Money and Monetary Policy

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Learning Objectives

1. Understand the importance of money;

2. Define money based on the concept of liquidity;
3. Explain how money can function effectively;
4. Classify financial institutions and describe their functions as players in the financial
sector;
5. Explain the functions of the Bangko Sentral ng Pilipinas; and
6. Understand how the Bangko Sentral ng Pilipinas manipulate money supply in attaining
economic goals.
7. Illustrate how demand deposit multiplier works.
The Role of Money

 In this world, money is very important in our lives. It seems we cannot live without it.
Thus, the tendency to make it the “master” of our lives.
 But as we look back, money did not exist since the world begun. Exchanging goods or
barter was practiced. But this system of exchange requires coincidence of needs. That is,
if you are a coffee grower and you want beef for your meal, you have to look for
somebody who needs coffee and a cattle raiser for the exchange to happen. This system
makes exchange slow, inconvenient and lacks standard measurement of values.
The Role of Money

 The problems in the barter system gave way to other media of exchange. The use of
commodity money such as personal ornaments like rare seashells and stones was
introduced. Then, in 3,000 B.C., people discovered the convenience of using precious
metals like gold and silver as money. In the 17th century, gold and silver were turned into
coins that eventually bore designs from nature, and later, symbols of the ruling power.
 Types of Philippine Money in the Past

 In the Philippines, various types of money were used through the centuries as enumerated below. Since its
establishment in 1948 through R.A. 265, the Central Bank of the Philippines (now Bangko Sentral ng
Pilipinas) has issued various currencies for the people’s day-to-day transactions.

Period Type of Money Used

Pre-Spanish Penniform gold barter ring, Piloncito
Spanish Spanish barilla, Dos Mundos, Pillar Isabelinas, gold
coins, Treasury Notes
American U.S. dollar, Conant coints
Japanese Mickey Mouse money
Liberation Treasury Notes marked “VICTORY”
Definition of Money

 Money is any object that is commonly accepted or authorized by the state as a means of
exchanging goods and services in a certain place and time.
 Money can also be defined by using the concept of liquidity. Any asset that can be used as
a means of immediate payment is considered liquid. Below are the definitions of money
based on liquidity:
M1 = Cash + Check Deposits
M2 = M1 + Savings Deposits + Time Deposits
M3 = M2 + Other Deposit Substitutes
Definition of Money

 M1 is the most liquid assets. This includes cash in the forms coins and papernotes, check
deposits. Coins are made of precious metals, therefore, with “intrinsic” value while
papernotes do not. But these are made of special materials and became exchangeable
through government decree, hence, called fiat money. Checks are given to a third party as
a form of payment that requires banks (where the owner of the check has his/her checking
account) to pay the third party.
Definition of Money

 M2 is composed of cash, checking accounts, savings deposits, and time deposits. Savings
and time deposits can be converted into cash before they can be used to pay for goods and
services. They are the next most liquid assets, after cash and checks.
 M3 is composed of M2 plus bonds and stock certificates. Bonds are issued by firms as a
means of borrowing money to be used in business operations. Bonds certificate indicates
the promise to pay back the amount with a fixed interest rate. While stocks are certificates
of ownership of the company. Common stockholders receive dividends, have the right to
vote the company’s directors and participate in the stockholders’ meetings to share their
ideas.
Functions of Money

 Money has four (4) primary functions; namely, as a means of exchange, a measure of value, as a
basis for valuation of loans and deferred payments, and as a storer and preserver of product
value.
1. In order to be an effective medium of exchange, money has to be
a) universally acceptable. The payee can easily recognize that the money presented by the
payor is genuine or counterfeit. So, paper monies should have security threads and other features
that guarantees its authenticity.
b) portable. People are naturally mobile. They have to buy and consume things wherever
they go. Money should be easy to carry around.
c) identical. Each denomination should have distinctive marks to avoid confusion. This
is usually done in terms of colors, shapes, texture and design.
Functions of Money

2. As a measure of value, money has to be divisible. The availability of the different

denominations, from 25-centavos to 1,000 peso bills, will make payments of the
commodities exactly equal to their prices.
3. As a basis for valuation of loans and deferred payments, money provides a fixed stable
standard for measuring future payments. It enables lenders to estimate how much they
should charge on loans and consigned goods. This function of money requires stability of
value. Monetary authorities should prevent sudden leaps in prices because this means
inflation and therefore decreasing the value of the peso.
Functions of Money

4. Most products are perishable and bulky, hence require huge warehouses and expensive
storage equipment. To get rid of these problems, the products are sold. Sales from these
goods can be kept in banks or invested in real estate, bonds and shares of stocks, where it
earns interests, profit or dividends. The disadvantage of keeping money instead of
commodities is the possible devaluation of money in times of inflation. Prudent
management of money supply is necessary to avoid inflation.
Financial Institutions

 The financial sector is the driver of a nation’s economy. It sustains the funding needs of
consumers and producers. The key players in the sector are the financial institutions.
 Financial institutions serve a intermediaries or bridges between the fund sources and the
fund users. Banks pool the savings and other deposits of their clients so that these may be
loaned out to investors, both private and public.
 There are two types of financial institutions in the Philippines – banking and non-banking
institutions. There are also foreign institutions like the International Monetary Fund (IMF)
, World Bank (WB), and Asian Development Bank (ADB), which also help our economy
in terms of funding.
The Banking Institutions

 The types of banking institutions include, but are not limited to:
1. Commercial banks – The primary function of commercial banks is to accept
deposits, check deposits and time deposits. They also offer short-term loans, accept drafts
and letters of credit, and give discounts on promissory notes, bills of exchange, and any
document on credit.
2. Thrift banks – This category includes:
2.1. Stock Savings and Loan Associations – This primarily consolidate the savings
deposits of their members or stockholders into a fund from which members can draw loans
with interest.
 2.2. Savings and Mortgage Banks (SMBs) - They comprise the majority of thrift banks. SMBs accept
deposits from the public.
2.3. Private Development Bank – These banks are fueled by savings deposits and funds from the
Development Bank of the Philippines. They provide loans for small and medium-scale industries.
3. Rural Banks – These banks primarily caters to funding needs of farmers and small business people,
mostly in rural areas.
Non-Banking Institutions

 There are financial institutions that are not banks, but can collect “contributions” that may
be invested in business or stocks or loaned with interest to individuals and organizations,
including government. These non-banks are owned either by the government or private
business.
 Government owned non-banks include the Government Service Insurance System (GSIS),
the Social Security System (SSS), and Pagtutulungan sa Kinabukasan: Ikaw Bangko,
Industria at Gobyerno (PAG-IBIG).
 Privately owned non-banks include investment houses, insurance companies, pawnshops,
security dealers, and brokers.
International Funding Institutions

 International funding organizations also help in funding government projects. The three
(3) international funding institutions are:
1. World Bank (WB) – This was originally set up as the International Bank for
Reconstruction and Development (IBRD) in a world conference convened by U.S. in
Bretton Woods, New Jersey in 1944, after the Second World War. Aimed at helping
rebuild and revitalize their economies, the WB was initially funded by the cash
contributions of 139 nations and the pledges or guarantees of many others. It was
formally established in 1946, and now, the WB inevitably changed focus to
reconstruction to the growth needs of developing countries. Organizational decisions are
done through votation. The weight or points of a member nation’s vote depends on its
contribution. The larger the contribution to the fund, the greater its influence in decision-
making.
International Funding Institutions

2. International Monetary Fund (IMF) – This is created together with the WB in 1946. It
aims to promote exchange rate stability and international trade by providing its members
with the currencies and technical assistance they need. It created an international reserve
currency called Special Drawing Rights (SDRs) in 1969 to supplement the reserves of
member countries. The value of SDRs is based on a basket of foreign currencies – US
dollars, Japanese yen, pound sterling, and euros. SDRs serve as the IMF’s unit of
account or its own currency. Philippines can borrow SDRs to pay for its imports from
IMF and pay back using Philippine peso. IMF pays back the creditor country through
SDRs, as well.
International Funding Institutions

3. Asian Development Bank (ADB) – This is established in 1966 which the Philippines
joined from the very start. ADB lends funds to government for development projects. It
has no individual clients. Poverty reduction is its primary strategy. Its other
development objectives include economic growth, development of human resources,
protection of the environment, private sector development, social development, and law
and policy reform.
The Bangko Sentral ng Pilipinas (BSP)

 The BSP is the central bank of the Republic of the Philippines which was established on
July 3, 1993. It is an organization responsible for the regulation, creation, and
management of money supply in our country.
 Some of the functions of BSP are:
1. Designing, foolproofing, and printing or minting of currency
2. Managing the government finances, such as bank account transfers and debt payments,
updating the government on local and global financial trends; and formulating and
implementing sound monetary policies
3. Serving as the mother bank of all the country’s banks by maintaining accounts for other
banks and settling conflicts among them
The Bangko Sentral ng Pilipinas (BSP)

4. Extending loan support to other banks when they run out of cash
5. Ensuring the sufficiency of our foreign exchange reserves
6. Coordinating and regulating the operations of all financial institutions in the country.
The BSP controls money supply primarily through the Monetary Board, which has seven
(7) members appointed by the President of the Philippines.
Money Supply

 Money supply is composed of coins, papernotes and demand deposits that are in
circulation. Coins and papernotes are issued by the BSP, while checks are obtained from
commercial banks.
 Determining the size of money supply is a crucial decision as this impacts the level of
economic activity. Monetary policy is needed to manage the money circulating in the
economy and achieve different goals especially price stability. The BSP is responsible in
the conduct of monetary policy.
 Monetary policy can either be expansionary (easy) or contractionary (tight) policy.
Increase in money supply is an easy money policy as it expands aggregate demand. While
tight money policy is implemented when there is inflation to eliminate excessive aggregate
demand that causes demand-pull inflation.
Monetary Tools

 There are different ways by which the BSP is able to create, control, regulate, and
manipulate money supply. These monetary tools are:
1. Fiat money authority – BSP is empowered to print or mint currencies. It can create
money whenever government runs out of funds for its various projects and programs. It
also regularly replaces lost and damaged coins and bills.
Monetary Tools

2.Reserve requirements - The BSP requires every bank to set aside a percentage of its deposits – called its
reserve requirements – which it can neither lend nor invest. Banks are supposed to hold on to this reserve
as a safety nets. More importantly, it is used by monetary authorities to regulate money supply in response to
economy’s condition. During recessionary periods, there is a need to decrease the require reserve requirement
ratio (rrr) to increase funds available for loans to consumers and producers, thus, boosting production and
eventually generating more employment.
3.Discount rate – As the mother of all banks, the BSP is the one that banks run to when have run out of cash
needed to meet the credit requirements of their clients. For example, Bank A needs 10 million pesos to meet
its clients need but it runs out of cash. BSP can help by lending bank A the 10 million pesos it needs with a
discount rate (dr) of 20% or 2 million pesos. If the BSP thinks that the economy is weak, it reduces
discount rate to improve liquidity or increase money supply. When the economy is inflated with too much
money, discount rate is raised.
Monetary Tools

4. Open Market Operation – This refers to buying and selling of government bonds to
commercial banks or to the public. The BSP can reduce money supply by selling government
bonds. Reserves of commercial banks will decrease and eventually less amount will be
available for loans. Cash held by the public will also be reduced by replacing them with bond
certificates which cannot be used for daily transactions. Monetary authorities take this action
whenever there is too much money in circulation to avoid causes inflation. Alternatively,
buying of government bonds is necessary in times of recession. This is to encourage more
consumption and investment spending needed to boost the economy.
Monetary Tools

5. Moral Suasion - This is a qualitative tool wherein the

BSP persuades banks to make their lending policies more
responsive to the needs of the economy. Banks must
tighten their credit programs in times of inflation, and
loosen them in times of recession.
The Demand Deposit Multiplier

 The demand deposit multiplier (m) is the number of times by which the injection of reserves
increase to get the total change in demand deposits. It is known as the reciprocal of the required
reserve ratio (rrr), or
m = 1/rrr
 To get the total change in demand deposits or change in money supply (MS) is,
Change in MS = (i/rrr)(change in reserve)
 Suppose the amount of 1,000 pesos is deposited and the rrr = 10%,
m = 1/0.1
m = 10
Change in MS = (10)(1000)
Change in MS = 10,000 pesos
 Cumulative Increase in Demand Deposits

Round Additional Demand Deposits Additional Demand Deposits

Created by this Bank Created by all Banks
Bank A 1,000 1,000
Bank B 900 1,900
Bank C 810 2,710
Bank D 729 3,439
Bank E 656 4,095
Bank F 590 4,685
Bank G 531 5,216
Bank H 478 5,694
Bank I 430 6,124
All Other Banks 3,876
Total 10,000