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Chap. 10. monetary policy
MONEY ANDMONETARY POLICIES
A. Function of Money & Money SupplyMoney as a medium of exchangebegan to assume a significant rolein the advent of the marketeconomy marked by 1-3specialization, interdependenceand trade.
Money SupplyMoney is a vehicle of economicactivities when in circulation (i.e. in thecircular flow)
The stock of money serving this function iscalled money supply and consists of thefollowing:Coins and Bills in circulationDemand deposits in banks - Savings Deposits - Time Deposits Deposit Substitutes
Money Velocity & Income4. Money Supply as medium of exchangemultiplies into income. The multipliercoefficient is only dependent on the rate ofmoney outflow.
Table 33 represents the country’s domesticliquidity from 1981 to 2001. The economic crisisin 1997 was marked by declining levels ofproduction and increasing rates of inflation(price increase) and unemployment.However the overall level of money supplycontinued to increase despite the economiccrisis due to two factors.The said overall increase in money supply waspresumably pocketed by the economy’s bigearners and channeled to quasi money.
MV = Y 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 quantitytheory of money and implies that the samelevel of money supply increases(decreases) in the money velocity.
The Fractional Reserve System 5. Banks are supposed to be a conduits of funds linking investors or borrowers to the sources. As such, they accept deposits which chiefly supply their lending operations.
However, commercial banks in particularcan create deposit liabilities (i.e. todepositors and borrowers) greater thantheir reserves or money in vault which isthe essence of the fractional reservesystem.Thus, a commercial bank can lend morethan its actual deposit by creating moredeposit liabilities while maintaining asmaller reserve to meet fractional cashdemand.
Money CreationIt has just been illustrated that the fractionalreserve system enables commercial banks tolend more than their reserves. They do so bycreating more demand deposits which cancirculate like money in the form of checkswhile supported by a smaller cash amount toonly meet fractional cash demand.Therefore, 6. commercial banks create moremoney by lending more and creating moredemand deposits while the opposite is truewhen they tighten credit.
The amount of money checks that a commercialbank can cause to circulate from every peso ofreserves is theoretically expressed as follows: L = mR m = L/R Since: r = R/L < 1 Therefore: m = 1/r Where: m = Money multiplier R = reserves L = deposit liabilities r = Ratio of reserves to deposit liabilities or fractional cash demand ratio
The 7. lending operation of thebanking systems determines thevolume of money checks it creates.Thus , lending more/less within thelimits of the fractional cashrequirements of the depositsincreases/decreases money checksand the level of money supply.
The government print new money at times ,to help finance its expanding operations. Thisincreases currency in circulation and themoney checks that banks create fromcurrency deposits.8. Money supply tend to increases withforeign currency inflows while the opposite istrue with foreign currency outflows. However, it is the net effect of foreign currencyinflows and outflows that changes the level ofmoney supply.
9. Taxes also changed the levelof money supply as leakages fromthe circular flow. Taxes areforegone consumption and savingswhich could otherwise be part ofcurrency in circulation and reserveswhich enables banks to createmoney checks.
The unspent portion of the budgetsurplus (unspent tax revenue) onlydecreases money supply when kept inthe National Treasury and not in thebanking system where it can bechanneled back to circulation. On theother hand , government borrows fromthe banking system to finance deficitspending.
It is the reponsibility of BangkoSentral ng Pilipinas toadminister the monetary,banking, and credit system ofthe republic as embodied inSection 2 , Articles of theamended Republic Act 2656.
The Objectives are as follows: To maintain internal and external monetary stability in the Philippines; and to preserve the international value of the peso and its convertibility to other freely convertible currencies. To foster monetary , credit , and exchange conditions conducive to a balanced and sustainable growth of the economy.
The Confidence in MoneyThe 10. Central Bank is the onlyauthorized government entity to printmoney and is responsible for the properadministration of the monetary ,banking , and credit system of therepublic to achieve monetary stabilityand create conditions conducive toeconomic development.
1) Some policy conceptThe central bank used monetary policy toregulate money through the credit andbanking system in order to attain monetarystability conducive to economic development.
2) short-run ToolsAffecting Money Supply A. RESERVE REQUIREMENTS It has been explained in section B.2 of this chapter that their actual deposits (reserves) and create money by creating more deposit liabilities.MONEY CREATED = (1/r)(R)MONEY CREATED = as r with R constant as r
B. Rediscounting The central bank can infuse money intothe coffers (reserves) of the banking system bybuying its loan papers (i.e. loan receivables) atrediscounted values. The central bank can raise the level ofreserves and credit money by widening itsrediscounting windows and buying more loanpapers at lower and more encouragingrediscounting rate .
MONEY CREATED = (1/r-1)(R)MONEY CREATED = as R with rconstant as R
The central bank offers a purchase orpresent value derived by discounting thematurity value of the paper to the purchaseperiod using a rate called the rediscount rate. P = F/ ( 1 + r ) t
C. Open market OperationFRAMEWORK Another way the central bank can changethe level of money supply is by buying andselling government securities in the openmarket.GOVERNMENT SECURITIES-> are financial paperswith short term maturities.
COMPARATIVE ADVANTAGECentral bank has more control over bankreserves with this instrument. To decreasemoney supply , it simply offers more treasurybills at higher interest to draw a momentumthat it can control within the volume it aimsto transact.
EFFECTIVENESS IN TRIMMING LIQUIDITYThe central bank floated more treasurybills with a weighted average interest rateof 35% relatively attractive to theprevailing rate of 20%-28% for short termloans and placements.
D. Selective control The effective range of an instrumentmay not necessarily lead to it’s target andeven if it does , may spill over to factorswhich are not its concern and thud createnew problems.
E. The need for policy CoordinationIt is not enough that an instrument beconfined to its target to create positiveeffects. For one, applying the instrumentalone may be inadequate to solve theproblem.