CHAPTER 2: INTRODUCING MONEY AND INTEREST RATES

ROLE OF MONEY IN THE ECONOMY

Money is any item or commodity that is generally accepted as a means of payment for goods and
services or for repayment of debt, and that serves as an asset to its holder. On the simplest level,
money is composed of the bills and coins which have been printed or minted by the National
Government (these are called currency). But money also includes the funds stored as electronic
entries in one's checking account and savings account.

Because money in a modern economy is not directly backed by intrinsic value (c.g., the coin's
weight in gold or silver), the financial system works on an entirely fiduciary basis, relying on
the public's confidence in the established forms of monetary exchange.

Money is the oil that keeps the machinery of our world turning. By giving goods and services an
easily measured value, money facilitates the billions of transactions that take place every day.
Without it, the industry and trade that form the basis of modern economies would grind to a halt
and the flow of wealth around the world would cease.

Money has fulfilled this vital role for thousands of years. Before its invention, people bartered,
swapping goods they produced themselves for things they needed from others. Barter is
sufficient for simple transactions, but not when the things traded are of differing values, or not
available at the same time. Money, by contrast, has a recognized uniform value and is widely
accepted. At heart a simple concept, over many thousands of years, it has become very complex
indeed.

At the start of the modern age, individuals and governments began to establish banks, and other
financial institutions were formed. Eventually, ordinary people could deposit their money in a
bank account and earn interest, borrow money and buy property, invest their wages in business,
or start companies themselves. Banks could also insure against the sorts of calamities that might
devastate families or traders, encouraging risk in the pursuit of profit.

Today it is the nation's government and central bank that control a country's economy. The
Federal Reserve (known as "The Fed") is the central bank in the US. The Fed issues currency,
determines how much of it is in circulation, and decides how much interest it will charge banks
to borrow its money,

In the Philippines, the central bank that controls the country's economy is the "Bangko Sentral ng
Pilipinas". While the government still prints and guarantees money, in today's world it no longer
needs to exist as physical coins or notes, but can be found solely in digital form.
CHARACTERISTICS AND KEY FUNCTIONS OF MONEY
Money is not money unless it has all of the following defining characteristics: Money must have
value, be durable, portable, uniform, divisible, in limited supply, and be usable as a means of
exchange. Underlying all of these characteristics is trust - people must be confident that if they
accept money, they can use it to pay for goods.

Store of value
Money acts as a means by which people can store their wealth for future use. It must not,
therefore, be perishable, and it helps if it is of a practical size that can be stored and transported
easily.

Item of worth
Most money originally has an intrinsic value, such as that of the precious metal that was used to
make the coin. This in itself acted as some guarantee the coin would be accepted.

Means of exchange
It must be possible to exchange money freely and widely for goods, and its value should be as
stable as possible. It helps if that value is easily divisible and if there are sufficient
denominations so change can be given.

Unit of account
Money can be used to record wealth possessed, traded or spent personally and nationally. It helps
if only one recognized authority issues money. If anybody could issue it, then trust in its value
would disappear.

Standard of Deferred Payment

Money is also useful because of its ability to serve as a standard of deferred payment

Money can facilitate exchange at a given point by providing a medium of exchange and unit of
account.

THE EVOLUTION OF MONEY

People originally traded surplus commodities with each other in a process known as bartering.
The value of each good traded could be debated, however, and money evolved as a practical
solution to the complexities of bartering hundreds of different things. Over the centuries, money
has appeared in many forms, but, whatever shape it takes, whether as a coin, a note, or stored on
a digital server, money always provides a fixed value against which any item can be compared.
Barter (10,000 - 3000BCE)
In early forms of trading, specific items were exchanged for others agreed by the negotiating
parties to be of similar value.

Barter - the direct exchange of goods - formed the basis of trade for thousands of years. Adam
Smith, 18h-century author of The Wealth of Nations, was one of the first to identify it as a
precursor to money.

Barter in practice
Essentially, barter involves the exchange of an item (such as a cow) for one or more of a
perceived equal "value" (for example a load of wheat). For the most part of the two
parties bring the goods with them and hand them over at the time of a transaction.
Sometimes, one of the parties will accept an "I owe you," or IOU, or even a token, that it
is agreed can be exchanged for the same goods or something else at a later date.

Advantages and Disadvantages of Barter

Advantages
● Trading relationship - Fosters strong links between partners
● Physical goods are exchanged - Barter does not rely on trust that money will retain its
value.

Disadvantages
● Market needed - Both parties must want what the other offers
● Hard to establish a set value on items - Two goats may have a certain value to one
party one day, but less a week later
● Goods may not be easily divisible - For example, a living animal cannot be divided.
● Large-scale transactions can be difficult. - Transporting one one goat is easy, moving
1,000 is not.

Evidence of trade records (7000BCE)

Pictures of items were used to record trade exchanges, becoming more complex as values were
established and documented.

Coinage (600bce-1100ce)
Defined weights of precious metals used by some merchants were later formalized as coins that
were usually issued by states.

Bank notes (1100-2000)

States began to use bank notes, issuing paper IOUs that were traded as currency, and could be
exchanged for coins at any time.

Digital money (2000 onward)

Money can now exist “virtually," on computers, and large transactions can take place without
any physical cash changing hands.

ARTIFACTS OF MONEY
Since the early attempts at setting values for bartered goods, "money" has come in many forms,
from IOUS to tokens. Cows, shells and precious metals have all been used

Barter (5,000bce)
Early trade involved directly exchanged items - often perishable ones such as a cow.

Sumerian cuneiform tablets (4,000bce)

Scribes recorded transactions on clay tablets, which could also act as receipts.

Cowrie shells (1,000bce)

Used as currency across India and the South Pacific, they appeared in many colors and sizes.

Lydian gold coins (600bce)

In Lydia, a mixture of gold and silver was formed into disks, or coins, stamped with inscriptions.

Athenian drachma (600bce)

The Athenians used silver from Laurion to mint a currency used right across the Greek world.

Han dynasty coin (200bce)

Often made of bronze or copper, early Chinese coins had holes punched in their center

Roman coin (278bce)

Bearing the head of the emperor, these coins circulated throughout the Roman Empire.

Byzantine coin (700ce)

Early Byzantine coins were pure gold; later ones also contained metals such as copper.

Anglo-Saxon coin (900ce)

This 10h century silver penny has an inscription stating that Offa is King ("rex") of Mercia

Arabic dirham (900ce)

Many silver coins from the Islamic empire were carried to Scandinavia by Vikings.
THE ECONOMICS OF MONEY
From the 16h century, understanding of the nature of money became more sophisticated.
Economics as a discipline emerged, in part to help explain the inflation caused in Europe by the
large-scale importation of silver from the newly discovered Americans. National banks were
established in the late 17h century. with the duty of regulating the countries' money supplies.

By the early 20 century, money became separated from its direct relationship to precious metal.
The Gold Standard collapsed altogether in the 1930s. By the mid20h century, new ways of
trading with money appeared such as credit cards, digital transactions, and even forms of money
such as cryptocurrencies and financial derivatives. As a result, the amount of money in existence
and in circulation increased enormously.

Potosi inflation (1540-1640)

The Spanish discovered silver in Potosi, Bolivia, and caused a century of inflation by shipping
350 tons of the metal back to Europe annually.

The great debasement (1542-1551)

England's Henry VIII debased the silver penny, making it three-quarters copper. Inflation
increased as trust dropped.

Early joint-stock companies (1553)

Merchants in England began to form companies in which investors bought shares (stock) and
shared its rewards.

Bank of England (1694)

The Bank of England was created as a body that could raise funds at a low interest rate and
manage national debt.

The Royal Mint (1696)

Isaac Newton became Warden and argued that debasing undermined confidence. All coins were
recalled and new silver ones were minted.

US dollar (1775)
The Continental Congress authorized the issue of United States dollars in 1775, but the first
national currency was not minted by the US Treasury until 1794.

Gold Standard (From 1844)

The British pound was tied to a defined equivalent amount of gold. Other countries adopted a
similar Gold Standard.
Credit Cards (1970s)
The creation of credit cards enabled consumers to access short-term credit to make smaller
purchases. This resulted in the growth of personal debt.

Digital Money (1990s)

The easy transfer of funds and convenience of electronic payments became increasingly popular
as internet use increased.

Euro (1999)
Twelve EU countries joined together and replaced their national currencies with the Euro. Bank
notes and coins were issued three years later.

Bitcoin (2008)
Bitcoin - a form of electronic money that exists solely as encrypted data on servers - is
announced. The first transaction took place in January 2009

HIGHLIGHTS IN THE HISTORY OF MONEY IN THE PHILIPPINES

Pre-Spanish Regime
Prior to the coming of the Spanish in 1521, the Philippine was already trading with neighboring
countries such as China, Java and Macau. Through the prevailing medium of exchange was
barter, some coins were circulating in the Philippines as early as the 8" century,

Commodity money such as gold, gold dust, silver wires, coffee, sugar rice, spices, carabao were
used as money. Between the 8 and 14" century the penniform gold barter rings were
predominantly used by foreign merchants. Piloncitos and other commodities were in circulation.

Spanish Regime
The Spanish introduced coins in the Philippines when they colonized the country in 1521. Silver
coins minted in Mexico were predominantly used in 1861, the first mint was established in order
to standardize coinage.

American Regime
After gaining independence in 1898 when Spain ceded the Philippines to the United States. The
country's first local currency, the Philippine Peso, was introduced replacing the Spanish-Filipino
Peso.

The Philippine National Bank was authorized to issue Philippine Banknotes. Later, the Bank of
the Philippine Island was authorized to issue its own bank notes. These notes were redeemable
by the issuer but not made legal tender.
Japanese Regime
When the Philippines was occupied by Japan during World War II, the Japanese issued the
Japanese War Notes. Their bills had no reserves nor backed up by any government asset and
were called "mickey mouse" money.

Post-War Period
In 1944, when the American forces defeated the Japanese Imperial army, the Philippine
Commonwealth was established under President Sergio Osmeña. All Japanese currencies
circulating in the Philippines were declared illegal, all banks were closed and all Philippine
National Bank notes were withdrawn from circulation.

The new treasury certificates (called Victory Money) were printed in P500, P200, P100, P50,
P20, P10, PS, P2 and Pl denominations with the establishment of the Central Bank. In 1949, a
new currency called "Central Bank Notes" was issued.

In 2010 the Central Bank launched the "New Generation Currency", which is uniform in size
where significant events in Philippine history, iconic buildings and heritage sites were featured

In 2018, the New Generation Currency Coin series was put in circulation.

THE SUPPLY AND DEMAND FOR MONEY

Money facilitates the flow of resources in the circular model of macroeconomy. Not enough
money will slow down the economy, and too much money can cause inflation because of higher
price levels. Either way, monitoring the supply and demand for money is vital for the economy's
central bank's monetary policy, which aims to stabilize price levels and to support economic
growth.

The Money Supply

Although the general description of money is relatively straightforward, the precise definition of
the overall supply of money is complex because of the wide variety of forms of money in
modern economies.

The Key Measures for the Money Supply are:

● MI. The narrowest measure of the money supply. It includes currency in circulation held
by the nonbank public, demand deposits, other checkable deposits, and traveler's checks.
MI refers primarily to money used as a medium of exchange.
● M2. In addition to MI, this measure includes money held in savings deposits, money
market deposit accounts, noninstitutional money market mutual funds and other
short-term money market assets (e.g., "overnight" Eurodollars). M2 refers primarily to
 money used as a store of value.
● M3. In addition to M2, this measure includes the financial institutions, (eg.,
large-denomination time deposits and term Eurodollars). M3 refers primarily to money
used as a unit of account.
● L. In addition to M3, this measure includes liquid and near-liquid assets (e.g., short-term
Treasury notes, high-grade commercial paper and bank acceptance notes)

The deposits of the public at banks and other depository institutions are considered money and
are therefore included in the Ml money supply. If the public withdraws money from bank
deposits to hold money as personal currency ("under the mattress"), this increase in inactive
money will affect the banks' ability to extend loans and will influence the supply of money.

Some common forms of public payment may not count as part of the supply of money. Cheque
payments from one person to another are not included in the money supply because a check
merely transfers money without being a net addition to the supply of money. Consumer credit
cards are not included in the money supply; they are considered instant loans to consumers and
therefore are not a net addition to the money supply.

The Bangko Sentral ng Pilipinas (BSP) is responsible for determining the supply of money. It
uses daily open market operations to influence the creation of money by banks and to guide the
availability of money in the economy. BSP also has an impact on the creation of money by banks
through reserve requirements and the discount rate that is, the interest rate at which banks can
borrow from the BSP as a lender of last resort. Changes in the supply of money will affect the
interest rate and therefore the cost of borrowing money. This will have an impact on
consumption and investment levels in the economy

The Demand for Money

The Sources of the Demand for Money are:
● Transaction demand. Money demanded for day-to-day payments through balances held
by households and firms (instead of stocks, bonds or other assets). This kind of demand
varies with GDP; it does not depend on the rate of interest.
● Precautionary demand. Money demanded as a result of unanticipated payments. This
kind of demand varies with GDP.
● Speculative demand. Money demanded because of expectations about interest rates in
the future. This means that people will decide to expand their money balances and hold
off on bond purchases if they expect interest rates to rise. This kind of demand has a
negative relationship with the interest rate
The rate of interest is the price paid in the money market for the use of money (or loans). The
rate is a percentage of the amount borrowed.
If a person holds P1.000 in currency, the opportunity cost of holding the money is the interest
that could be earned on the P1,000 in an interest-bearing account. The opportunity cost of
holding money goes up if the interest rate increases, which may lead to decreased consumption
and increased saving. Conversely, if the interest rate is low, it is relatively cheap to borrow
money and the quantity of money demanded goes up. Therefore, the demand for currency has a
negative relationship with the interest rate.

Changes in other factors will lead to shifts in the demand curve for money. Increases in the
economy's price level will increase the demand for money (note that the demand for money is
tied to the interest rate, not the price level). If the real GDP increases, the demand for money
increases because of the higher demand for products. Also, when banks develop new money
products that allow for easier, low-cost withdrawal, the demand for money will decrease, such as
banks offering savings accounts with shorter (or, less stringent) time deposit requirements and
lower penalties for withdrawal.

THE IMPACT OF MONEY

In the macroeconomic short-run, some prices (e.g., wage rates affected by labor contracts) will
be inflexible. This causes economic fluctuations, with real GDP either below potential GDP
(recessionary gap) or above potential GDP (inflationary gap).

The BSP's monetary policy has an immediate, short-run impact on the economy. In particular,
higher interest rates will decrease investment because it becomes more expensive to borrow
money, and will also decrease consumption because consumers will tend to, save more as interest
rate returns increase. In addition, as higher Philippine interest rates increase the demand for
pesos on the foreign exchange markets (because of the higher returns on Philippines deposits),
the higher pesos will decrease exports by making them increasingly expensive. This means that
real GDP growth and the inflation rate slow when the BSP raises the interest rate. The reverse
occurs when the interest rate is lowered.

Monetary policy can be applied in the short-run when the economy faces an inflationary gap
(real GDP exceeds potential GDP). The BSP may then pursue a policy to avoid inflation by
decreasing the quantity of money and raising the interest rate. The higher interest rate decreases
investment, consumption and net export. This decrease in aggregate demand will decrease real
GDP and lower the price level. In the macroeconomic long-run, prices are assumed to be fully
flexible, and this will move real GDP toward potential GDP.

If the economy is at its long-run equilibrium and the BSP increases the money supply, it will
increase aggregate demand. Consequently, the price level goes up. as well as the real GDP. This
means that an inflationary gap exists, with the actual unemployment rate being below the natural
rate. The tightness in the labor market will lead to a rise in the money wage rate. Because of
higher labor costs, the short-run aggregate supply will increase returning real GDP to the level of
potential GDP

THE QUANTITY THEORY OF MONEY

The quantity theory of money holds that changes in the money supply MS directly influences
the economy's price level, but nothing else. This theory follows from the equation of exchange:
MxV=PxY

where
M= quantity of money
V = velocity of money (i.c., the average number of times a unit of money is used during a year to
purchase GDP's goods and services)
P = price level
Y= real GDP

The equation of exchange essentially states that the economy's nominal GDP or expenditures (P
x Y) equal the money actually used in the economy (Mx V). According to the quantity theory of
money, velocity V is not affected by the quantity of money M and is considered constant: V = V
constant. Also, potential real GDP (i.e., long-run equilibrium) is not affected by M and is
considered constant: Y=Y constant. It not follows directly from the equation of exchange (M x V
constant) (P X Y constant) that changes in Marc equal to the changes in P, in the long-run. This
view of the equation of exchange expresses the (neo) classical neutrality of money, that is,
money affects only nominal values but not real values. In other words, the money supply leaves
real output unaffected.

Historical evidence suggests that the money growth rate and the inflation rate are positively
related in the long-run. However, the year-to-year relationship is weaker.

The equation of exchange does not hold in the short-run, as the economy does not immediately
adjust because of price inflexibility. Although, the relationship between M and P may not be
casual, as suggested by quantity money theorists, it appears that there is a correlation between M
and P in the long-term. Therefore, growth in M can be used as a statistical estimate for the rate of
inflation, that is, the Central bank can be effective in stabilizing prices. It is less clear what the
Central bank's impact on short-term real GDP and real interest rates is.

THE TIME VALUE OF MONEY

In general business terms, interest is defined as the cost of using money over time. This
definition is in close agreement with the definition used by economists, who prefer to say that
interest represents the time value of money.

Present Value
The concept of present value (or present discounted value) is based on the commonsense notion
that a peso of cash flow paid to you one year from now is less valuable to you than a peso paid to
you today: This notion is true because you can deposit a peso in a savings account that earns
interest and have more than a peso in one year. Economists use a more formal definition, as
explained in this section

Let's look at the simplest kind of debt instrument, which we will call a simple loan. In this loan,
the lender provides the borrower with an amount of funds (called the principal) that must be
repaid to the lender at the maturity date, along with an additional payment for the interest. For
example, if you made your friend Jane a simple loan of P100 for one year, you would require her
to repay the principal of P100 in one year's time along with an additional payment for interest;
say, PIO. In the case of a simple loan like this one, the interest payment divided by the amount of
the loan is a natural and sensible way to measure the interest rate. This measure of the so-called
simple interest rate, i, is:

If you make this P100 loan, at the end of the year you would have P110, which can be rewritten
as:
P100 x (1 + 0.10) = P110
If you then lent out the P110, at the end of the second year you would have:
P110 x (1 + 0.10) = P121
or, equivalently,
P100 x (1 + 0.10) x (1 + 0.10) = P100 x (1 + 0.10)^2 = P121

Continuing with the loan again, you would have at the end of the third year
P121 x (1 + 0.10) = P100 x (1 + 0.10)^3 = P133

Generalizing, we can see that at the end of n years, your P100 would turn into:
P100 x (1 + 1)"

INTEREST RATES
The interest rates link the future to the present. It allows individuals to evaluate the present value
(the value today) of future income and costs. In essence, it is the market price of earlier
availability,

From the viewpoint of a potential borrower, the interest rate is the premium that must be paid in
order to acquire goods sooner and pay for them later. From the lender's viewpoint, it is a reward
for waiting - a payment for supplying others with current purchasing power. The interest rates
allow the lender to calculate the future benefit (future payments earned) of extending a loan or
saving funds today.

In a modern economy, people often borrow funds to finance current investments and
consumption. Because of this, the interest rate is often defined as the price of loanable funds.
This definition is correct. But we should remember that, it is the earlier availability of goods and
services purchased, not the money itself that is desired by the borrower

HOW INTEREST RATES ARE DETERMINED

Interest rates are determined by the demand for and supply of loanable funds. Investors demand
funds in order to finance capital assets that they believe will increase output and generate profit.
Simultaneously, consumers demand loanable funds because they have a positive rate of time
preference. They prefer earlier availability.

The demand of investors for loanable funds stems from the productivity of capital. Investors are
willing to borrow in order to finance the use of capital in production because they expect that
expanding future output will provide them with more than enough resources to repay the amount
borrowed (the principal) and the interest on the loan.

As Figure 2-1 illustrates, the interest rate brings the choices of investors and consumers wanting
to borrow funds into harmony with the choices of lenders willing to supply funds. Higher interest
rates make it more costly for investors to undertake capital spending projects and for consumers
to buy now rather than later. Both investors and consumers will therefore, curtail their borrowing
as the interest rate rises. Investors will borrow less because some investment projects that would
be profitable at a low interest rate will be unprofitable at higher rates. Some consumers will
reduce their current consumption rather than pay the high

interest premium when the interest rate increases. Therefore, the amount of funds demanded by
borrowers is inversely related to the interest rate.

The interest rate also rewards people (lenders) willing to reduce their current consumption in
order to provide loanable funds to others. If some people are going to borrow in order to
undertake an investment project (or consume more than their current income), others must curtail
their current consumption by an equal amount. In essence, the interest rate provides lenders with
the incentive to reduce their current consumption so that borrowers can either invest or consume
beyond their present income. Higher interest rates give people willing to save (willing to supply
loanable funds) the ability to purchase more goods in the future in exchange for sacrificing
current consumption. Even though people have a positive rate of time preference, they will give
up current consumption to supply funds to the loanable funds market if the price is right. Higher
interest rates will induce people to save more. Therefore, as the interest rate rises, the quantity of
funds supplied to the loanable funds market will increase.

Figure 2-1: Determining the Interest Rate

As Figure 2-1 illustrates, the interest rate will bring the quantity of funds demanded into balance
with the quantity supplied. At the equilibrium interest rate, the quantity of funds borrowers
demand for investment and consumption now (rather than later) will just equal the quantity of
funds lenders save. So, the interest rate brings the choices of borrowers and lenders into
harmony.

The rate of interest functions as the price in the money market. Money has a time value, and its
use is bought and sold in the money market in return for the payment of interest. The financial
institutions that deal in government securities and loans, gold and foreign exchange make up the
money market. The money market is not a specific physical location but consists of transactions
made electronically or by phone. Equilibrium in the money market occurs when the MD and MS
curves intersect at the equilibrium interest rate, as shown in Figure 2-2.

If the BSP were to decide to increase the quantity of money from MS to MS', the supply of
money curve would shift to the right, resulting in a decrease in the equilibrium interest rate. The
lower cost of borrowing could spur higher consumption and investment.

The equilibrium interest rate goes down from r to r’ as the money supply curve shifts to the right
from MS to MS' (e.g., when the BSP increases the quantity of money)
Figure 2-2: Money market equilibrium

According to Keynesian theory, the rate of interest is determined as a price in two markets:
1. Investment funds. The rate of interest balances the demand for funds (required for
investment) and the supply of funds (from savings). If investors can earn a 10 percent
return on a capital investment project (e.g., building a factory), they will be willing to pay
a rate of interest of up to 10 percent. Households delay consumption by saving (and are
rewarded by earning interest) depending on their time preference and the rate of interest.
Savings percentages can differ significantly from one nation to another.
2. Liquid assets. Households and businesses may have reasons to hold assets in liquid form
(ie., readily available money). Because borrowers require cash in the long-term (that
doesn't need to be repaid to the lender immediately), they are willing to compensate
lenders for giving up liquidity. Keynes introduced the influence of the liquidity
preference on the interest rate. The classical economists, who considered investment
funds as the critical market for the interest rate, disregarded the topic of liquidity
preference.

Although intermediaries can achieve equality between the rates of interest in two markets, the
potential lack of balance between the investment and money markets was essential to
Keynesians, who claimed that it caused unemployment in the short-run.

THE NOMINAL OR MONEY RATE VERSUS THE REAL RATE OF INTEREST

We have emphasized that the interest rate is a premium paid by borrowers for earlier availability
and a reward received by lenders for delaying consumption. However, during a period of
inflation (a general increase in prices), the nominal interest rate or money rate of interest is a
misleading indicator of how much borrowers are paying and lenders are receiving. Inflation
reduces the purchasing power of a loan's principal. Rising prices means that, when the borrower
repays the principal in the future, it will not purchase as much as it would have when the funds
were initially loaned.

When inflation is common, lenders will recognize they are being repaid with pesos of less
purchasing power. Unless they are compensated for the anticipated inflation by an upward
adjustment in the interest rate, they will supply fewer funds to the loanable funds market. At the
same time, when borrowers anticipate inflation, they will want to purchase goods and services
now before they become even more expensive in the future. Thus, they are willing to pay an
inflationary premium, an additional amount of interest that reflects the expected rate of future
price increases. For example, if borrowers and lenders fully anticipate a 5 percent rate of
inflation, they will be just as willing to agree on a 9 percent interest rate as they were earlier to
agree on a 4 percent interest rate when both anticipated price stability

Unlike when the general price level is stable, the supply of loanable funds will decline (the
supply curve will shift to the left) and the demand will increase (the demand curve will shift to
the right) once decision makers anticipate future

inflation. The money interest rate thus, rises overstating the "true" cost of borrowing and the
yield from lending. This true cost is the real rate interest, which is equal to the money rate of
interest minus the inflationary premium. It reflects the real burden to borrowers and payoff to
lenders in terms of their being able to buy goods and services.

Our analysis indicates that, high rates of inflation will lead to a high money rate of interest. The
real world is consistent with this view.

INTEREST RATES AND RISK

So far, we have assumed there is only a single interest rate present in the loanable funds market.
In the real world, of course, there are many interest rates. There is the mortgage rate, the prime
interest rate (the rate charged to business firms with strong credit ratings), the consumer loan rate
and the credit card rate, to name but a few.

Interest rates in the loanable funds market will differ mainly because of differences in the risks
associated with the loans. It is riskier, for example, to loan money to an unemployed worker than
to a well-established business with substantial assets. Similarly, credit card loans are riskier than
loans secured by an asset. An example of a secured loan would be a mortgage loan on a house. If
the borrower defaults, the lender can repossess the house. The risk also increases with the
duration of the loan. The longer the time period of the loan, the more likely it is that the
borrower's ability to repay the loan will deteriorate or market conditions changes in an highly
unfavorable manner.
As Figure 2-3 shows, the money rate of interest on a loan has three components. The
pure-interest component is the real price one must pay for earlier availability. The inflationary
premium component reflects the expectation that the loan will be repaid with pesos of less
purchasing power as the result of inflation. The risk-premium component reflects the probability
of default (the risk imposed on the lender by the possibility that the borrower may be unable to
repay the loan).

Figure 2-3: The Three Components of Money Interest

Risk premium

Inflationary premium

Pure interest

THE IMPACT OF CHANGING INTEREST RATES

Control over short-term interest rates is one of the main tools of the BSP to achieve its main
goals of controlling inflation, smoothing out the business cycle and ensuring financial stability.

Short-term interest rates are relevant for loans with a relatively short length for repayment while
long-term interest rates on the other hand, are relevant for loans such as long-term corporate
borrowing and 10-20-30 year fixed rate mortgages.

If the BSP pushes short-term interest rates up or down, the effects of its actions are felt most
directly by interest-rate sensitive sectors of the economy. When it is more expensive to borrow,
people make fewer purchases that require borrowing. But when the BSP cuts the short-term
interest rate, that encourages borrowing and spending in the economy and puts upward pressure
on prices.

If interest rates fluctuate all the time, the economy would become volatile. This is why the
government and central bank work together to keep inflation and interest at stable rates. Every
time the interest rate is changed, it sends a signal to society to either spend or save - and many
also increase or decrease confidence in the state of the economy. A rise in interest rates
encourages saving, since higher interest will be paid on money in savings accounts, and
investments can grow. Meanwhile, borrowing becomes less attractive as interest repayments are
steeper, and banks more selective about who they lend to. This impacts the affordability of
obtaining or repaying an existing loan, such as a mortgage.
By contrast, a drop in interest rates is intended to cause an increase in spending, since borrowers
are able to take out loans more cheaply. For those with mortgages tracking the base rate, interest
repayments will drop. At the same time, savers will tend to spend or invest deposits that are
attracting little interest. While discouraging saving through very low interest rates might
stimulate the economy, this can ultimately negatively impact long-term savings plans, such as
pensions.

WHEN INTEREST RATES ARE RAISED

Higher interest rates make loans less affordable, while high interest on savings accounts
encourages saving rather than spending. As spending slows, so does the economy, with demand
for goods and services decreasing. This eventually affects business and employment levels.

WHEN INTEREST RATES ARE LOWERED

Lower interest rates make it cheaper to take out loans, and hence to spend more money. Saving
becomes less attractive as interest rates are low. With more money in circulation, demand for
products and services rise, stimulating businesses and increasing employment.

REVIEW QUESTIONS
Questions
1. Describe what money is.
2. Explain briefly the significance of money in the economy of a country.
3. Briefly describe each of the four main functions of money.
4. Describe the history of money in the Philippines.
5. Explain briefly how money facilitates the flow of resources in macroeconomy
6. Enumerate and describe the sources of demand for money.
7. When is an asset suitable to use as a medium of exchange.
8. Why are economists and policy makers interested in measuring money?
9. A student makes the following assertion:
"It is not possible for the total value of production to increase unless the money supply
also increases. After all, how can the value of the goods and services being bought and
sold increase unless there is more money available."
Explain whether you agree with this assertion.