MONETARY THEORY Created by: Darlene N.

Catipay
AND POLICY
LECTURE GUIDE
oMonetary Theory
oValue of Money
oTheories about Money
oMonetary Policy
oTools of Monetary Policy
MONETARY THEORY Section I
INTRODUCTION
Human beings are blessed with intellects so that they may prepare for
whatever may happen in the future. To anticipate developments, people make
use of theories.
With the use of good theories, people are able to “take appropriate action to
forestall or offset the event or any undesirable effects.”
As the concern for economic growth became paramount, reference to
monetary theories became important. These theories provide the authorities
with bases for the formulation of monetary policy.
Some of the relevant theories about money and will deal with discussions
about monetary policy shall be presented in this lecture.
MONETARY THEORY
Monetary theory is a general statement that describes the
causes of changes in financial variables, such as money
supply and interest rates, and the effects of these changes,
changes in variables in the real sector, such as
employment, production and prices.
MONETARY THEORY
Theories may be good or bad, useful or not useful. A good
monetary theory is one that can well and simply predict an actual
event. It is useful because it permits us to explain an event and its
consequence in advance rather than after it has occurred. Thus, we
can prepare for the consequence and take measures that will
minimize if bot totally eliminate the ill effects of any unwanted
development.
VALUE OF MONEY Section I-Part B
VALUE OF MONEY
The value of money refers to the amount of goods or
services which will be given in exchange for a unit of
money. The value of money is synonymous with its power
to purchase economic goods.
VALUE OF MONEY
The value of a peso may be expressed in terms of goods
such as a piece of pan de sal or one-fourth kilo of
tomatoes. The value of the peso may change from time to
time, however. This is exemplified by the fact that about
ten years ago, a peso can buy two pieces of pan de sal.
Also, one-fourth kilo of tomatoes will cost two pesos or
more during off-seasons.
VALUE OF MONEY
When money can buy more goods than before, it is
said that the value of money has gone up and the
prices of commodities has gone down. Inversely,
when money can command less goods in exchange,
the value of money has gone down and the prices of
commodities has gone up.
VALUE OF MONEY
Prices and value of money are, thus, related. As abrupt
changes in the value of money affects the economy, the
government finds it necessary to manage the monetary
system. The need for an effective monetary policy
follows. Monetary policy, however, is formulated based
on some theories about money.
REVIEW
(SECTION 01)
You can reread and review this section if
the topic presented is still blurry in your
mind. You can research for terms to
understand it better for your
consumption in this lecture.
Drink a lot of water and have a break in
between sections to clarify your thoughts
or ideas throughout this lecture. You got
this!
THEORIES ABOUT Section II
MONEY
IMPORTANT THEORIES ABOUT
MONEY
Economists have forwarded various theories about money. Some of these theories
were discarded, while some were modified to suit current circumstances. As new
theories are being cooked up, some are being used or referred to extensively even
after the passing of so many years.
Some important theories about money are:
1. the quantity theory of money
2. the income theory
3. the transactions theory, and
4. the cash-balance theory
 PRICES AND THE VALUE OF
MONEY
Downward Downward
movement movement
(Cause A) (Effect B)

PRICES OF VALUE
COMMODITI OF
ES
MONEY
upward upward
movement movement
(Cause B) (Effect A)
FINAL QUIZ FOR THIS
LESSON:
Explain the relationship of prices of commodities and value of
money through this guide question:
• If prices of commodities (Cause A) will go down, what will
happen to the value of money (Effect A)? Is this true in reality
or not? Elaborate your answer by giving examples.

Place your answer on the space provided in the next section.

QUANTITY THEORY OF Section II-Part B
MONEY
QUANTITY THEORY
The quantity theory of money is “ a theory that states the
relationship between the quantity of money in an economy and the
price level.” When the other factors are constant, a change in the
quantity of money will result in proportional changes in the price
level.
If, for instance, money is increased by 20% during a period, prices
would be expected to rise by an average of 20% also. This
happens because more money will now bid for the same quantity
of goods, the effect of which is the jacking up of prices.
QUANTITY THEORY
The quantity theory was first developed in the late
1500’s when money was primarily a medium of
exchange used to purchase commodities. If there is
more money in circulation, more spending will be
made, and with less money, less spending.
QUANTITY THEORY
The quantity theory of money suggests that inflation can be
controlled by the monetary authorities through control of the
quantity of money in circulation. Thus, if a certain rate of growth
in gross national product is anticipated, this can be achieved
without inflation by allowing the quantity of money in circulation
to increase proportionately.
QUANTITY THEORY
Thus, to compute for the price level, the mathematical formula used is as
follows:
P= MV
T
Where P= the price level
M= the amount of money in circulation
V= the velocity of circulation or the rate of money turnover
T= the total volume of trade
The money in circulation is that money which is being used to finance transactions,
as opposed to idle or inactive money.
QUANTITY THEORY
The velocity of circulation refers to the rate at which money
circulated through the economy in order to finance transactions.
Velocity is calculated by using the formula.
V=Y/M
Where M= the money supply available in the economy for a specified period
(usually one year)
V= the money value of national income over that period.
INCOME THEORY Section II-Part C
THE INCOME THEORY
The income approach to monetary theory is an expression of a
belief by some economists about the relationship between income
and money. They thought that “changes in the economy are not
influenced by the changes in the value of money or price levels”
but through the interaction of the various aggregates like income,
investments, savings, and consumption.
THE INCOME THEORY
The theory recognizes that one person’s spending is another’s
income and in analyzing the value of money, one must focus on
the factors that affect income and spending in the economy.
This simply means that a person with an income will have a means
to spend, and when he does, somebody is provided with an
income, who in turn, is in a position to spend and provide another
with an income.
This will bring us the need for a brief understanding of the
aggregates composing the national income.
NATIONAL INCOME
National income refers to the value of income from the
sales of goods and services in a country. It includes not
only the incomes which arise from production within the
economy but also income which accrues to domestic
residents from activities carried on abroad.
NATIONAL INCOME
National income may be calculated in three ways:
1. as the value of the outputs of all goods and services in the economy, net of
indirect taxes and subsidies, and corrected for inter-industry sales so as to
avoid double-counting.
2. as the total flow of incomes paid out to households in return for the supply
of production services, plus profits retained by firms as reserves.
3. as the sum of expenditures on consumer goods and investment goods,
government expenditures, and expenditures by foreigners on the nation's
exports less domestic expenditures on imports.
INVESTMENTS
Investment is expenditure on real capital goods which refer to
physical goods. Investment does not include the following:

1. investments of commercial banks and other financial

institutions in terms of purchases of securities; and

2. purchases of existing capital goods like a seven year old school

building.
INVESTMENTS
For purposes of national income analysis, investment will mean
spending for new capital goods like constructing a new school
building. It will result to increased income for construction
workers who will build the faculty.
It will also result to income provided to teachers who will be
hired, increased income to producers of school supplies,
publishers of books, and printers of enrollment forms and class
cards.
INVESTMENTS
As investment expenditures fluctuate, some tools of
monetary policy must be used by the central
monetary authority to influence the total amount of
such expenditures.
SAVINGS
Savings refer to that part of income not spent on
consumption. Savings represents money which having
been paid out as income to households by business firms
or the government is not returned to them in the form of
expenditure on goods and services.
SAVINGS
People will tend to save more if real interest rates rose. With high
interest rates, people could acquire more goods in the future for
each peso income they did not spend on current consumption.
When people save too much money however, the demand for
products and services will be less and production will be affected.
In this case, monetary policy may be directed to motivate people
to spend more and to save less.
CONSUMPTION
Consumption refers to the total expenditure in an
economy on goods and services which are used up within
a specified, usually short period of time, generally a year.
This expenditure will include consumer goods and
services, as well as raw materials and other inputs used in
the production processes.
CONSUMPTION
Changes in consumption expenditures are affected by the
following:
1. changes in the holdings of money by the individual members of
the public;
2. changes in the availability of credit and the effective rates of
interest;
3. changes in the perception of the consumers regarding their
current purchasing power.
CONSUMPTION
When money holdings of individuals increase, their
consumption expenditures will tend to increase.
When credit becomes more readily available,
consumption expenditures also tend to increase.
When consumers think that the value of securities they
hold increased, thereby increasing their purchasing power,
they will tend to increase their purchases of various
commodities.
EFFECTS OF CHANGES IN THE
VARIOUS AGGREGATES
The income stream is a circular flow of income with business
firms and consumers as the main propellers. Businesses provide
income to consumers in the form of wages, interest, rent,
dividends, and royalties. These payments flow into the income
stream. But business firms also provide additions to the stream by
making investment expenditures.
EFFECTS OF CHANGES IN THE
VARIOUS AGGREGATES
When consumers receive income, they are faced with two options:
(1) to spend on consumption, or
(2) to save.
A simplified illustration is presented in the next slide which
indicates that saving tends to reduce the size of the income stream
and investment tends to increase the level of national income.
 CIRCULAR FLOW OF INCOME
Income payments wages,
INVESTMENT
rent, interest, royalty, and
dividends

BUSINES CONSUMER
S FIRMS S

Consumption
expenditures SAVINGS
TRANSACTIONS Section II-Part D
THEORY
TRANSACTIONS THEORY
The transactions approach indicates that the value
of money is determined by the forces of supply and
demand over a period of time, rather than at a given
time in a given market. The approach focuses on
the spending of money.
TRANSACTIONS THEORY
The proponent of this approach, Irving Fischer,
agrees that “one of the normal effects of an increase
in quantity of money is an exactly proportional
increase in the general level of prices.”
TRANSACTIONS THEORY
The foregoing statement according to Fischer, hinges on three assumptions, the
validity of which confirms the validity of the quantity theory. The assumptions
are as follows:
1. that changes in the quantity of money do not affect velocity;
2. that changes in the quantity of money do not affect the volume of
transactions;
3. the chain of causation runs from money to prices and not in the other
direction. This means that changes in the quantity of money affect the price
level, but changes in the price level do not affect the amount of money in
circulation (M), the velocity of circulation (V), or the total volume of trade (T).
CASH-BALANCE Section II-Part D
THEORY
THE CASH-BALANCES
APPROACH
The Cash-Balances Approach is a version of the quantity
theory of money that focuses on the demand for money.
The approach relates the determination of the value of
money to the motives and decisions of individuals
holding money.
THE CASH-BALANCES
APPROACH
People or organizations with income may decide to partly
forego spending their money on consumption or
investment. The result is saving. The savers however, will
still decide on whether or not their savings will be made
available to the financial markets.
THE CASH-BALANCES
APPROACH
The question of why people want to hold money must be
considered. In short, some serious thought must be spent
on the motivation of people who decide on what their
cash balances must be, say 20% of their annual income.
REVIEW
(SECTION II)
You can reread and review this section if
the topic presented is still blurry in your
mind. You can research for terms to
understand it better for your
consumption in this lecture.
Drink a lot of water and have a break in
between sections to clarify your thoughts
or ideas throughout this lecture. You got
this!
MONETARY POLICY Section III
MONETARY POLICY
Monetary policy involves the manipulation of financial
variables by the central monetary authority in order to
achieve the economy’s ultimate goals of full employment
and balanced economic growth at stable prices.
As such, monetary policy is viewed as an instrument to
stabilize the economy.
MONETARY POLICY
Monetary policy is a major instrument of macroeconomic
policy, which government conducts through the
management of the nation’s money, credit, and banking
system.
TOOLS OF MONETARY Section III-B
POLICY
TOOLS OF MONETARY POLICY
Central monetary authorities use various tools to
implement monetary policy. These tools are as follows:
1. open market operations
2. discount policy
3. reserve requirements
 WHAT MONETARY POLICY IS
SUPPOSED TO ACHIEVE?
Monetary Policy Actions
FINANCIAL MARKETS AND
INSTITUTIONS

CONSUMPTION

INVESTMENT

GOVERNMENT EXPENDITURE

MARKET
LEVEL OF
PRICES INTEREST
ECONOMIC RATES
ACTIVITY
OPEN MARKET Section III-Part C
OPERATIONS
OPEN MARKET OPERATIONS
Open market operations refer to the central bank’s activity of
buying or selling of government securities in the open market.
This tool is used to effect changes in interest rates. When the
central bank makes open market purchases, the monetary base is
expanded, thereby raising the money supply and lowering short-
term interest rates.
Conversely, when the central bank makes open market sales, the
monetary base shrinks, lowering the money supply and raising
short-term interest rates.
OPEN MARKET OPERATIONS
Open market operations consist of two types as follows:
1. dynamic open market operations- those which are intended to
change the level of reserves and the monetary base.
2. defensive open market operations- those which are intended to
offset movements in other factors that affect reserves and the
monetary base.
Open market operations is a tool used by the Bangko Sentral ng
Pilipinas (BSP). This activity is made possible through the sale of
BSP holdings of Treasury securities.
OPEN MARKET OPERATIONS
Open market operations have the following advantages over other tools of
monetary policy:
1. The BSP has complete control over the volume of transactions. The BSP
demonstrated that power once when it partially rejected some bids for its T-
bill offerings to arrest an abrupt appreciation in the yields of such financial
instrument.
2. They are flexible and precise and can be used to any extent. If only a small
change in reserves or monetary base is required, the central bank can achieve
it with a small sale or purchase of securities. If a big change is needed, a large
sale or purchase is made.
OPEN MARKET OPERATIONS
Open market operations have the following advantages over other tools of
monetary policy:
3. Mistakes, can easily be corrected if the central bank feels that the rate of
government securities purchased is too low, it can reverse the error by
conducting open market sales.
4. The implementation of open market operations can be made quickly,
involving no delays in administration. To change the monetary base or
reserves, the central bank will just place orders with securities dealers, and
the transactions are effected immediately.
DISCOUNT POLICY Section III-Part D
DISCOUNT POLICY
The central bank lends money to depository institutions. The
interest rate charged to the borrowers is called the discount rate.
Discount policy is that which primarily involves changes in the
discount rate. Any increase in discount loans adds to the monetary
base and results to an expanded money supply. Any decrease in
discount loans reduces the monetary base which results to a
reduced money supply.
DISCOUNT POLICY
The volume of discount loans granted may be achieved by the
central bank through any of the following measures:
1. by affecting the discount rate;
2. by affecting the quantity of the loans.
DISCOUNT POLICY
The reduction of discount rates provides an incentive to
depository institution to obtain additional reserves thereby
creating additional lending capacity. The result is that
credit becomes easier for the individual borrowers.
An increase in the discount rate may discourage increase
in reserve availability resulting to the reduction of the
expansion rate of the economy.
 EFFECTS OF
DISCOUNT POLICY
DISCOUNT
POLICY

DISCOUNT
ANY INCREASE
LOANS
ANY DECREASE

results to results to

BIGGER SMALLER
MONETAR MONETAR
Y BASE Y BASE

and and

EXPANDE SHRINKIN
D MONEY G MONEY
SUPPLY BASE
 RESERVE Section III-Part E
REQUIREMENTS
RESERVE REQUIREMENT
Reserve requirements refer to the regulation making it obligatory
for depository institutions (i.e, those accepting deposits) to keep a
certain fraction of their deposits in accounts with the central bank
(the BSP in the case of the Philippines).
This requirement helps the central bank exercise more precise
control over the money supply.
RESERVE REQUIREMENT
The reserve requirements are imposed by the BSP on the following:
1. against peso deposits
2. against foreign currency deposits
3. against unused balances of overdraft lines.
If the central bank wishes to reduce the ability of depository
institutions to grant credit, it will increase the reserve requirement. If
the central bank wants to expand credit availability, it will lower
reserve requirements.
REVIEW
(SECTION III)
You can reread and review this section if
the topic presented is still blurry in your
mind. You can research for terms to
understand it better for your
consumption in this lecture.
Drink a lot of water and have a break in
between sections to clarify your thoughts
or ideas throughout this lecture. You got
this!
BOOK SOURCE:
MONEY, CREDIT, AND BANKING
BY DR. ROBERTO G. MEDINA
END OF LESSON
05: MONETARY
THEORY AND
POLICY
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