Monetary policy and the control of money in South Africa
The South African Reserve Bank (SARB ) controls money using inflation. The SARB tries to achieve its inflation target by employing the instruments of monetary policy: the repo rate and the open-market operations. We shall look at each in turn:
-Repo rate> Repo rate is the rate at which the bank borrows money from the SARB, so the repo rate is the borrowing cost of money for banks. Like any good business, a bank will buy at a low price and sell at a high price. The average rate at which banks lend money to their clients is called the prime rate. So if banks borrow money from the SARB at a repo rate of 8%, they will lend that money to their clients at more than 8%, say at a prime rate of 11%, and make a 3% profit. If the SARB increases the repo rate to 9%, banks will increase their prime rate to 12% in order to maintain their profit margins. The repo rate therefore becomes the anchor for all other interest rates in the money and financial markets.
The word ‘repo’ is short for ‘repurchase’. When banks borrow money from the SARB, they have to sell at low-risk financial instruments (such as government bonds0 to the SARB as collateral for the money that they borrow. At the same time banks agree to buy these financial instruments back at a high price in the future. By buying back financial instruments at a higher price, banks make a loss. The loss as a percentage of the initial loan is equal to the repo rate.
If the SARB expects inflation to increase, it will increase the repo rate. the SARB’s thinking is that the higher repo rate will cause banks to increase their prime rates, thus making credit more expensive. Consumers and firms will borrow less, leading to lower consumer spending and lower real investment, and lower real investment, and lower demand for all goods, services and assets. Lower demand will cause prices to fall or increase at a slower rate, thus reducing inflation. The process through which interest rate affects the real sector is called transmission mechanism.
-Open-market operations> open-market operations involve buying and selling of financial instruments (like government bonds and foreign exchange) by the SARB. If the SARB expects inflation to rise, it will sell financial instruments to the banks. By selling, the SARB provides financial instruments to the banks and the banks have to give money in return. The money that the SARB receives from the banks is thereby removed from the financial system, and the supply of money falls. Lower money supply will put upward pressure on the interest rate and the downward pressure on the inflation rate.