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The Monetary System

Book Ch. (page)

Class Econ 101

Zoom link - Passcode

Date: @September 22, 2020

Topic: The Monetary System

Recall Notes
Reserves are Definitions of Money
liabilities of the M0 to M4 (arranged by liquidity, M0 most liquid and M4 least
central bank
liquid)
Liquidity - easy convertibility to cash
M0 - Base/Reserve Money

Currency in circulation + bank reserves

Bank reserves = cash in bank vaults + banks' reserve

balances or deposits with the BSP, including those in the
demand deposit account (DDA)

DDA = deposits of banks and other financial institutions

with the BSP to comply with reserve requirement

Note: M0 is NOT a subset of M1 because bank reserves

are not counted in M1

M1 - Narrow Money

The Monetary System 1

 Currency in circulation (outside of depository corporations)
+ peso demand deposits (e.g. ATM accounts)

M2 - Broad Money

M1 + peso savings and time deposits

M3 - Broad Money Liabilities

M2 + peso deposit substitutes, such as promissory notes

and commercial papers (i.e. securities other than shares
included in broad money)

M4 - M3 + transferrable and other deposits in foreign currency

Essentially, M (money supply) = C (currency in circulation) + D
(deposits varying in liquidity)

Functions of Money

1. Medium of exchange (used for transactions)

2. Store of value (used to transfer purchasing power from

present to future)

3. Unit of account (unit by which prices and values are

measured)

Kinds of Money

1. Commodity Money - money with intrinsic value, can be

used to barter (e.g. gold, cows)

2. Fiat money - no intrinsic value, valuable only by gov't

decree, under control of central bank

"legal tender" - must be accepted as payment

3. Digital currencies (e.g. bitcoin) - no intrinsic value nor

backing by gov't decree, outside of control of central bank

accepted only by social convention

The Monetary System 2

 Demand for Money - governed by 3 motives

1. Transactions demand for money - people demand money

to buy or sell goods and services

2. Precautionary demand for money - people may hold money

for contingencies

3. Speculative demand for money - people hold money rather

than bonds or other interest-bearing assets if they
anticipate the value of those assets will drop

1 and 2 are in line with Classical Theory - transactions and

precautionary demand for money increase with people's
incomes (positively related)

3 is a Keynesian concept - money is treated as another asset.

People choose to hold their wealth either in money or in bonds
(interest-bearing)

If people anticipate a decrease in bond prices, they will

unload their bond holdings to increase their money
holdings, avoiding capital losses from the price decrease of
bonds

When interest rates increase, people will hold their wealth

in bonds, lessening the demand for money

Negative relationship between interest rate and demand for

money

Money Multiplier

Fractional-reserve banking system - banks hold a fraction of the

money deposited as reserves and lend out the rest
Reserves - deposits that banks have received but not loaned
out

The Monetary System 3

 Reserve ratio - fraction of deposits that banks hold as reserves
Note that reserves are LIABILITIES OF THE CENTRAL BANK
("pananagutan ng bangko sentral")

Banks hold reserves for:

Required reserves - to satisfy minimum reserve ratio

requirement of central bank

Excess reserves - precaution for unanticipated withdrawals

of bank deposits; as buffers against economic uncertainty;
due to absence of productive financing

When a bank lends money, that money is generally deposited

into another bank, creating more deposits and more reserves.
When a bank makes a loan from its reserves, the money supply
increases
Money multiplier - increase in money supply that the banking
system generates with a peso-increase of reserves

ΔM = (1/RRD) ∗ ΔR0
interpreted as the change in money supply is equal to
1/RRD times initial change in reserves

where RRD = required reserve deposit ratio

Simple money multiplier - reciprocal of RRD (i.e. 1/RRD)

ex. if RRD ratio is 20% or 1/5, then simple money multiplier

is 5

The Monetary System 4

 implies that every peso increase in bank reserves increase
the money supply five times

2 assumptions in deriving simple money multiplier:

1. Banks do not hold excess reserves

2. Agents prefer to deposit the loans they take out instead of

holding them in cash

To derive a more realistic money multiplier (letting go of above

assumptions):

B - monetary base or M0

RRD - required reserves deposit ratio

ERD - excess reserves deposit ratio

CD - currency deposit ratio (ito ata yung ratio of their

money na hinohold ng tao instead of depositing)

M - money supply

By definition:

M=C+D

B=C+R

R = RR + ER

The Monetary System 5

 Check pic above for formula of money multiplier m and M=mB

C is currency in circulation, does not include bank reserves

What happens to M if CD, RRD, or ERD is increased, with B

constant?

reduces the m (money multiplier)

Money supply M decreases, B constant

How changes in ratios affect the money supply M:

Examples (connected):

The Monetary System 6

 Central bank's control of money supply is not precise
Central bank deals with two problems due to fractional-reserve
banking:

central bank can't control the amount of money households

choose to hold as deposits in banks

central bank can't control the amount of money banks

choose to lend

Monetary Policy

set of measures by central bank to influence liquidity levels

of the economy (money supply)

The Monetary System 7

 Central bank - regulates banks to follow laws

acts as a lender of last resort for other banks

conducts monetary policy by regulating money supply

BSP - inflation-targeting regime starting 2002

to achieve its inflation target, BSP announces an explicit

target bandwidth. For 2015-2020, bandwidth is at 3% +/-
1%. This means inflation should only be from 2% to 4%, or
else BSP will conduct monetary policy

BSP uses core inflation to define its inflation target

Core inflation - CPI less volatile components

Volatile components - goods that are prone to supply

disturbances (outside of control of BSP, since BSP can only
affect demand side)
BSP Monetary Policy Tools

Overnight RRP & RP Rates

The Monetary System 8

 RRP rate- interest rate for BSP borrowing from
other banks (key policy rate of BSP). Increasing
RRP encourages other banks to lend to BSP,
decreasing the money supply

RP rate - interest rate for BSP lending to other

banks

Increasing either RRP or RP rate are both

contractionary monetary policies

Reserve requirements

Increasing reserve req - contractionary MP

Decreasing reserve req - expansionary MP

Rediscount window - credit facility by the BSP to help

banks meet temporary liquidity needs

Increasing rediscount rate - contractionary MP

Decreasing rediscount rate - expansionary MP

Open Market Operations (OMO) - sale/purchase of

government securities by BSP in secondary market

Secondary market - market for securities that have

already been issued by Treasury and bought by
institutions

Open market sales - contractionary MP

Open market purchases - expansionary MP

The Monetary System 9

 Overnight deposit facilities (O/N DF) - used to absorb
excess liquidity

Excess liquidity can result from a lot of foreign

deposits (inflows), basically madaming liquid cash
in the monetary system that's not being used
productively (?).

O/N DF rate = RRP rate - 0.50 percentage point

O/N DF rate should be the ceiling of O/N interbank

rate (rate at which banks lend to each other)

If inflation is above bandwidth - raise O/N DF rate,

and vice versa

Term deposit facilities (TDF) - deposit facilities by BSP

to absorb excess liquidity

If inflation is above bandwidth - raise TDF rate to

attract deposits

previously called special deposit account (SDA)

Essentially the same as overnight deposit facility,

but longer term (O/N is short term)

Summary of BSP tools:

The Monetary System 10

 📌 SUMMARY:

The Monetary System 11