FINANCIAL INSTITUTIONS, MONEY AND INTEREST RATES: THE IS-LM

MODEL
 The monetary sector comprises various financial institutions such as
Commercial Banks, Merchant Banks and the Reserve Bank (SARB) as well
as the Financial Markets, which is where nominal and real interest rates are
determined.
 Real activities such as consumption invariably imply financial transactions
which involve bank transactions and often bank credit to consumers.
 Commercial credit is essential for business activities: The monetary sector can
be seen to handle the oil (money, credit and financial transactions) necessary
for the smooth functioning of the wheels of real activities (production,
employment, consumption, investment etc.) in the real sector.
 Real sector changes have monetary impacts and monetary disturbances can
have real impacts and these interactions must be analyzed to understand the
short run and medium run cyclical behavior of the economy (as long as the
long-term issue of economic growth).
MONETARY SECTOR AND INTEREST RATES
 We analyze interest rates from two perspectives: first in terms of the practical,
everyday operation of money markets and secondly more formally in terms of
the behavioral relationships that lie behind and explain this everyday
operation—the supply of money MS and the Demand for money MD.
 Nominal interest rates are the rates usually mentioned when the bank charges
a customer say, the prime rate, or the rate earned on a savings account, or
when the Reserve Bank announces a change in the REPO RATE
 Real interest rates are the interest rates earned in effect after the eroding effect
of inflation has been removed from the nominal value. An approximate
formula for the real interest rate is :
R≈I–𝛑
 Main interest rates are those determined in the money market—other interest
rates usually depend largely on what happens in the money market.
PRACTICAL DETERMINATION OF NOMINAL INTEREST RATES IN THE
MONEY MARKET.
 Financial market is arbitrarily divided into the money market and the
capital market.
  The money market handles instruments/assets with a term or maturity of up
to one year (short term). Associated with these are short-term interest rates
 Transactions in financial instruments with a term of more than one year (long
term) occur in the Capital market, which is organized exactly in the same
fashion as the money markets
 Money market dealers trade on behalf of clients in short term financial
instruments or financial paper. Purpose of trade is to interlink, Lenders
(financial investors) and borrowers i.e., the money market channels funds.

FINANCIAL
MARKETS

MONEY CAPITAL DERIVATIVES

MARKET MARKETS MARKET

Bond Market
Money Demand & futures
Equity Market
Money Supply Options
Property Market

 We make an assumption that there are only two assets available in which
financial wealth can be held, namely Money and Bonds. We also assume that
the only instrument in the bonds market is TREASURY BILLS.
TREASURY BILLS
 Treasury bills are one type of debt instrument issued by the
treasury/government when it borrows from the Private Sector during the
course of the year to finance the Budget Deficit.
 A TB is issued as proof of the loan and it entitles the holder/lender to receive
a specified amount (the nominal or face value) typically after 91 or 182 days.
 The interest that the lender/investor receives for the loan to the government
(i.e. for the financial investment in the TBs) derives from the fact that the
lender pays less than the face value of the TB at maturity: this discount
 depends on the interest that the government is willing to pay or that it has to
pay inorder to sell the TBs.
 Lets assume that the lender will give the Government R95000 for a 3 months
TB to receive R100000 at maturity, the nominal interest rate is calculated as:
100000 − 95000 365
∗( ) ∗ 100 =
95000 91
 We notice that we calculate the Nominal Interest rate as the difference
between the value of the TB at maturity and the initial value spread over 91
days thus the interest rate is equivalent to: 21.11%
 The higher the price the lender has to pay, the lower the Nominal Interest Rate
and the lower the price the lender has to pay, the higher the nominal interest
rate.
 Government issues of TBs comprises what is called the Primary Market, the
secondary market is when a Lender for some reasons decides to sell his/her
bill to someone before the maturity date of the bill, obviously at a price below
the face value and depending on the market conditions at that stage (the supply
and demand for TBs). Lets say 30 days after the initial issue the Lender
decides to liquidate his/her bond holdings to someone for R98200, we will
calculate the interest rate at the remaining price of the bond, thus

100000−98200 365
∗( ) ∗ 100 = 10.96%
98200 61

 Thus trade and prices in the secondary market determine corresponding

nominal interest rates. In this way the TB rate is determined daily, depending
on the buying and selling conditions (demand and supply) of TBs. When
investors have surplus funds and eager to invest in the TBs (other things
constant), the demand for financial paper is high and the prices increases
accordingly.
INTERESTR RATE DETERMINATION
 The Reserve Bank determines the supply of Money in the economy, the
Reserve Bank thus determines the interest rates in the economy.
 It does this by observing the monetary conditions of the economy and the
macroeconomic impact of these on prices and output: Now since Commercial
Banks have the money creation ability via the issuing loans and the multiplier
 effect process, the Reserve Bank ensures that the supply and demand of
money is well within controllable range.
 If people or institutions hold more money that they really want in their
portfolio—i.e. there is a surplus of money holdings (the supply of money
exceeds the demand for money) they are likely to buy financial paper (as short
term financial investment)---An increased demand for such paper is likely to
cause an increase in the price and a decrease in the nominal interest rate.
 If there is a shortage of money (the demand for money exceeds the supply of
money)—i.e. people want to improve their cash position—they tend to sell
financial paper.
o The increased supply of financial paper on the market causes a decrease
in price and the nominal interest rate increases
 Thus we conclude that nominal interest rates depend on the trade in money
market instruments and this trade is determined by the supply and the demand
for money.
DEMAND FOR MONEY
 Aggregate demand for money in the economy depends mainly on the amount
of money that people require for transactions (Transactional Demand for
Money).
 Total money value or nominal value of transactions (say annually) is a country
is decisive. This in turn depends on the total volume of goods and services
(real GDP or Y) that is exchanged
 If Y increases (the economy is in an upswing, economy activity increases), the
demand for money typically increases—as more goods and services are
produced and exchanged, more money is required to conclude these
transactions. There is a direct positive relationship between Y & MD.
 The nominal value of transactions also depends on the average price level P
[Nominal GDP = P * Y]. Accordingly an increase in the price level (as
experienced when inflation occurs) also increases the demand for money.
There is a positive relationship between P & MD.
 Money demand is determined also by the nominal interest rate, i. The demand
for money depends on the amount of money people want to hold at one time
(instead of going to the Bank to get money for each transaction). The interest
rate is the opportunity costs of holding money.
o The higher the Nominal Interest rate, the less willing people will be to
hold significant amounts of money/cash—i.e. a higher nominal interest
 rate will decrease the demand for money; a lower rate is likely to
increase the demand for money. There is an inverse or negative
relationship between i and MD.

𝑴𝑫 = 𝒇[(−)𝒊; (+)𝒀; (+)𝑷]

 Demand for Money is divided into 3

o Transactions demand (depends on the value of transactions, i.e. nominal Y
o Precautionary Demand: holding money in ready form, for contingency
demand, since we cannot at all times foresee all transactions. This depends
much in Income(Y) and interest rates (i) i.e. the opportunity costs of
holding money as against holding financial paper, as well as expectations
(optimism or pessimism about the economic outlook)—people generally
hold more money when they are pessimistic about the economic outlook.
o Speculative demand for money: comprises a person’s asset portfolio,
together with other financial assets such as bonds. If a person expects the
prices of other assets to go up, he will hold less cash and rather buy other
assets, hoping to profit from the expected price increase
 If a decrease in asset prices is expected, people will generally want
to hold more cash
 The higher the price of financial assets (the lower the interest
rates)—if interest rates are low it is not unreasonable to expect that
they may increase at some time in the future (implying that the
prices of bonds may decrease)—it may then be preferable to sell
one’s bond holdings and hold more cash/money in passive form
 This a low interest rate creates an incentive for a greater demand for
money (from a speculative perspective). Speculative demand for
money is therefore a function of interest rates.

REAL MONEY DEMAND

 MS and MD are nominal variables, we convert MD to a real variable by dividing
it with the Price Level P.
 MS/P represents the Real Money Supply and MD represents the Real Money
Demand.
 The real Interest rate is also used: 𝒓 = 𝒊 − 𝝅
  The demand for money can then be mathematically expressed as
𝑀𝐷
( ) = (𝑘𝑌 − ℎ𝑖 )
𝑃
 The LHS represents the real demand for money (money demand divided by
the price level),
 The parameter K measures how responsive real money demand is to changes
in real income, and H represents how responsive real money is to changes in
the nominal interest rate i.
 We demand money mainly to buy conduct Transactions (purchase goods and
services). If the average price level increases by a certain percentage (e.g.
when there is inflation) we will require proportionally money nominal money
so that in real terms we will have the same amount of money to conduct our
transactions of goods and services.

THE MONEY SUPPLY

 The nominal stock of money is the amount that the monetary system (i.e. the
Reserve Bank plus all other financial institutions) is supplying at a particular
moment, under the oversight of the Reserve Bank.
 Nominal stock of money can be defined as the total amount of money that is
present in the economy at a particular moment.
 There are 4 different definitions of the money stock:
1. M1A: Sum of coins and banknotes in circulation, plus cheque and
transmission deposits of the domestic private sector at monetary
institutions
2. M1: M1A plus other demand deposits held by the domestic private
sector at monetary institutions.
3. M2: M1 plus other short-term deposits and all medium term deposits at
monetary institutions (including savings deposits)
4. M3: M2 plus all long-term deposits held by the domestic private sector.
 What determines the money supply relationship in the economy?
1. This relationship reflects the money creation process that occurs mainly
(a) via lending activities of commercial banks in reaction to demand for
credit within the economy but also influenced by, (b) the deliberate
actions of the Reserve Bank as part of Monetary Policy.
  The nominal quantity of money available at any moment is the result of the
credit creation process and the interaction between individuals, firms, and
bank, and between banks and the Reserve Bank.
1. Money creation does not occur via the printing of notes but rather via,
the extension of credit (loans) by the Banks.
2. Banks lend money that has been deposited by clients to other clients.
(Each time this occurs, there is an addition to both the total amount of
credit extended and the total amount of bank deposits in the country,
and each creation of a deposit is equivalent to money creation.
3. There are a number of rounds of lending and relending, with deposits
being created and recreated all the time. Gradually this process slows
down—The cumulative result of this process of relending is the total
money stock or stock of money—in this way an initial injection of a
deposit is multiplied, with an eventual effect on the money stock much
greater than the initial injection (CREDIT MULTIPLIER PROCESS)
4. The extent of the money creation process i.e. the value of the credit
multiplier depends on how much is relent in each round---A Credit
ceiling is placed in this by the legally prescribed minimum cash reserve
requirement that Banks have to hold. In 2009 for South African
Commercial Banks, this reserve requirement was 2.5%.
5. The higher this percentage leakage, the smaller the portion that can be
lent in each round—therefore the maximum scope of the money
creation process is inversely proportional to the minimum reserve
requirement (the leakage rate)
1
𝐿𝐸𝐴𝐾𝐴𝐺𝐸 𝑅𝐴𝑇𝐸 =
𝑅𝐸𝑆𝐸𝑅𝑉𝐸 𝑅𝐸𝑄𝑈𝐼𝑅𝐸𝑀𝐸𝑁𝑇

The higher the reserve requirement (The specified non-extendable funds in credit),
the smaller the cumulative effect of the money creation process.
If Banks should decide to hold reserves in excess of the legally prescribed reserves,
what is termed Excess Reserve Holdings (say of 1%), the formula becomes:
1
𝐿𝐸𝐴𝐾𝐴𝐺𝐸 𝑅𝐴𝑇𝐸 =
𝐶𝑅𝑅 + 𝐸𝑋𝐶𝐸𝑆𝑆 𝑅𝐸𝑆𝐸𝑅𝑉𝐸[1%]
Proportion of excess reserves Commercial Banks hold is very sensitive to the
nominal interest rate they can charge on loans—When the prime rate increases e.g.
the opportunity cost of holding excess reserves increases—the bank has an incentive
to reduce the excess reserves and lend a larger proportion of the deposits that it holds.
THE MONEY SUPPLY FUNCTION
 Instruments of monetary policy are the main determinants of the money
supply. The nominal money supply MS is mainly a function of exogenous
policy factors under the control of the monetary authorities (exogenous—
determined by external considerations beyond merely the supply and demand
of monetary assets)
 The Money Supply Function is thus vertical at a given quantity of money, and
shifts left or right when the nominal money supply contracts or expands as a
consequence of monetary policy decisions.
𝑀𝑆
 Consider Real Money Supply ( ) i.e. Nominal Money Supply divided by
𝑝
the price level
 If the MS (Nominal Money Stock goes up by a percentage significantly higher
than the price level) the Real Money Supply goes up—If the Price Level (P)
falls (i.e. p gets smaller,) the real money supply goes up and vice-versa.
 When Banks holds excess reserves, the effective money supply is lower than
it would have been without excess reserves (i.e. when only exogenous policy
factors play a role): Bank hold excess reserves because:
o Of Security: in periods of uncertainty excess reserves provides such
security.
o Excess reserves also provides a buffer to protect a Bank against
unexpectedly large withdrawals of funds by its clients: this is important
especially when the Repo-rate is high, Banks want to ensure that they
are not subjected to High Reserve Bank accommodation interest rates,
when they appeal to the Reserve Bank for assistance (Accommodation).
 To hold excess reserves, Banks have to forego the interest that they might
have earned if they had extended credit: The interest rate is the Opportunity
cost of holding excess cash reserves.
 High interest rates as such will likely discourage holding of Excess Cash
Reserves and encourage maximum lending. Lower interest rates can induce
Banks not to lend to the fullest extent.
o This suggests the possibility of a positive relationship between the
Interest Rate and Money Creation (extension of credit by Commercial
Banks) hence a slightly positive sloping Money Supply Function, at
least up a Ceiling (The Cash Reserve Requirement).
o The Money Supply Function will thus have an upward sloping function
up to the interest rate maintained by the Ceiling (the Cash Reserve
Requirement),
o The slope of this curve will be a function of the responsiveness of the
rate of interest (interest responsiveness of the money supply).