MACROECONOMIC POLICIES CHAPTER 10 — Money and Monetary Policies 11 — Fiscal Policy 42 — International Trade Practices and Policies 43 — The Dynamics of Development 44 — The Comprehensive Agrarian Reform PChapter MONEY AND MONETARY 1 POLICIES ‘The initial discussions of the chapter focus on money as a medium of exchange and vehicle of economic activities. ‘Then, discussions explore the banking and credit system and how it influences the mone- tary system. After presenting the workings ofthe monetary system, the chapter discus- ses the role of the Central Bank in regula- ting the flow, composition, and distribution of money through the banking and credit system, Finally, the chapter elaborates on the tools that the Central Bank use to direct, and regulate the monetary system both from long-term and short-term perspectives. FUNCTION OF MONEY AND MONEY ‘SUPPLY Function of Money Money as a medium of exchange began to assume a significant role in the advent of the market economy marked by specializa- tion, interdependence, and trade. Today, the distinct advantage of the monetary system over the barter system defines the role of money in the economy. To illustrate this role, let us assume in- dividuals 1, 2, and 3 with goods, A, B,and C, on hand, respectively (Figure 68). Exchange from individual 3. Likewise, individual 3 neods produet B from individual 2 who instead needs product A from individual 1, [ea [aa] [22] Figure 68 ; Desired Product Flow However, the introduction the system makes ex‘ it passes from one hand te 69). Let us assume th money to buy pro In turn, individual to buy product © likewise buys produ In effect, goods flor money payment: shown in Figure is not possible among these individuals is ¢ under a barter trade system if desire exists between them. arrows in the followingFigure 69 Product and Money Flow The stock of money serving this function is called money supply and consists of the following: Coins and bills in circulation Demand deposits in banks Quasi-money — Savings deposits — Time deposits * Deposit substitutes Demand deposits in commercial banks are intended for spending and circulated through the use of checks which are as good as money. On the other hand, quasi-money consists of savings and time deposits in commercial banks while deposit substitutes are deposits in savings banks, savings and loans associations, and even in credit unions. These two instruments are also components of money supply as they serve to meet short-run transactions during these times of inflation and rapid economic growth. Table 33 supported by Figure 70 pres~ ents the country’s domestic liquidity fi was marked by declining tion and increasing rates of demand deposits and decreased as banks ti ings to give way Positor’s preference This was due to th income which led th for current requirements and save le future consumption. Thus, coins and bills) in circulation ‘increase and its ratio to dem and deposit substitutes inere However, the overall supply continued to incr economic crisis due to two other factor was the g to restrict imports in or country’s dollar resTable 33 oa Domestic Liquidity, Composition of Money Supply ‘Quasi-Money Deposits 2010 to 2013 illion pesos) ‘Narrow Money . Currency Outside Depository Circulation) S ‘Transferable Deposits (Dem: Deposits) Other Deposits (Quasi Bills Payable Deposits with Note: Data used are records fie Source: Banko Sentral ng Pilig money the economy hol idle balances which can erated into more tr if circulated faster, this propensity is le cireulation,intice rece g etry arch Figure 70 Total Money Supply and Quasi-Money Deposit: 2001 since: BANKS AND MO Y = PQ(Economic income or income derived from production) Alternatively: MV=PQ where: M-= Money supply V = Velocity Y = Nominal money income P = Price Q = Volume of goods and services The equation embodies the quantity tbe theory of money and implies that the same ~ Tes® level of money supply increases (decreases) 4. T ‘income due to an increase (decrease) in the ‘money velocity. 4 Institutional factors may cause: velocity to change like paying labor instead of bi-monthly increases ficient. In such a case, workers Porarily hold less money as id snd firms would turnover mo 8tnerate more transactions and “ay one time, Thus, the same ley “upply could generate more in “higher velocity or moneyis 20%. The deposit becomes an initial addition to its assets in the form of cash (reserves) and to its liabilities in the form of demand deposit liability as shown in Table 34. In turn, the bank can lend P80,000 since only 20,000 or 20% of the initial deposit ‘of 100,000 circulating as money checks is necessary to meet current cash demand. ‘This new amount further increases the asset account in the form of loans receivable and the liability account in the form of demand deposit liabilities as shown in the same table. Furthermore, the bank can still lend an additional amount of 64,000 since only 16,000 or 20% of the initial loanable amount of P80,000 is necessary to meet current cash demand. Likewise,» the loan receivable account and deposit. liability account each increases further by this amount. Table 34 Deposit Liability Creation equals to zero implying no mo available for additional ler In the final analysis, multiplying the bank’s a continues until reserves 01 just enough to meet deposit liabilities. left for additional Ie that the bank can inet 7a sible for the bank to meet the fractional ag omand of its remaining deposit liabilities fer using its current reserves with t future inflows of loan repayments, — Money Creation i thas just been illustrated tional reserve system enables banks tolend more than their do so by creating more de circulate of checks while suppo amount to’ only 7 L mand. Therefore, more money by more demand depo: true when they ti ‘The amou! ‘commercialone AND MONETARY POLICIES R =P100B It should be noted from the last equa- tion that altering the level of reserves and the rate of fractional cash demand (r) nges the amount of money checks that an create. Going back to Table 33 in Chapter, the economy's preference for more cash holdings channeled more currency to circulation and increased fractional cash demand which contributed to the decline in credit and the demand deposit component of money supply. In addition, de- mand deposits declined further despite the se in quasi-money (é.e. time and sav- which could hardly be made available for lending, because of weaker credit demand. ‘SOURCES OF MONEY SUPPLY The lending operation of the banking system determines the yolume of money checks it creates. Thus, lending more/less within the limits of the fractional eash — requirement of deposits inet eases money checks and supply-On the other hand,changes the level of money. ‘supply. The level increases when inflows exceed outflows while the opposite is true when outflows exceed inflows. Taxes also change the level of money supply as leakages from the circular flow. Taxes are foregone consumption and sav- ings which could otherwise be part of cur~ rency in circulation and reserves which enable banks to create money checks. Thus, an increase in taxes decreases money supply while the opposite is true with a decrease in tax revenue. However, taxes do not become leakages at all if channeled back to circulation in the form of government spending. In addition, the unspent portion of the budget surplus (unspent tax revenue) only decreases money supply when kept in the National Treasury and not in the banking system where it can be channeled back to circulation. On the other hand, the government borrows from the banking system to finance deficit spending. This is non-inflationary unless the government borrows idle funds and increases money in cireulation. MONEY AND THE CENTRAL BANK Functions of the Central Bank It is the responsibility of Bangko Sen- tral ng Pilipinas to administer the mone- tary, banking, and credit , republic as embodied in Section of the amended Republic Act responsibility is exercised netary objectives in 0 2, Tofoster monetary, oredity and e gonditions conducive to a b sentainable growth of the economy, ‘therefore, the Central Bank regu the magnitude and movement through the banking and Which serves as a conduit of fu Sources to users. Any institu business is borrowing and serving direct or between sources and U its jurisdiction. At the « are the banks sinee the ot)gation to erode its value, AS a result, less “ney is made available for investment, ijuction, and employment to acquire productive assets. Thus, less production apports consumption spending, However, al ines mayevendecline time to indus sce take some with the workings of the banking system, 5 forces and are, Forone, spending bank deposits sooner onthe mediante Changing their cours sequire non-productive assets decreases turns of event mayen eon ‘edit money that banks create. Ontheother and create eo! re only sow w hand, the preference for non-productive Thisis inasmach an eens, assets may decrease investment demand — resources by this time, and likewise limit credit. In both eases, the tructured toward policy jorelsofmoney supply, income, and product other hand, some instrun demand drop to further curb production and h employment. prot However, Another example is a pervasive and 2nd, therefore, serve as unchecked circulation of fake money. Like- fine-tune policy band wise, money loses value and may even be mesception than a rule as a medium of ‘xchange. As such, the economy may resort instead to a system where the medium of ‘xchange is in real form like products and omtributions to produetion. In addition, the dollar currency, which is the country’s orinipal foreign curreney, may even be used directly as another medium of exchange. However, the process of shifting to the sltemative system may cause serious dis- locations to production and employment xystem itself may hinder the free flow of economic activities and products cinsidering that money is a liquid instru nent of exchange. The possibility of resor- tng to this system is not remote once} lose confidence in money. The m sconomy took off where the barter ‘ef off and grounding the former the latter to be desired. rf __ The Central Bank “6 to regulate money | nd bankin,banks to limit the creation of deposit liabil- ities using the same reserves while the opposite is true when the floor limit is low- ered. The following is an illustration using the fractional reserve equations. Money crested =(+) (®) Money created = Tas r/with R constant dasrt For example, a minimum required re- serve ratio of 0.20 allows a bank to lend a maximum of 5 from every peso of currency deposit (reserves). is a certain amount banking institutions reactions to the p and the amount willing to buy. The! the levels of widening its 1 Table 35 Selected Domestic Interest Ratespaying more loan papers at lower and more Pacouraging rediscount rate. Conversely sr decreases reserves and money supply ih raising the rediscount rate and narrow- ing its rediscounting windows to buy less- tan papers. This is illustrated using the equations of the preceeding section ag fol- ows: Money created = ( : J Money created = Tas RLwith r constant tasRT ‘oillustrate simply, let us assume that a hank lends 100,000 at an annual interest rote of 30% and, therefore, expects to get tack « compounded value of P169,000 after two years. However, let us assume further that at the end of the first year, the bank ells the loan paper to the Central Bank to get back the principal and possibly earn interest for the one-year period completed Ifore maturity. The Central bank offers a purchase or present value derived by dis- counting the maturity value of the paper to the purchase period using a rate called the rediscount rate. The following equation maturity to purch In the example just given, Bank discounts the sm paper equals to He to lowever, increasing the 40%effect of increasing money supply while the opposite is done to decrease the stock of money in the system. ‘The Central Bank may buy and sell these bills through the commercial banks for convenience. It siphons the public's bank deposits when it sells government secu- rities. In addition, commercial banks may commit some of their reserves to buy these bills as one alternative lending scheme. In effect, the Central Bank decreases bank reserves and limits credit money when it sells government securities and the opposite is true when it buys back securities. ‘Table 36 Total Revenue of the Philippine for End Periods Indicated insoe Lr ‘Table 37 Number of Financial institutions, 1996-2002 1 mel and Conte Banks Universal Bass ye Darzi Bans Prat Tht Banksy {Baral and Cooperative ‘Vlsuding Micrfinance Oriented Banks ‘Par i, for December 2012) ten Feng Co, laren Ci Sa Hens (wa QB fetion) Ibe Bone Seal ng Pilipinas Comparative Adit Furthermore, | ore control over |ing rate of 20-28% for short-term loans and placements. Thus, the amount of securi- ties that the public held increased tremen- dously to a level of ®22 billion in 1984 from only P5 billion in 1983 or by a rate of 340%. The ratio of this increase to domestic liquidity in 1984 was 15% and, therefore, had a significant share in displacing money supply. d. Selective Control The effective range of an instrument may not necessarily lead to its targets and even if it does, may spill over to factors which are not its concern and, thus, create new problems. This is where monetary authorities exercise selective control in order to confine the workings of an instrument only to the factors it aims to manipulate and, therefore, avoid its indiscriminate effects. For example, the government has been inducing the banking system to expand resources and credit toward the agricul- tural and rural areas. However, banks are _ traditionally prejudicial against rural lend- ing and tend to channel more credit to the industrial sector.’ So as not to misdirect th policy, the government has also 1i policies without thejem. For example, increasing the required ve ratio is ineffective to decrease upply if banks can still avail of the non’ f Oe in Central Bank's rediscounting facilities and oie pen market operations to augment eredit, Onthe other hand, the use of an instrument nay effectively manipulate the target fac {ors but may also throw other factors out of palance and do more harm than good. For example, selling more government securities and decreasing the rediscount rate may ef- fectively expand money supply but may also induce demand and fuel inflation, In other words, the application of an instrument may have side effects that disturb the balance of economic forces The aforementioned problems imply that one instrument is the simplest but problem adds to relevance if coordinated to complement effectiveness and ne side effects. Thus, more instruments. solve a problem more effectively. Ilustration To take advantage of tary effects of other instru_—_—_ ee ame: — .d Section: veo poor 1 ; atch Column A.with Column B, Write the letter ofthe ¢ A Savings and time deposit | 1. 2. Checking accounts . Money created by the Central Bank A vehicle of economic activity Value of peso in terms of foreign cu . Ability of banks to create dep liabilities greater than their rese . Percentage of deposits kept i bank's vaults ful |. Administers the mo credit system . Regulates the investmentsited. by a c0 IL Solve for the additional money Pe i requirement of 20%, discount vate of 30%, rediseount 800,000. the IIL Determine the effect of the following on decreases, C for no change. : Higher rediscount: Exercise 2 Fill in the blanks. Give the supply. 1. 2. EE 4a Bi Surplus in importation — | Tnerease in government Decrease in bank Adoption of government sur Tnerease in interest ratesExpansive savings campaign Increased tourist spending in Decreased export receipts Increased tax collections Tight credit policy Increased ceiling on loans 121%. Leercise 5 1, How does a delay in spendioay and income? Give one poly that cam.