ECS AND 2021 (ALL)MEMO AND NOTES SUMMARY AND MORE EXAMINATION QUESTIONS AND ANSWERS ALSO MEMO MANY SUMMARY NOTES (95% PASS RATE)

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. 121 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. 122 3.4 Explain the meaning of the following terms as well as its advantages/disadvantages in facilitating payments: (15) Description Advantages Disadvantages Commodity Money: money made up of precious metals or other valuable commodities. An early medium of exchange that was universally acceptable. This form of money is very heavy and is hard to transport from place to place. Fiat Money: paper currency decreed by government as legal tender. It is largely dependent upon trust of the value of the currency. Much lighter than precious metals or even coins. Easily stolen. Can be expensive to transport in large quantitites. Cheques: an instruction from you to your bank to transfer money from your account to someone else’s account. Allow transactions to take place without carrying around large sums of money. Improved the efficiency of the payment system. Loss from theft is greatly reduced. Takes time to get cheques from place to place. The administration required to support the use of cheques is expensive. Electronic payments: transmit payments via the internet. “Money” moves directly from one persons account to that of another. It is quick and efficient. It is a cheap means of payment. Problems of making errors in transmission do exist and are really difficult to reverse. While security is good, there is a risk of “hackers” being able to intervene in transactions. E-Money: substitute for cash and exists only in electronic form. The debit card is a form of e-money. Efficient and convenient. Expensive to set up. Electronic means of payment raise security and privacy concerns. Leaves an electronic trail which contains personal data. 123 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 = 124 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. 125  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 126 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. 127 [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. 128 A normal yield curve: 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 Yield to Maturity Term to Maturity 129 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:130  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.131 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.132  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 133 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 134 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.135 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 136 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 137 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 138 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. 139 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”.