What is money?

Any commodity or token that is generally acceptable as a means of payment.

Functions of money:

1.) Medium of exchange or means of payment

2.) Unit of account

3.) Store of value

Money functions as a medium of exchange or means of payment because it is

accepted as payment for goods and services. Compare this to a barter
economy, where if someone has a goat and wants an ox, they have to find
someone willing to trade one for the other. With money, it is possible to sell the
goat and buy the ox with the money received. A means of payment is a method
of settling a debt.

Money functions as a unit of account because prices of all goods and services
are expressed in units of money: dollars, yen, rupees, pesos, and so forth. This
allows us to determine how much of any good we are foregoing when consuming
another.

Money functions as a store of value because I can work for money now, save
it, and use the value of my labor later. Money preserves value better when
inflation is low.

Describe the components of the M1 and M2 measures of money.

M1 – includes all currency not held at banks, travelers’ checks, and checking
account deposits of individuals and firms (but not government checking
accounts).

M2 – includes all the components of M1, plus time deposits, savings deposits,
and money market mutual fund balances.

Checking account deposits are counted as money, but outstanding checks

are not.

Using credit card does not increase the money supply but it is a means of
payment.

Three primary types of depository institutions:

1.) Commercial banks – essentially operate as intermediaries between savers

and borrowers. Savers make deposits in banks to keep their money safe, but
 also earn a return on their savings. Banks take the deposits and put a
proportion of those deposits to work by buying short-term securities such as
Treasury bills, by investing in longer-term securities such as Treasury and
corporate bonds, and by making loans. In a fractional reserve banking
system, the bank must hold a specified proportion of deposits in reserve as
cash or deposits with the Bangko Sentral ng Pilipinas. This allows the bank to
meet customer needs for withdrawals and still earn a return on the deposits
not committed to reserves. The bank must manage the risk of its portfolio of
loans and other assets to make sufficient interest income to be competitive
but, at the same time, not take on risk that its depositors would consider
excessive.

2.) Thrifts / Thrift institutions – refer to savings banks, credit unions, and savings
and loan associations (S&Ls). An S&L offers both checking and savings
accounts and makes loans of various types by using customer deposits.

3.) Money market mutual fund – technically, it’s an investment company.

“Money Market” is usually used to refer to debt securities with maturities of
one year or less. A money market mutual fund manages the pooled funds of
many investors, investing it in short-term debt securities to preserve the
fund’s value and earn returns for the investors. Investors (depositors) have
ready access to their funds, but some funds restrict liquidity by imposing
minimum check amounts or a maximum number of withdrawals each month.
Offering less liquidity keeps expenses down and consequently increases
returns (interest earned).

Four main economic functions of depositary institutions:

1.) They create liquidity by using the funds from deposits to make loans or
purchase debt securities (creating liquidity).

2.) By acting as financial intermediaries, depositary institutions lower the cost of

funds to borrowers, compared to the cost if borrowers had to seek out
lenders on their own (minimizing the cost of obtaining funds).

3.) Depository institutions are in a better position than individuals would be to

monitor the risk of loans (minimizing the cost of monitoring borrowers).

4.) Institutions pool the default risks of individual loans by holding a portfolio of
loans (pooling risk).

In US, bank and S&L deposits are insured in the event of failure of the
institution to a maximum of $100,000 by the Federal Deposit Insurance
Corporation. In our country, the maximum amount insured by Philippine Deposit
Insurance Corporation (PDIC) is PhP 500,000.
 Since the existence of deposit insurance significantly reduces the incentive
for depositors to monitor the risk of an institution’s portfolio, there is significant
regulation of banks with respect to their balance sheets in four primary areas:

1.) A minimum amount of equity capital must be maintained to give owners

strong incentives to manage the risk of their asset portfolio well.

In the Philippines, banks must comply with the required minimum

capitalization and with the required capital adequacy ratio (CAR).

What is Capital? (Lifted from BSP Manual of Regulations for Banks)

The term capital shall be synonymous to unimpaired capital and surplus,

combined capital accounts and net worth and shall refer to the total of the
unimpaired paid-in capital, surplus and undivided profits, less:

a.) Unbooked valuation reserves and other capital adjustments as may be

required by the BSP;

b.) Total outstanding unsecured credit accommodations, both direct and

indirect, to directors, officers, stockholders, and their related interests
(DOSRI) granted by the bank;

c.) Unsecured loans, other credit accommodations and guarantees granted to

subsidiaries and affiliates;

d.) Deferred income tax;

e.) Appraisal increment reserve (revaluation reserve) as a result of

appreciation or an increase in the book value of bank assets;

f.) Equity investment of a bank in another bank or enterprise, whether

foreign or domestic, if the other bank or enterprise has a reciprocal equity
investment in the investing bank, in which case, the investment of the
bank or the reciprocal investment of the other bank or enterprises,
whichever is lower; and

g.) In the case of RBs/Coop Banks, the government counterpart equity,

except those arising from conversion of arrearages under the BSP
rehabilitation program.

Minimum capitalization

The minimum capitalization of banks shall be as follows:

a.) UBs – PhP 5.4 billion each

b.) KBs – PhP 2.8 billion each

c.) TBs

a. With head offices within MM – PhP 400 M each

b. With head offices outside MM – PhP 64 M each

d.) RBs

An RB may be established in any city or municipality, except in the

cities of Manila, Kalookan, Quezon, Pasay, Mandaluyong, Makati,
Parañaque, Malabon, Navotas and San Juan; and in the cities of Cebu
and Davao, with minimum capital requirements as follows:

a. In first, second and third class cities and in first class municipalities
– PhP 8 M each

b. In fourth, fifth and sixth class cities and in second, third, and fourth
class municipalities – PhP 4.8 M each

c. In fifth and sixth class municipalities – PhP 3.2 M each

Existing RBs within the excepted cities and municipalities shall

maintain the following minimum capital requirements:

a. All cited cities and municipalities except Cebu and Davao – PhP 32
M each

b. In Cebu and Davao – PhP 16 M each

e.) Coop Banks

a. National Coop Banks (divided into such number of shares with a

minimum par value of PhP 1,000 per share, with a private paid-in
capital of at least PhP 20 M) – PhP 200 M each

b. Local Coop Banks (divided into such number of shares with a

private paid-in capital of at least PhP 1.25 M) – PhP 20 M.

Exceptions to item b:

1.) PhP 20 M minimum private paid-in capital for Coop

Banks to be established in Metro Manila;

2.) PhP 10 M minimum private paid-in capital for Coop

Banks to be established in Cebu and Davao; and
 3.) PhP 5 M minimum private paid-in capital for Coop
Banks to be established in other cities: Provided,
however, that for the first Coop Bank organized in the
province, although it will be located in a city, the
minimum private paid-in capital shall be PhP 1.25 M

Risk-based capital adequacy ratio

The Philippine Banking System conforms to the recommendations of

revised International Convergence of Capital Measurement and Capital
Standards, or popularly known as Basel II.

The risk-based CAR of UBs and KBs and their subsidiaries and QBs,
expressed as a percentage of qualifying capital to risk-weighted assets, shall
not be less than ten percent (10%).

2.) Reserve requirements set a minimum percentage of deposits (different for

different types of accounts) that must be retained by the institution, either in
cash or as deposits with the central bank.

Regular reserves against deposit and deposit substitute liabilities:

The rates of regular reserves against deposit and deposit substitute liabilities
in local currency of banks shall be as follows (lifted from BSP Manual of
Regulations for Banks)

Type of deposit UBs/KBs TBs RBs/Coop

Banks

A Demand deposits 10% 6% 6%

B Negotiable Order of 9% 6% 6%
Withdrawal (NOW)
Accounts

C Savings Deposits 10% 6% 2%

D Time Deposits, Negotiable 10% 6% 2%

CTDs, Long-Term Non-
Negotiable Tax-Exempt
CTDs

E Deposit substitutes 10% 6% NA

 F IBCL 0% 0% 0%

G Bonds 5% 5% NA

H Mortgage/CHM cert. NA 5% NA

3.) There are restrictions on the types of deposits (e.g., savings deposits versus
checking deposits) that the various institutions may accept.

4.) There are rules about the proportions of various types of loans that the
institutions can make. An example would be a restriction on the proportion
of, or prohibition of commercial loans. These restrictions differ by type of
institutions as well.

Decrease in regulation was accompanied by a high degree of financial

innovation. Financial innovation refers to the introduction of new financial
products, both for depositors and for those who seek debt capital.

Creating money by creating loans:

Banks create money. Remember that most money is deposits and banks
create deposits by making loans.

In a fractional reserve banking system, such as the Fed system and BSP, a
bank is only required to hold a fraction of its deposits in reserve. The required
reserve ratio is used to measure the reserve requirement. Deposits in excess of the
required reserve (excess reserves) may be loaned.

When a bank makes a loan, the borrower spends the money. The sellers who
received the cash may deposit it in their banks. This action creates additional
loanable funds, because only a fractional amount of the deposit is required by law
to be held in reserve. This process of lending, spending, and depositing can
continue until the amount of excess reserves available for lending is zero. This is
referred to as the multiplier effect.

Illustration:

Ms. Tisa used her credit card to purchase whitening soap from Ma. Benta Co.
By signing the card sales slip, Ms. Tisa took a loan from her bank and obligates
herself to repay the loan at a later date. Ma. Benta Co will bring the card sales slip
to its bank and immediately, its bank will credit its account.

If Ma. Benta Co’s bank is the same as Ms. Tisa’s bank, the effects would be as
follows:

Ma. Benta Co and Ms. Tisa’s bank – increase in assets (loan from Ms. Tisa),
liabilities (deposit from Ma. Benta Co)and revenues (bank’s commission).

If Ma. Benta Co’s bank is different from Ms. Tisa’s bank, the effects would be as
follows:

Ma. Benta Co’s bank – increase in liabilities (deposit from Ma. Benta Co) and
increase in the reserve held by the central bank.

Ms. Tisa’s bank – increase in assets (loan from Ms. Tisa), increase in revenue
(bank’s commission) and decrease in reserves held by the central bank.

Factors that limit the quantity of deposit that the banking system can
create:

1.) The monetary base – the sum of central bank’s notes, coins, and banks’
deposits at the central bank.

2.) Desired reserves – the reserves that a bank wishes to hold

Desired reserve ratio – the ratio of reserves to deposits that a bank want to
hold. This ratio exceeds the required reserve ratio by an amount that the
banks determine to be prudent on the basis of their daily business
operations.

Actual reserves – the notes and coins in a bank’s vaults and its deposits at
the central bank.

When bank’s customer makes a deposit, reserves and deposits increase by

the same amount. When bank’s customer makes a withdrawal, reserves and
deposits decrease by the same amount.

Excess reserves – difference between the actual reserves and desired

reserves.

Whenever the banking system as a whole has excess reserves, the banks are
able to create money.

How do banks achieve their desired reserves?

To lower reserves, banks increase their loans and deposits.

 To increase reserves, banks decrease their loans and deposits.

3.) Desired currency holding – Because households and firms want to hold some
proportion of their money in the form of currency, when the total quantity of
bank deposits increases, so does the quantity of currency that they want to
hold. Because desired currency holdings increases when deposits increase,
currency leaves the bank when money is created.

Currency drain – the leakage of currency from the banking system

Currency drain ratio – ratio of currency drain to deposits

The greater the currency drain ratio, the lower the amount of money that the
banking system can create given the amount of monetary base.

The money creation process

The money creation process begins when the monetary base increases and
the banking system has excess reserves. These excess reserves come from a
purchase of securities by the central bank from a bank.

The process has 9 steps. They are:

1.) Banks have excess reserves.

2.) Banks lend excess reserves.

3.) Banks deposits increase.

4.) The quantity of money increases.

5.) New money is used to make payments.

6.) Some of the new money remains on deposit.

7.) Some of the new money is a currency drain.

8.) Desired reserves increase because deposits have increased.

9.) Excess reserves decrease but remain positive.

Money Multiplier

Money multiplier is the ratio of the change in the quantity of money to the
change in the monetary base.
 Money multiplier = Change in Money/Change in Monetary Base

Change in money is computed as follows:

S = A/(1-L)

Where:

S = total increase in money or change in the quantity of money

A = initial increase in excess reserves

L = proportion of the new loan to the previous loan

The magnitude of the money multiplier depends on the desired reserve ratio
and the currency drain ratio.

When there are no excess reserves,

MB (monetary base) =

Money multiplier = (1+a)/(a+b)

a = currency drain ratio

b = desired reserve ratio

When there are no excess reserves, monetary base is equal to the sum of
desired currency holdings and desired reserves while Money is equal to the sum of
deposits and desired currency holding. Desired currency holding is equivalent to
the product of currency drain ratio and deposits. Desired reserve is equivalent to
the product of desired reserve and deposits.

The market for money

The quantity of money that people plan to hold depends on four main factors:

1.) The price level

Nominal money – the quantity of money measured in dollars

Real money – the quantity of money measured in constant dollars.

Real money is equal to nominal money divided by the price level and is
the quantity of money measured in terms of what it will buy.

2.) The nominal interest rate

 The nominal interest rate on other assets minus the nominal interest
rate on money is the opportunity cost of holding money. The higher
the opportunity cost of holding money, other things remaining the
same, the smaller is the quantity of real money demanded.

3.) Real GDP –

The quantity of money that households and firms plan to hold depends
on the amount of money they are spending.

The quantity of money demanded in the economy as a whole depends

on aggregate expenditure – real GDP.

4.) Financial innovation

Technological change and the arrival of new financial products change

the quantity of money held.

The demand for money

The demand for money is the relationship between the quantity of real
money demanded and the nominal interest rate when all other influences on the
amount of money that people wish to hold remain the same.

Movement along the demand curve – influenced by changes in interest rates

Shifts in the demand curve – influenced by changes in real GDP and financial
innovation.

Shift to the left – effect of a decrease in real GDP (aggregate expenditures)

and financial innovation

Shift to the right – effect of an increase in real GDP (aggregate expenditures)

Money market equilibrium

Equilibrium occurs when the quantity of money demanded equals the

quantity of money supplied.
Short run equilibrium – the quantity of money supplied is determined by the
actions of the banks and the central bank. The central bank adjusts the
quantity of money to hit its interest rate target.

Long run equilibrium – the price level adjusts to make the quantity of real
money demanded equal the quantity supplied.

Quantity theory of money - the proposition that in the long run, an increase in
the quantity of money brings an equal percentage increase in the price level.

Velocity of circulation (V) – the average number of times a dollar of

money (M) is used to annually buy the goods and services that make up GDP
(PY).

Nominal GDP = Price level (P) * Real GDP (Y)

V = PY/M

Equation of exchange (MV=PY) becomes the quantity theory of money

if the quantity of money does not influence the velocity of circulation or real
GDP. In the long run, the price level is determined by the quantity of money.

P = M(V/Y)

Note: (V/Y) is independent of M so that a change in M brings a

proportional change in P.

In terms of growth rate,

Money growth rate + rate of velocity change = Inflation rate + real

GDP growth rate

Inflation rate = Money growth rate + rate of velocity change – real GDP
growth rate

Note: rate of velocity change is not influenced by the money growth

rate and in the long run, it approaches zero.

In the long run, inflation rate is

Inflation rate = Money growth rate – Real GDP growth rate.