Study unit 2

MONETARY SECTOR

EXPECTED OUTCOMES

Explain the money creation process

Discuss the money multiplier

Explain the demand for money

Explain and illustrate money market equilibrium

Explain the effect of income and interest rate

changes on money market equilibrium

DEFINITION OF MONEY:

Money is anything that is generally acceptable as a

means of payment for goods and services or for
the settlement of debts.

(Source: Mohr & Fourie; 2008)

Money is legal tender.

FUNCTIONS OF MONEY

Medium of exchange

Unit of account

Store of value

Standard for making deferred payments

PROPERTIES OF MONEY

Uniformity
Durability
Divisibility
Ability to be carried

DEFINITION OF MONEY SUPPLY

Its the total amount of money held by the nonbank

public at a point in time in the economy.

Money supply is a stock concept which can only

be measured at a particular time.

The SARB uses broad monetary aggregates like

M1, M2 and M3 to measure money supply.
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MONETARY AGGREGATES

M1= Notes and coins in circulation outside the

monetary sector (with the non banking public) as
well as demand deposits.

Thus M1= Cash + Demand deposits

(Narrow definition of money)

Deposits are normally the largest component

of M1
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MONETARY AGGREGATES

Broader definition of money

M2 = M1 + Short term deposits (< 30days), medium

term deposits (180 days) of the domestic private
sector with banking institutions.

These can be withdrawn early at considerable cost.

MONETARY AGGREGATES

M3 = M2 + long term deposits (>6months)

This is a reliable indicator of the developments in

the financial sector

Reflect the store of value function.

The ratio of M3/GDP is an indicator of the level

of financial deepening in the economy.
9

CENTRAL BANK

This is a financial institution that is at the

apex of the financial sector and is most
important in any monetary economy.

The functions of the SARB can be grouped

into the following areas:
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CENTRAL BANK

Formulation and implementation of monetary

policy (repo rate; cash reserve ratio and OMO).

Adviser to the government (Banker, TBs etc).

Maintaining financial stability.

Provision of economic and statistical data (used

by policy makers and researchers).

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MAINTAINING STABILITY

SARBs role is to promote price and financial stability.

This is achieved through:

Bank supervision (license and regulate)

National Payment System (reduce interbank risk)

Banker to other banks (lender of last resort, cash

reserve ratio etc)

Sole issuer of notes and coins (issue, destroy and

change notes etc)
12

CREDIT CREATION

Money supply is normally regarded exogenous and

varied mostly by the central banks

Commercial banks can also influence the level of

money supply through credit creation (multiple
expansion of bank deposits over and above cash
reserves).

13

TO ILLUSTRATE CREDIT CREATION

To illustrate credit creation

Assume there is one bank and John deposits R1000 with
this bank
Assume cash reserve ratio is 10%
Bank A

Total

Deposit
1000
900
810

CRR
100

New loans
900
90
810
81
729

10 000

1000

9000

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MONEY MULTIPLIER

Magnitude (extent) by which an initial deposit can

be expanded to, with a given reserve ratio.

It is the inverse of the reserve ratio

rr=10%, then multiplier is 10 (1/rr=1/0.1)

The lower the reserve ratio the higher is the multiplier;

vice versa.

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DEMAND FOR MONEY

This is the amount of money various participants in

the economy plan to hold in the form of money
balances.

Why do households and firms plan to hold

money balances?

Keynes liquidity Preference theory (1930)

Money is demanded to be held for 3 reasons

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DEMAND FOR MONEY

Transaction demand for money

finance day to day expenditures (medium of exchange)

Lack of synchronization between money receipts and
expenditure payments

Varies with income.

Precautionary demand

Cater for unforeseen future expenditures

Determined largely by income

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SPECULATIVE MOTIVE (STORE OF VALUE MOTIVE)

This motive is based on the choice between holding money in

cash form (no interest) or in form of assets like bonds (interest).

People make choices between holding cash or financial asset.

This choice is determined by the opportunity cost of holding
money- interest rate

Demand for money for speculative purposes varies inversely

with interest rates.

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PASSIVE AND ACTIVE BALANCES

Active = Transaction + precautionary

Passive = Speculative

Active + Passive balances = Liquidity Preference

Money market equilibrium

Exogenous : (not vary with interest rate)

Endogenous : (varies with interest rate : demand

determined)
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CHANGES IN MONEY MARKET EQUILIBRIUM

Equilibrium is affected by:

Changes in income.

Changes in interest rates.

SHOW DIAGRAMATICALLY

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CHANGES IN MONEY MARKET EQUILIBRIUM

i

Interest rate

i1

E1
E2

i2

L,M
0

M1

M2

Quantity of money

MONETARY POLICY

Manipulation by central bank of interest rate and money

supply so as to achieve desired changes in the economy,
i.e.

Stable prices

Full employment

Economic growth

Stable BOP

In RSA monetary decisions are taken by the

Monetary Policy Committee.
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OTHER MP INSTRUMENTS:

(NON MARKETED MEASURES)

Credit ceilings

Deposit rate control

SARB intervention in forex market

Terms of hire purchase agreements

Moral suasion

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Study unit 3

THE PUBLIC SECTOR

LEARNING OUTCOMES

Explain what fiscal policy is about

Explain budget deficit.

Discuss criteria of a good tax system

Distinguish between different types of taxes.

Analyse tax burden

25

DEFINITION

The part of the economy concerned with providing basic

government services (roads, law and order, education,
health etc).

26

PUBLIC SECTOR

The part of the economy concerned with providing basic

government services (roads, law and order, education,
health etc).

The public sector consists of

Central government

Provincial government

Local government

Public corporations

general
government

Public
sector

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ROLE OF GOVERNMENT

Protect the lives and property of citizens ( maintaining law

and order, upholding justice, recognizing property rights and
enforcing contracts)

Ensure equitable distribution of income and wealth since

markets may be efficient but unjust or unfair

Ensure security of the countrys borders ( national defense

protecting the country from invasion or attack by foreign powers)

Provide services that can not be provided efficiently and

effectively by the private sector (correct problems of market
failure such as in the case of public goods, externalities etc)
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THREE FUNCTIONS OF GOVERNMENT

ROLE

In summary government role is to perform three functions:

Allocative function: (correct market failure)

Distribution function: (redistribute income fairly)

Stabilisation function: (promote full employment and

stable prices). This is related to business cycles

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FISCAL POLICY

Is a demand management policy just like monetary policy

Manipulation of government expenditure and taxation to

achieve desired changes in the economy.

The national budget is the main instrument of fiscal policy

Governments use fiscal policy to stimulate growth,

redistribute income, control inflation, address BOP
problems.

30

FISCAL POLICY

Fiscal policy should be complementary to monetary policy

vice versa.

Thus when in a depression they should all be expansionary

and contractionary to control inflation, BOP problems when
there is a boom.

Difference between government expenditure and taxation is

called BUDGET DEFICT/ SURPLUS.

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FINANCING OF EXPENDITURE

Income from property: (dividends, profits from production in

SOE)

Taxation: (using direct and indirect taxes)

Borrowing to finance the deficit: (done using TBs Bonds

overdrafts)

This is normally inflationary.

Government borrowing places a burden on future generations.

Borrowing is fine if used to finance capital projects and not

recurrent expenditure.
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TAXATION

Taxes are compulsory contributions made to government

without any specific reference to the benefits received.

Taxes are used to finance government expenditure and a

good tax system should meet the following criteria
(Cannons of taxation)

33

NEUTRALITY

Taxes should have the minimum impact on incentive to

work and efficient allocation of resources.

Taxes should have a minimal impact on relative prices and

thus not distort the signaling role of the price mechanism.

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EQUITY

A good tax system should be fair.

For a tax system to meet this criterion it should be based

on the ability to pay principle as well as benefit principle

Ability to pay: people should pay tax according to their

ability. High income earners should pay more than low
income earners. A progressive tax system achieves this.

Under this principle there should be vertical equity

and horizontal equity

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EQUITY

The ability principle may sometimes violate neutrality on

the wealthy who get taxed heavily and this becomes a
burden on production.

Benefits principle - Those who are beneficiaries of

government expenditure should pay for the goods /services
supplied.

These are in form of user charges like toll fees, park

fees, electricity rates etc

36

ADMINISTRATIVE SIMPLICITY

Thus a good tax system should be simple to understand,

and cheap to collect with low compliance and administration
cost.

This reduces tax avoidance and tax evasion.

37

TYPES OF TAXES

We have direct and indirect taxes

Direct taxes: are those levied on incomes and paid by the

persons on whom imposed. Includes personal income taxes,
corporation taxes, inheritance tax.

Indirect taxes: are collected by an intermediary (such as a

retail store) from the person who bears the ultimate economic
burden of the tax (such as the customer). Includes VAT,
custom duties and excise taxes.
38

TYPES OF TAXES

General taxes: are levied on most goods and services like

VAT

Selective taxes: are levied on specific goods like tobacco,

alcohol etc. They are called excise duties.

39

TYPES OF TAXES

Progressive tax: Increases with income (e.g. personal

income taxes)

Proportional tax: Pay same tax regardless of level of

income e.g. 20% income tax

Regressive tax: Falls as income increase e.g. proportional

tax and VAT.

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TAX INCIDENCE

2 TYPES OF TAX INCIDENCE

Statutory(legal) incidence:

Refers to the legal liability to pay the tax over to

government

Economic incidence: entity that finally pays the tax.

This incidence is a result of tax shifting backwards or

forwards.

Forwards tax shifting: tax paid by consumers.

Backward shifting: tax paid by employees.

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WHO REALLY PAYS THE TAX?

Tax incidence

The ability to shift the burden of the tax depends mostly

on price elasticity of demand and supply.

To analyse the impact of the tax we assume a specific/

unit tax:

USE DIAGRAM to illustrate this

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STUDY UNIT 4

THE FOREIGN SECTOR

EXPECTED OUTCOMES

Explain why international trade occurs

Explain economic impact of an import tariff

Evaluate the case for and against the use of trade barriers

Describe the major elements of the balance of payments

Explain how exchange rates are determined

Define the terms of trade and their significance.

DEFINITIONS

An economy that engages in international trade is called an

Open Economy

One that does not is called a Closed Economy

A situation in which a country does no foreign trade is called

Autarky

Measures of openness

WHY DO COUNTRIES TRADE?

Consider trade among individuals:

Without specialization and trade each individual has to be

self sufficient.

A world with individual self sufficiency is a world with

extremely low living standards.

Therefore trade among individuals allows people to

specialize in those activities they can do well and buy
from others, commodities they cannot easily produce.

WHY DO COUNTRIES TRADE?

Thus specialization and trade are intimately connected.

Without trade everyone must be self sufficient.

But with trade everyone specializes in what he/ she does

well and satisfy other needs by trading

WHY DO COUNTRIES TRADE?

Countries also gain if they specialize in producing some

goods and then trade for other goods.

Differences in factor endowments explain why countries

have to trade with each other

Developing countries are endowed with natural resources

and so produce primary products,

whilst developed

countries are endowed with capital, hence produce

manufactured goods.

INTERNATIONAL TRADE

International trade is necessary to realise the gains that

international specialization make possible.

To illustrate the gains from trade we use the theories of

ABSOLUTE ADVANTAGE and that of COMPARATIVE
ADVANTAGE.

ABSOLUTE ADVANTAGE

Developed by Adam Smith

One country is said to have an absolute advantage over

another in the production of product X when an equal
quantity of resources can produce more X in the first
country than in the second.

To illustrate this, look at this example:

ABSOLUTE ADVANTAGE

Assume two countries: RSA and USA

Produce two goods Wine and Computers.

Assume that using one worker RSA and USA produce as

follows per month:

South
Africa
United
States

Computer
s
2
8

Wine
10
5

ABSOLUTE ADVANTAGE

Without specialization 10 computers and 15 bottles of wine

will be produced by these two countries.

If they specialize in accordance with absolute advantage

then, SA will produce 20 bottles of wine and 0 computers
and USA will produce 16 computers and 0 bottles of wine.

ABSOLUTE ADVANTAGE

World production has therefore increased.

This increase represent the gains from specialization.

Assuming that they can trade 1 computer for 1.25 bottles of

wine then

SA8 computers and 10 bottles of wine

USA 8 computers and 10 bottles of wine

COMPARATIVE ADVANTAGE

When each country has an absolute advantage over the

other in a product the gains from trade are clear.

But what if South Africa in the above example can produce

both computers and wine more efficiently than USA

COMPARATIVE ADVANTAGE

Computers

Wine

South Africa

10

United States

COMPARATIVE ADVANTAGE

In this example SA has an absolute advantage in the

production of all the goods and therefore according to Adam
Smith specialization and trade is not possible

David Ricardo and Comparative advantage.

Based on differences in opportunity cost.

COMPARATIVE ADVANTAGE

Computers

Wine

South Africa

10 (6/10 =
0.6)

6 (10/6 =
1.667)

United States

2 (4/2 = 2)

(2/4 = 0.5)

COMPARATIVE ADVANTAGE

The opportunity cost of producing computers is lower in

South Africa as compared to USA.

The opportunity cost of producing wine is lower in USA

compared to South Africa.

Thus South Africa has a comparative advantage in

producing computers and USA a comparative advantage in
wine production.

These countries should therefore specialize.

EQUAL ADVANTAGE

South Africa will after specialization produce 20 computers.

USA will produce 8 barrels of wine.

EQUAL ADVANTAGE

If countries have the same comparative advantage then

mutually beneficial trade is not possible
Computers
RSA
10 (0.6)
USA
5 (0.6)

Wine
6 (1.667)
3 (1.667)

TRADE POLICY

Although trade leads to a greater world production of goods

and also increases economic welfare

Many government continue to use measures:

that protect domestic firms from foreign competition

They control the amounts of imports entering the country

PROTECTIVE MEASURES

The protective measures include

Import tariffs

Import quotas or subsidies

Other non tariff barriers and exchange controls

Import tariffs

These are duties or taxes levied on imported products by

government to protect domestic firms from foreign competition or
simply to raise revenue

Import tariffs are generally of two types: specific and ad

valorem.

PROTECTIVE MEASURES

When import tariffs are imposed to raise revenue they are

called REVENUE TARIFF

If imposed to protect domestic firms are called

PROTECTIVE TARIFF.

ECONOMIC IMPACT OF AN IMPORT TARIFF

Assume a tariff is imposed on imported goods like

computers

We use demand and supply analysis

SPECIFIC IMPORT TARIFF

Price of computers

Ed

Pd

Et

Pt

Ew
Pw
0

Sw
D

Q1

Q2

Q3

Q4

Quantity of computers

Q5

ALTERNATIVE MEASURES

Other measures of controlling imports

Quotas

Subsidies

Administrative regulations

Exchange controls

Exchange rate policy

ARGUMENTS FOR THE USE OF TRADE BARRIERS

Balance of payments

Tariffs to correct a BOP deficit

Elasticity of demand for imports

Retaliation

Dumping

Impose barriers so as to counter dumping

Selling a product in foreign market at a price lower than that

charged in domestic market

Predatory dumping need for countervailing duties for this

ARGUMENTS FOR THE USE OF TRADE BARRIERS

Export subsidies

Creates unfair competitive advantage over foreign firms

Losers (foreign producers , tax payers: beneficiaries

foreign consumers and subsidised firms

ARGUMENTS FOR THE USE OF TRADE

BARRIERS

Infant industry argument

Support new industries

Complacency of protected firms

Employment

Protecting domestic industries protects employment

Critics argue : this may delay restructuring of jobs

Use fiscal and monetary policies etc

ARGUMENTS FOR THE USE OF TRADE

BARRIERS

Government revenue

Customs taxes are important source of government

revenue

Easy to collect

National security

Industries producing goods essential in times of war or

international crises e.g Defence industries, some
agricultural goods etc

REASONS AGAINST TRADE BARRIERS

Retaliation by trade partners

Trade barriers attract retaliation by other countries

reducing world gains

Inefficiency

Protective tariffs encourage firms to be inefficient

Consumers pay unnecessarily higher prices in protected

countries

Protected firms benefit and foreign firms lose market

share

BALANCE OF PAYMENTS

Balance of payments:

An account where we record the economic transaction

made by residents of a country with the outside world over
a certain period of time, normally a year.

It is composed of the:

current account.

financial account (portfolio investment and direct

foreign investment) and

unrecorded transactions.

changes in gold and foreign reserves

BALANCE OF PAYMENTS

Current account records international trade in tangible and

intangible commodities (services).

The balance on tangible goods is called TRADE

BALANCE

The current account balance plus the financial account

balance gives us the BOP balance

EXCHANGE RATES

Goods that are traded in the international or world market are

paid for using FOREIGN CURRENCIES like US$, pounds,
euros, yen etc.

South African importers use foreign currency to buy

goods. They exchange their rands for foreign currency

South African exporters are paid in rands by importers

from other countries. These importers have to exchange
their foreign currency for rands

EXCHANGE RATES

The rate at which currencies are exchanged is known as the

exchange rate.

Exchange rate is the price of one currency in terms of

another e.g 1US$ = 8R, 1BP = 1.1R etc

Just like prices of commodities , the price of foreign

currency is determined by supply and demand

FOREIGN CURRENCY

Demand for foreign currency arises because of a need by locals to

purchase

Imported products

Invest in foreign markets

A foreigner converting his rand proceeds into foreign currency

Speculators

Demand for foreign currency is also down ward sloping since the lower the
price of foreign currency, the cheaper are foreign goods and hence the
higher the quantity demanded of foreign currency.

DEMAND FOR FOREIGN CURRENCY IS THE SAME AS SUPPLY OF

LOCAL CURRENCY IN THE FOREX MARKET.

FOREIGN CURRENCY

Supply of foreign currency result from a need to buy local

products (mostly done by foreigners)

South African exporters

Foreigners buying local financial or real assets

Speculators

Foreign tourists

FOREIGN CURRENCY

The supply function for foreign currency is upward sloping.

Thus when the exchange rate moves from 1US$=10 rands

to 1US$=20 rands, the price of South African produced
goods become cheaper to Americans and hence they will
demand more of them supplying more US dollars in the
process.

APPRECIATION AND DEPRECIATION

Appreciation and Depreciation of the exchange rate.

Terms of trade (TOT)

Its a relationship between the prices of exports and the

prices of imports (normally expressed as an index)

exp ort price index

x 100
import price index

TERMS OF TRADE

A fall in the terms of trade means that the prices of exports

are falling relative to prices of imports.

This indicates a welfare loss or a country has becomes

poorer

An increase in TOT means the welfare of a nation has

increased