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ECS3701
Monetary Economics
Assignment 02
2.1. Three tools that the South African Reserve Bank (SARB) can use to decrease inflation include\
Interest rate
Open market operations, and
Reserve requirement
Interest Rate Policy: The SARB can increase the interest rate. This in turn makes it expensive to
borrow money, and reduces lending and borrowing. Households and firms borrow less and this
reduces aggregate demand in the economy. An increase in interest rate also curtails the ability of
banks to lend money, there money supply decreases, leading to low aggregate demand
Open Market Operations (OMO): SARB can decide to use OMO to decrease inflation by selling
government bonds and securities. This reduces money supply in the economy. A decrease in
money supply lead to a decrease in the amount of money in circulation and available for spending,
which can help lower inflation.
Reserve Requirements: SARB can increase the reserve requirement. This requirement mandates
commercial banks to hold a higher percentage of deposits received. This reduces the amount of
money available for lending, thereby decreasing the money creation process and reducing
inflation.
, There are adverse effects associated with using these tools to reduce inflation. Firstly, increasing
the interest rate lead to reduced investment and consumption spending: Higher interest rates lead
to reduced borrowing. A large part of investment and consumption are financed by borrowing,
hence leading to slow economic growth. Reduction in borrowing reduces aggregate demand in the
economy, creating demand deficiency unemployment as businesses may cut back on hiring and
investment.
Increasing the interest also strengthens the domestic currency on the foreign exchange market,
affecting import and export competitiveness. Lastly, OMO can mop out money from the economy,
leading to liquidity crunch in the economy
2.2. Inflation refers to a persistent increase in the general price level. It is a macro-economic
phenomenon. The two main causes of inflation in an economy are
Increases in aggregate demand (demand pull inflation)
Increase in cost of production (cost push inflation)
Demand pull inflation is caused by high aggregate demand which is not matched by commensurate
increase in aggregate supply. The increase in aggregate demand can be triggered by any of the
components of aggregate demand, such as increase in government spending, increase in consumer
spending, increase in foreign demand, decrease in taxes, expansionary monetary (decrease in
interest rates, increase in money supply) and expansionary fiscal policies. An increase in aggregate
demand, without a corresponding increase in aggregate supply will cause the price level to bid up,
thus causing inflation.
Barnett et al., (2020) and Rizvi and Sahminan (2020) attributed South Africa’s inflation to
demand-pull causes. Rising wages, lower interest rates, and increase in export demand were cited
as the chief culprit for rising inflation in South Africa. Barnett et al. (2020) also argued that
inflation in South Africa is exacerbated by an increase in government expenditure cycles that has
the South African government running perennial budget deficit. The economy’s ability to meet the
country’s demand seems less than the demand for goods and services, causing an upward pressure
on prices.
ECS3701
Monetary Economics
Assignment 02
2.1. Three tools that the South African Reserve Bank (SARB) can use to decrease inflation include\
Interest rate
Open market operations, and
Reserve requirement
Interest Rate Policy: The SARB can increase the interest rate. This in turn makes it expensive to
borrow money, and reduces lending and borrowing. Households and firms borrow less and this
reduces aggregate demand in the economy. An increase in interest rate also curtails the ability of
banks to lend money, there money supply decreases, leading to low aggregate demand
Open Market Operations (OMO): SARB can decide to use OMO to decrease inflation by selling
government bonds and securities. This reduces money supply in the economy. A decrease in
money supply lead to a decrease in the amount of money in circulation and available for spending,
which can help lower inflation.
Reserve Requirements: SARB can increase the reserve requirement. This requirement mandates
commercial banks to hold a higher percentage of deposits received. This reduces the amount of
money available for lending, thereby decreasing the money creation process and reducing
inflation.
, There are adverse effects associated with using these tools to reduce inflation. Firstly, increasing
the interest rate lead to reduced investment and consumption spending: Higher interest rates lead
to reduced borrowing. A large part of investment and consumption are financed by borrowing,
hence leading to slow economic growth. Reduction in borrowing reduces aggregate demand in the
economy, creating demand deficiency unemployment as businesses may cut back on hiring and
investment.
Increasing the interest also strengthens the domestic currency on the foreign exchange market,
affecting import and export competitiveness. Lastly, OMO can mop out money from the economy,
leading to liquidity crunch in the economy
2.2. Inflation refers to a persistent increase in the general price level. It is a macro-economic
phenomenon. The two main causes of inflation in an economy are
Increases in aggregate demand (demand pull inflation)
Increase in cost of production (cost push inflation)
Demand pull inflation is caused by high aggregate demand which is not matched by commensurate
increase in aggregate supply. The increase in aggregate demand can be triggered by any of the
components of aggregate demand, such as increase in government spending, increase in consumer
spending, increase in foreign demand, decrease in taxes, expansionary monetary (decrease in
interest rates, increase in money supply) and expansionary fiscal policies. An increase in aggregate
demand, without a corresponding increase in aggregate supply will cause the price level to bid up,
thus causing inflation.
Barnett et al., (2020) and Rizvi and Sahminan (2020) attributed South Africa’s inflation to
demand-pull causes. Rising wages, lower interest rates, and increase in export demand were cited
as the chief culprit for rising inflation in South Africa. Barnett et al. (2020) also argued that
inflation in South Africa is exacerbated by an increase in government expenditure cycles that has
the South African government running perennial budget deficit. The economy’s ability to meet the
country’s demand seems less than the demand for goods and services, causing an upward pressure
on prices.
