Bangko Sentral ng Pilipinas

How Monetary Policy Works

The BSP
The Bangko Sentral ng Pilipinas (BSP) is the central bank of the Republic of the Philippines. It was established on 3 July 1993 pursuant to the provisions of the 1987 Philippine Constitution and the New Central Bank Act of 1993. The BSP took over from the Central Bank of Philippines, which was established on 3 January 1949, as the country’s central monetary authority. The BSP enjoys fiscal and administrative autonomy from the National Government in the pursuit of its mandated responsibilities.

Functions
The Bangko Sentral ng Pilipinas has three core functions ( three pillars of central banking): 1.) Maintenance of price stability 2.) Supervision and examination of banks and other financial institutions (regulation) 3.) Establishment and maintenance of an efficient payments and settlements system

Maintenance of Price Stability
• Price stability refers to the condition of low and stable inflation. By keeping inflation low, the BSP helps ensure strong and sustainable economic growth and better living standards. With price stability, prices of goods do not rise too quickly and people have a degree of certainty when deciding how to spend, save or invest their money.

Because of the very strong demand for goods and services relative to supply. and then there's a weak demand for goods and services.• The BSP conducts monetary policy using an approach called inflation targeting. The BSP also ensures adequate liquidity on the banking system with loans to banks through the rediscounting facility. if forecasted inflation below the target. the BSP can raise its policy interest rates pumping market interest rates to follow suit. buy government securities or bring down the reserve requirements. To tighten monetary policy. Or it can raise reserve requirements imposed on banks. prices are rising more rapidly than the desired inflation rate. The BSP can also accept fixed-term deposit from banks and non-banks financial institutions. For example. In this approach. then the BSP will take action to bring down inflation to the target level by tightening monetary policy. If for example. . then the BSP will ease monetary policy. It can also sell government securities as part of its open market operations to reduce the amount of money in the the financial system. The BSP has several means or instruments to carry out its monetary policy. On the other hand. To ease monetary policy. it can reduce policy rates. the BSP does the opposite. the BSP promises to keep average inflation close to pre-announce target.

As such. loans and advances to banking institutions in order to influence the volume of credit consistent with objective of price stability. the BSP has acquired assets which it administers.• The BSP extends discounts. . Banks also pay their loans with properties under a dacion en pago agreement. preserves and disposes properly. private banks assign to BSP their receivables including the collaterals. It also grants loans or advances to banking institutions in precarious financial condition or under serious financial pressures. Upon failure of these banks or their borrowers to pay their loans. the BSP forecloses these real properties. • When availing of the loan facilities of the BSP. subject to certain conditions.

Supervision of Financial Institutions • The Bangko Sentral has supervision over the operations of banks and exercises such regulatory powers as provided in the New Central Bank Act and other pertinent laws over the operations of finance companies and non-bank financial institutions performing quasi-banking functions. .

Establishment of Efficient Payment Systems • Efficient payment systems are important because they allow the safe and timely completion of big ticket transactions. These big tickets include the following: Interbank loan transactions. purchase and sale of government securities. and interbank settlement of ATM transactions.” . then the payments and settlements system is the circulatory system for these transactions. Undoubtedly. Director Bella Santos. head of the BSP's Payments and Settlements Office says: “If transactions are the lifeblood of market economy. the payments and settlements system plays a crucial role in the Philippine economy. foreign currency transactions.

the Bangko Sentral ng Pilipinas established in December 2002 the Philippine Payments and Settlements System or PhilPaSS.• For this purpose. . The PhilPaSS is a real time gross settlement system (RTGS) that enables the highvalue payment transactions between participating institutions through the deposit accounts which they maintain with the BSP.

. The banks and NBQBs send electronic messages to the BSP through the PhilPaSS. banks and other non-banks with quasibanking functions (NBQBs) could settle their payments in real time.• Under the system. instructing the central monetary authority to debit their account with the BSP and credit the account of the payee bank.

This dilutes the value of the existing money. • Whenever we borrow money. They simply give the loan which is a promise to pay the actual money which they never really have to do. This is because total debt has to keep expanding in order for people to be able to pay back what they owe. 95% of the money is in the form of bank credit. otherwise there simply won‟t be enough money to earn to pay back what we owe. There is no real currency backing it. .How does the BSP create money? • When banks give out loans. This process constantly (almost) expands the money supply. the bank creates new money. In the economy. When that happens. they do not give out money that they already have. we declare bankruptcy. there are foreclosures. unemployment and so on which causes the vicious cycle of deflation.

collectively. which in turn affects interest rates. or changing the amount of money banks need to keep in the vault (bank reserves). .What is Monetary Policy? Monetary policy. The primary objective of BSP's monetary policy is to promote a low and stable inflation conducive to a balanced and sustainable economic growth. Monetary policy is maintained through actions such as increasing the interest rate. are actions of a central bank. currency board or other regulatory committee that determine the size and rate of growth of the money supply. The adoption of inflation targeting framework for monetary policy in January 2002 is aimed at achieving this objective.

producing. and loaning. monetary policy deals with the very creation and availability of money. . These two policies interplay to regain control over the excess or lack of different economic activities like spending. saving.Monetary & Fiscal Policies While fiscal policy deals with government spending in relation to the different economic circumstances in the market.

BSP‟s Approach to Monetary Policy • Inflation targeting is focused mainly on achieving a low and stable inflation. This approach entails the announcement of an explicit inflation target that the BSP promises to achieve over a given time period. supportive of the economy’s growth objective. .

Inflation rate refers to a general rise in prices measured against a standard level of purchasing power.08 Percent reaching an all time high of 62.10 Percent in January of 1959. The most well known measures of Inflation are the CPI which measures consumer prices.80 Percent in September of 1984 and a record low of -2. . Philippines Inflation Rate averaged 9.80 percent in August of 2012. which measures inflation in the whole of the domestic economy. This page includes a chart with historical data for Philippines Inflation Rate. Historically. and the GDP deflator.• The inflation rate in Philippines was recorded at 3. from 1958 until 2012.

0 percentage point for 2010 and 4.0 percent with a tolerance interval of + 1.0 percentage point for 2011.5 percent with a tolerance interval of + 1.• The Inflation Target • The government‟s inflation target is defined in terms of the average year-on-year change in the consumer price index (CPI) over the calendar year. . The inflation targets have been set at 4.

offers standing facilities and requires banking institutions to hold reserves on deposits and deposit substitutes. the BSP uses open market operations. accepts fixed-term deposits.• The BSP has a number of monetary policy instruments at its disposal to promote price stability. . To increase or reduce liquidity in the financial system.

• Open market operations are a key component of monetary policy implementation. These consist of repurchase and reverse repurchase transactions. .Open Market Operations • Open Market Operations (OMO) – the sale or purchase of government securities by the BSP to withdraw liquidity from or inject liquidity into the system. outright transactions. and foreign exchange swaps.

in a reverse repo. . RP and RRP transactions have maturities ranging from overnight as well as two weeks to one month. The BSP‟s payment to the bank increases the latter‟s reserve balances and has an expansionary effect on liquidity. The interest rates for the overnight RRP and RP facilities signal the monetary policy stance and serve as the BSP‟s primary monetary policy instruments. the BSP acts as the seller of government securities and the bank’s payment has a contractionary effect on liquidity. • Conversely. • In a repurchase or repo transaction. the BSP buys government securities from a bank with a commitment to sell it back at a specified future date at a predetermined rate.Repurchase and reverse repurchase transactions are carried out through the repurchase (RP) facility and the reverse repurchase (RRP) facility of the BSP.

• When the BSP buys securities. In an outright transaction. creating a more permanent effect on money supply.• Outright transactions refer to the direct purchase/sale by the BSP of its holdings of government securities from/to banking institutions. Conversely. when the BSP sells securities. the buyer‟s payment (made by direct debit against his Demand Deposit Account with the BSP) causes the money supply to contract. The transaction thus increases the buyer‟s holdings of central bank reserves and expands the money supply. it pays for them by directly crediting its counterparty‟s Demand Deposit Account with the BSP. . The transactions are conducted using the BSP‟s holdings of government securities. the parties do not commit to reverse the transaction in the future.

• The agreement consists of swapping principal and interest payments on a loan made in one currency for principal and interest payments of a loan of equal value in another currency. and a reverse exchange of the same two currencies at a date further in the future (the second leg) at a rate (different from the rate applied to the first leg) agreed on deal date. .• Foreign exchange swaps refer to transactions involving the actual exchange of two currencies (principal amount only) on a specific date at a rate agreed on the deal date (the first leg).

Since the receiving central bank may auction off the maximum amount but can only supply as much funds as are effectively demanded by its banking system. the uncertainty in the growth of the money supply increases.• The main worry is that such swap agreements could create inflationary pressure since opening new means to distribute liquidity can increase the total demand for and consequently the supply of money. Moreover. . the maximum amount of a swap agreement is agreed upon several months in advance or may even be unlimited.

. banks tend to hoard any funds they receive and increasing the money supply does not create inflationary pressure. in calm times. In contrast. When liquidity demand spikes. their effect on inflation is minimal. the swaps are not used since banks finance themselves on the interbank market. Since swap agreements are essentially not used precisely in circumstances were increasing money supply would create inflationary pressure.• The fact that demand for foreign-denominatedcurrency spikes only when liquidity tensions are high implies that the inflationary effect of these swap agreements is very contained.

Acceptance of Fixed-Term Deposits • The BSP also accepts deposits from banks. the BSP expanded access to the SDA facility by allowing trust entities to deposit in the SDA facility in order to better manage liquidity in the face of strong foreign exchange inflows. In April 2007. The Special Deposit Accounts (SDA) facility consists of fixed-term deposits by banks and by trust entities of banks and non-bank financial institutions with the BSP. . It was introduced in November 1998 to enable the BSP to expand its toolkit in liquidity management.

the BSP offers interest rates relatively higher than the rates offered by regular savings and time deposit accounts. . • To motivate retail and institutional investors to invest in SDAs. Special Deposit Accounts (SDA) are one of these liquidity management tools. so there is very low risk of default. the agency in charge of printing the country‟s currency.SDAs • SDAs are money instruments employed by the BSP as a tool to mop up excess liquidity in the market. the agency utilizes several tools to help achieve this goal. Excess funds can lead to inflation and since the BSP‟s primary mandate is to control inflation in the country. Placements are also backed by the BSP.

poses a risk to the Philippine‟s foreign exchange market because wild swings in the inflows and outflows of currencies can produce volatility in the Peso-Dollar exchange rate. Partly to blame is the foreigners‟ increased appetite for the Peso. meaning. This scenario. dumping the US Dollar (and other foreign currencies) in the process. . however. • The Philippine Peso has emerged as Southeast Asia‟s fastest-rising currency during the first half of 2012. the investor can already earn interest and pull out the placement after one month.SDAs • Deposit terms are usually up to one month.

foreign institutional fund companies engage in currency carry trade which puts additional pressure to the Peso against the Dollar. Such erratic movement of funds produce. • Foreign funds flowing into the country contribute to an appreciating peso which may be good to some sectors but it also creates market instability when these funds turn out to be “hot money. Carry trade occurs when fund managers borrow currencies that pay low interest rate (such as the US Dollar or the Japanese Yen) and converts them into currencies paying high interest rates. some large.SDAs • Worse. among others. as in the case of the Philippine Peso and the SDA offering.” or funds that flow in and out of the country very quickly. a fluctuating exchange rate. .

The rediscounting facility allows a financial institution to borrow money from the BSP using promissory notes and other loan papers of its borrowers as collateral. There are two types of rediscounting facilities available to qualified banks: the peso rediscounting facility and the Exporters‟ Dollar and Yen Rediscount Facility (EDYRF) which was introduced in 1995.Standing Facilities • The BSP extends discounts. Rediscounting is a standing credit facility provided by the BSP to help banks meet temporary liquidity needs by refinancing the loans they extend to their clients. loans and advances to banking institutions in order to influence the volume of credit in the financial system. .

Reserve Requirements • Reserve requirements refer to the percentage of bank deposits and deposit substitute liabilities that banks must keep on hand or in deposits with the BSP and therefore may not lend. Changes in reserve requirements have a significant effect on money supply in the banking system. . making them a powerful means of liquidity management.

In the early days of banking. . Any reserves above what are required are excess reserves. • (1) Required Reserves = (Required Reserve Ratio)x(Deposits). • Banks can hold more reserves than are required.Required Reserves. Today the amount of reserves and the form that they take are determined by government regulation.Reserve Requirements • We saw that banks created money as a by-product of their quest for profit. banks needed reserves so that they could redeem deposits or notes on demand. or: • (2) Excess Reserves = Legal Reserves . Banks are limited in the process of money creation by the need to hold some assets in the form of reserves.

and liquidity reserves. In March 2006. savings. The use of liquidity reserves help to reduce bank intermediation costs since they are paid market-based interest rates. Deposits maintained by banks with the BSP up to 40 percent of the regular reserve requirement are paid interest at 4 percent per annum. time deposit and deposit substitutes (including long-term nonnegotiable tax-exempt certificates of time deposit or LTNCTDs) of universal banks (UBs) and commercial banks (KBs) and may be kept in the form of cash in vault. deposits with the BSP and government securities. while liquidity reserves are paid the rate on comparable government securities less half a percentage point. the Monetary Board began to require banks to keep liquidity reserves in the form of term deposits in the reserve deposit account (RDA) with the BSP instead of government securities bought directly from the BSP.• Reserve requirements apply to peso demand. • Required reserves consist of two forms: regular or statutory reserves. .

for example. If.2) in deposits. the remaining $80 can be loaned out to other bank customers. the reserve requirement is 20%. the tighter the money supply.• The expansion of a country's money supply that results from banks being able to lend. This $80 is then deposited by these customers into another bank. in reserve but can lend out the remaining $64. which means more money is being created for every dollar deposited. the larger the money supply. it is money used to create more money and is calculated by dividing total bank deposits by the reserve requirement. for every $100 a customer deposits into a bank. The higher the reserve requirement. This cycle continues . However. . The size of the multiplier effect depends on the percentage of deposits that banks are required to hold as reserves. or $16. which in turn must also keep 20%. $20 must be kept in reserve. which results in a lower multiplier effect for every dollar deposited. This creation of deposits is the multiplier effect.as more people deposit money and more banks continue lending it .until finally the $100 initially deposited creates a total of $500 ($100 / 0. In other words. The lower the reserve requirement.

you would expect some prices to be rising but others to be falling.Monetary Policy and Inflation • Price stability exists when prices overall are stable (ie. This does not mean that prices are frozen. if the excess capacity persists. • The rate of inflation tends to increase when the overall demand for goods and services exceeds the economy's capacity to sustainably supply goods and services. In an environment of price stability. Likewise. but rather that taken on the whole they are stable. when productive capacity is greater than demand. deflation can occur. the rate of inflation tends to decrease. and. . money is an effective store of value).

then to get rid of the stock that is building up they may have to reduce their prices. inflationary pressure may emerge. if factories are working flat out to meet demand. which may require overtime payments. • Thus. Factory staff will work longer hours. • By "the economy's capacity to sustainably supply those goods and services" we mean the level of production that can be sustained without shortages occurring. throughout the economy. . • Conversely. thereby forcing firms to put up their prices. If enough do this the rate of inflation will start to fall.• By "demand" we mean the desire for goods and services that is supported by the means to purchase those goods and services. if factories are producing more goods than they can sell.

in the late 1980s. .Monetary Policy and Inflation • Monetary policy can control the growth of demand through an increase in interest rates and a contraction in the real money supply. interest rates went up to 15% because of the excessive growth in the economy and contributed to the recession of the early 1990s. For example.

Philippines Interest Rate averaged 10. Historically.75 percent.75 Percent in July of 2012. from 1985 until 2012. .60 Percent in December of 1990 and a record low of 3.16 Percent reaching an all time high of 56.• The benchmark interest rate in Philippines was last reported at 3.

• The Lending interest rate (%) in Philippines was last reported at 6. according to a World Bank report published in 2012.66 in 2011. Lending interest rate is the rate charged by banks on loans to prime customers. .

according to a World Bank report published in 2012. .32 in 2011.• The Real interest rate (%) in Philippines was last reported at 2. Real interest rate is the lending interest rate adjusted for inflation as measured by the GDP deflator.

The effects of higher interest rates • Higher interest rates reduce aggregate demand in three main ways • • Discouraging borrowing by both households and companies • • Increasing the rate of saving (the opportunity cost of spending has increased) • • The rise in mortgage interest payments will reduce homeowners' real 'effective' disposable income and their ability to spend. A rise in real interest rates should reduce the demand for lending and therefore reduce the growth of broad money. . Some planned investment projects will now become unprofitable and. • • Higher interest rates could also be used to limit monetary inflation. as a result. aggregate demand will fall. Increased mortgage costs will also reduce market demand in the housing market • • Business investment may also fall. as the cost of borrowing funds will increase.

the difference between demand and the economy's capacity to supply is known as the output gap. monetary policy can stimulate or dampen demand. Monetary policy can't affect the economy's capacity to supply.Monetary Policy and Inflation • The balance between the overall demand for goods and services and the economy's capacity to sustainably supply them determines inflation. . This is done by adjusting short-term interest rates. • In the jargon of economists. However.

This is the difference between the „actual' level of output (GDP) and the economy's „potential' level of output (potential GDP). if the economy is running below its full capacity (GDP < potential GDP) the output gap will be negative. • If the economy is running above capacity (GDP > potential GDP) the output gap is positive.• The output gap is the difference between demand and the economy's capacity to supply. Conversely. .

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Thus. A rise in interest rates boosts the return on savings in building societies and banks. the rate of interest can impact the holding of particular assets. This influences money supply. Alteration in the rate of interest can be used to control inflation by controlling the supply of money in the following ways: A high interest rate influences spending patterns and shifts consumers and businesses from borrowing to saving mode. Low interest rates encourage investments in shares. Investors with funds in other countries now see investment in this country as a more profitable option than before. the inflation rate. consequently. resulting in an increased supply of money. Central governments use the interest rate to control money supply and. banks are able to lend more. A rise in the interest rate in a particular country fuels the inflow of funds. When interest rates are low. it becomes more expensive to borrow money and savings become attractive. .Monetary Policy and Inflation • A reiteration of the things that you already know Inflation is an autonomous occurrence that is impacted by money supply in an economy. When interest rates are high.

. it will perform an open market sale (purchase) of government bonds that will lead to a reduction (increase) in the money supply and an equilibrium increase (fall) in the short term interest rate.• A central bank affects the level of short term interest rate via changes in the money supply. When the it wants to tighten (loosen) monetary policy.

in fact. the central bank changes the supply of money through open market purchases or sales of government bonds. money and domestic and foreign Treasury Bills. . a liability of the government. orrespondingly.• Consider first how the money supply is increased. the balance sheet of the private sector is: Private Sector Balance Sheet Assets Currency 500 Liabilities and Net Worth Net Worth 2000 • • • • • • • • Treasury Bills held by public 1200 Foreign T-Bills held by public 300 Here. In general. private agents do not have any liabilities so that their net worth is equal to their assets. Consider the following balance sheet of the central bank: Central Bank Balance Sheet Assets -------------- • • • Liabilities ------------------ • • • Treasury Bills held by the CB Foreign Exchange Reserves 300 200 Currency 500 The liabilities of the central bank are equal to the total amount of currency in circulation. a zero interest rate loan that the private sector makes to the public sector by being willing to hold cash. we assume that all private wealth is held only in three assets. Money is.

from 500 to 600b: Central Bank Balance Sheet Assets Treasury Bills 400 Forex Reserves 200 • • • • • • • Liabilities Currency 600 Private Sector Balance Sheet Assets Liabilities and Net Worth • • • Currency 600 Treasury Bills held by public 1100 Foreign T-Bills held by public 300 Net Worth 2000 . this open market purchase of T-bills leads to an increase in the money supply by 100b. Since the central bank buy these bonds from the public by printing more money.• Now. consider the effects on the supply of money of an open market purchase by the central bank of 100b of domestic T-bills previously held by the public.

At the initial interest rate.• Consider now the effects of this open market operation on the money and bond markets (see Figure 5): the supply of money increases (as the MS curve shifts to the right) while the supply of bonds available to the public decreases (as the BS curve shifts to the left). the open market purchase of bonds leads to an increase in the money supply (from 500 to 600) and a reduction in the supply of T-bills available to the private sector (1200 to 1100). .

• The increase in the money supply implies that now the money supply is greater than the money demand: agents were happy with their initial holdings of cash and are now forced to hold more cash than they desire. they try to get rid of the excess money balances by buying more T-bills. • . Then. Since private agents have now more cash than they desire and less bonds than they desire. the interest rate has to fall so that the demand for money is increased and demand for bonds is decreased. Since the supply of money and bonds is exogenously given. the reduction in the supply of T-bills implies that the demand for bonds is now greater than its supply. reduces the excess supply of money and the excess supply of bonds. Their attempt to buy bonds in exchange for cash leads to an increase in the price of bonds and a fall in the interest rate. an increase in the money supply through an open market purchase of T-bills leads to a reduction in the equilibrium interest rate. Therefore. in turn. This process has to continue up to the point in which the interest rate has fallen enough so that the demand of money is equal to the higher money supply while the bond demand is equal to the lower bond supply. The interest rate fall. in the bond market. the attempt of agents to get rid of excess cash in exchange of more bonds cannot succeed: in equilibrium the greater amount of cash has to be willingly held by agents and the lower supply of bonds has to be willingly held by agents. Conversely.

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