Address by Dr Chris Stals, Governor of the South African Reserve Bank, at a Pretoria News/MBA Executive Breakfast Club, Pretoria. 1. The role of interest rates in a market economyThe interest rate is one of the most important prices in the market economy. It represents the price of loanable funds and, like all other prices, has a fundamental role to play in the allocation of a scarce commodity, and in the determination of the amount that will be supplied, on the one hand, and of the amount that will be demanded, on the other, of this special commodity.The main source of loanable funds is saving by the community; the demand comes mainly from consumers, investors and governments that borrow funds to finance their expenditure. If the demand increases without a balancing increase in supply, the price of the commodity, that is the interest rate, will rise. If supply grows faster than demand, or demand declines to a lower level with no change in supply, interest rates will decline.This very simple and basic economic law of demand and supply is complicated, in the case of interest rates, by the process of the creation of new money, by capital inflows from and outflows to the rest of the world, and by inflation. The layman often finds it difficult to see beyond the veils surrounding interest rates and to accept the normal demand and supply disciplines of the market economy, particularly when it comes to the pricing of this very special commodity traded in the financial markets as loanable funds.In South Africa, where the economy is based primarily on the foundations of a market structure, interest rates are determined in well-developed and well-functioning financial markets to reflect underlying demand and supply conditions. But, unfortunately, the South African economy operates in a financial environment where the demand for funds chronically exceeds a relatively limited supply. Total domestic saving of the private sector now amounts to about 20 per cent of gross domestic product. Government requires about 5 per cent of gross domestic product to cover the annual deficit on the budget, which leaves only about 15 per cent of gross domestic product for investment in the private sector. And yet, this country needs investment of at least 25 per cent of gross domestic product every year to increase the production capacity and to create new jobs for the growing population.Unless the low level of domestic saving can therefore be supplemented with a regular large net inflow of real long-term investment funds from the rest of the world, equal to about 10 per cent of the South African gross domestic product of R500 billion per annum, there will be a continuous upward pressure on interest rates. This is the built-in self-regulating force of the market economy. Higher interest rates must encourage more saving, and discourage the excessive demand for funds emanating from government and the private sector. High interest rates therefore depress the economy, restrict new investment and consumption, and make it more difficult for governments to finance budget deficits. High interest rates represent one of the most important disciplinary actions of the market economy to bring about better balance between the demand for, and the supply of, loanable funds. It is understood and accepted that high interest rates hurt the economy, but this is, after all, what they are intended to do. 2. Can the Reserve Bank create lower interest rates ?The Reserve Bank is a special institution that has been given the power to create money, and to control the creation of money by other banking institutions. This power, conferred on the South African Reserve Bank by Parliament in 1920, gives the Bank a powerful position in the economy, but also a great responsibility. This responsibility has been clearly identified and was included in the Reserve Bank Act, and also in the Constitution of the Republic of South Africa. It is to protect the value of the currency.The South African legislation does not provide any specific target for inflation, but it is clearly understood t