Money and the Money and the Philippine Philippine

Monetary SystemMonetary SystemManagement 4Management 4

Basic FinanceBasic Finance

Lourdes CollegeLourdes College

2 August 20112 August 2011

SignificanceSignificance Some of the more controversial economic Some of the more controversial economic

issues involve the conduct of monetary issues involve the conduct of monetary policy as it is used to deal with inflation, policy as it is used to deal with inflation, budget deficits, unemployment, incomes, budget deficits, unemployment, incomes, international economic relationships, etc. international economic relationships, etc.

Monetary policy has profound effects on Monetary policy has profound effects on our jobs, incomes, livelihood, and career our jobs, incomes, livelihood, and career choices.choices.

This chapter, therefore, introduces the This chapter, therefore, introduces the role and functions of money in the role and functions of money in the economic systemeconomic system

OutlineOutline

evolution of money and modern evolution of money and modern payment systems payment systems

basic insights as to why people and basic insights as to why people and firms hold money (demand for money). firms hold money (demand for money).

determinants of money supply, the determinants of money supply, the simple "creation of money" by a system simple "creation of money" by a system of banks of banks

major instruments or tools that the major instruments or tools that the Bangko Sentral ng Pilipinas (BSP) uses Bangko Sentral ng Pilipinas (BSP) uses for monetary control.for monetary control.

Definition of MoneyDefinition of Money

Money serves as means of payment or Money serves as means of payment or temporary store of value.temporary store of value.

Money is an Money is an asset asset which is anything that which is anything that serves as a means to store value over a period serves as a means to store value over a period of time. of time.

Economists have not really agreed on a single Economists have not really agreed on a single definition but they agree that money supply definition but they agree that money supply refers to all things refers to all things generally acceptable generally acceptable in in payment of debt (store of value) and as payment of debt (store of value) and as payment for goods and services (medium of payment for goods and services (medium of exchange) whatever its legal status may be.exchange) whatever its legal status may be.

Functions of MoneyFunctions of Money Money serves as a Money serves as a unit of account – unit of account – Money Money

represents an item with which the values of all represents an item with which the values of all other goods and services are expressed or other goods and services are expressed or quoted. quoted.

Money serves a Money serves a medium of exchange. medium of exchange. This This means that money is an accepted means of means that money is an accepted means of payment for goods and services.payment for goods and services.

Money serves as a Money serves as a store of value store of value (and a (and a standard of deferred payment). standard of deferred payment). Money can be kept today (i.e., stored) and spent at a Money can be kept today (i.e., stored) and spent at a

later period. It also implies that goods can be bought later period. It also implies that goods can be bought today and paid for at a later date (deferred payment).today and paid for at a later date (deferred payment).

However However inflation, inflation, may decreases the ability of money may decreases the ability of money to act as a store of value and deferred payment.to act as a store of value and deferred payment.

Evolution of MoneyEvolution of Money Autarky Autarky refers to a family or tribal group, which, refers to a family or tribal group, which,

in the absence of trade, produces that level of in the absence of trade, produces that level of goods and services equal to their consumption; goods and services equal to their consumption; the output of production is then shared the output of production is then shared according to the group's distribution rules. according to the group's distribution rules. Money is not used.Money is not used.

Barter systemBarter system involves trading of goods and involves trading of goods and services for other goods and services. Money is services for other goods and services. Money is not used but the barter system requires a not used but the barter system requires a double double coincidence of wants.coincidence of wants.

Evolution of MoneyEvolution of Money Commodity MoneyCommodity Money - overcame the inconveniences - overcame the inconveniences

that went with barter system by using uncoined that went with barter system by using uncoined metals like gold, silver or copper. metals like gold, silver or copper. had the advantage of ease of transport and durability. had the advantage of ease of transport and durability. new set of problems came up with the use of uncoined new set of problems came up with the use of uncoined

metals such as adulteration (impurities in content) and short metals such as adulteration (impurities in content) and short weighing by unscrupulous traders.weighing by unscrupulous traders.

Coinage Coinage solved the problem of adulteration and solved the problem of adulteration and short weighing, with the king's seal being stamped short weighing, with the king's seal being stamped on the metals for authentication. However, some on the metals for authentication. However, some more problems came up like storage, theft, costly more problems came up like storage, theft, costly and risky transport, and so on.and risky transport, and so on.

IOU'sIOU's tend to minimize risk in transport since coins tend to minimize risk in transport since coins were left to a reputable person with were left to a reputable person with "vault "vault or or safekeeping" safekeeping" means. IOU's means. IOU's ("I owe you") ("I owe you") were simply were simply written on paper/receipt instead of going to the written on paper/receipt instead of going to the safekeeper to transact.safekeeper to transact.

Evolution of MoneyEvolution of Money Bank noteBank note involves the promise to pay a debt (IOU) involves the promise to pay a debt (IOU)

which is evidenced by a piece of paper backed by which is evidenced by a piece of paper backed by specie.specie.

Specialized BankersSpecialized Bankers evolved because it was evolved because it was observed that not all people who observed that not all people who "deposited" "deposited" their their money were demanding payment at the same time. money were demanding payment at the same time. Hence, there was no need to hold all the gold/silver Hence, there was no need to hold all the gold/silver pieces all the time. The idea of lending out a portion pieces all the time. The idea of lending out a portion of the entrusted money for a fee while holding on to of the entrusted money for a fee while holding on to the rest for safe keeping paved the way for fractional the rest for safe keeping paved the way for fractional reserve banking.reserve banking.

Electronic Funds Transfer SystemElectronic Funds Transfer System (EFTS)- (EFTS)- Electronic money make use of computer terminals for Electronic money make use of computer terminals for transactions and automated computer clearing house transactions and automated computer clearing house that does away with a physical medium of exchange.that does away with a physical medium of exchange.

Demand for Money – Why to Demand for Money – Why to people hold money?people hold money?

Transactions Demand for Money Transactions Demand for Money - arises from - arises from the need of households and firms to have money for the need of households and firms to have money for the regular payments of goods and services the regular payments of goods and services

Precautionary Demand for Money – Precautionary Demand for Money – Households want extra money for Households want extra money for contingenciescontingencies like paying like paying

bills for the unexpected hospitalization of a family member.bills for the unexpected hospitalization of a family member. Firms, likewise, will desire to extra cash to prepare Firms, likewise, will desire to extra cash to prepare

themselves for untoward events like labor strikes. themselves for untoward events like labor strikes. Speculative or Portfolio Allocation Motive - Speculative or Portfolio Allocation Motive - the the

speculative demand stems from the preference of speculative demand stems from the preference of households and firms to hold other assets that are households and firms to hold other assets that are "perfectly liquid and perfectly free from risk of "perfectly liquid and perfectly free from risk of depreciation in terms of money" in order to "take depreciation in terms of money" in order to "take advantage of market movements." advantage of market movements."

Demand for MoneyDemand for Money

Demand for money is primarily determined Demand for money is primarily determined by by the level of real output or income the level of real output or income and the and the interest rate. interest rate.

Other factors:Other factors: (a) credit availability and affordability; (a) credit availability and affordability; (b) expectations on future income; (b) expectations on future income; (c) expectations on prices; (c) expectations on prices; (d) risk and expected returns on alternative (d) risk and expected returns on alternative

assets; and assets; and (e) financial innovations that allow easy movement (e) financial innovations that allow easy movement

of funds from less liquid to more liquid forms. of funds from less liquid to more liquid forms.

Supply of MoneySupply of Money M1 M1 consists of items used as medium of consists of items used as medium of

exchange such as currency or coins in exchange such as currency or coins in circulation and demand deposits.circulation and demand deposits.

M2 M2 consists of consists of M1M1, plus savings and small , plus savings and small time deposits.time deposits.

M3 M3 refers to money supply, peso savings, refers to money supply, peso savings, negotiable order of withdrawals (NOW negotiable order of withdrawals (NOW accounts), time deposits and deposit accounts), time deposits and deposit substitutes of money-generating banks.substitutes of money-generating banks.

RM RM or or reserve money reserve money represents liabilities of represents liabilities of the Bangko Sentral ng Pilipinas (Central Bank) the Bangko Sentral ng Pilipinas (Central Bank) to the public sector in the form of currency in to the public sector in the form of currency in circulation and to the banking sector inthe circulation and to the banking sector inthe form of cash reserves.form of cash reserves.

Instruments of Monetary Instruments of Monetary ControlControl

The Bangko Sentral ng Pilipinas is the The Bangko Sentral ng Pilipinas is the central monetary authority that governs the central monetary authority that governs the level of money supply through policies set by level of money supply through policies set by the Monetary Board, the BSP's policy-the Monetary Board, the BSP's policy-making arm.making arm.

Its primary objective is to maintain price Its primary objective is to maintain price stability and the convertibility of the peso. stability and the convertibility of the peso.

It makes use of monetary instruments It makes use of monetary instruments 1.1. reserve requirement reserve requirement (rr), (rr),

2.2. rediscount rate rediscount rate (i(iDRDR), ), and and 3.3. open market operations open market operations (OMO), (OMO), among others, to among others, to

control the supply of money.control the supply of money.

Instruments of Monetary Instruments of Monetary ControlControl

1. Reserve Requirement (rr) 1. Reserve Requirement (rr) – what banks – what banks are required to keep in reserve (in their vaults)are required to keep in reserve (in their vaults) the BSP the BSP lowers lowers the reserve requirement if it wants to the reserve requirement if it wants to

engage in an engage in an expansionary expansionary monetary policy, that is, if monetary policy, that is, if it wants to increase money supply in circulation. This it wants to increase money supply in circulation. This is so because a decrease in reserve requirement is so because a decrease in reserve requirement means that banks shall have more deposits available means that banks shall have more deposits available for lending. for lending.

On the other hand, if the BSP wants to contract On the other hand, if the BSP wants to contract money supply, perhaps to "mop out excess liquidity" money supply, perhaps to "mop out excess liquidity" in the economy, it will have to increase the reserve in the economy, it will have to increase the reserve requirement so that more deposits are kept in the requirement so that more deposits are kept in the banks' vaults. banks' vaults.

Instruments of Monetary Instruments of Monetary ControlControl

2. Rediscount rate2. Rediscount rate is the rate of interest is the rate of interest that the BSP lends to banks. that the BSP lends to banks. The BSP increases the rediscount rate if it The BSP increases the rediscount rate if it

wants to contract money supply and decreases wants to contract money supply and decreases it if it wants to increase money supply. it if it wants to increase money supply.

When there is an increase in the rediscount When there is an increase in the rediscount rate, banks are discouraged from borrowing rate, banks are discouraged from borrowing funds from the BSP since it is more expensive funds from the BSP since it is more expensive to borrow. Banks will therefore have the to borrow. Banks will therefore have the tendency to increase their excess reserves to tendency to increase their excess reserves to refrain from having to make loans with BSP.refrain from having to make loans with BSP.

Instruments of Monetary Instruments of Monetary ControlControl

3. Open market operations (OMO)3. Open market operations (OMO) – – means the means the buyingbuying and and sellingselling of government securities to the of government securities to the publicpublic By open market By open market purchase, purchase, we refer to the BSP's we refer to the BSP's buying buying of of

government securities (e.g., bonds) from private individuals. government securities (e.g., bonds) from private individuals. By open market By open market sale, sale, we mean the BSP's we mean the BSP's selling selling of of

government securities (e.g., bonds) to private individuals. government securities (e.g., bonds) to private individuals. Thus, if the BSP wants to Thus, if the BSP wants to expand expand money supply, it money supply, it

will engage in open market will engage in open market purchase purchase of bonds. This of bonds. This way, the BSP releases money into the economy in way, the BSP releases money into the economy in exchange for government securities. On the other exchange for government securities. On the other hand, if the BSP thinks that there is too much money hand, if the BSP thinks that there is too much money circulating in the economy, and therefore needs to circulating in the economy, and therefore needs to contract it, then the BSP will engage in an open contract it, then the BSP will engage in an open market market sale sale of government securities.of government securities.

Monetary Equilibrium Monetary Equilibrium Simplifying assumptions: that the price level Simplifying assumptions: that the price level

(P) and the level of real income (P) and the level of real income (Y(Y) are given or ) are given or fixed. This assumption will imply that the fixed. This assumption will imply that the demand for money will be just a function of the demand for money will be just a function of the interest rate. interest rate.

Demand for real money balances increases as Demand for real money balances increases as the interest rate decreases since the the interest rate decreases since the opportunity cost of holding money is lower. opportunity cost of holding money is lower.

Supply of money is upward sloping which Supply of money is upward sloping which implies that as the interest rate increases, implies that as the interest rate increases, banks will hold less reserves, thus increasing banks will hold less reserves, thus increasing the money multiplier and consequently raising the money multiplier and consequently raising money supply.money supply.

MS

MD

i*

iIn

tere

st R

ate

E

Stock of Money

FIGURE 12.1. Money equilibrium.

M/P*

M/P

Money equilibrium• Demand for money (MD) is shown as a

downward sloping curve that is inversely proportional to the interest rate i. This means that as the interest rate increases, the demand for real money balances decreases since the opportunity cost of holding money is lower.

• The supply of money (MS) is assumed to be an increasing function of the interest rate .

• In equilibrium, MD = MS and the equilibrium interest rate (i*) and the stock of money (M*/P) are determined at the point of intersection, E.

Simple Money Creation:Simple Money Creation:How do Banks “Create” How do Banks “Create”

Money?Money? It takes a system of banks and not just a single It takes a system of banks and not just a single

bank to create money.bank to create money. ““Money CreationMoney Creation“ refers to the multiple “ refers to the multiple

expansion of deposits. expansion of deposits. Simplifying assumptions:Simplifying assumptions:

1.1. depository institutions (e.g., banks) issue only depository institutions (e.g., banks) issue only transaction accounts;transaction accounts;

2.2. all banks face the all banks face the same same reserve requirement reserve requirement of eg. 10 percent of eg. 10 percent

3.3. banks have no desire to hold excess reservesbanks have no desire to hold excess reserves4.4. the public currency-deposit ratio is zero the public currency-deposit ratio is zero 5.5. Initial amount of P1000 is deposited in bank A.Initial amount of P1000 is deposited in bank A.

Table 12.1 The Money Creation Process (figures in pesos)\

BankAdditional transaction

Deposits received

Additional Loans Made

Additional Required

Reserves (rr = 10%)

A 1,000 900 100

B 900 810 90

C 810 729 81

- - - -

- - - -

Total, first 3 banks 2,710 2,439 271

Other banks’ turn 7,290 6,561 729

Grand Total 10,000 9,000 1,000

SUMMARYSUMMARY There is no single definition of money but economists There is no single definition of money but economists

agree that money supply refers to all things agree that money supply refers to all things generally generally acceptable acceptable in payment of debt (store of value) and as in payment of debt (store of value) and as payment for goods and services (medium of payment for goods and services (medium of exchange) whatever its legal status may be.exchange) whatever its legal status may be.

There are three (3) general functions of money: There are three (3) general functions of money: (a) Money serves as a (a) Money serves as a unit of account, unit of account, which means it which means it

represents an item with which the values of all other goods represents an item with which the values of all other goods and services are expressed or quoted; and services are expressed or quoted;

(b) Money serves a (b) Money serves a medium of exchange medium of exchange which implies that which implies that money is an accepted means of payment for goods and money is an accepted means of payment for goods and services; services;

(c) Money serves as a (c) Money serves as a store of value store of value (and a (and a standard of standard of deferred payment). deferred payment). This means that money can be kept today This means that money can be kept today (i.e., stored) and spent at a later period of time with the (i.e., stored) and spent at a later period of time with the assurance that the same amount of goods and services that assurance that the same amount of goods and services that money can buy today can still be bought at that future period money can buy today can still be bought at that future period of time.of time.

SUMMARYSUMMARY Most modern payment systems nowadays rely on credit Most modern payment systems nowadays rely on credit

money and electronic money because over time, people money and electronic money because over time, people have realized the various advantages that a money have realized the various advantages that a money economy has provided, i.e., with money, the condition of economy has provided, i.e., with money, the condition of a double coincidence of wants that is a necessary a double coincidence of wants that is a necessary requirement in barter trading has been eliminated. requirement in barter trading has been eliminated. Furthermore, money facilitates exchange and reduces Furthermore, money facilitates exchange and reduces costs associated with previous payment systems.costs associated with previous payment systems.

The demand for money is said to be a demand for "real The demand for money is said to be a demand for "real balances", i.e., it is the purchas ing power and not the balances", i.e., it is the purchas ing power and not the number of peso bills or coins that matters to holders of number of peso bills or coins that matters to holders of money. How much money is held depends upon three money. How much money is held depends upon three motives: (a) transactions motive; (b) precautionary motives: (a) transactions motive; (b) precautionary motive; and (c) speculative or portfolio allocation motive. motive; and (c) speculative or portfolio allocation motive. The demand for money is primarily determined by the The demand for money is primarily determined by the level of real output or income and the interest rate.level of real output or income and the interest rate.

SummarySummary Money supply is determined by the behavior of three principal Money supply is determined by the behavior of three principal

agents - the public, the banks, and the BSP. The public affects agents - the public, the banks, and the BSP. The public affects money supply through their demand for currency and deposits as money supply through their demand for currency and deposits as represented by the currency-deposit-ratio. On the other hand, represented by the currency-deposit-ratio. On the other hand, the banks' behavior may be represented by the reserve-deposit the banks' behavior may be represented by the reserve-deposit ratio where bank reserves refer to coins and paper bills that are ratio where bank reserves refer to coins and paper bills that are held by banks and those which they deposit with the BSP. The held by banks and those which they deposit with the BSP. The BSP's behavior affects the stock of high-powered money or the BSP's behavior affects the stock of high-powered money or the monetary base and it is through this that the BSP affects money monetary base and it is through this that the BSP affects money supply. The stock of high-powered money consists of currency supply. The stock of high-powered money consists of currency that is partly held by the public and partly held by banks as that is partly held by the public and partly held by banks as reserves.reserves.

The stock of money (M) and the stock of high-powered money or The stock of money (M) and the stock of high-powered money or monetary base (H), are linked by the money multiplier. The monetary base (H), are linked by the money multiplier. The money multiplier is just a ratio of money multiplier is just a ratio of M M to to H H and it is also the factor and it is also the factor by which by which M M will change given a change in will change given a change in H.H.

The BSP makes use of monetary instruments such as the reserve The BSP makes use of monetary instruments such as the reserve requirement requirement (rr), (rr), re discount rate (ire discount rate (iRDRD) and open market ) and open market operations (OMO), among others, to control the supply of money.operations (OMO), among others, to control the supply of money.