MONEY AND THE BANKING SYSTEM

WHAT IS MONEY?
❖ Money is defined as any items that are regularly used in economic transactions or exchanges
and accepted by buyers and sellers.
3 PROPERTIES OF MONEY
1. MONEY SERVES AS A MEDIUM OF EXCHANGE
❖ Suppose that money does not exist. How can economic exchanges occur?
❖ Barter - The exchange of one good or service for another.
❖ Double-coincidence of Wants - The problem in a system of barter that one person may not
have what the other desires.
❖ Individuals are better off through voluntary exchange.
2. MONEY SERVES AS UNIT OF ACCOUNT
❖ Money also provides a convenient measuring rod when prices for all goods are quoted in
money terms.
❖ A unit of account is a standard unit in which we can state prices and compare the value of
goods and services.
❖ In our economy, money is the unit of account because we quote all prices in terms of money.
3. MONEY SERVES AS A STORE OF VALUE
❖ The property of money that holds that money preserves value until it is used in an exchange.
❖ Money is a somewhat imperfect store of value because of inflation.

TYPES OF MONETARY SYSTEM

❖ Commodity Money - A monetary system in which the actual money is a commodity, such as
gold or silver.
❖ Gold Standard - A monetary system in which gold backs up paper money.
❖ Fiat Money - A monetary system in which money has no intrinsic value but is backed by the
government.
SUPPLY OF MONEY
❖ Coins and bills in circulation
❖ Demand deposits in banks
❖ Quasi-money - Savings Deposit & Time Deposit
❖ Deposit Substitutes
BEHAVIOR OF BANKS

HOW BANKS CREATE MONEY

HOW THE MONEY MULTIPLIER WORKS

❖ Sum of Deposits = initial cash deposit x 1/reserve ratio
❖ Ex. 1,000 x 1/0.1 = 10,000
❖ The multiplier is the 1/reserve ratio.
❖ In reality, not all of the amount loaned will go to the banks.
HOW BANK REDUCES ITS OUTSTANDING LOANS?
DOES WRITING A CHECK TO OTHER PERSON INCREASES MONEY SUPPLY? NO
THE CENTRAL BANK
❖ It is the responsibility of the Bangko Sentral ng Pilipinas to administer the monetary,
banking, and credit system of the republic as embodied in the Sec. 2, Articles of the Republic
Act 2656.
OBJECTIVES OF THE CENTRAL BANK
❖ To maintain the internal and external and internal monetary stability in the Philippines: and
to preserve the international value of peso and its convertibility to other freely convertible
currencies
❖ To foster monetary, credit, and exchange conditions conducive to a balanced and sustainable
growth of the economy.
WITH THE MANDATE OF THE GOVERNMENT
❖ Central bank regulates the magnitude and movement of money through the banking and
credit system which serves as conduit of funds from sources to users.
❖ Any institutions whose business is borrowing and lending, and serving direct or indirect
intermediation between sources and users comes under its jurisdiction.
 ❖ Ex. Banks (core), investment houses and insurance companies, savings and loans
associations, and pawnshops.
THE CONFIDENCE OF MONEY
❖ The central bank is the only authorized government entity to print money and is responsible
for the proper administration of the monetary, banking, and credit system.
INSTANCES THE PEOPLE LOSE CONFIDENCE IN MONEY
UNRESTRAINED GROWTH IN MONEY
❖ Unrestrained growth in money can cause people to lose confidence on money. Increase in
money supply will cause severe inflation and distorts investment, production, and
employment.
❖ In this case, money tends to lose value and people prefer tying money to rapidly
appreciating but non-productive assets in real forms. (jewelries & idle lands).
❖ Even holding to interest-earning money is not ideal as inflation erodes its value.
❖ As a result, less money is made available for investment, production, and employment to
acquire nonproductive assets.
UNCHECKED CIRCULATION OF FAKE MONEY
❖ Money loses value and may even be an exception than a rule as a medium of exchange.
❖ An economy may resort to barter system.
❖ Dollars maybe used as an alternative currency.
MONETARY POLICY
THE MONEY MARKET
The money market is the market for money where the amount supplied and the amount demanded
meet to determine the nominal interest rate.
DEMAND FOR MONEY
INTEREST RATES AFFECT MONEY DEMAND

❖ As interest rates increase in the economy, the

opportunity cost of holding money also increases.
❖ Economists have found that as the opportunity
cost of holding money increases, the public demands
less money.
❖ The quantity demanded of money will
decrease with an increase in interest rates.
THE PRICE LEVEL AND GDP AFFECT MONEY DEMAND

OTHER COMPONENTS OF MONEY DEMAND

❖ Liquidity Demand For Money - The demand for money that represents the needs and
desires individuals and firms have to make transactions on short notice without incurring
excessive costs.
❖ Speculative Demand For Money - The demand for money that arises because holding money
over short periods is less risky than holding stocks or bonds.
HOW THE CENTRAL BANK CHANGES THE MONEY SUPPLY?
❖ Open Market Operations - The purchase or sale of government bonds by the Central Bank.
❖ Open Market Purchases - The Central Bank’s purchase of government bonds from the
private sector.
❖ Open Market Sales - The Central Bank’s sale of government bonds to the private sector.
OTHER TOOLS OF THE CENTRAL BANK
CHANGING RESERVE REQUIREMENT
❖ If the Central Bank wishes to increase the supply of money, it can reduce banks’ reserve
requirements so they have more money to loan out. This would expand the money supply.
To decrease the supply of money, the Federal Reserve can raise reserve requirements.
❖ Changing reserve requirements is a powerful tool, but the Federal Reserve doesn’t use it
very often, because it disrupts the banking system.
CHANGING DISCOUNT RATE
❖ The discount rate is the interest rate at which banks can borrow directly from the Central
Bank.
❖ If the Central Bank raises the discount rate, banks will be discouraged from borrowing
reserves because it has become more costly. Lowering the discount rate will induce banks to
borrow additional reserves.
QUANTITATIVE EASING
❖ Central Bank can change the money supply by buying or selling long-term Treasury bonds,
for example, bonds with maturities of ten years.
 ❖ By engaging in a policy of quantitative easing, the central bank can potentially lower long-
term interest rates directly at the same time it injects more money in the economy.
DETERMINING INTEREST RATE
COMBINING THE DEMAND AND SUPPLY OF MONEY

Equilibrium in the money market occurs at an interest

rate of r, at which the quantity of money demanded equals the
quantity of money supplied.

SHIFT IN THE SUPPLY OF MONEY

(A) An open market purchase shifts the supply

of money to the right and leads to lower interest
rates.
(B) An open market sale shifts the supply of
money to the left and leads to higher interest
rates.

RELATIONSHIP BETWEEN INTEREST RATE AND BOND PRICES

DETERMINING BOND PRICES

Price of the Bond = promised Example: 106/1.06 = 100

payment/1+interest rate
What if the interest rate decreased to 4 percent? 106/1.04 = 101.92
What if the interest rate increased to 8 percent? 106/1.08 = 98.15

MARKET OPERATIONS AND BOND PRICES

❖ What will happen to the interest rate if the central bank engages in open-market purchase?
❖ What will happen to the demand of the bonds?
❖ What will happen to the price of the bonds?
❖ Similarly, interest rates rise following an open market sale of bonds by the Central Bank.
When the Central Bank conducts an open-market sale, it is selling bonds, increasing the
supply of bonds in the market. With an increase in the supply of bonds, the price of bonds
will fall.
GOOD NEWS FOR ECONOMY IS BAD FOR BOND PRICES
❖ When real GDP increases, the demand for money will increase.
❖ As the demand for money increases, the money demand curve will shift to the right.
❖ From our model of the money market, we know that increased money demand will increase
interest rates.
❖ Bond prices move in the opposite direction from interest rates.
INTEREST RATE AND ITS EFFECT TO INVESTMENT AND OUTPUT (GDP)
❖ As the supply of money increases, interest
rates fall from r0 to r1.
❖ With lower interest rates, investment
spending will increase from I0 to I1.
❖ This increase in investment spending will
then increase aggregate demand—the total
demand for goods and services in the economy—
and shift the aggregate demand curve to the right.
SHIFT IN AGGREGATE DEMAND CURVE

IN SUMMARY