Chapter 10 - Monetary Policy

1. MONETARY
POLICY
Central Bank use to direct
and regulate the monetary
system bith from long-term
and short-term perspectives
CHAPTER 10

2. MONETARY POLICY
• the process by which the monetary
authority of a country control the
supply of money, often targeting an
inflation rate or interest rate to ensure
price stability and general trust in the
currency

3. FUNCTION OF MONEY AND
MONEY SUPPLY

4. Function of Money
• Money as a medium of exchange
began to assume a significant
role in the advent of the market
economy marked by
specialization, interdependence,
and trade.
• Today, the distinct advantage of
the moentary sytemn over the

6. Function of Money
• However, the introduction of
money in the system makes
exchange possible when it
passes from one hand to the
other.
• Money serves as a vehicle for the
free flow of products to satisfy
human wants since it can be

7. Function of Money
• Money is the pillar of the price
system and can, therefore, induce
economic activities.

8. Money Supply
• Money is a vehicle of economic
activities when in circulation.

10. Money Supply
• The stock of money serving this
function is called money supply
and consists of the following:
Coins and bills in circulations
Demand deposits in banks
Quasi-money (savings deposits, time
deposits)
Deposit substitutes

12. Money Supply
• The overall level of money supply
continued to increase despite the
econimic crisis due to two factors:
1. Peso increase in export earnings
2. Government’s move to restrict
imports in order to conserve the
country’s dollar reserves which
resulted in a balance of payment
supplies for the year.

13. Money Velocity and Income
• Money supply as a medium of
exchange multiplies to income.
• The multiplier coefficient is only
dependent on the rate of money
outflow.

14. Money Velocity and Income
• However, the number of time the
money supply circulates and changes
hands to become income also
depends on the propensity of every
wealth holder to temporarily hold
money as idle balances before
transactions.

15. Money Velocity and Income
• The greater this propensity is, the
more money the economy holds
temporarily as idle balances which
can otherwise be generated into more
transactions and income if circulated
faster.
• The opposite is true if this propensity
is less to increase money circulation.

16. Money Velocity and Income
• The two main determinants embody
the wider concept of the multiplier
process called the “money velocity.”
• Multiplying this coefficient by money
supply yields income, as follows:
MV = Y

17. Money Velocity and Income
• Since:
Y= PQ -> Economic income
• Alternatively,
MV = PQ

18. Money Velocity and Income
• Where:
M = money supply
V = velocity
Y = nominal money income
P = price
Q = volume of goods and
services

19. Money Velocity and Income
• The equation embodies the quantity
theory of money and implies that the
same level of money supply
increases (decreases) income due to
an increase (decrease) in the money
velocity.

20. BANKS AND MONEY SUPPLY

21. The Fractional Reserve
System
• Banks are supposed to be conduits of
funds linking investors/borrowers to
the sources.
• They accept deposits which chiefly
supply their lending operations.
• In the process, they are liable to the
depositors and borrowers in turn for
periodic loan repayments.

23. The Fractional Reserve
System
• Commercial banks in particular can
create deposit liabilities greater trhan
their reserves or money in vault which
is the essence of the fractional
reserve system.
• Depositors and borrowers can
circulate their demand deposits in the
banks using checks which are as
good as money.

24. The Fractional Reserve
System
• However, only a fraction of the total
amount of checks circulated is
encashed from the banks, at any one
time.
• Thus, a commercial bank can lend
more than its actual deposit by
creating more deposit liabilities while
maintaining a smaller reserve to meet
fractional cash demand.

25. Money Creation
• Commercial banks create more
money by lending more and creating
more demand deposits while the
opposite is true when they tighten
credit.

27. Money Creation
• The amount of money checks that a
commercial bank can cause to
circulate from every peso of reserves
is theoretically expressed as follows:
L = mR
m = L/R

28. Money Creation
• since:
r = L/R < 1
• Therefore:
m = 1/R

29. Money Creation
• Where:
m = money multiplier
R = Reserves
L = Deposit Liabilities
r = Ratio of reserves to
deposit liabilities or
fractional cash demand ratio

30. Money Creation
• Liabilities are not entirely bank-
created money.
• They partly represent currency in the
vault of the bank which circualtes as
checks and constitutes money
already created.

31. SOURCES OF MONEY
SUPPLY

33. Sources of Money Supply
• The lending operation of the banking
system determines the volume of
money checks it creates.
• Thus, lending more/less within the
limits of the fractional cash
requirement of deposits
increase/decrease money checks and
the level of money supply.

34. Sources of Money Supply
• On the other hand, the
government prints new money at
times to help finance its
expanding operations.
• This increases currency in
circulation and the money checks
that banks create from currency
deposits.

35. Sources of Money Supply
• Furthermore, foreign currency
inflows are sold to the Central
Bank for pesos through
commercial banks based on a
fixed exchange rate prescribed by
the former.

36. Sources of Money Supply
• In turn, the peso currency inflows
find their way into the vaults of the
banking system and then to
currency in circulation and
money checks that banks create
from cash deposits.

37. Sources of Money Supply
• Thus, money supply tends to
increase with foreign currency
inflows while the opposite is true
with foreign outflows.

38. Sources of Money Supply
• However, it is the net effect of
foreign currency inflows and
outflows that changes the level of
money supply.
• The level increases when inflows
exceed outflows while the
opposite is true when outflows
exceed inflows.

39. Sources of Money Supply
• Taxes also change the level of
money supply as leakages from
the circular flow.
• Taxes are foregone consumption
and savings which could
otherwise be part of currency in
circulation and reserves which
enable banks to create money

40. Sources of Money Supply
• Thus, an increase in taxes
decreases money supply while
the opposite is true with a
decrease in tax revenue.

41. Sources of Money Supply
• In addition, the unspent portion of
the budget surplus only
decreases money supply when
kept in the National Treasury and
not in the banking system where it
can be channeled back to
circulation.

42. Sources of Money Supply
• However, taxes do not become
leakages at all if channeled back
to circulation in the form of
government spending.

43. MONEY AND THE CENTRAL
BANK

44. Functions of the Central Bank
• It is the responsibility of the
Banko Central ng Pilipinas to
administer the monetary, banking,
and credit system of republic.
• This responsibility is exercised to
achieve monetary objectives in
consonance with the overall
economic policies of the

46. Functions of the Central Bank
• The objectives are as follows:
1. To maintain internal and external
monetray stability in the
Philippines; and to preserve the
international value of the peso
and its convertibility to other freely
convertible currencies; and

47. Functions of the Central Bank
2. To foster monetray, credit, and
exchange conditions cunducive to
a balanced and sustainable
growth of the economy.

48. Functions of the Central Bank
• Therefore, the Central Bank
regulates the magnitude and
movement of money through the
banking and credit system which
serves as a conduit of fund from
sources to users.

49. The Confidence in Money
• The Central Bank is the only
authorized government entity to
print money and is responsible for
the proper administration of the
monetary, banking, and credit
system of the republic to achieve
monetary stability and create
conditions conducive to economic

50. The Confidence in Money
• As such, it preserves the
confidence of the people in
money as a thing of value and an
essential institution of the
economic system.
• Once the trust is broken, money
ceases to function as it should be,
i.e. as a vehicle of economic

51. MONETARY POLICIES

52. Some Policy Concepts
• The Central Bank use monetary
policies to regulate money
through the credit and banking
system in order to attain monetary
stability conducive to economic
development.

53. Some Policy Concepts
• However, monetary authorities
have to use instruments to make
policies workable and, therefore,
realize objectives.
• The use of these instruments
should be flexible enough to
contend with the dynamic forces
that they direct.

54. Short-run Tools Affecting
Money Supply
• Reserve requirements
• Rediscounting
• Open Market Operations
• Selective Control
• The Need for the Policy
Coordination