Monetary Policy

Monetary policy is a broad concept covering a number of measures implemented by the South African Reserve Bank to achieve its economic objectives. These objectives are regulating price fluctuations (controlling inflation); the balance of payments; the international value of the rand; and employment.

The idea is that by stabilising the short-term performance of these variables, the monetary policy aims to affect the money supply, credit extension by financial institutions to borrowers and interest rates.

One of the decisions the Reserve Bank has to make, which are often debated, is what to do with the interest rate. Some factors that play a role in determining the level of long-term interest rates include:

• Perceptions about the stability of the South African economy
• Expectations about the inflation
• Short-term interest rates

If the economy is perceived to be stable, and if inflation as well as short–term interest rates are expected to fall, long term interest rates tend to decrease.

On the other hand, if the South African economy is seen to be unstable and an increase in inflation and short-term interest rates are expected, long-term interest rates usually rise.

Now you may ask the question: How can a rise in interest rates in the USA cause the rand to depreciate which, in turn, may lead to higher inflation in South Africa and a renewed bout of rand depreciation?

Click here to view a video that explains the impact of a depreciation of the Rand/Dollar exchange rate on exports and imports.

Let’s assume that the prime overdraft rate in South Africa is 15% and in the USA 12%. A South African importer wishes to buy goods abroad, but he needs to borrow money to finance his purchases. Assuming that he has access to foreign financing, he would prefer to borrow the money from a bank in the USA – it is cheaper. In this case, foreign funds are used to finance South African imports and there will be no outflow of Rands. If the prime rate in the USA rises to 18%, while the South African prime rate remains unchanged at 15%, local importers will prefer to borrow money from South African banks. These Rands are offered in exchange for Dollars (used to buy the goods from sources overseas). This means that Rands become cheaper – the rand depreciates. And if the rand depreciates significantly, inflation rates often rise; which can lead to further depreciation of the Rand.

So, because the rising of foreign interest rates can lead to the depreciation of the rand and even a rise in inflation, you will find that the Reserve Bank may decide to raise local interest rates should the interest rates in the USA, the European Union, Japan or England (some of our major trading partners) rise.

Next time you listen to the economic news or read the financial pages of the newspapers, you will have a good idea of what’s being said or written!