MONEY AND MONEY AND MONETARY MONETARY POLICIESPOLICIES

A. Function of Money & A. Function of Money & Money SupplyMoney Supply

Money as a medium of Money as a medium of exchange began to assume exchange began to assume a significant role in the a significant role in the advent of the market advent of the market economy marked by 1-3 economy marked by 1-3 specialization, specialization, interdependence and trade. interdependence and trade.

Money SupplyMoney Supply

Money is a vehicle of Money is a vehicle of economic activities when in economic activities when in circulation (i.e. in the circular circulation (i.e. in the circular flow)flow)

The stock of money serving this The stock of money serving this function is called money supply and function is called money supply and consists of the following:consists of the following:

Coins and Bills in circulation Coins and Bills in circulation

Demand deposits in banks Demand deposits in banks - Savings Deposits - Savings Deposits

- Time Deposits- Time Deposits

Deposit SubstitutesDeposit Substitutes

Dependencies and Dependencies and ResourcesResources

Money Velocity & Money Velocity & IncomeIncome

4. Money Supply as medium of 4. Money Supply as medium of exchange multiplies into income. exchange multiplies into income. The multiplier coefficient is only The multiplier coefficient is only dependent on the rate of money dependent on the rate of money outflow.outflow.

Table 33 represents the country’s Table 33 represents the country’s domestic liquidity from 1981 to 2001. domestic liquidity from 1981 to 2001. The economic crisis in 1997 was marked The economic crisis in 1997 was marked by declining levels of production and by declining levels of production and increasing rates of inflation (price increasing rates of inflation (price increase) and unemployment. increase) and unemployment.

However the overall level of money However the overall level of money supply continued to increase despite the supply continued to increase despite the economic crisis due to two factors. economic crisis due to two factors.

The said overall increase in money The said overall increase in money supply was presumably pocketed by the supply was presumably pocketed by the economy’s big earners and channeled to economy’s big earners and channeled to quasi money. quasi money.

MV = YMV = Y

Y = PQ (Economic Income or Income derived Y = PQ (Economic Income or Income derived from production)from production)

AlternativelyAlternatively

MV= PQMV= PQ

• Where :Where :

• M = Money SupplyM = Money Supply

• V = VelocityV = Velocity

• Y = Nominal Money IncomeY = Nominal Money Income

• P = PriceP = Price

• Q = Volume of Goods and ServicesQ = Volume of Goods and Services

The equation embodies the The equation embodies the quantity theory of money and quantity theory of money and implies that the same level of implies that the same level of money supply increases money supply increases (decreases) in the money (decreases) in the money velocity. velocity.

B. BANKS AND B. BANKS AND MONEY SUPPLYMONEY SUPPLY

The Fractional Reserve The Fractional Reserve SystemSystem

5. Banks are supposed to be a 5. Banks are supposed to be a conduits of funds linking conduits of funds linking investors or borrowers to the investors or borrowers to the sources. As such, they accept sources. As such, they accept deposits which chiefly supply deposits which chiefly supply their lending operations. their lending operations.

However, commercial banks in particular However, commercial banks in particular can create deposit liabilities (i.e. to can create deposit liabilities (i.e. to depositors and borrowers) greater than depositors and borrowers) greater than their their reserves or money in vault reserves or money in vault which is which is the essence of the fractional reserve the essence of the fractional reserve system.system.

Thus, a commercial bank can lend more Thus, a commercial bank can lend more than its actual deposit by creating more than its actual deposit by creating more deposit liabilities while maintaining a deposit liabilities while maintaining a smaller reserve to meet fractional cash smaller reserve to meet fractional cash demand.demand.

TABLE 34TABLE 34

Deposit Liability CreationDeposit Liability Creation

Asset Asset LiabilitiesLiabilities

100,000 100,000 100,000 100,000

80,000 80,000 80,00080,000

60,000 60,000 60,00060,000

: : : :

n n n n

_________ __________________ _________

500,000 500,000 500,000500,000

Money CreationMoney CreationIt has just been illustrated that the It has just been illustrated that the fractional reserve system enables fractional reserve system enables commercial banks to lend more than their commercial banks to lend more than their reserves. They do so by creating more reserves. They do so by creating more demand deposits which can circulate like demand deposits which can circulate like money in the form of checks while money in the form of checks while supported by a smaller cash amount to supported by a smaller cash amount to only meet fractional cash demand.only meet fractional cash demand.

Therefore, 6. commercial banks create Therefore, 6. commercial banks create more money by lending more and creating more money by lending more and creating more demand deposits while the opposite more demand deposits while the opposite is true when they tighten credit.is true when they tighten credit.

The amount of money checks that a The amount of money checks that a commercial bank can cause to commercial bank can cause to circulate from every peso of circulate from every peso of reserves is theoretically expressed reserves is theoretically expressed as follows:as follows:

L = mRL = mR

m = L/Rm = L/R

Since: r = R/L < 1Since: r = R/L < 1

Therefore: m = 1/rTherefore: m = 1/r

Where:Where:

m = Money multiplierm = Money multiplier

R = reservesR = reserves

L = deposit liabilitiesL = deposit liabilities

r = Ratio of reserves to deposit liabilities or r = Ratio of reserves to deposit liabilities or fractional cash demand ratiofractional cash demand ratio

C . SOURCES OF C . SOURCES OF MONEY SUPPLYMONEY SUPPLY

The 7. lending operation of the The 7. lending operation of the banking systems determines the banking systems determines the volume of money checks it volume of money checks it creates. Thus , lending more/less creates. Thus , lending more/less within the limits of the fractional within the limits of the fractional cash requirements of the cash requirements of the deposits increases/decreases deposits increases/decreases money checks and the level of money checks and the level of money supply. money supply.

The government print new money at The government print new money at times , to help finance its expanding times , to help finance its expanding operations. This increases currency in operations. This increases currency in circulation and the money checks that circulation and the money checks that banks create from currency deposits.banks create from currency deposits.

8. Money supply tend to increases 8. Money supply tend to increases with foreign currency inflows while with foreign currency inflows while the opposite is true with foreign the opposite is true with foreign currency outflows. However , it is the currency outflows. However , it is the net effect of foreign currency inflows net effect of foreign currency inflows and outflows that changes the level of and outflows that changes the level of money supply.money supply.

9. Taxes9. Taxes also changed the also changed the level of money supply as level of money supply as leakages from the circular leakages from the circular flow. Taxes are foregone flow. Taxes are foregone consumption and savings consumption and savings which could otherwise be part which could otherwise be part of currency in circulation and of currency in circulation and reserves which enables banks reserves which enables banks to create money checks.to create money checks.

The unspent portion of the The unspent portion of the budget surplus (unspent tax budget surplus (unspent tax revenue) only decreases revenue) only decreases money supply when kept in the money supply when kept in the National Treasury and not in National Treasury and not in the banking system where it the banking system where it can be channeled back to can be channeled back to circulation. On the other circulation. On the other hand , government borrows hand , government borrows from the banking system to from the banking system to finance deficit spending.finance deficit spending.

D. D. MONEY AND MONEY AND THE CENTRAL THE CENTRAL

BANKBANK

It is the reponsibility of It is the reponsibility of Bangko Sentral ng Pilipinas Bangko Sentral ng Pilipinas to administer the monetary, to administer the monetary, banking, and credit system banking, and credit system of the republic as embodied of the republic as embodied in Section 2 , Articles of the in Section 2 , Articles of the amended Republic Act amended Republic Act 2656. 2656.

The Objectives are as follows:The Objectives are as follows:

To maintain internal and external To maintain internal and external monetary stability in the Philippines; monetary stability in the Philippines; and to preserve the international and to preserve the international value of the peso and its convertibility value of the peso and its convertibility to other freely convertible currencies.to other freely convertible currencies.

To foster monetary , credit , and To foster monetary , credit , and exchange conditions conducive to a exchange conditions conducive to a balanced and sustainable growth of balanced and sustainable growth of the economy.the economy.

The Confidence in MoneyThe Confidence in Money

The 10. Central Bank is the only The 10. Central Bank is the only authorized government entity to authorized government entity to print money and is responsible print money and is responsible for the proper administration of for the proper administration of the monetary , banking , and the monetary , banking , and credit system of the republic to credit system of the republic to achieve monetary stability and achieve monetary stability and create conditions conducive to create conditions conducive to economic development.economic development.

MONETAMONETARY RY POLICIEPOLICIESS

1) Some policy 1) Some policy conceptconcept

The central bank used monetary The central bank used monetary policy to regulate money through policy to regulate money through the credit and banking system in the credit and banking system in order to attain monetary stability order to attain monetary stability conducive to economic conducive to economic development.development.

2) short-run Tools 2) short-run Tools Affecting Money Affecting Money

SupplySupplyA. RESERVE REQUIREMENTSA. RESERVE REQUIREMENTS

It has been explained in section B.2 It has been explained in section B.2 of this chapter that their actual of this chapter that their actual deposits (reserves) and create money deposits (reserves) and create money by creating more deposit liabilities.by creating more deposit liabilities.

MONEY CREATED = (1/r)(R)MONEY CREATED = (1/r)(R)

MONEY CREATED = as r with R MONEY CREATED = as r with R constant as rconstant as r

B. Rediscounting B. Rediscounting

The central bank can infuse money The central bank can infuse money into the coffers (reserves) of the into the coffers (reserves) of the banking system by buying its loan banking system by buying its loan papers (i.e. loan receivables) at papers (i.e. loan receivables) at rediscounted values.rediscounted values.

The central bank can raise the The central bank can raise the level of reserves and credit money by level of reserves and credit money by widening its rediscounting windows widening its rediscounting windows and buying more loan papers at lower and buying more loan papers at lower and more encouraging rediscounting and more encouraging rediscounting rate .rate .

MONEY CREATED = (1/r-MONEY CREATED = (1/r-1)(R)1)(R)

MONEY CREATED = as R MONEY CREATED = as R with r constant as R with r constant as R

The central bank offers a purchase The central bank offers a purchase or present value derived by or present value derived by discounting the maturity value of the discounting the maturity value of the paper to the purchase period using a paper to the purchase period using a rate called the rediscount rate. rate called the rediscount rate.

P = F/ ( 1 + r )P = F/ ( 1 + r )tt

C. Open market OperationC. Open market Operation

FRAMEWORKFRAMEWORK

Another way the central bank can Another way the central bank can change the level of money supply is by change the level of money supply is by buying and selling government buying and selling government securities in the open market.securities in the open market.

GOVERNMENT SECURITIES-> are GOVERNMENT SECURITIES-> are financial papers with short term financial papers with short term maturities.maturities.

COMPARATIVE ADVANTAGECOMPARATIVE ADVANTAGE

Central bank has more control Central bank has more control over bank reserves with this over bank reserves with this instrument. To decrease money instrument. To decrease money supply , it simply offers more supply , it simply offers more treasury bills at higher interest to treasury bills at higher interest to draw a momentum that it can draw a momentum that it can control within the volume it aims control within the volume it aims to transact.to transact.

EFFECTIVENESS EFFECTIVENESS IN TRIMMING IN TRIMMING

LIQUIDITYLIQUIDITYThe central bank floated more The central bank floated more treasury bills with a weighted treasury bills with a weighted average interest rate of 35% average interest rate of 35% relatively attractive to the relatively attractive to the prevailing rate of 20%-28% for prevailing rate of 20%-28% for short term loans and short term loans and placements.placements.

D. Selective controlD. Selective control

The effective range of an The effective range of an instrument may not necessarily instrument may not necessarily lead to it’s target and even if it lead to it’s target and even if it does , may spill over to factors does , may spill over to factors which are not its concern and which are not its concern and thud create new problems.thud create new problems.

E. The need for policy E. The need for policy CoordinationCoordination

It is not enough that an It is not enough that an instrument be confined to its instrument be confined to its target to create positive effects. target to create positive effects. For one, applying the instrument For one, applying the instrument alone may be inadequate to solve alone may be inadequate to solve the problem.the problem.