1. The market economy

Monetary policy in South Africa is based on the assumption that this country has, wants and will maintain, an economy that is based on the principles of the free market. This does not mean that the South African economy represents the ideal example of the text book definition of a free market. There are many deficiencies in the structure of the economy that deviate from the strict requirements of free competition, restrictions that were created by past socio-economic policies, that reflect the undeveloped stage of major parts of the country, and that form an integral part of the complexity of the composition of the total population.

However, the assumption recognises the many tested and proven advantages of the market economy, and the objective is to adhere to the principles of a market economy with the implementation of monetary policy for as far as this is possible and feasible. Deviations will and often do occur from the basic principles of the market economy, but such deviations should in all cases be treated with circumspection, and corrective policy measures should continuously be directed towards the gradual removal of the underlying deficiencies in the structure of the economy.

The market economy is based on the principles of private ownership, and on the guidance of macro-economic decisions by private initiatives. This does not rule out a role for government -- even in those countries that are the biggest proponents of the market economy, governments take an active part in major issues such as public administration, security, health care and social services. In most countries, governments also take a more or a less active part in total economic activity. The important issue is, however, that even government economic activity should be guided by the sound principles of a market economy, for only then will the country be able to obtain maximum wealth for all of its people.

The market economy also requires well-functioning and efficient markets, for it is only through markets where information can be disseminated, analysed and assessed by the many participants in the economy, each one acting in his own interest. As Adam Smith already argued con-vincingly in the eighteenth century, it is through the "invisible hand" of the market system that optimum economic growth and development will be obtained. Here again there is a role for government to play, namely to encourage the development of the markets, to improve competition and to raise the quality of the decision making process in the market place.

Finally, the market economy needs competition. In many countries the size of the economy may often be too small to support effective competition in domestic economic activity, but the opening-up of the economy to international participation can bring even to such countries the advantages of a global free market economy.

These then, are the basic principles on which the model for monetary policy in South Africa has been based:

• private ownership;

• efficient market systems, and

• effective competition by domestic and international participants.

2. The function of monetary policy

In terms of the South African Reserve Bank Act and of the Constitution of the Republic of South Africa, the primary objective of the Reserve Bank must be "to protect the value of the currency of the Republic in the interest of balanced and sustainable economic growth in the Republic".

Although the legislation provides for some autonomy for the Reserve Bank to pursue its objective, the Bank has no freedom to set its own goals -- its primary and only goal has been defined for it by Parliament. The Reserve Bank must protect the value of the currency, that is, must work against inflation.

In terms of the Reserve Bank Act, the Bank is accountable to Parliament and must, from time to time, report to Parliament on progress made with the achievement of its mandate, namely to protect the value of the currency. The Bank on its own cannot prevent the development of all inflationary pressures in the economy, but must at all times use the powers at its disposal to prevent such forces from eroding the value of the currency. The Reserve Bank's powers are, however, restricted to the area of money creation and financial activities related to this very important function conferred upon central banks in all market economies. The Reserve Bank therefore operates mainly in the financial system in pursuing its objective of protecting the value of the currency.

Money plays a vital role in the market economy. As a means of payment, it facilitates the exchange of goods and services which would, without money, only be tradeable in complex barter deals. As a store of value, it enables purchasing power to be accumulated and to be held for future use. Money indeed enables the market economy to work. Money must, however, be trusted by the public, and must hold its value to retain this trust: without trust, money will not be able to fulfil its functions as a means of payment and as a store of value. The task of the central bank to protect the value of money is therefore indeed an assignment to protect the market economy.

3. The Reserve Bank and money creation

The South African financial system is very well-developed and money is created mainly by private banking institutions that create money (or purchasing power) for their clients by extending loans or by buying non-money assets in exchange for money. The ability of banks to create money is, in turn, dependent on the amount of primary money that the Reserve Bank will at any time be prepared to make available to them.

The measurement of the money supply, the appropriate definition of the money supply, and the relationship between central bank primary money and the total money supply, are subjects economists like to argue and disagree about, often to the confusion of the general public. Most economists that support the principles of the market economy will agree, however, that in the fight against inflation, the money supply does matter, and that it is important for the central bank to exercise some constraint on the amount of money that is being made available for spending.

The South African Reserve Bank therefore sees it as its main function in pursuing its objective of fighting inflation to control the rate of increase in the money supply. This it must do, firstly, by restricting the amount of liquidity available to the banking system, and secondly, by influencing the total demand for money, emanating from both the private and the public sectors.

4. The Reserve Bank and money creation

The Reserve Bank's policy to control the money supply has direct consequences for the level of interest rates in the country. Interest rates, like all other prices in the market economy, are determined by the forces of demand and supply; in this case, the demand for, and the supply of, loanable funds. Barring money creation through the banking system,the level of interest rates will be determined primarily by total saving in the economy, and by the demand for funds emanating from Government (to finance the budget deficit), from private individuals (for consumption), and from businesses (for investment in capital goods and inventories).

If the total demand for funds exceeds the total supply, the price of loanable funds, that is the interest rate, will go up. In a closed economy, this will encourage more domestic saving and depress expenditure to find an eventual equilibrium in the financial market. In an open economy, the higher interest rates will also attract funds from the outside world to supplement the insufficient savings within the country, and an equilibrium interest rate will be found at a lower level.

The introduction of a central bank with the power to create the money needed as a lubricant to facilitate the exchange of goods and services in the market economy, confuses the general public in understanding this basic principle of the market economy. Central banks can influence the level of interest rates by adding to the amount of available loanable funds, not by increasing genuine savings generated in the production of goods and services, but rather through the creation of new money. Potential borrowers will therefore almost always exert pressure on central banks to establish an artificially lower level of interest rates by adding more newly created money to the supply side of the market formula for the determination of the price of loanable funds.

Such a policy, however, is a paradox, for the creation of an excessive amount of money through the banking system will lead to higher inflation, and higher inflation will cause nominal and real interest rates to rise. In its effort to reduce interest rates below the market level of equilibrium, the central bank will indeed renounce its prime responsibility of protecting the value of the currency. No government can instruct its central bank to protect the value of the currency, and at the same time expect of the central bank to maintain an artificially low level of interest rates in the country, particularly not if the virtues of the market economy should at the same time also be preserved.

5. Interest rates in South Africa

In South Africa, there is almost always serious disequilibrium between the amount of loanable funds demanded by government, businesses and private individuals on the one hand, and the supply of funds made available through saving out of current income, on the other. In this situation, there is continuous upward pressure on the level of interest rates.

South African interest rates, measured in real terms, that is after adjustment for the current level of inflation of between 6 and 8 per cent, are extremely high. It is understandable that, in the situation of relatively low saving, not all demands for loanable funds can be met, and also that continuous pressure is therefore being exerted on the Reserve Bank to create more money. Over the past twelve months, however, the total money supply has already risen by more than 15 per cent, which is extremely high if compared with the current rate of inflation, plus real growth of only about 4 per cent in the economy. If anything, monetary policy has already gone too far in accommodating some excess demand for funds, and the Reserve Bank is already risking the negligence of its prime responsibility, namely to protect the value of the currency.

In this situation, it is extremely frustrating for a central banker to be accused almost on a daily basis of running an undesirably "high-interest-rate policy". Economists, business people and politicians, who claim to be supporters of the market economy, often fail to understand the basic principles of demand and supply when it comes to the pricing of money. The most formidable adversaries of inflation often fail to understand that they invite more inflation by demanding lower interest rates, to be created or maintained even against the underlying trends of the market economy. The politicians who instruct the central bank to protect the value of the currency, and then press for factitiously low interest rates, do not understand that they are asking for the impossible.

6. Concluding remarks

It is against this background of almost permanent frustration that the South African Reserve Bank must pursue its imposed obligation of protecting the value of the rand -- an obligation that is not achievable unless we are prepared to restrict the rate of growth in the money supply more or less to the level of growth in the real economy, plus a small margin for a tolerable low rate of inflation (more or less in line with the average rate of inflation in the economies of our major trading partners). And this will not be possible unless we are prepared to accept realistic interest rates that reflect the underlying demand for, and supply of, loanable funds.

For this reason, I am particularly grateful to the Rotary Club of Johannesburg for presenting me with the "Achiever of the Year Award". I accept it also on behalf of all my colleagues in the Reserve Bank who are devoting their skills, their knowledge, and their wisdom, to the great but difficult and often ungrateful task of protecting the value of the South African currency.

It was no easy task to reduce inflation in South Africa to its present level of only about 6 per cent. It will be no easy task to keep it at this level, which is low in terms of South African standards, but still high in the context of the world economy. We in the Reserve Bank thank you, the Rotary Club of Johannesburg, for your encouragement.