15)
14.4 List and briefly explain the six main functions of the SARB. (6x3=18)
14.5 Explain
(a) the advantages and disadvantages of the independence of a
central bank (10)
(b) and whether the SARB is in fact independent (9)

True or false review questions

1. A nominal anchor is a nominal variable that monetary policymakers

use as an intermediate target to achieve an ultimate goal such as
price stability. The nominal anchor affects people's price expectations.
2. Monetary policy is considered time-inconsistent because of the lags
associated with the implementation of monetary policy and its effect
on the economy.
3. If the central bank promotes price stability in the long term, then the
other goals of monetary policy such as high employment, economic
growth, stability of financial markets, interest rate stability and stability
in foreign exchange markets are also achieved in the long term.
4. High employment and price level stability can, at times, conflict in the
short run.
5. Either a dual or hierarchical mandate is acceptable as long as price
stability is the primary goal in the long run.
6. A potential problem of a dual mandate (price stability and
employment) is that the central bank emphasises inflation control
rather than reducing business-cycle variations.
7. A potential problem of a hierarchical mandate is that the central bank
may focus too much on short-term objectives.
8. Monetary policy in South Africa is an ineffective tool to achieve higher
employment because monetary policy does not address the root of
the unemployment problem and lower interest rates do not necessarily
increase employment over the long term.
9. The Minister of Finance and parliament can, in principle, overrule the
execution of monetary policy decisions of the SARB.
10. The ability of a central bank to set its monetary policy instruments is
called goal independence.
11. The SARB is not goal independent.
12. The theory of bureaucratic behaviour suggests that the objective of a
bureaucracy is to maximize the public's welfare.
 67

13. Recent research indicates that low inflation has been found to be best
in countries with the most independent central banks.
14. The case for central bank independence rests on the idea that
monetary policy is performed better by professional experts such as
the SARB.
 68

CHAPTER 15: THE MONEY SUPPLY PROCESS

Three players in the money supply process

The creation of money is explained by the interaction between the three

main players in money supply process.

1. The central bank: the government agency that oversees the banking
system and is responsible for the conduct of monetary policy.

2. Banks (depository institutions): accept deposits from individuals and

institutions and make loans.

3. Depositors: individuals and institutions that hold deposits in banks.

[Referred to as the nonbank public (or nonbank private sector)]

The Fed’s (SARB’s) Balance Sheet

The operation of the Fed (SARB) and monetary policy involve actions that
affect the holdings of assets and liabilities by these organizations.

Balance sheet of SARB (1st player)

Assets: changes lead to changes in reserves and monetary base  money

supply. These assets also earn higher interest rates than the liabilities, so Fed
makes billions every year.

Securities: issued by the US Treasury or foreign currency

Loans to banks: borrowings from Fed (SARB) at the repo rate.

Liabilities: Currency in circulation - held by nonbank public

Bank Reserves
Central government and other deposits
Other Liabilities e.g SARBDs

Balance sheet of South African commercial banks (2nd player)

Assets: Deposits with the SARB (R)

Bank notes & coins
Securities
Loans

Liabilities: Deposits (D)

Borrowings of banks
Capital
 69

Control of the monetary base

It is necessary to understand how financial transactions between any of the

four participants are recorded in the balance sheets of the banks. The way in
which transactions affect banks reserves is a really important matter.

The following has been taken from the textbook to give you an idea of how a
central bank influences the monetary base in an economy.

[The monetary base is also called high-powered money. It comprises the

currency (C) in circulation as well as the total reserves (R) in the banking
system.

MB = C + R

The Fed exercises control over the MB through the purchase of government
securities in the open market. These are called open market operations.

 Open Market Purchase from a Bank: if Fed purchases $100 of

bonds from a bank and pays for them with a $100 cheque: the
end result is that reserves increase by $100, but there is no change
in currency, so the MB has increased by $100.

 Open Market Purchase from the Nonbank Public:

o If the person or corporation that sells the bonds to the Fed
deposits the cheque in a local bank, then the outcome will be
the same as the transaction with a bank (reserves increase but
no change in currency).
o If the proceeds from the sale are kept in currency then there is
no effect on reserves, but does affect the level of currency.
Therefore the MB still increases.

Mishkin (2007: 350) states that “the effect of open market operations on
reserves is much more uncertain than the effect on the monetary base.
Therefore, the Fed can control the monetary base with open market
operations more effectively than it can control reserves. This is because it
depends on whether the seller of the bonds keeps the proceeds from the sale
in currency or in deposits.”

As a main conclusion: however, note the following: “the effect of open

market operations (OMOs) on reserves is not a great deal more uncertain –
for two reasons: a significant proportion of OMOs are conducted directly with
the banks, in which case the effect on bank reserves is direct and certain;
only when OMOs are conducted with the nonbank public will their effect on
reserves be uncertain .”
 70

Shifts from deposits into currency

This shift will affect the reserves in the banking system but not the monetary
base  another reason why the Fed has more control over the monetary
base than over reserves.

e.g public wishes to hold more currency to buy gifts during Christmas, they
withdraw $100 million in cash. Banking system loses $100 million in deposits
and hence reserves. Monetary base is unaffected since M = c(+) + R(-). These
shifts cause random fluctuations in reserves making the monetary base a
more stable variable.

Overview of the Fed’s ability to control the monetary base

Whereas the amount of OMO’s is completely controlled by the Fed, it cannot

perfectly predict the amount of borrowings from the Fed by banks. So we can
split the monetary base into that which is created by loans from Fed,
borrowed reserves (less tightly controlled) and nonborrowed monetary base
(tightly controlled as it results from OMOs).

MBn = MB – BR

MBn = nonborrowed monetary base

MB = monetary base
BR = borrowed reserves from Fed.

Multiple deposit creation: a simple model

When the Fed supplies the banking system with $1 of additional reserves,
deposits increase by a multiple of this amount – multiple deposit creation.

 Deposit creation: the single bank. A single bank can make loans
up to the amount of its excess reserves, thereby creating an equal
amount of deposits. Assume that the new account holder (the
individual with the loan) withdraws the amount he has been
granted to make a payment from FNB. This amount is then
deposited in another bank.

 Deposit creation: the banking system. When another bank, say

Bank A, receives the amount from FNB it will have an increase in its
reserves. The balance of any excess reserves will be used to grant
loans as a bank does not wish to hold idle excess reserves.
Consequently the deposits in the banking system will increase
again and again as each new bank receives deposits and grants
loans.

 A single bank can create deposits equal to the amount

of its excess reserves, while the banking system as a
whole can generate a multiple expansion of deposits,
because when the reserves leave an individual bank
 71

they are not leaving the banking system. The initial

increase in reserves results in a multiple increase in
deposits.

Example:

Philip Mohr, Louis Fourie and associates. 2007. Economics for South African
Students. Fourth edition. Pretoria: Van chaik.

 Suppose Ms X receives R1000 as a gift and deposits it with Bank A. Bank

A’s cash reserves increase by R1000 and in exchange it creates a
demand deposit of R1000 in favour of Ms X. Money supply is unaffected at
this stage.
 If the cash reserve requirement is 20%, Bank A has to keep R200 of the
R1000 deposited by Ms X as cash reserves.
 This leaves Bank A with R800 which it can lend to Mr Y in the form of an
overdraft facility.
 Mr Y uses this facility to write a cheque to pat Mr Z, who deposits it into his
bank, Bank B.
 At this stage the total amount of demand deposits has increased from
R1000 to R1800. The money creation process by the banks has thus
begun.
Mr Z’s deposit of R800 raises Bank B’s cash reserves, again 20% of this
(R160) has to be kept in the form of cash reserves. The other R640 can be
lent out to another customer.
This process will continue until it works itself out. For every rand received by a
bank in the form of a cash deposit, 20 cents have to be kept as a cash
reserve with the central bank, but the remaining 80 cents can go out on loan.
Bank New deposits Additional cash New loans
reserves required granted
A R1000 R200 R800
B R800 R160 R640
C R640 R128 R512
D R512 R102,40 R409,60

 Note: the total increase in demand deposits will be equal to the

original deposit multiplied by the credit multiplier.

 Deriving the formula for multiple deposit creation. The multiple

increase in deposits caused by the increase in the banking system’s
reserves is called the simple deposit multiplier:
 72

 Formula:

 Where ΔD = change in total cheque deposits in the

banking system; rr = required reserve ratio; ΔR =
change in reserves for the banking system.

For the banking system as a whole deposit creation will only stop
when all excess reserves in the banking system are used up; the
banking system will be in equilibrium when the total amount of
required reserves equals the total amount of reserves (RR = R). For
this reason a given level of reserves in the banking system
determines the level of deposits when the banking system is in
equilibrium. Given level of reserves supports the given level of
deposits.

 Critique of the simple model. This model seems to imply that the
Fed has complete control over the level of deposits through the
reserve ratio and the level of reserves. This does depend upon
whether the proceeds from loans are deposited or kept as
currency.
o If the proceeds are used to raise the level of currency then D will
not increase by as much as the “multiplier” might suggest.
o If a single bank decides not to grant loans to the full extent of its
excess reserves then the full expansion of the simple model of
multiple deposit creation does not occur.
o The Fed is not the only player whose behaviour influences the
level of deposits. The decisions of banks, depositors and
borrowers will all have an effect.

Factors that determine the money supply

The monetary base consists of reserves plus currency (MB = R + C = RR + ER

+C). Reserves are either nonborrowed (MBn) or borrowed (BR) – discount
loans.

 MBn is directly controlled by the central bank – money supply is

positively related to the nonborrowed monetary base.
 BR depends on the banks’ action - the money supply is positively
related to the level of borrowed reserves from the central bank.
BRs in South Africa are the amount of refinancing and depend on
the repo rate. A high repo rate might discourage banks from
borrowing from the SARB.
 If the required reserve ratio (rr) increases, there will be less multiple
deposit expansion and money supply will fall
 As shown before, deposits undergo multiple expansions while
currency doesn’t. Therefore when deposits are converted into
currency, there is a switch from a component of the money supply
 73

that undergoes multiple expansion to one that doesn’t. Money

supply is negatively related to currency holdings.
 The money supply is negatively related to amount of excess
reserves.

Overview of the money supply process

Refer to table 1 on page 395 in the prescribed textbook to see how the
different factors affect the money supply.

The money multiplier

The money multiplier is a ratio that relates the change in the money supply to
a given change in the monetary base.

The money multiplier, m, tells us what multiple of the monetary base is

transformed into money supply, M.

Derivation of the money multiplier equation:

 simple definition of money (M1 = C + D)
 Linking relationship: M = m x MB, where M = money supply and
MB is the monetary base; m is the money multiplier
 Holdings of excess reserves are now included and it is assumed
that the desired level of C and excess reserves (ER) grows
proportionally with D:
o c = C/D = currency ratio
o e = ER/D = excess reserves ratio
 Total amount of reserves in the banking system R is the sum of
required reserves RR and excess reserves ER So, the total
 74

amount of required reserves equals the required reserve ratio, rr,

times the amount of deposits D:
o R = RR + ER and
o RR = rr x D [rr will be less than 1]
 Now link the reserves in the banking system to the amount of
deposits and excess reserves that they can support:
o R = (rr x D) + ER
 Remember that MB = C + R, so now it is possible to derive an
equation that links the amount of the monetary base to the
levels of D and C:
o MB = C + R = C + (rr x D) + ER
 An important feature of this equation is that an additional dollar
of C does not support an increase in D. An increase in the
monetary base that is only in currency is not multiplied, whereas
an increase that goes into deposits is multiplied.
 Now derive the money multiplier in terms of the currency and
excess reserve ratios:
o MB = (rr x D) + (e x D) + (c x D) = (rr + e + c) x D
 Write down the expression that links demand deposits D to the
monetary base MB (refer page 397 in textbook):

D = 1/(rr + e + c) x MB [Equation 3]

 Finally, using M1 = D + C and specifying C as c x D, derive

the money multiplier, m by referring to page 397 in the
textbook:

o M = D + (c x D) = (1 + c) x D
 Substituting in for D from equation 3:

1+c
o M = rr + e + c x MB

o m =

 It is a function of the currency ratio set by depositors c, the excess

reserve ratio set by banks e, and the required reserve ratio set by the
Fed rr.

Please work through Intuition behind money multiplier on pg 398 of textbook!!

75
 76

Factors that determine the money multiplier (m)

Changes in the required reserve ratio, rr:

 If rr increases while other variables stay the same, the same
level of reserves cannot support as large an amount of cheque
deposits and more reserves are needed.
 Deficiency in reserves means that banks must contract loans,
causing a decline in deposits and in money supply
 When rr is higher less multiple expansion of D occurs and so the
money multiplier decreases.
 Money multiplier and the money supply are negatively related
to the required reserve ratio.

Change in the currency ratio, c:

 An increase in c means that people wish to convert some of D
into C.
 Overall multiple expansion declines and so does the multiplier.
 The money multiplier and the money supply are negatively
related to the currency ratio c.

Changes in excess reserves ratio, e:

 When banks increase e, they have less reserves to support D.
 This means that given the same level of MB, an increase in e will
cause loans to contract and money supply will decrease.
 Because e is so small it does not have a large impact on m, but
nevertheless, if e increases m will decrease.
 Money multiplier and the money supply are negatively related
to the excess reserves ratio. There are two factors that affect
the costs and benefits of excess reserves:
o Market Interest rates (i): when i increases the opportunity
cost of holding excess reserves increases and so e falls. So,
the banking system’s excess reserves ratio is negatively
related to the market interest rate.
o Expected deposit outflows: excess reserves provide
insurance against deposit outflows. If expected deposit
outflows rise then excess reserves will increase. So, the
excess reserve ratio is positively related to expected deposit
outflows.

Work through additional material in study guide C7, C8 and C9 on monetary

policy in SA!!

Typical Exam questions

15.1 You must be able to record the (direct) changes arising from any of the
transactions in section D question 2, in both the balance sheets of the SARB
and that of banks.
 77

15.2 Derive the simple multiple deposit creation model (formula: ΔD =

(1/r)ΔR). Explain its meaning, the underlying behaviour of the three players of
the money creation process, its simplifying assumptions and its critique. (20)
15.3 Explain how each of the following factors change money supply:
changes in the nonborrowed monetary base; changes in the borrowed
reserves; changes in the required reserve ratio; changes in the currency
holdings; and changes in excess reserves. (Hint: Make use of appropriate
formulas which you do not have to derive.) (9)
15.4 Derive the money multiplier equation mathematically:

M = (MB).

Explain the meaning of the variables (M and MB; and r, e and c) and the
effect on the multiplier of an increase in each of r, e and c. (12)
15.5 Briefly explain the arguments for a reversed causality in South Africa, that
is, "deposit creation leads to reserve holding" (D → R) could be more realistic.
(15)
 78

CHAPTER 16: TOOLS OF MONETARY POLICY

The market for reserves and the federal funds rate (interbank rate in the USA)

The market for reserves is where the federal funds rate is determined.

Demand for reserves:

 quantity of reserves demanded equals required reserves
(required reserve ratio x amount of deposits on which reserves
are required) plus the quantity of excess reserves demanded
 the interest rate or the federal fund rate indicates the
opportunity cost of holding excess reserves
 after 2008, the Fed started paying interest on reserves, a fixed
amount below the Federal Funds rate
 When the Federal Funds rate is above the rate paid on reserves
ior, the opportunity cost of holding reserves starts to fall. As the
Federal Funds rate decreases, (Holding other variables constant
ie: Required Reserves), the quantity of reserves demanded will
increase.
 For this reason the demand curve for reserves slopes
downwards. Refer Figure 1 on page 410 (374) in the textbook.
 If however the Fed funds rate begins to fall below the interest
paid on excess reserves ior, banks would not lend in the
overnight market at a lower rate, instead they would just keep
adding to their excess reserves.
 The result is that the demand curve becomes flat at ior .

Figure 1: Equilibrium in the Market for reserves With excess supply of

reserves, the federal funds
rate falls to i*n

Federal
Funds rate

NBR Quantity

With excess demand

for reserves, the
federal funds rate
rises to i*ff
 79

Supply of reserves:
 two components:
o NBR = non-borrowed reserves (supplied by Fed’s OMO’s)
o BR = borrowed reserves
 Primary cost of borrowing from the Fed is the interest rate the
Fed charges on these loans, the discount rate (id).
 As long as the cost of borrowing from the other banks (called
federal funds) is cheaper than the discount rate, banks would
rather borrow from each other and the borrowed reserves will
be zero. Therefore supply of reserves will be just equal to amount
of non-borrowed reserves, so supply curve is vertical.
 If the federal fund rate rises above the discount rate, banks
would want to keep borrowing more and more at the discount
rate and then lend this money out at the higher federal fund
rate. The supply curve then becomes horizontal (perfectly
elastic). Refer figure 1 on page 410 (374).

Market Equilibrium:

 This occurs at the point where the quantity of reserves

demanded equals the quantity supplied. Rs = Rd
 This will determine the federal funds rate.
 When the federal funds interest rate is above the equilibrium
rate, there will be more reserves supplied than are demanded
(excess supply) and so the federal fund rate will move
downwards.
 When the federal funds interest rate is below the equilibrium
rate, there will be more reserves demanded than supplied
(excess demand) and the federal funds rate will move upwards.

How changes in the tools of monetary policy affect the federal funds rate (in
the USA)

Examining how changes in our 4 monetary policy tools affect the market for
reserves and equilibrium federal funds rate.

1. Open market operations (OMOs):

 The effect of an OMO depends on whether the supply curve
initially intersects demand curve in its downward sloping or flat
section.
 OMOs lead to a greater quantity of reserves supplied and shifts
the supply curve to the right (refer Figure 2 on page 413 (376).
 The rightward shift of the supply curve causes the federal funds
rate to decrease.
 An open market purchases causes the federal funds rate to fall,
whereas an open market sales causes the federal funds rate to
rise.
 80

Advantages of OMOs:
 Open market operations occur at the initiative of the Fed which
has complete control over their volume.
 Open market operations are flexible and precise; they can be
used to any extent no matter how small the change in reserves
or monetary base required.
 Open market operations are easily reversed.
 Can be implemented quickly with no administrative delays.
When the Fed decides it wants to change the monetary base or
reserves it just places orders with securities dealers, and the
trades are executed immediately.

Figure 2: response to an open market operation

Federal Federal
Funds Funds
rate rate

Quantity Quantity

2. Discount Lending (discount policy):

 Effect of a discount rate change depends on whether the
demand curve intersects the supply curve in its vertical section
or its flat section.
 Refer to Figure 3. If the intersection occurs on the vertical
section of supply curve, there is no discount lending and BR are
zero. Here, when the discount rate is lowered, the horizontal
section of supply curve falls. Thus there is no change in
equilibrium federal funds rate.
 Since this is the typical situation, most changes in the discount
rate have no effect on the federal funds rate.
 However if demand curve intersects supply on its flat section,
there is some discount lending, and changes in discount rate do
affect federal funds rate. So when discount rate is lowered, the
horizontal section of the supply curve falls, and equilibrium
federal funds rate falls.
 81

Advantages and Disadvantages of Discount Policy:

 Most important advantage is that the Fed can use it to perform

its function of lender as last resort.
 In the past discount policy was used as a tool of monetary
policy with discount rate changed to affect money supply and
interest rates.
 This is no longer the case because the discount loan decisions
are made by the banks (not the Fed). Fed has more control
through OMOs.
 Presently the discount facility is not used to set the federal funds
rate but is only a backup facility to prevent the federal fund rate
from rising too far above its target or is used to provide liquidity
during financial crises.

Figure 3: Response to a change in the discount rate

Federal Federal
Funds Funds
rate rate

Quantity Quantity

3. Reserve Requirement:
 When the required reserve ratio increases then required reserves
will also increase and hence the quantity of reserves demanded
increases for any given interest rate.
 An increase in the required reserve ratio will shift the demand
curve to the right (refer Figure 4). This raises the federal funds
rate.
 A rise in reserve requirements reduces the amount of deposits
that can be supported by a given monetary base and therefore
reduces money supply.
 A rise in reserves also increases the demand for reserves and
raises the federal fund rate.
 82

Figure 4: Response to changes in Required

Step 1: Increasing the Reserves
reserve requirement causes
the demand curve to shift to Federal
the right… Funds
rate

Step 2: The Federal Funds

rate will rise. Due to the
decreased money supply. –
Liquidity Preference
Framework

Quantity

Disadvantages:

 This tool is much less effective than it once was because the reserve
requirements are no longer binding for the banks.
 Another disadvantage of using reserve requirements to control money
supply and interest rates is that raising the requirements can cause
immediate liquidity problems for banks where reserve requirements are
binding.
 Does not have much to recommend it so is no longer used. Some
economists suggested it should be eliminated altogether.

4. Interest on Reserves (Not Applicable in SA):

An increase in the interest paid to banks on reserves will only have an impact
if the supply curve intersects the demand curve at the downward sloping
section ie: when the equilibrium federal funds rate is at the interest rate paid
on reserves. At this point, a rise in the interest rate paid on reserves will cause
the federal funds rate to rise.

Conventional monetary policy tools

Open market operations

These are the primary determinants of changes in interest rates and the
monetary base, therefore main source of fluctuations in money supply.
Purchases expand reserves and the monetary base, thereby increasing
money supply and lowering short term interest rates. Sales shrink reserves and
monetary base, decreasing the money supply and raising short-term interest
rates.
 83

Discount policy and lender of last resort

Operation of the discount window: healthy banks are allowed to borrow all
they want at very short maturities from the primary credit facility. The interest
rate on these loans is the discount rate, which is set higher than the federal
funds rate target. This facility is intended to be a backup source of liquidity for
sound banks.

Lender of last resort: to prevent bank failures from spinning out of control by
providing reserves to banks when no one else will. This is very effective
because reserves are immediately channeled to the banks that need them
the most. This however also has a cost. If a bank expects that the Fed will
provide it with discount loans when it gets into trouble, it will be willing o take
on more risk. This creates a moral hazard problem that is most severe for large
banks who may believe that the Fed view them as “too big to fail”.

Reserve requirements

A rise in reserve requirements reduces the amount of deposits that can be

supported by a given level of the monetary base and will lead to a
contraction of the money supply. This also increases the demand for reserves
and raises the federal funds rate. The newly instated interest on reserves is
currently being used

A framework for monetary policy in South Africa (C3)

Study this section in the study guide together with these notes.

The instruments of monetary policy in South Africa:

a) OMO instruments are used to ensure that the supply of non-borrowed

reserves always falls short of the total liquidity requirement.
b) Banks are thus required to borrow reserves from the SARB at the repo
rate.
c) The SARB does not rely on changes in the required reserve ratio in its
day-to-day management of the money market.

How monetary policy is applied in South Africa (C4)

Study this section in the study guide.

Open market operations:

 SARB actively maintains a liquidity requirement by means of OMOs
which compel banks to borrow a substantial amount from the SARB at
the repo rate. i.e SARB is constantly active in the money market to
drain excess liquidity in order to force a liquidity shortage.
 SARB estimates the banks’ overall liquidity requirements on a daily,
weekly, monthly basis and takes account of all factors that may affect
the liquidity shortage. SARB then offers a number of securities on
 84

auction at varying interest rates. Banks estimate their liquidity shortage

for the coming week and tender to the amounts and interest rates. The
interest rates on bids are generally below that of the repo rate.

Accommodation Policy (Discount Lending):

 The purpose of accommodation policy in South Africa is that the SARB
provides liquidity (borrowed cash reserves: BR) to banks. Because the
SARB uses repurchase agreements (repo's) and the USA mainly uses
discount instruments for this purpose, it is called discount policy in the
USA and accommodation policy in SA.
 The SARB provides liquidity to the banks by means of repurchase
agreements (repos) whereby the SARB "buys" government securities.
When these repos mature (usually after a week), the banks repay the
central bank the original amount provided a week ago plus interest at
the repo rate.
 To ensure that the repo rate remains effective, the SARB compels the
banks to borrow a substantial amount of the liquidity requirement from
the SARB.
 If individual banks in South Africa or the banking sector as a whole
face a severe cash reserve shortage that threatens to undermine the
stability of the banking system, the central bank may have to act as
lender of last resort. It will then provide emergency loans to banks at a
rate higher than the repo rate.

Reserve requirements:
 Formally, banks are required to hold 2,5% of their total liabilities to the
public as required reserves. In practice this is somewhat less because
banks are allowed to exclude certain liabilities as required reserves.
 Banks are required to adhere to the reserve requirement on an
average daily basis over a full month period. This implies that if a bank
falls below its required reserves for a few days, it has to hold additional
reserves during the remainder of the month.
 The bank's holdings of vault cash to service daily withdrawals of
currency also do not qualify as part of the required reserves
 In principle, the SARB can change the required reserve ratio whenever
the need arises. In practice it does not do so. The variation of the
required reserve ratio is a slow, unwieldy and crude instrument.
Changes in the reserve requirements have to be announced through
a notice in the Government Gazette, which is a slow process. It is
crude because small changes in the reserve requirement may lead to
relatively large changes in required reserves.

Make sure you are able to use a graph to illustrate the South African market
for reserves as well as the one applicable to the USA.

Refer to Graph 16.1 in the study guide and compare it to Figure 1 on page
410 (374) in the textbook. Note your findings below with particular reference
to SA:
 85

Figure 1, page 410 (374): Market for Graph 16.1, page 71 in the study
Reserves in the USA guide: Market for Reserves in SA

Typical Exam questions

16.1 Explain and graphically illustrate a model of the supply and demand in
the market for reserves (as applicable to the US) which explains how the
federal funds rate is determined. Also explain how changes in the tools of
monetary policy (OMOs, changes in the discount lending rate, and changes
in the reserve requirements) affect the federal funds rate. (15)
16.2 Explain and graphically illustrate how the market for reserves operates in
SA. Also explain in principle how the tools of monetary policy (OMOs, BRs and
the required reserve ratio) fit into this framework. (15)
16.3 Explain in more detail how monetary policy is conducted in South Africa.
Explain the manner in which
(i) OMOs are used by the SARB as well as the operation of other tools
used to supplement OMOs (10)
(ii) accommodation policy is applied (5)
(iii) the discount rate is used (5)
16.4 Comment on the following statement: "The formula M=(1+c)/(r+e+c).MB
implies in the case of South Africa the central bank can accurately predict M
given MB". Also comment on the question of causality between MB and M.
(Hint: This matter is dealt with in the Activities section: D2-D6.)(10)
 86

CHAPTER 17: THE CONDUCT OF MONETARY POLICY: STRATEGY AND TACTICS

The price stability goal and the nominal anchor

 Price stability = low and stable inflation. Viewed as one of the most
important goals of monetary policy
 This is because rising price level (inflation) causes uncertainty. Such
uncertainty is believed to hamper economic growth.
 Nominal anchor = a nominal variable such as the inflation rate or
money supply, that limits the increases in price level to achieve price
stability. Adherence to a nominal anchor that keeps the nominal
variable within a narrow range promotes price stability by directly
promoting low and stable inflation expectations.
o Nominal anchor is also important because it can limit time-
inconsistency problem.
 Time-inconsistency problem: monetary authorities are tempted to
conduct monetary policy in a discretionary way (day-by-day basis)
which produces poor long-run outcomes. For example they might
pursue an expansionary monetary policy to boost economic growth in
the short run, but the best policy might be not to pursue expansionary
monetary policy so as to ensure inflationary conditions do not arise in
the long run. (more on this topic in ch 25)

Other goals of monetary policy

1. High employment and output stability

Important since high unemployment causes much human misery and
economy has both idle workers and resources (closed factories and unused
equipment), resulting in a loss of output (lower GDP).
How high should employment be? What about structural and frictional
employment?

2. Economic growth
Related to high employment goal because businesses are more likely to
invest in capital equipment to increase productivity and economic growth
when unemployment is low. Supply side economics discusses policies aimed
at encouraging firms to invest or people to save, such as tax incentives. What
is the role for monetary policy?

3. Stability of financial markets

Financial crises interfere with the ability of financial markets to channel funds
between people.

4. Interest rate stability

Fluctuations in interest rates can create uncertainty and make it harder to
plan for the future. E.g. affecting consumers’ willingness to buy houses and for
construction firm to plan how many houses to build. Upward movements in
interest rates generate hostility toward central banks and lead to demands
that their power be curtailed.
 87

5. Stability in foreign exchange markets

With increased international trade, a country’s exchange rate has become a
major consideration of central banks. A rise in the Rand makes S. African
exports less competitive with those abroad, and declines in the value of the
Rand stimulate inflation in South Africa.

Should price stability be the primary goal of monetary policy?

Mishkin believes that in the long run there is no trade-off between inflation and
economic growth. In the long run price stability promotes economic growth
as well as financial and interest-rate stability. Although price stability is
consistent with the other goals in the long run, in the short run price-stability
often conflicts with the goals of high employment and interest-rate stability.

Hierarchical versus dual mandates

Mandates (objectives that are made primary) that put the goal of price
stability first and believe that as long as this is achieved the other goals can
be achieved more easily are called hierarchical mandates. It is this type of
mandate that is followed by Bank of England, the Bank of Canada, the
European Central Bank and the Reserve Bank of New Zealand.

The mandate faced by the Federal Reserve is stated as, “The Board of
Governors of the Federal Reserve System and the Federal Open Market
Committee shall maintain long-run growth of the monetary and credit
aggregates commensurate with the economy’s long-run potential to
increase production, so as to promote effectively the goals of maximum
employment, stable prices, and moderate long-term interest rates.” This is a
dual mandate to achieve two co-equal objectives: price stability and
maximum employment.

Theoretically there is not much difference between the two mandates,

however, in reality there may be. The public and politicians may believe that
the hierarchical mandate puts too much emphasis on keeping inflation low
and not enough on reducing business-cycle fluctuations. As long as price
stability is a long-run goal, not short-run, central banks can focus on reducing
output fluctuations by allowing inflation to deviate from the long-run goal for
short periods of time and can therefore operate under a dual mandate.

Price stability as the primary, long run goal of monetary policy

Because low and stable inflation rates promote economic growth, central
bankers have come to realize that price stability should only be the primary,
long run goal of monetary policy. Attempts to keep inflation at the same level
in the short run, no matter what, would likely lead to excessive output
fluctuations. As long as price stability is a long run and not a short run goal,
central bankers can focus on reducing output fluctuations by allowing
inflation to deviate from the long run goal for short periods and, therefore,
can operate under a dual mandate.
 88

Inflation targeting

Inflation targeting involves several elements:

(1) public announcement of medium term numerical targets for
inflation;
(2) an institutional commitment to price stability as the primary, long-
run goal of monetary policy and a commitment to achieve the
inflation goal;
(3) an information-inclusive approach in which many variables are
used in making decisions about monetary policy;
(4) increased transparency of monetary policy strategy through
communication with the public and the markets about the plans and
objectives of monetary policymakers;
(5) increased accountability of the central bank for attaining its
inflation objectives.

Advantages of inflation targeting:

 Allows the monetary authorities to use all available information, not just
one variable, to determine the best settings for monetary policy.
 It is readily understood by the public and highly transparent.
 It has the likelihood of reducing the problem of time-inconsistency of
central bank trying to increase output and employment in the short
run.
 It helps focus the political debate on what a central bank can do in
the long run (control inflation).
 Encourages frequent communication with the public.

Disadvantages of inflation targeting (pg 443)

 Delayed signals:
______________________________________________________________

____________________________________________________________________

 Too much rigidity:

______________________________________________________________

____________________________________________________________________

 Potential for increased output fluctuations:

_____________________________________________________________

____________________________________________________________________
 89

____________________________________________________________________

 Low economic growth:

_________________________________________________________

____________________________________________________________________

Tactics: choosing the policy instrument

Refer to the section in the textbook (pg 454) and explain why the central
bank cannot target both the interest and aggregate money supply
simultaneously. The following is an example of such an explanation:

A central bank (e.g. US Fed) has at its disposal two basic types of policy
instruments: (i) reserve aggregates (total reserves, non-borrowed reserve
(NBR), MB and non-borrowed base) and (ii) interest rates.

By trying to achieve an aggregate target, the central bank is forced to let go

of the interest rate. For example if the central bank has a specific target for
NBR, the central bank will have a certain expectation of what the demand
for reserves will be however, the final demand is dependent upon the
individual banks and, with NBR given is likely to vary. Depending upon the
variation in the levels of demand, the interest rate differs and must therefore
be variable. (Refer figure 3 on page 410: Result of targeting on Non-
borrowed reserves).

If the central bank decided to target the interest rate instead. In this case the
central bank may expect the demand for reserves and the level of NBR to be
at a specific level given the interest rate. However, due to unexpected
changes in deposits or banks’ desire to hold excess reserves the central bank
will be forced to engage in open-market transactions to maintain the interest
rate. This will lead to changes in the level of NBR. If the demand for reserves
increases, the central bank will need to raise the supply of NBR until the
interest rate is restored.
 90

Criteria for choosing the policy instrument

Three criteria apply when choosing an appropriate policy instrument:

 Observability and measurability: quick observability and accurate
measurement of a policy instrument is necessary, because it will be
useful only if it signals the policy stance rapidly. It seems that interest
rates are more observable and measureable than are reserves and
are therefore better policy instruments.

 Controllability: a central bank must be able to exercise effective

control over a variable if it is to function as a useful policy instrument.
Once again short-term interest rates are preferable to reserve
aggregates as a policy instrument.
 91

 Predictable effect on goals: this is the most important characteristic of

a policy instrument. Central banks have concluded that the link
between interest rate and other goals, such as controlling inflation, are
tighter than the link between aggregates and inflation.

C2 Monetary targeting in South Africa (Study Guide, pg 78 -82)

In pursuing monetary targeting, the central bank announces that it will

achieve a certain value (the target) of annual growth rate of a monetary
aggregate. Usually refers to either M1 or M2.

Refer to study guide (page 78) and study the “additional explanations”

The advantages of monetary targeting:

 one advantage is that information on whether the central bank is
achieving its target is known almost immediately – monetary figures
are reported within a couple of weeks.
 Monetary targets can send immediate signals to the public and the
market about the stance of monetary policy and the intention of
policymakers to keep inflation in check.
 Allow for immediate accountability for monetary policy to keep
inflation low and help to constrain monetary policymakers from
falling into the time-inconsistency trap.

The disadvantages of monetary targeting:

 if the relationship between the monetary aggregate and the goal

variable (inflation or nominal income) is weak, monetary
aggregate targeting will not work.
 This seems to have been the problem in countries pursuing this type
of policy and yet not achieving the desired outcomes.

Students must be able to give a summarized version of the changes in

monetary policy from the 1970s when it was based on a monetary
targeting approach, through to the late 1990s when monetary targeting
was abandoned and the move to a policy of inflation targeting began.

Typical exam questions:

1. Briefly explain the meaning of monetary targeting and its main

advantages and disadvantages. Then briefly explain the major
lessons that were learnt from the application of monetary targeting
in the US, Japan and Germany as it was applied from the 1970s to
the 1990s. (15)
2. Explain the five elements of inflation targeting. Also explain the
advantages and disadvantages of inflation targeting (15)
3. Explain and illustrate graphically why the central bank (in the USA)
cannot target both the NBR and the cash funds rate
 92

simultaneously. (Hint: Use a supply and demand for reserves

framework.) (10)
4. Explain which monetary policy instrument/s may be used by the
central bank and which criteria apply when choosing a monetary
policy instrument. (10)

True or false review questions

1. Monetary targeting means that the central bank targets a growth rate
of some monetary aggregate (for example M2) or interest rate to
counter high inflation.
2. Monetary targeting can only work well when there is a reliable and
stable relationship between the growth of the monetary aggregate
and the inflation rate.
3. Monetary targeting worked quite well in South Africa when it was
strictly applied and succeeded in reducing the inflation rate to a level
below 10% per year for most of the 1990s.
4. The advantages of monetary targeting are that data on the instrument
and the goal become available without a long delay, and that the
central bank can be held accountable for executing monetary policy.
5. Monetary targeting was abandoned in South Africa after 1994 when
the ANC came into power.
6. The advantages of inflation targeting are that is highly transparent and
that inflation can be readily controlled by the central bank.
7. The central bank cannot simultaneously set both a monetary
aggregate instrument and an interest rate instrument.
8. Endogenous money means that the level of the money stock changes
mainly as a result of changes in the demand for bank loans.
 93

PART SIX: MONETARY THEORY

(Textbook: Chapters 20, 21, 24, 25 and 26)

CHAPTER 20: THE DEMAND FOR MONEY

The study of the effect of money on the economy is called Monetary Theory.
Having learnt about Money Supply, it is now necessary also to consider the
demand for money.

1. Quantity theory of money

 this theory was developed by the classical economists of the 19th

and early 20th centuries
 a theory of how nominal value of aggregate income is determined.
 Tells how much money is held for a given level of income.
 Most important point is that this theory suggests that interest rates
have no effect on the demand for money

Velocity of Money and Equation of exchange:

 explained by Irving Fisher

 Fisher examined the links between the total quantity of money M
(money supply) and the total amount of spending on final goods and
services produced in the economy. Total spending (P x Y) is also
thought of as aggregate nominal income for the economy (e.g. GDP).
 The link between M and P x Y is referred to as V (velocity of money).
 Definition: V = average number of times per year (turnover) that a
dollar is spent in buying the total amount of goods and services
produced in the economy.

 Equation of exchange:

 Equation of exchange is simply an identity. It does not tell us that when

the money supply, M changes, nominal income (P x Y) changes in the
same direction. In fact the identity leads to the argument that an
increase in M would be offset by a decrease in V which leaves M x V
and therefore P x Y unchanged.

 The identity has to be converted into a theory of how nominal income

is determined.

Determinants of velocity
According to Fisher, velocity is determined by the institutions in an
economy. If people use credit cards to conduct transactions, therefore
use money less often, then less money is required (M falls relative to PxY),
and velocity (PxY)/M will increase. Conversely, if its more convenient to
use cash, cheques and debit cards (all of which are money), more money
is used to conduct the transactions generated by the same level of
nominal income, and velocity will fall. Fisher took the view that velocity
would be normally reasonably constant in the short run.
 94

From the equation of exchange to the Quantity Theory of money

 Fisher’s view that velocity is fairly constant in the short run,

transforms the equation of exchange into the QUANTITY THEORY OF
MONEY.
 This theory states that nominal income is determined solely by
movements in the quantity of money: when M doubles, M x V
doubles and so must P x Y.

Quantity theory and the price level

 Classical economists believed that wages and prices were

completely flexible and that Y would remain at full-employment
level.
 Conclusion of quantity theory is that if M doubles then P must
double because Y and V are constant.
 They believed that any change in M would lead to a proportional
change in the price level.
 Movements in the price level resulted solely from changes in the
quantity of money.
 This theory implicitly assumed that the causal direction in the
quantity equation runs from MV to PY.
 BUT: A case can also be made for the causal direction in the
opposite way: PY to MV: price/wages increase and therefore the
public’s demand for credit increases and MV also increases.

Quantity theory and inflation

 Recall that the percentage change (%Δ) of a product of two

variables is approximately equal to the sum of the percentage
changes of each of these variables.
 %Δ in (x.y) = (%Δ in x) + (%Δ in y)
 Rewriting the equation of exchange, subtracting %ΔY from both
sides and realizing that the inflation rate, π, is the growth rate of the
price level, %ΔP:
 Π = %ΔP = %ΔM + %ΔV - %ΔY
 Since we assume velocity is constant, is growth rate is zero, so the
quantity theory of money is also a theory of inflation:
 Π = %ΔM - %ΔY
 The theory indicates that the inflation rate equals the growth rate of
the money supply minus the growth rate of aggregate output
 95

Quantity Theory of Money Demand:

 Quantity theory of money tells us how much money is held for a

given amount of aggregate income, it is, in fact, a theory of the
demand for money.

 Fisher’s quantity theory of money suggests that the demand for

money is purely a function of income, and interest rates have no
effect on the demand for money.

Is velocity really constant?

The classical view that velocity can be treated as a constant is not supported
by empirical data. The fact that velocity is not always constant became
particularly clear to economists during the years of the Great Depression,
when the velocity of money dropped drastically.
 96

2. Keynes’ Liquidity Preference Theory

Keynes developed a theory of money demand that took into account the
importance of interest rates. This theory is called the liquidity preference
theory. Why do individuals hold their wealth in money rather than
investments? Keynes used three motives to explain this behaviour.

Transactions Motive: individuals are assumed to hold money because it

is a medium of exchange that can be used to carry out everyday
transactions. According to Keynes this is largely dependent upon
 97

people’s level of transactions which he believed were related to

income.

Precautionary Motive: individuals will hold money “just in case”. This

motive for holding cash is determined mainly by the level of
transactions individuals expect to make in the future. These balances
are also related to income.

Speculative Motive: the final motive for holding wealth in the form of
money, according to Keynes, was as a store of wealth and to be able
to take advantage of wealth increasing opportunities. This was
referred to as the speculative motive and is viewed as being sensitive
to interest rates as well as expected future movements in interest rates.
This part of the theory implies that the velocity of money is not
constant. Note that when interest rates are high, individuals are more
likely to hold their wealth in bonds and the demand for money will be
low. When interest rates are low, individuals are more likely to hold
their wealth in the form of cash (rather than bonds) and the demand
for money will increase. There is a negative relationship between the
quantity of money demanded and the interest rate.

When all three motives are considered together:

 by putting all three motives together Keynes was able to develop a
demand for money equation.
 He distinguished between nominal and real quantities. Money is
valued in terms of what it can buy.
 Keynes reasoned that people want to hold a certain amount of real
money balances which would be related to income (Y) and interest
rates (i).
 Write down the liquidity preference function (pg 543 in the textbook):

 The above function can be explained as follows: the demand for real
money balances Md/P is a function of i and Y.
 Keynes’ view was a major departure from Fisher’s (interest has no
effect on demand for money).
 Keynes’ liquidity preference theory “postulated three motives for
holding money, the transaction motive, the precautionary motive and
the speculative motive. Although Keynes took the transactions and
precautionary motives to be proportional to income, he reasoned that
the speculative motive would be negatively related to the level of
interest rates.
 Keynes’ model has an important implication: velocity is not constant
and is in fact positively related to interest rates. His liquidity preference
theory casts doubt on the classical quantity theory that nominal
income is determined primarily by movements in the quantity of
money.
 98

3. Friedman’s Portfolio Theory of Money Demand

 Milton Friedman developed this theory in 1956. He questioned why

people chose to hold money.
 Friedman stated that demand for money must be influenced by
the same factors that influence the demand for any asset and so
he applied the theory of asset demand to money.
 The theory of asset demand indicates that the demand for money
should be a function of the resources available to individuals (their
wealth), the expected returns on other assets relative to the
expected return on money and relative liquidity. Whereas it is
negatively related to risk.
 As had Keynes, Friedman also recognized that people wanted to
hold a certain amount of real money balances, which was
positively related to income and negatively related to interest rates.
 Demand for an asset is positively related to wealth.

Distinguish between Keynesian and Friedman theories

Friedman:
 By including more than one asset as substitutes for money, he
recognized that more than one interest rate is important to the
overall economy. However, he considered the effects in relation to
the return on investments rather than the effect of interest on the
demand for money.
 He viewed money and goods as substitutes and as a result
changes in the quantity of money might have a direct effect on
aggregate spending.
 He did not take expected return on money to be constant, as
Keynes did.
 Suggests that changes in the interest rates have little effect on the
demand for money.
 Believed that money is stable and insensitive to interest rates.
 Velocity is predictable and leads to the quantity theory conclusion
that money is the primary determinant of aggregate demand.

Keynes:
 lumped all assets other than money in one group (bonds) and felt
that the returns would move together.
 Considered the expected return on money to be constant
 Interest rates are important determinant of demand for money,
through the speculative demand for money.
 This theory implies that velocity is unstable and cannot be treated
as a constant.
 99

Factors that determine the demand for money (table 1 pg 546)

Variable Change in Money demand Reason

variable response

Interest rates Opportunity cost

of money rises
Income Higher
transactions
Payment Less need for
technology money in
transactions
Wealth More resources to
put into money
Risk of other Money relatively
assets less risky and so
less desirable
Inflation risk Money relatively
more risky and so
less desirable
Liquidity of other Money relatively
assets less liquid and so
less desirable

Empirical evidence on the demand for money

Interest rates and money demand

The more sensitive the demand for money is to interest rates, the more
unpredictable the velocity will be and the less clear the link between the
money supply and aggregate spending will be. According to the textbook,
if interest rates do not affect the demand for money then velocity is more
likely to be constant and the more likely it is that aggregate spending will be
determined by the quantity of money. There is an extreme case of ultra-
sensitivity of the demand for money to interest rates, called the liquidity trap,
in which conventional monetary policy has no effect on aggregate
spending, because a change in the money supply has no effect on interest
rates.

Stability of money demand

If money demand function is unstable and undergoes substantial
unpredictable shifts, then velocity is unpredictable and the quantity of money
may not be tightly linked to aggregate spending. The stability of money
demand is important to the central bank in the decision as to whether to
target interest rates or the money supply. After 1973 the rapid pace of
financial innovation, which changed the items that could be used for money,
resulted in the instability of the money demand function and velocity being
hard to predict.
 100

The overall conclusion is that the demand for money is unstable and that the
setting of rigid money supply targets to control aggregate spending may thus
be ineffective.

Study the additional explanations in the study guide.

Typical Exam questions

20.1 Briefly explain the quantity theory of money (QT), that is, its assumptions
and predictions.
Demonstrate that the QT can be transformed into the quantity theory of
money demand. Does the assumption regarding V agree with the empirical
findings? (10)
20.2 Explain why Keynes's liquidity preference theory predicts that both
nominal income and interest rates affect the demand for money. (10)
20.3 Explain the major findings of empirical evidence on the demand for
money function and its implication for monetary policy. (5)
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CHAPTER 21: THE IS CURVE

This chapter is a revision of what students learnt in ECS202 (Macroeconomics,

2nd year). Student should study the content in the study guide and use both
the study guide and the textbook to answer the questions below. Once a
student has completed the questions and graphs, he or she should have a
good understanding of the IS-LM model and the use of this model for
analyzing fiscal and monetary policy.

Note: There is only one possible exam question on this chapter which refers to
the realism of the ISLM model. But in order to evaluate the realism of the ISLM
model, you must understand what ISLM is all about.

1. Who developed the IS-LM model?

_________________________________________________________________

_________________________________________________________________

2. Why is it considered useful?

_________________________________________________________________

_________________________________________________________________

_________________________________________________________________

Determination of aggregate output:

3. Total quantity demanded of an economy’s output is the sum of what?

__________________________________________________________________

__________________________________________________________________

Consumer expenditure and the Consumption function:

4. Draw the Consumption function and give the expression used to

represent the Consumption function.
 102

5. List the main elements of C.

_____________________________________

_____________________________________________________________

Investment Spending:

6. Name the two type of investment that make up I._______________

______________________________________________________________

______________________________________________________________

7. What comprises planned investment spending? _______________

______________________________________________________________

8. Write down the equation for the aggregate demand function (in a
simple, closed economy).

_____________________________________________________________

Expenditure Multiplier:

10. Explain the implications and derivation of the expenditure multiplier.

_____________________________________________________________

_____________________________________________________________

______________________________________________________________

______________________________________________________________

______________________________________________________________
 103

Government’s Role:

11. Use a graph to illustrate the role of government and its effect on
aggregate spending and output.

12. Briefly explain the effects of changes in the variables of aggregate

output in an open economy with a government sector.
__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

13. Differentiate between exogenous and endogenous variables.

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

The IS Curve:

14. What does the IS curve tell us? ____________________________________

__________________________________________________________________

15. What causes the IS curve to shift? ____________________________________

__________________________________________________________________
 104

The LM Curve:

16. What does the LM curve tell us? ____________________________________

_________________________________________________________________

17. Use a graph to explain the effects on the money market of an

autonomous rise in money demand. What could cause this rise in Md?

Is the IS-LM model realistic?

Study this section in the study guide and note the following:
 Many economists argue that the IS-LM is unrealistic
 Remember any model is a simplification of reality
 The purpose of the ISLM model is to show the links between the
major macroeconomic variables – this it does well.
 Is the model close to reality? To answer this it is necessary to
consider which variables are exogenous and which are
endogenous.
 A major assumption of the ISLM model is the M is an exogenous
variable. This is not the case in modern economies and this does
limit the use of the ISLM model.
 The model also takes prices as given and so is unable to tell us
anything about inflation. Consequently it is good for the short run
when inflation is low.
 This model is still considered a “first approximation” for
understanding the real world.

Exam question

21.1 Briefly explain why the assumptions/predictions of the ISLM model are
unrealistic in the case of South Africa. Explain the meaning of endogenous
and exogenous variables and explain why the money supply is
endogenous/exogenous in South Africa. Which additional assumption can be
made to make ISLM more realistic? (12)
 105

Chapter 24: Monetary Policy Theory

Fluctuating levels of inflation have been a “headache” to policymakers,

politicians, consumers and producers for decades. Keeping inflation under
control is a key element of monetary policy in the USA and SA. Milton
Friedman proposed that “inflation is always and everywhere a monetary
phenomenon”. He believed that because inflation was caused by high
growth rates of the money supply, the reverse was the solution; keep the
growth rate of money supply low and inflation will be prevented.

Response of monetary policy to shocks

The main goal of central banks is price stability: try to maintain inflation, Π,
close to the target level ΠT, slightly above zero and usually between 1 – 3 %.

1) Response to an aggregate demand shock

The economy is initially at point 1, where output is at Y P and inflation is at ΠT .
the negative demand shock decreases aggregate demand, shifting AD1 to
the left. Policymakers can respond to this in two ways:

a) No policy response. The AD curve remains at AD2, here aggregate

output falls to Y 2 below potential output Y p and inflation falls to Π2,
below the target. With output below potential, slack begins to
develop in the labour and product markets, lowering inflation. The
SRAS curve will shift down to AS3, and economy will move to point 3.
Output will again be at its potential level while inflation will fall to a
lower level of Π3.

Figure 1

LRAS AS1

AS3

AD1
AD2
Y2 Yp
 106

Policy stabilizes economic activity and inflation in the short run.

Policymakers can eliminate both the output and inflation gap in the
short run by pursuing policies to increase demand to its initial level and
return economy to its pre-shock state. CB does this by easing monetary
policy (cutting interest rates). This stimulates investment spending and
increases quantity of aggregate output demanded, thereby shifting
AD curve right.

Figure 2

LRAS

AS1

1, 3

AD1
AD2

Application: Quantitative (credit) easing in response to the global financial

crisis

If the negative demand shock is so large that CB can’t lower interest rate
further because it hits a floor of zero, bank needs to turn to nonconventional
monetary policy. This involves liquidity provision and asset purchases, which
result in an expansion of the CB balance sheet and so are referred to
quantitative easing or more accurately credit easing.

How did QE stabilize output and inflation during the GFC? – see figure 2 above
After the Lehman Brothers collapse, the real cost of borrowing to households
and businesses shot up due to increased financial frictions. This led to a
decline in consumption and investment expenditure, causing a contraction in
AD and a leftward shift to AD2.
By engaging asset purchases and liquidity provision, the Fed was able to
reduce financial friction and lower the real cost of borrowing. AD curve
shifted to right, thereby avoiding deflation and boosting economic activity so
the economy did not enter a depression as in the 1930s. However the Fed
was unable to shift the aggregate demand curve all the way back to AD1.
 107

2) Response to a permanent supply shock

Suppose an increase in regulations permanently reduces the potential level

of output. Potential output falls from Yp1 to Yp3, and LRAS shifts left to LRAS3.
This triggers a price shock that shifts SRAS upward to AS2. Two possible policy
responses to this permanent supply shock are possible:

a) No policy response. (see figure 3) if monetary policy is unchanged,

the economy will move to point 2, with inflation rising to Π2 and
output falling to Y 2. Since this level of output is still higher than
potential, the SRAS keeps shifting up until it reaches AS3, where it
intersects AD1. The economy moves to point 3, eliminating the
output gap but leaving inflation higher at Π3 and output lower at Y p3.

Figure 3

LRAS1

AS1

AD1
 108

b) Policy stabilizes inflation. (see figure 4) monetary authorities can keep

inflation at the target rate and stabilize inflation by decreasing AD to
AD3 where it intersects LRAS3. To do this they need to tighten monetary
policy by increasing the real interest rate causing investment spending
to fall and lowering aggregate demand. The economy goes to point 3,
where the output gap is zero and inflation is at the target.

Figure 4

LRAS1

AS1

AD1

The divine coincidence still remains true when a permanent supply shock
occurs: there is no trade-off between the dual objective of stabilizing inflation
and economic activity.
 109

3) Response to a temporary supply shock

With a temporary shock such as an oil price surge, the divine coincidence
does not always hold. Policymakers face a short-run tradeoff between
stabilizing inflation and economic activity. The shock shifts the SRAS left to AS2
but leaves the LRAS unchanged because the shock is temporary. The
economy moves to point 2, with inflation rising to Π2 and output falling to Y2.
Policymakers can respond in two ways:

a) No policy response. (see figure 5)here the AD curve does not shift.
Since aggregate output is less than potential, eventually the SRAS will
shift right to AS1. Economy will return to point 1 and close both the
output and inflation gap. Both inflation and economic activity will
stabilize over time. In the long run there is no tradeoff between the two
objectives, and the divine coincidence holds.

While we wait in the long run however, the economy will undergo a
painful period of reduced output and higher inflation rates. This opens
the door for stabilization of inflation or economic activity in the short
run.

Figure 5

LRAS1

AS1

AD1
 110

b) Policy stabilizes inflation in short run. (see figure 6) By raising interest

rates, investment and aggregate demand will fall, shifting the AD left
to AD3. Economy moves to point 3, where output is below potential,
the slack in the economy shifts the SRAS back down to AS1. To keep
the inflation rate at ΠT, monetary authorities will need to move the
SRAD back to AD1 by reversing the tightening and eventually the
economy will return to point 1. Stabilizing inflation reduces aggregate
output in the short run and only over time will output recover back to
potential levels.
Stabilizing inflation in response to a temporary supply shock has led to
a larger deviation of aggregate output from potential, so this action
has not stabilized economic activity.

Figure 6

LRAS1

AS1

AD1
 111

c) Policy stabilizes economic activity in the short run. (see figure 7) To

increase AD to AD3, they would have to ease monetary policy by
lowering real interest rates. At point 3, the output gap is zero so
monetary policy has stabilized economic activity, however inflation
has risen to Π3 which is greater than the target, so inflation has not
been stabilized.
Stabilizing economic activity in response to a temporary supply shock
results in a rise in inflation.

Figure 7

LRAS1

AS1

AD1

The bottom line: The relationship between stabilizing inflation and stabilizing
economic activity.

We can draw the following conclusions from the above analysis:

1. If most shocks to the economy are aggregate demand shocks or
permanent aggregate supply shocks, then policy that stabilizes
inflation will also stabilize economic activity, even in the short run.
2. If temporary supply shocks are more common, then a central bank
must choose between the two stabilization objectives in the short run.
3. In the long run there is no conflict between stabilizing inflation and
economic activity in response to shocks.
 112

How actively should policymakers try to stabilize economic activity?

All economists have similar policy goals however they disagree on the best
approach to achieve them. Suppose we are faced with an economy with
high unemployment resulting from a negative demand or supply shock. Non-
activists believe wages and prices are very flexible, so the self-correcting
mechanism is very rapid. They believe government action is unnecessary to
eliminate unemployment. Activists (Keynesians) regard the self-correcting
mechanism as very slow because wages and prices are sticky. They therefore
see the need for the government to pursue active policy to eliminate high
unemployment when it develops.

Lags and policy implementation

If policymakers could shift the aggregate demand curve instantaneously,

activist policies could be used to immediately move the economy to the full-
employment level. However several types of lags prevent this immediate shift
from occurring:
1. Data lag is time it takes for policymakers to obtain data indicating
what is happening in the economy.
2. Recognition lag is time it takes for policymakers to be sure of what the
data are signaling.
3. Legislative lag is time it takes to pass legislation to implement a
particular policy. This does not exist for monetary policy actions.
4. Implementation lag is time it takes to change policy instruments once
a new policy is decided on. Again, less important for monetary policy
than fiscal.
5. Effectiveness lag is time it takes for policy to actually have an impact
on the economy. This lag is both long (often a year or longer) and
variable (a lot of uncertainty about how long it is).

Inflation: Always and everywhere a monetary phenomenon.

We see that policymakers can target any inflation rate in the long run by
shifting the aggregate demand curve with monetary policy. Suppose the
central bank believes the inflation target is too low, it will ease monetary
policy by lowering the real interest rate at any inflation rate, thereby
increasing investment spending and aggregate demand, the AD curve shifts
to AD3. Because output is above potential output, the SRAS will shift up,
stopping at AS3, where inflation is at a higher target level of Π3T and the
output gap is back to zero. The analysis in figure 8 demonstrates the following
points:

1. Monetary authorities can target any inflation rate in the long run with
monetary policy instruments.
2. Potential output – and therefore the quantity of aggregate output
produced in the long run – is independent of monetary policy.
 113

Figure 8: A rise in the inflation target

LRAS

AS3

AS1

AD3
AD1

Causes of inflationary monetary policy

If everyone agrees that high inflation is so bad, why do we see so much of it?
Monetary authorities can set the inflation rate in the long run, so it must be
that in trying to achieve other goals, governments end up with overly
expansionary monetary policy and high inflation.

Two types of inflation can result from activist stabilization policy to promote
high employment:
1. Cost-push inflation results either from a temporary negative supply
shock or a push by workers for wage hikes beyond what productivity
gains can justify
2. Demand-pull inflation results from policymakers pursuing policies that
increase aggregate demand

Cost-push versus demand-pull inflation

How do we know whether it is demand-pull or cost-push inflation? We would

normally expect to see demand-pull when unemployment is below the
natural level, and cost-push when unemployment is above the natural level.
However we still struggle measuring the natural level of unemployment. A
further complication, cost-push can be initiated by demand-pull. When
demand-pull inflation produces higher inflation rates, expected inflation will
eventually rise and cause workers to demand higher wages (cost-push
inflation).
 114

Application: The Great Inflation

We can now investigate the causes of the rise in U.S. inflation from 1965 to
1982, a period dubbed the “Great Inflation”. See figure 11 on pg 639. The CPI
rate was below 2% in the early 1960s, but by the late 1970s, it was averaging
8% and peaked at over 14% in 1980 after the oil price shock in 1979. The
economy experienced unemployment below the natural rate in all but one
year between 1960 and 1973, suggesting a demand-pull inflation.
Policymakers pursued monetary policy easing that shifted the aggregate
demand curve right trying to achieve an output target that was too high, thus
increasing inflation.
In hindsight, most economists today agree that the natural rate of
unemployment was substantially higher than first thought in the 1960s and
1970s, between 5-6%. After 1975, the unemployment rate was regularly above
the natural rate yet inflation continued, suggesting a cost-push inflation.
Only when the Fed committed to an anti-inflationary monetary policy, which
involved hiking the federal funds rate to the 20% level, did inflation come
down, ending the Great Inflation.

Please see Additional material for South Africa in study guide.

C3: Inflation: an overview of the main issues
C3.1. Definition and measurement of inflation
C3.2. Impulses versus spirals
C3.3. Money and inflation
C3.4. Social conflict and inflation proneness
C3.5. Combating inflation
C3.6. The cost of inflation

Typical Exam questions

24.1 Provide a perspective on Friedman's proposition that inflation is always

and everywhere a monetary phenomenon. Firstly evaluate the empirical
evidence in this regard (you may refer to the experience of any country),
then explain whether inflation is always and everywhere a demand-pull
phenomenon. Lastly explain why money plays a vital role in sustaining the
inflationary process. (15)
24.2 Define inflation and explain how inflation is measured in South Africa.
Refer to the CPI, PPI and core inflation. (10)
24.3 Provide a definition of inflation. Specifically refer to the difference
between an inflationary impulse and an inflationary spiral initiated by an initial
increase in the price of a good. (8)
24.4 Comment on the statement: "Inflation is essentially a symptom of conflict
over income distribution, which cannot be settled by relative price/wage
movements". Then discuss three factors which make an economy more
inflation prone. (18)
24.5
(a) Explain the importance of the foreign sector in the SA economy and
explain the effect which changes in the R/$ exchange rate have on the
 115

revenue earned by SA and the foreign sector and the speed at which R-
prices change in SA. (12)
(b) Also explain the effects of the increase in dollar parity pricing in SA and
the real income gains and sacrifices to be made in SA due to changes in the
R/$ exchange rate. (8)
24.6 Briefly discuss solutions to inflation problem in South Africa.
(a) Explain the essence of any anti-inflationary policy and briefly discuss a
structural solution to inflation. (9)
(b) Explain the effect of a stronger and weaker exchange rate (R/$) on the
domestic inflation rate. (6)
24.7 Briefly discuss the following counter-inflationary policy measures:
(a) Price controls (6)
(b) A voluntary social contract between business, labour and
government (4)
(c) Tight monetary policy (8)
In each case, explain its meaning, whether it is likely to be successful, and if
applicable, its advantages and disadvantages.
24.8 Briefly explain how inflation was contained in SA during the 2004-2007
period, how this situation was reversed in August 2008 and the implications of
this for the SA economy. (7)
24.9 Explain the self-reinforcing nature of lower inflation, that is, the role of
inflationary expectations (6)
24.10 Explain the costs of inflation, that is, on productivity, income distribution
and foreign investment. (18)
 116

Chapter 25: The role of expectations in monetary policy

Purpose of study unit

To explain the role of monetary policy in time-inconsistency situations and
benefits of a credible nominal anchor.

Policy conduct: rules or discretion?

Policymakers operate with discretion when they make no commitment to

future actions, instead make what they believe in that moment to be the right
choice. Time inconsistency problem introduces limitations of discretionary
policy. Time Inconsistency is the tendency to deviate from good long run
plans when making short run decisions.

Policymakers are always tempted to pursue more expansionary policy than

firms expect because it would boost economic output in short run. But the
best policy is not to, because decisions about wages and prices reflect
workers expectations about policy. And when they see a CB pursuing
discretionary expansionary policy, they know this will lead to inflation and will
therefore raise expectations about inflation and drive up wages and prices.
This leads to higher inflation.

Policymakers will have better inflation performance in the long run if they do
not try to surprise people with unexpectedly expansionary policy, but instead
keep inflation under control  abandon discretion and adopt rules to govern
policy making

Role of credibility and a nominal anchor

An important way to constrain discretion is by committing to a nominal

anchor such as the inflation rate. If this commitment has credibility – believed
by the public – it has important benefits:

1. It has elements of a behavior rule which can help overcome the time
inconsistency problem by providing an expected constraint. CB will be
subject to public scrutiny and criticism if they miss the objective.
2. It helps to anchor inflation expectations, which leads to smaller
fluctuations in inflation, thus contributes to price stability, but also helps
stabilize aggregate output. It makes monetary policy more efficient.
 117

CHAPTER 26: Transmission Mechanisms of Monetary Policy

The transmission mechanism of monetary policy explains how monetary

policy works – which variables respond to interest rate changes, when, why,
how, how much and how predictably.

Traditional interest rate channels

The traditional view of monetary transmission mechanism:

An important feature of the interest rate transmission mechanism is its

emphasis on the real rather than nominal interest rate that affects consumer
and business decisions. Also, it is often the real long term interest rate that has
the major effect on spending. The phenomenon of sticky prices, the fact that
the aggregate price level adjusts slowly over time, so that expansionary
monetary policy, which lowers short term nominal rate, also lowers short term
real interest rate.

The expectations hypothesis of term structure (ch 6) says that long term
interest rate is an average of expected future short term rates, also suggests
that a lower short term rate, as long as it persists, leads to a fall in the long
term rate. This leads to rise in business investment, residential housing
investment, inventory investment and consumer durable expenditure, all of
which produce a rise in aggregate demand.

That the real interest rate rather than the nominal rate affects spending
provides an important mechanism for how monetary policy can stimulate the
economy. If nominal interest rates are at a floor of zero, with a commitment
to future expansionary monetary policy expected inflation can raise, thereby
lowering the real interest rate and stimulating spending through the interest
rate channel:

Due to the empirical failure of traditional interest rate monetary transmission

mechanisms, the search for other transmission mechanisms came about.

Other asset price channels

Exchange rate effects on exports

When domestic real interest rates fall, domestic dollar assets become less
attractive relative to other assets denominated in foreign currencies. As a
result, the value of dollar assets relative to other currency assets, dollar
depreciates. This makes domestic goods cheaper than foreign goods causing
a rise in exports and hence aggregate demand.

Tobin’s q theory
This explains how monetary policy can affect the economy through its effect
on the valuation of equities (stock). q is the market value of firms divided by
the replacement cost of capital. If q is high, market price of firms is high
 118

relative to replacement cost of capital, and new plant and equipment

capital is cheap relative to the market value of firms. Companies can then
issue stock and get a high price for it relative to the cost of the facilities and
equipment they are buying. Investment spending will therefore rise.

But how might monetary policy affect stock prices? Lower real interest rates
on bonds mean that expected return on this alternative to stocks will fall. This
makes stocks more attractive relative to bonds so demand for them increases
and raises their price.

Wealth effects
The basic premise of the life cycle hypothesis of consumption is that
consumers smooth out their consumption over time. Therefore what
determines consumption spending s the lifetime resources of consumers, not
just today’s income. Important component of resources is consumer’s
financial wealth common stock. When stock prices rise, financial wealth
increases and consumption should rise. Now monetary easing can lead to a
rise in stock prices.

Credit view
Based on the problem of asymmetric information in financial markets that
leads to financial frictions. Two types of monetary transmission channels arise
as a result:

1. Bank lending channel

Because of banks’ special role, certain borrowers will not have access
to credit markets unless they borrow from banks. Therefore the channel
operates as follows: expansionary monetary, which increase bank
reserves and bank deposits, raises the quantity of bank loans available.
This causes investment and possibly consumer spending to rise.

2. Balance sheet channel

Arises from financial frictions in credit markets. In chap 8 we saw the
lower the net worth of businesses, the more severe the adverse
selection and moral hazard problems in lending to these firms. Lower
net worth means that lenders in effect have less collateral for their
loans, so their potential losses from adverse selection are higher. This
leads to decreased lending to finance investment spending.
Monetary policy can affect firms balance sheets in several ways.
Easing of monetary policy, which causes a rise in stock prices, which
rises their net worth and leads to higher investment spending and
aggregate demand because of the decrease in adverse selection
 119

and moral hazard problems. This leads to the following schematic for
one balance sheet channel of monetary transmission:

Why are credit channels likely to be important?

There are three reasons to believe that credit channels are important
monetary transmission mechanisms:
1. A large body of evidence on the behavior of individual firms
supports the view that credit market imperfections of the type
crucial to the operation of credit channels do affect firms’
employment and spending decisions.
2. There is evidence that small firms are hurt more by tight monetary
policy than large firms.
3. The asymmetric information view of credit market imperfections at
the core of the credit channel analysis is a theoretical construct
that has proved useful in explaining many other important
phenomena, such as why financial institutions exist, why our
financial system has the structure that it has and why financial crises
are so damaging.

Typical Exam questions

26.1 Explain the meaning of the transmission mechanism of monetary policy in

South Africa in general, describe its main links, explain how it influences
domestic inflation and why monetary policy is subject to lags. (12)
26.2 Explain how the interest rate channel of monetary policy operates. (6)
26.3 Explain how the other financial asset prices channel of monetary policy
operates. (9)
26.4 Explain how the credit channel of monetary policy operates. (9)

GOOD LUCK AND MAY YOUR EFFORTS BE JUSTLY REWARDED!!

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ECS3701
SUGGESTED SOLUTIONS TO SELECTED TUTORIAL QUESTIONS

1.2 Explain briefly what a common stock is, what purpose it serves, and
how it affects business investment decisions. (3)

A common stock refers to a share of ownership in a company

(corporation). The owner of the stock has a claim on the earnings of the
company (corporation). The stock is an important factor in business
investment decisions, because the price of shares affects the amount of
funds that can be raised by selling newly issued stock to finance investment
spending.

1.3 List two ways in which the quantity of money may affect the economy.
(2)

There is evidence to support the fact that money plays an important

role in generating business cycles and evidence exists that the rate of money
growth has declined before every recession.
Empirical data indicates that an increase in the supply of money
(quantity of money) is linked to increases in prices (inflation).

1.5 List and define three (3) commonly used measures of the aggregate
price level.

The three measures of aggregate price level are:

 GDP deflator is defined as nominal GDP divided by real GDP.
 PCE deflator is the nominal personal consumption expenditures
divided b real PCE.
 CPI is the consumer price index and is expressed as a price index
with the base year equal to 100.

2.1 Explain briefly the function of financial markets, the meaning of direct
and indirect financing, and the meaning of a financial intermediary. (5)

Financial markets allow funds to flow from people who lack productive
investment opportunities but have surplus funds to people who have
opportunities but do not have the necessary funds.

Direct financing: borrowers borrow funds directly from lenders in the

financial markets.

Indirect financing: this refers to the activities of financial intermediaries

such as commercial banks in facilitating and reconciling the different
requirements of borrowers and lenders via the process of financial asset
transformation.
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Financial intermediary refers to an institution that acts as a link

between surplus units and deficit units in an economy.

2.5 Explain the functions performed by financial intermediaries and how

they can promote economic efficiency in financial markets. (8)

The basic function of financial markets is to channel funds from savers

who have an excess of funds to borrowers (spenders) who have a
shortage of funds. Financial markets can do this either through direct
finance, or through indirect finance which involves a financial
intermediary. The intermediary acts by channeling funds from the
surplus unit to the deficit unit and helps to overcome some of the
problems that exist such as transactions costs and asymmetric
information.

This channeling of funds helps improve the economic welfare of

everyone in society because it allows funds to move from people who
have no productive investment opportunities to those who have such
opportunities. In this way financial markets contribute to economic
efficiency. In addition the channeling of funds can directly benefit
consumers by allowing them to make purchases when they need them
most.

3.1 Provide a formal definition of money. Then explain in principle how

money stock is measured (5)

Money is defined as anything that is generally accepted as payment

for goods and services or in repayment of debt. In a modern economy
it consists of two major components: currency (C) and deposits (D).
Money stock in SA is measured based on the types of deposits
included in D:
M1A consists of cash plus cheque and transmission deposits.
M1 consists of M1A plus “other demand deposits”.
M2 consists of M1 plus deposits and includes short-term and medium-
term deposits.
M3 is the most comprehensive measure of money.
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3.4 Explain the meaning of the following terms as well as its

advantages/disadvantages in facilitating payments: (15)

Description Advantages Disadvantages

Commodity Money: An early medium of This form of money is

money made up of exchange that was very heavy and is hard
precious metals or other universally acceptable. to transport from place
valuable commodities. to place.

Fiat Money: paper Much lighter than Easily stolen. Can be

currency decreed by precious metals or even expensive to transport in
government as legal coins. large quantitites.
tender. It is largely
dependent upon trust of
the value of the
currency.

Cheques: an instruction Allow transactions to Takes time to get

from you to your bank take place without cheques from place to
to transfer money from carrying around large place.
your account to sums of money. The administration
someone else’s Improved the efficiency required to support the
account. of the payment system. use of cheques is
Loss from theft is greatly expensive.
reduced.

Electronic payments: It is quick and efficient. Problems of making

transmit payments via It is a cheap means of errors in transmission do
the internet. “Money” payment. exist and are really
moves directly from one difficult to reverse.
persons account to that While security is good,
of another. there is a risk of
“hackers” being able to
intervene in
transactions.

E-Money: substitute for Efficient and Expensive to set up.

cash and exists only in convenient. Electronic means of
electronic form. The payment raise security
debit card is a form of and privacy concerns.
e-money. Leaves an electronic
trail which contains
personal data.
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4.1 In principle, explain the rationale of discounting future cash flows.

Then explain the meaning of the formula: PV = CF/(1 + i) n (5)

The process of calculating today’s value of rands received in the future

is called discounting the future. This concept allows one to work out
today’s value (price) of a credit (debt) market instrument at a given simple
interest rate by adding up the individual present values of all the future
payments received. Furthermore this allows one to compare the values of
two or more instruments with different timing of their payments.
PV = present value
CF = cash flow
i = annual interest rate
n = number of years

4.3 Explain the meaning of thefollowing concepts in the context of a

coupon bond: coupon rate, yield to maturity of a bond and the return on a
bond. Please provide the relevant formula/s. (7)

Coupon rate: the rand amount of the yearly coupon payment

expressed as a percentage of the face value of a coupon bond.

Yield to Maturity: of the several common ways to calculate interest

rates, the most important is the yield to maturity. The key to
calculating the yield to maturity for any credit market instrument, is to
equate today’s value of the credit instrument with the PV of all of its
future cash flow payments. The bond price and the yield to maturity
are negatively related.

The formula used to calculate the yield to maturity depends upon the
specific credit instrument being considered. In this case the yield to maturity
on a bond could be represented as: Refer to TB page 75/76.

P =

The return on a security shows how well you have done by holding this
security over a stated period of time and it can differ substantially from
the interest rate measured by the yield to maturity. The rate of return is
defined as the payments to the owner plus the change in its value expressed
as a fraction of its purchase price. Because of fluctuating interest rates, the
capital gains and losses on long-term bonds can be large.

Formula for the return on a bond: Refer to page 81

R =
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4.4 Distinguish between nominal and real interest rate (4)

The real interest rate is defined as the nominal interest minus the
expected rate of inflation. The real interest rate reflects the real cost of
borrowing and is likely to be a better indicator of the incentives to borrow
and lend.

The nominal interest rate ignores the effects of inflation and is

frequently the interest rate which is generally referred to in an economy.

5.3 Derive a bond demand curve (price of a bond versus its quantity
demanded) and a bond supply curve and explain how the equilibrium
P and Q for the bond is determined. (8)

For the sake of simplicity consider a bond that has no coupon

payments but pays a fixed amount at the maturity date.
Demand Curve (lenders)
 Assume a discount bond worth R10000.
 Bond is sold at R9000, discount rate is 10%.
 The formula to calculate the interest rate: i = Re = (F – P)/ P
 i = interest rate; Re = expected return; F = face value of the
discount bond; P = initial purchase price of the discount bond.
 Formula shows that a particular value of the interest rate
corresponds to each bond price. The lower the price of a bond
the higher the interest.
 Ceteris paribus all other factors, the lower the price (higher the
interest) the greater will be the demand for that bond. This is as
per the theory of asset demand.
 This implies a downward sloping demand curve for bonds.

Supply Curve (borrowers):

 Assume all other variables except the price of the bond remain
constant.
 Assuming the same amounts as in the example above, if the
price of the bond was, say R7000, the return on this bond would
be higher than 10%.
 This higher return implies that this bond is relatively expensive to
firms who wish to borrow by issuing bonds. Thus a firm is more
likely to supply more bonds to the market when price is higher
and interest rate is correspondingly lower.
 This implies a positive relationship between price and quantity
supplied for bonds.

Market Equilibrium:
 This occurs when the amount that people are wiling to buy
(quantity demanded) equals the amount that people are
willing to sell (quantity supplied) at a given price. The point
where the market will settle.
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 In the bond market this is achieved when the quantity of bonds

demanded is equal to the quantity of bonds supplied: Bd = Bs.
 The concepts of excess demand and excess supply can be
used to explain the establishment of the equilibrium price and
quantity in the bond market.
 Excess demand means that more people want to buy bonds
than others are willing to sell, this will drive the prices of bonds
upwards.
 Excess supply means that more people wish to sell bonds than
wish to buy bonds. This will drive the price of bonds downwards.

5.6 Explain how Keynes’ liquidity preference framework can be used to

explain the effects of an increase in income, a rise in the price level
and an increase in the money supply (assume that all other economic
variables remain constant). Then explain why an increase in money
supply does not necessarily lead to a decrease in interest rates over
the longer term. (12)

The liquidity preference framework is based on the assumption that

there are two main categories of assets that people use to store
wealth: money and bonds. The total wealth in the economy is
therefore equal to the sum of money and bonds. The liquidity
preference framework uses the demand and supply of money to
determine interest rates.

In Keynes’s liquidity preference framework two factors cause the

demand curve for money to shift: income and the price level.

Increase in income: referred to as the income effect. Any increase in

income leads to an increase in the demand for money for the
following reasons:

 As an economy expands and income rises, wealth increases

and people want to hold more money as a store of value.
 As an economy expands, people will want to transact more
and this will also cause the demand for money to increase.

The conclusion is there reached that a higher level of income causes

the demand for money at each interest rate to increase and the
demand curve to shift to the right. (Refer to the graphs in Summary
table 4 on page 115).

Price-level effect: A rise in price levels means that people will have to
hold more money in order to transact. That is they will increase the
nominal amount of money they hold. The conclusion, therefore is that
a rise in the price level causes the demand for money at each interest
rate to increase and the demand curve to shift to the right.

Increase in the money supply: assume that the money supply is

completely controlled by the central bank. An increase in money
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supply implies that the money supply curve shifts to the right. The
interest established at the new equilibrium point will be at a lower rate
of interest, ceteris paribus, in the short-term. This is referred to as the
liquidity effect.

Increase in money supply does not necessarily lead to a lower interest

rate in the longer term:

 An increasing money supply has an expansionary influence on

the economy. National income and wealth will increase and
the income effect of an increase in the money supply leads to
an increase in the interest rate.
 An increase in the money supply can also cause the overall
price level in an economy to increase. An increase in the price
level will also result in an increase in the interest rate.
 The higher inflation rate (i.e. increasing prices) that results will
also lead to an increase in interest rates.

The conclusion that may be reached from the above is that there are
four possible effects on interest rates when money supply increases:
the liquidity effect, the income effect, the price-level effect and the
expected inflation effect. The liquidity effect indicates that an
increase in money supply will lead to a decrease in the interest rate.
The other effects work in the opposite direction and are likely to
dominate. Therefore, an increase in the money supply leads to higher,
rather than lower interest rates.

[Note the difference between the price-level effect and expected

inflation effect:
price-level effect remains even after prices have stopped rising,
whereas the expected inflation effect disappears]

6.1 Explain the meaning of the risk structure of interest rates (3). List and
explain 3 factors which affect the risk structure of interest rates using a
supply of /demand for bonds –framework. (18)

Risk structure of interest rates refers to the relationship between interest

rates on bonds with the same maturity. Interest rates on bonds with
the same maturity differ on different categories of bonds in any given
period and the spread between interest rates varies over time.

The three factors that affect the risk structure of interest rates are:
Risk of defaulting: bonds that have no default risk are referred to as
default-free bonds. The spread between default-free bonds and
bonds with default risk is referred to as the risk premium. This refers to
how much additional interest a bond must earn in order to make a
person willing to hold it. A bond with default risk will always have a
positive risk premium, and an increase in its default risk will raise the risk
premium.
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[Use of demand/supply framework: Refer to FIGURE 2 (page 125) and

complete the diagram below. Also make sure you can explain the
process as an example of the effects of default risk on demand and
supply of bonds and the conclusion drawn from this.]

Price of Bonds Price of Bonds

Quantity of Corporate Bonds Quantity of Treasury

bonds

Liquidity of bonds: the more liquid an asset is the more people will
wish to hold it. The greater the liquidity of a bond, the lower the
interest rate required. The spread between a bond with high liquidity
and one with low liquidity is also referred to as a risk premium.

Tax treatment: the fact that interest payments on municipal bonds in

the USA are tax free has the same effect on the demand for these
bonds as an increase in their expected returns. The demand for
municipal bonds tends to be higher, therefore prices are higher and
interest rates have been lower (implying lower risk) than the Treasury
bonds. Refer to figure 3 on page 129.

6.2 Explain the meaning of the “term structure of interest rates” and the
yield curve. Draw a normal yield curve and explain why its shape applies.
List three (3) empirical facts generally observed about the yield curve. (10)

Term structure of interest rates refers to the behavior of bonds with

identical risk, liquidity and tax characteristics which may have different
interest rates because of different times remaining to maturity.

When the yields on bonds with differing terms to maturity but the same
risk, liquidity and tax considerations are plotted on a graph, this is
called a yield curve. Normal yield curves are upward-sloping and this
means that the long-term interest rates are above the short-term
interest rates.
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A normal yield curve:

Yield to Maturity

Term to Maturity

The following empirical facts relating to yield curves are also important:
(1) interest rates on bonds of differing maturities move together over time.
(2) When short-term interest rates are low, yield curves are more likely to
have an upward slope; when short-term rate are high, yield curves are
more likely to slope downwards and be inverted.
(3) Yield curves almost always slope upward.

8.4 Explain in general why indirect financing is more important than direct
financing and in particular, why banks are the most important source
of external finance for financing businesses. Then comment on the two
statements: “The role of banks in lending will probably decline in
future” and “The more established a firm is, the more likely it will issue
securities to raise funds”. (10)

According to the statistics from the USA, direct financing (since 1970s)
is used in less than 10% of the external funding of American business.
This position is changing in the USA. In most other countries the amount
of financing raised through direct financing is even less. This is an
indication that direct financing is much less important than indirect
financing in most economies. For this reason the role of financial
intermediaries if very important.

Financial intermediaries, particularly banks, are the most important

source of all external funds used to finance business. They help to
overcome the problems of adverse selection which prevents the
securities market from being effective in channeling funds from savers
to borrowers. However, banks’ share of external funds for businesses in
industrialized countries have been declining in recent years.

“The role of banks in lending will probably decline in future”: due to

improvements in information technology in the USA, the lending role of
financial institutions such as banks has declined. The simultaneous
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decline of costs and income advantages of banks has resulted in

reduced profitability of traditional banking and an effort by banks to
leave this business and engage in new and more profitable activities.

“The more established a firm is, the more likely it will issue securities to
raise funds”: It is a fact that well-known corporations find it much
easier to raise finance in the securities market than do the smaller
businesses. People and markets are better informed on these
companies and it will therefore be easier for such companies to find
funds directly when required.

8.9 Explain why the underdeveloped financial systems in developing and

transitional economies face several difficulties that restrict their
efficiency, and how certain practices in developing and transitional
countries reduce economic efficiency. (6)

In general underdeveloped financial system leads to a low state of

economic development and economic growth. The main difficulties
faced are:
 in many countries the system of property rights (rule of law,
constraints on government expropriation, etc.) functions poorly,
making it difficult to use these tools to help solve the adverse
selection and moral hazard problems.
 A poorly developed or corrupt legal system may make it
extremely difficult for lenders to enforce restrictive covenants.
Lenders are therefore less likely to lend and this will decrease the
opportunity for investment.
 Governments often use the financial systems to direct credit to
themselves or to favoured sectors of the economy by, for
example, setting artificially low interest rates on certain types of
loans.
 Banks in many transition and developing countries are owned
by their governments and because of the absence of the profit
motive, these state-owned banks have little incentive to
allocate their capital to the most productive uses. Often the
primary loan customer is the government.
 Many developing countries have an underdeveloped
regulatory apparatus that prevents the provision of adequate
information to the marketplace, e.g. weak accounting
standards.

10.4 Explain briefly the meaning of credit risk and how banks can manage
it. (7)

Credit risk is the risk that arises because borrowers might default. To be
profitable, financial institutions must overcome the adverse selection
and moral hazard problems that make loan defaults more likely. In order
to manage credit risk the following process are followed:
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 Screening and monitoring: whereby the institution collects

information about the potential client and the credit risk
involved and then monitor the borrowers to see that they are
complying with the restrictive covenants.
 Long-term customer relationships: long-term relationships mean
that financial institutions are able to collect reliable information
on clients.
 Loan Commitments: this is a commitment by a bank to provide
loans to a client, e.g. a firm. This encourages a long-term
relationship and allows banks to request necessary information
from the parties concerned.
 Collateral and compensating balances. Collateral lessens the
consequences of adverse selection and reduces moral hazard
because the borrower has more to lose from defaulting.
 Credit rationing. This may take place in two ways: (i) when the
financial institution refuses to make a loan of any amount to a
borrower, even if the borrower is willing to pay a higher interest
rate; (ii) when a lender is willing to make a loan but restricts the
size of the loan to less than the borrower would like.

13.4 List and briefly explain the six (6) main functions of the South African
Reserve Bank (SARB). (6 x 3 = 18).

In relation to the payment system, the SARB performs the following

functions:
1. Sole issuer of cash or currency. The SARB controls the SA Mint
Company and the SA Bank Note Company.
2. The SARB provides facilities for clearing and the settlement of
interbank obligations. The SARB also oversees the safety and
soundness of the payment system through the introduction of settlement risk
reduction measures.

In relation to the supervision of the commercial banks, the SARB

performs the following:
3. Acts as banker for and supervisor of other banks and the lender
of last resort to all banks. The purpose of this function is to maintain sound
and effective banking practices in the interest of depositors and ultimately
the economy as a whole.

In relation to the conduct of monetary policy, the central bank

performs the following critical function:

4. The primary function of the SARB, but also politically, the most
sensitive one, is the formulation and implementation of monetary policy.
Monetary policy works through several levels (channels).

5. The SARB acts as banker for government. The main services

provided are administering the auctions of government bonds and treasury
bills, participating in the National Treasury’s debt management meetings and
managing the flow of government funds in the money market.
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6. The SARB is the custodian of the greater part of South Africa’s

gold and other foreign exchange reserves.

14.2 Derive the simple multiple deposit creation model (formula: ΔD =

1/rΔR). Explain its meaning, the underlying logic of the process, its
simplifying assumptions and its critique. (20)

In the case of the USA, when the Federal Reserve supplies the banking
system with additional reserves, the deposits increase by a multiple of
this amount, this process is called multiple deposit creation.

Assumptions of the model (process):

 In the case of the single bank: a single bank will not make loans
that exceed the value of the excess reserves it has before
making the loan.
 In the case of many banks, or the banking system: whether a
bank chooses to use its excess reserves to make loans or to
purchase securities, the effect on deposit expansion is the same.

The workings of the model:

 In the case of the single bank: a single bank cannot by itself
generate a multiple expansion of deposits. It cannot make
loans greater in amount than its excess reserves because the
bank will lose these reserves as the deposits (money made
available) created by the loan find their way to other banks
and the bank will then lose its reserves.
 In the case of the banking system: although one bank may lose
excess reserves to another bank, these reserves do not leave
the banking system. As a result the process of money creation
continues as reserves move from bank to bank. This multiple
increase in deposits is called the simple deposit multiplier. It is
the dependent upon the required reserve ratio and the formula
for the multiple expansion of deposits can be written as follows:
ΔD = 1/r x ΔR

Where: ΔD = change in total cheque deposits in the

banking system
r = required reserve ratio
ΔR = change in reserves for the banking system

Critique of the model:

 The simple model of multiple deposit creation has serious
deficiencies. Decisions by depositors to increase their holdings
of currency or of banks to hold excess reserves will result in a
smaller expansion of deposits than the simple model predicts.
All four players – the central bank, banks, depositors and
borrowers – are important in the determination of the money
supply. This leads to the derivation of a more complex money
multipliers.
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 The simple model seems to imply that the central bank (the Fed)
has complete control over the level of deposits through (r) and
the level of reserves (R). This depends, however, whether the
proceeds from loans are deposited or kept as currency.
 If the proceeds are used to raise the level of currency then
demand deposits (D) will not increase by as much as the
“multiplier” might suggests.
 If a single bank decides not to grant loans to the full extent of its
excess reserves then the full expansion does not occur.

14.5 Briefly explain the arguments for a reversed causality, that is, “deposit
creation leads to reserve holding” (D → R) could be more realistic.
(15)

Mishkin’s analysis assumes that the reserve holdings of banks leads to

deposit creation. Many other economists argue that in fact “deposit
creation leads to reserve holding” and that this better describes what
really happens. This is referred to as reverse causality.
 In a modern money system, cash reserves consist of money
issued by the central bank which is mainly in the form of
deposits which are kept with the SARB. Commercial banks are
dependent upon the central bank for their cash.
 The central bank provides the banking system with its normal
cash needs.
 The central bank can choose between two strategies: control
the amount of cash it provides and allow the cash fund rate
(repo rate) to find its own level; alternatively it can fix the cash
funds rate and allow the amount of cash reserves it makes to
find its own level. The second strategy is the one used: central
banks seek to set the cash fund rate at a certain target level.
 For this reason there is a price constraint, but no quantity
constraint on the amount of cash the central bank offers to the
banking system.
 An individual bank that is prudent is most likely assured of the
required cash reserves at the prevailing cash fund rate. For this
reason it can grant all the credit and issue all the deposits
required and then seek to obtain cash reserves. This means that
D leads to R (reverse causality).
 This implies that changes in r, c and e do not cause a change in
the impact of R on D but rather a change in the impact of D on
R.
o If r increases banks would need more reserves for deposits
created and since the central bank will provide these
reserves.
o If the currency ratio (c) increases, the central bank will have
to provide more cash (MB) into the system
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o If the value of excess reserves (e) increases the central bank

will also have to provide more cash (MB).

 Banks hold few excess reserves (ER). This seems to confirm the
reversed causal direction view. In South Africa, particularly,
banks do not have to comply with the cash reserve
requirements on a day-to-day basis but only over a month
period. This further removes the rationale for holding excess
reserves.

16.1 Briefly explain the meaning of monetary targeting and the lessons
learnt form the application of monetary targeting the US, Japan and
Germany as it was applied from 1970s – 1990s. What are the main
advantages and disadvantages of monetary targeting? (15)

In following a monetary targeting strategy, the central bank

announces that it will achieve a certain value of the annual growth
rate of a monetary aggregate.

Although policies of monetary targeting was followed in the USA,

Germany, Japan and others in the 1970s it was quite different from the
type of monetary targeting recommended by Milton Friedman. The
central banks did not adhere to strict rules for monetary growth.

USA: In 1979 the Fed switched to an operating procedure that

focused on nonborrowed reserves and control of the monetary
aggregates and less on the federal funds rate. However, it had little
success in achieving the monetary targets. In 1982 the Fed decreased
its emphasis on monetary targets and in 1993 it abandoned this
approach.

Japan: In 1974 Japan experience a large increase in the inflation rate

(it increased to greater than 20%). It was believed that this was
accommodated by the growth in money supply (also in excess of
20%). As a result in 1978, the central bank of Japan began to
announce “forecasts” at the beginning of each quarter for M2 and
CDs. The Bank of Japan’s monetary policy performance during the
1978 – 1987 period was much better than the Fed’s. Money growth in
Japan slowed and was much less variable than in the USA. The result
was a more rapid stop to inflation being achieved with less variability in
real output than in the USA. During the period 1987 to 1989 there were
concerns about the appreciation of the Yen and so the Bank of Japan
increased the rate of money growth. Many blame the speculation in
Japanese land and stock prices on this increase in money growth. To
reduce speculation, the Bank of Japan switched to a tighter monetary
policy aimed at slower money growth. The aftermath was a
substantial decline in land and stock prices. The resulting weakness of
the economy lead to deflation which promoted further financial
instability. Critics have argued that Japan’s monetary policy has been
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overly restrictive and this has contributed to the stagnation of the

economy over the past few years.

Germany: Germany’s central bank (Bundesbank) chose to focus on a

narrow monetary aggregate called central bank money. In 1988 this
was switched back to M3. The key fact about the monetary targeting
regime in Germany is that it was not a Friedman type monetary
targeting rule. The Bundesbank allowed growth outside of its target
ranges for periods of two to three years. The monetary targeting
regime in Germany demonstrated a strong commitment to clear
communication of the strategy to the general public. Monetary
targeting was primarily a method for communicating strategy of
monetary policy focused on long-run considerations and the control of
inflation.

Advantages of monetary targeting:

 information on whether the central bank is achieving its target is
know almost immediately.
 Can send almost immediate signals to the public and markets
about the stance of monetary policy.
 These signals help fix inflation expectations and produce less
inflation.
 Help to constrain monetary policyholders from falling into the
time-inconsistency trap, by calling for almost instant
accountability for monetary policy to keep inflation low.

Disadvantages of monetary policy:

 The above only occurs if the following exist:
o Strong and reliable relationship between goal variable and
the targeted monetary aggregate. If this relationship is
weak monetary targeting will not work.

19.1 Briefly explain the Quantity theory of money (QT), that is, its
assumptions and predictions. Demonstrate that the QT can be
transformed into the Quantity theory of money demand. Does the
assumption regarding V agree with the empirical findings? (10).

The quantity theory of money is derived from the equation of

exchange. It states that the nominal income is determined solely by
movements in the quantity of money. When the quantity of money
(M) doubles, M x V doubles and so does P x Y, the value of nominal
income.

The classical economists believed that wages and prices were

completely flexible (assumption) and so the level of aggregate output
(Y) in an economy during normal times would remain at full-
employment level and was therefore fairly constant. The QT implies
that if M increases then there will be an increase in P, because V and Y
are assumed to be constant.
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The quantity theory of money provided an explanation of movements

in the price level: movements in the price level result solely from
changes in the quantity of money.

Because the QT tells how much money is held for a given amount of
aggregate income, it is considered to be a theory of the demand for
money. Fisher’s QT suggests that the demand for money is purely a
function of income, and interest rates have no effect on the demand
for money.

Empirical data has shown that velocity of money is not constant. V

may be defined in two ways:
 V = PY/M [MV = PY] and this is referred to as “income velocity of
circulation”.
 V = PT/M [MV = PT] and is referred to as “transaction velocity of
circulation”.
 The transaction velocity measures the average number of times
a given amount of money is spent over a given period. It
reflect the number of transactions that need to take place for a
given amount of finished output (Y) to be produced.

19.3 Explain Friedman’s approach of his modern quantity theory of money

and which factors determine the demand for M/P. Then explain why
changes in interest rates, according to Friedman, have little effect on
the demand for money and why the money demand function is stable.
(15)

Milton Friedman developed his quantity theory of money in 1956.

Friedman believed that the demand for money should be influenced
by the same factors that influenced the demand for any other assets.
He then applied the theory of asset demand to the demand for
money.

The theory of asset demand indicates that the demand for money
should be a function of the resources available to individuals and the
expected returns on other assets relative to the expected return on
money. Like Keynes, Friedman recognised that people want to hold a
certain amount of real money balances .

The factors that Friedman argued would affect the demand for money
were:
 Permanent wealth (Friedman’s measure of wealth)
 Expected return on money
 Expected return on bonds
 Expected return on equity
 Expected inflation rate

Friedman did not take the expected return on money to be a

constant. He argued that changes in interest rate would result in the
difference between the return on bonds and the return on money
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remaining relatively constant (incentive terms for holding money

remain fairly constant). As a result the demand for money would not
be influenced by interest rates. So Friedman’s demand for money
function is one in which permanent income is the primary determinant
of money demand.

Friedman also suggested that the random fluctuations in the demand

for money are small and that the demand for money can be
predicted accurately by the money demand function. When
combined with his view that the demand for money is insensitive to
changes in interest rates, this means that velocity is highly predictable.

In conclusion, Friedman’s theory of demand is based on the theory of

asset demand and he argues that the demand for money will be a
function of permanent income and the expected returns on
alternative assets relative to the expected return on money. The final
outcome of Friedman’s theory is that velocity is highly predictable and
therefore money is the primary determinant of aggregate spending.

20.1 Briefly explain why the ISLM model is unrealistic. Focus on the meaning
of endogenous and exogenous variables and how the ISLM models
deals with it. Which additional assumption can be made to make the
ISLM more realistic? (10)

Some academics and economists argue that the ISLM model should
no longer be used in economic theory because it is unrealistic. A
number of factors need to be considered in this regard:

(i) Any economic model is a simplification of reality and so all

economic models can be called unrealistic.
(ii) The intended purpose of the ISLM model is to show the links
between the major macroeconomic variables and it shows how
the real components of Y are related to each other. [Y = C + I
+ G + NX]. It provides an “elegant framework” to determine
how changes in one variable (exogenous variables) impact on
other (endogenous) variables.
(iii) Exogenous variables in the case of the ISLM model refer to those
that affect certain variables in the model but are not, in turn,
affected by any of the variables in the model. Endogenous
variables are those which are affected by other variables in a
model. An important assumption is made that money supply
(M) is exogenous, while income (Y) and interest rate (i) are
endogenous. In SA at present the SARB controls the interest
rate making it exogenous and not the money supply, therefore,
the assumption that money supply is exogenous it not
applicable at all, money supply is, in fact, endogenous.
(iv) The ISLM model assumes that the aggregate price level is
constant because there is no variable within the model that
represents the aggregate price level. Despite this assumption
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being unrealistic, it does not impact on the use of the ISLM

model as long as it is used for short-periods with low inflation.
(v) The main problem stems from the assumption that the interest
rate is endogenous to the money market, and money supply is
exogenous.
(vi) If the model was adapted to account for this reality, the LM
curve would be reflected as a straight line (horizontal, elastic) at
the interest rate fixed by the central bank. When this is done the
model does loses some of its “neatness and elegance”.

In conclusion, the ISLM model no longer provides a good

representation of reality but nevertheless remains the main paradigm
in undergraduate macroeconomic theory.

23.3 Explain the meaning of the transmission mechanism of monetary

policy in South Africa in general, describe its main links, explain how it
influences domestic inflation and why monetary policy is subject to
lags. (12)

The transmission mechanism of monetary policy refers to the role that

interest rates play in linking the financial sector with the real sector of
the economy. This is seen in the processes that are set in motion when
the SARB changes the repo rate.

The main links are:

 the operational instrument of monetary policy which is the repo
rate. This has a direct effect on other variables in the economy
(other interest rates, exchange rate, money and credit and
other asset prices).
 Pressure of demand relative to the supply capacity of the
economy is a key factor influencing domestic inflationary
pressures.
 If market interest rates, the exchange rate, credit or other asset
prices do not respond meaningfully to changes in the repo rate
then monetary policy will have little effect.

In South Africa the repo rate affects the economy through a number
of channels:
 Interest rate channel. Any change initially influences the interest
on retail financial products. Almost immediately after the repo is
changed, domestic banks adjust their lending rates. Firms and
individual respond to the changes in interest rates by altering
their investment and spending patterns.
 Other financial asset prices: prices of foreign exchange act as
achannel for the transmission of monetary effects. When the SA
interest rate falls, deposits denominated in rand become less
attractive than deposits in foreign currencies and the rand
depreciates. The lower rand makes domestic goods cheaper
causing a rise in net exports and hence aggregate output. The
depreciation of the rand will also cause the price of imports to
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increase and becomes inflationary. Monetary policy can also

affect the economy through its effects on the valuation of
equities. When monetary policy is relaxed, the public finds that
it has more money to spend, and one place this can be spent is
the stock market. A higher demand for shares leads to an
increase in prices. The combination of higher prices with higher
fixed capital formation leads to an increase in output (Y).
Household wealth can be affected by the repo rate and is also
a powerful channel.
 Credit: this operates through bank lending. Expansionary
monetary policy increases bank reserves and bank deposits,
thus increasing the amount of loans available. This increase in
loans will cause fixed capital formation and consumer spending
to rise. Credit also affects the balance sheets of households
and firms and arises from asymmetric information in credit
markets.

24.1 Provide a perspective on Friedman’s proposition that inflation is always

and everywhere a monetary phenomenon. Firstly evaluate the
empirical evidence in this regard (you may refer to the experience of
any country), then explain whether inflation is always and everywhere
a demand-pull phenomenon. Lastly explain why money plays a vital
role in sustaining the inflationary process. (15)

Milton Friedman believed that because inflation was caused by high

growth rate of money supply, the reverse was the solution: keep the
growth rate of money supply low and inflation would be prevented.

Reduced-form evidence shows a high correlation between the

inflation rate and the growth rate of the money supply. In the case of
German hyperinflation (1921 – 1923) the German government printed
large amounts of money in order to make available the cash required
to reconstruct Germany after World War I. Evidence shows that as the
money supply increased so did prices. Zimbabwe’s hyperinflation is
the same as Germany’s: extremely high money growth because the
weak government of Robert Mugabe was unwilling to finance
government expenditures by raising taxes, which led to a very high
budget deficit financed by money creation.

Strong empirical evidence indicates that rapid inflation in many

countries seem to have links with increases in money supply. This is has
also been seen in the case in the Latin American countries that had
highest growth rates in money supply and the highest inflation rates.

Mishkin indicates that if inflation is viewed as a continuing and rapid

increase in the price level, almost all economists agree with Friedman.
The issue to be considered is why and how does inflationary monetary
policy come about. The intention is not to create inflation but rather to
achieve some significant macroeconomic objective, e.g. economic
growth. Friedman argues that upward movements in the price level
are a monetary phenomenon only if this is a sustained process.
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Demand-pull inflation is caused by large increases in aggregate

demand which are not counteracted by increases in aggregate
supply. This increase in AD leads to an increase in the price level. If
such an increase in AD is driven by an increase in money supply it is
likely to lead to serious inflation. However, if the increase in AD is
caused through some other factor, such as an increase in government
spending it will not necessarily result in high inflation unless it is
accompanied by an increase in the money supply.

For this reason it may be concluded that Milton Friedman was correct
with regards to his statement that “inflation is always and everywhere a
monetary phenomenon”.