Chapter 6- Money, Interest Rates and Financial Markets

• What does money do?

– Medium of exchange
– Store of value
– Unit of account
Counting money
• Count the deposits
– M0 = notes and coins (physical money)
– M1a
– M1
– M2
– M3 = All deposits (broadest definition)
Evolution of the Payment systems
• IOU
• Barter
• Commodity (gold standard)
• Notes and coins
• Cheques
• E- Money

➢ Money is more than just notes and coins. All deposits are money, when
you borrow money, the bank deposits that money in your account…..so
credit is also money
➢ Banks don’t need deposits to make loans, banks extend credit simply by
crediting your account with a certain number…..They only make loans if:
❖ There is a demand for loans
❖ The loans are expected to be profitable
❖ They have enough capital
How bank capital works
According to the Basel accord bank capital is mainly:
❖ Equity
❖ Retained earnings
• Capital ensures solvency
❖ i.e. that Assets ≥ Liabilities
❖ Assets = mainly loans
❖ Liabilities = mainly deposits
NB*
A bank makes a loan to a borrowing customer. The borrower is credited
with a deposit in his account and incurs a liability for the amount of the
loan. The bank now has an asset equal to the amount of the loan and a
liability equal to the deposit.
Bank capital is the difference between a bank's assets and its liabilities, and it
represents the net worth of the bank or its equity value to investors. The asset
portion of a bank's capital includes cash, government securities, and interest-
earning loans. The liabilities section of a bank's capital includes loan-loss
reserves and any debt it owes. A bank's capital can be thought of as the margin
to which creditors are covered if the bank would liquidate its assets.
<<If some loans go bad (defaults)… capital absorbs the loss>>
The SARB decides the rate
• Repo rate
• Interbank rate
• Prime rate
Changes in the money market
• Demand for credit
– Determined by income
– Higher income: demand more credit
– Lower income: demand less credit
• Change in repo rate
– Higher rate: credit more expensive
– Lower rate: credit cheaper
Why do central banks change rates?
Inflation target (3-6%), But interest rate takes 12-24 months to affect
inflation rate.…because transmission mechanism takes time.
 How does the SARB maintain faith?
• Protect buying power of the Rand
• Regulate banks
➢ Keep banks solvent
➢ Avoid bank runs
• Make people believe the SARB
– Moral suasion
– Independence
Central bank independence
• Types of independence
– Goal independence
– Instrumental (operational) independence
• How it helps with inflation targeting
– Creates credibility (combined with target)
– Influences inflation expectations
Making the repo rate effective
• By ensuring banks always need to borrow reserves from the SARB. How?
 • Through policy instruments
– Open-market operations
• Quantitative easing/tapering
– Reserve requirement
Maturity
• Financial assets = debt (which is why a yield is offered)
– Bonds
– Deposits (call, notice, fixed…)
– Options
• Differentiate based on maturity = how long before repaid
• What is the maturity of a:
– 6-month fixed deposit?
– Cheque account?