MONETARY POLICY INSTRUMENTS AND IMPLEMENTATION

The South African Reserve Bank (SARB) uses what is known as the
classical cash reserve system as the basis for the implementation of
monetary policy, making use of three main policy instruments:

• Accommodation policy - the repurchase (repo) rate

• Open market operations
• Cash reserve requirements

The repo rate is the main policy instrument that is used in this
framework, with open market operations and cash reserve
requirements being used (as will be seen) to give effect to changes in
the repo rate.

Accommodation Policy. SARB makes a short-term loan facility

available to the commercial banks through repurchase transactions
should they need or wish to supplement their reserves. For example,
should there be an upsurge in demand for credit by the public, the
banks would be keen to expand their lending and thereby increase
their profits. These additional advances would result in liquidity
ratios falling and, should new reserves not become available from
other sources (mainly via the interbank market), the banks would need
to supplement their reserves by borrowing from SARB through the
repurchase facility. The commercial banks sell assets that qualify as
liquid assets to SARB and simultaneously contract to buy these assets
back at a future date. The difference between the price at which these
assets are sold and that at which they are repurchased represents the
interest cost of the transaction. Expressed as a percentage, this is the
repurchase or repo rate. Changes (if any) to the repo rate are
proposed by the Monetary Policy Committee.

In order to make repo rate policy effective, SARB must ensure that
the banks need to approach it for accommodation; in other words,
they must ensure that there is a liquidity shortage in the banking
system. To achieve the required liquidity shortage SARB maintains a
cash reserve requirement and engages in open market operations.
Cash reserve requirements. This policy tool has previously been
referred to as the required reserve ratio. The commercial banks are
required to hold a minimum percentage of deposits as reserves. This
reserve requirement has two components, a cash reserve requirement
and a liquid asset requirement. The cash reserve requirement is set at
2.5% of total deposits and the liquid asset requirement at (an
additional) 5% of total deposits. These liquid assets include treasury
bills, government bonds and securities issued by both SARB and the
Land Bank. This requirement, used in conjunction with open market
operations, will ensure that liquidity shortages are created and
maintained.

Open market operations. Open market operations refer to the

purchase or sale of financial securities, in the open market, by SARB
and are conducted in order to affect the level of reserves (or,
equivalently, liquidity) in the banking system. These financial
securities would include Treasury bills, government bonds and
Reserve Bank Debentures.

You will recall that SARB can conduct either open market purchases
or sales and these will affect the levels of the banks’ reserves; open
market purchases of bonds by SARB will lead to an increase in
bank’s reserves and sales to a decrease. In order to ensure that the
banks’ reserve balances fall below the required minimum indicated by
the cash reserve requirement (a liquidity shortage), and that they will
be obliged to approach SARB for accommodation, SARB will
conduct open market sales. As explained earlier, whether the
securities sold are bought by the banks or the non-bank public, the
banks’ reserve balances held at SARB will decline. The banks will
then be obliged to approach SARB for accommodation as described
above.

THE MARKET FOR RESERVES

In order to analyse the market for reserves it is necessary to derive the
demand and supply curves for reserves (See Mishkin Chapter 16) and
set this market in the context of South African Monetary Policy.

Demand for Reserves

Unlike the situation in the US, (i) SARB does not pay interest on
reserve balances and (ii), as will be seen, SA commercial banks do
not hold excess reserves. In terms of the endogenous money model
described, the banks’ demand for reserves is determined by the
amount of loans extended and hence the level of demand deposits,
given the cash reserve requirement. If the level of borrowing is
(reasonably assumed to be) a negative function of interest rates, then
as interest rates fall and the level of borrowing (as well as deposits)
increases, the banks will require additional reserves in order to meet
the cash reserve requirement set by SARB. The demand curve is
accordingly negatively sloped (see the diagram below).

Supply of Reserves

The total stock (supply) of reserves (TR) consists of non-borrowed

reserves (NBR) and borrowed reserves (BR). NBR are created
through open market operations, purchases of foreign exchange by
SARB and government spending. BR are made available by SARB in
any quantity demanded by the banks at the repo rate; this is the prime
cost to the banks for borrowed reserves and set by SARB and adjusted
as circumstances require.

The stock of NBR at any time is given and constant, and represented
by a vertical supply curve. Any additional reserves required beyond
this level are borrowed and, given that SARB is committed to
supplying the level demanded, is represented by a horizontal supply
curve at the repo rate.

Market Equilibrium
The demand for and supply of reserves can be represented in the
diagram below:
Interest Rates

i-repo SR

DR
NBR (= CRR) Quantity of Reserves

The diagram illustrates the position where TR is equal to NBR, so that

BR is zero. In order to ensure that BR is positive and changes to the
repo rate effective, SARB would have to use open market operations
to reduce NBR to below the cash reserve requirement (CRR). This
may be illustrated as follows:

Interest Rates

i-repo SR
i-repo1 SR1

BR
DR
BR

NBR TR (= CRR) Quantity of Reserves

By ensuring that NBR < TR (= CRR), SARB can make monetary

policy effective by “forcing” the banks to come to it for
accommodation; the repo rate becomes “effective” and changes in the
repo rate will accordingly affect the rates at which the banks borrow
and lend.

This is illustrated by the fact that the demand curve intersects the
supply curve on the horizontal section of the latter – this would be
achieved by reducing the level of NBR through open market sales.

A decrease in the repo rate would mean that other interest rates
change in the same direction, provided that the banks’ BR’s are
positive. Lending would increase, new deposits would be created and
additional reserves would have to be borrowed (illustrated by the red
arrow).

MONETARY POLICY IN ACTION

At a meeting of the MPC in June 2007 it was noted that, after

remaining within the target range since August 2003, CPIX
inflation had breached the upper bound of the target range.
Following year-on-year inflation rates of 4.9% in February
and 5.5% in March, a higher than expected increase of 6.3%
was recorded. While food and petrol price increases were
major contributors to this increase, the strong upward trend
was regarded as being indicative of more broadly-based price
pressures developing. Risks to the inflation outlook were
regarded by the MPC as being strongly on the upside.
Among the risks to future inflation were the continued high
rates of household consumption expenditure. Expectations
of future inflation are also important because of their impact
on wage and price setting processes and these were noted to
have deteriorated, particularly those of labour and business
which were notably higher than those of other analysts.

The underlying strength in household consumption

expenditure was indicated by the high rates of domestic
credit extended to the private sector, growing at around 29%.
This was underpinned by higher levels of employment and
 real incomes with economic growth, although having
declined moderately in the first quarter of 2007, still
reflecting a strong performance with an annualised quarter-
on-quarter growth rate of 4.7%.

The Monetary Policy Committee has decided that in view of

the further deterioration in the inflation outlook, the
monetary policy stance needs to be adjusted to ensure that
CPIX inflation returns to within the inflation target range
over time. Accordingly, the repo rate will be increased by 50
basis points to 9,5 per cent per annum with effect from
Friday 8 June 2007. The MPC will continue to monitor
developments which have a bearing on inflation outcomes
and will not hesitate to adjust the policy stance as may be
appropriate.

Read this extract from a statement by the governor of the Reserve

Bank and, using a diagram to illustrate your answer, explain how the
change in the repo rate would affect the level of domestic credit
extension and thus the demand for reserves by the banks.,