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ECONOMICS 121
Money and Banking
“Money bewitches people. They fret for it, and they sweat for it. They devise the most ingenious
ways to get it, and the most ingenious ways to get rid of it. Money is the only commodity that is
good for nothing but to be gotten rid of. It will not feed you, clothe you, shelter you, or amuse
you unless you spend it or invest it. It imparts value only in parting. People will almost do
anything for money, and money will do almost anything to people. Money is a captivating,
circulating, masquerading puzzle.”
-Federal Reserve Bank of Philadelphia, 1957
Lecturer: Harvey V. Baldovino, DE Rm. 10
Consultation hours: Tuesday to Friday 11-12 and 1-2:30
COURSE DESCRIPTION
Theories and problems concerning money, credit and financial institutions
COURSE OBJECTIVES
At the end of the semester, the students should be able to:
• Define the basic concepts and principles of the money, financial markets, financial
institutions, and monetary policy; and
• Apply these ideas in dealing with the issues and policies in the national and international
economy
COURSE OUTLINE
I. Introduction
A. Overview of Course Importance
B. What is Monetary Economics?
C. Brief Evolution of Monetary Economics
II. Money
A. The Basic Definition of Money
B. General Functions of Money
C. Monetary Aggregates
D. Classification of Money
E. Evolution of Payment Mechanisms
F. Monetary Transmission Mechanisms and Channels of Monetary Influence
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III. The Demand for Money
A. Transaction Motives
B. Portfolio Allocation Motives
C. Keynesian Approach to Portfolio Allocation Theory
D. Friedman’s Contribution to Portfolio Allocation Theory
IV. The Supply of Money
A. The Balance Sheet and T-Accounts
B. Deposit Creation
C. Multiple Expansions of Deposits
D. Determinants of Money Supply
E. Instruments of Monetary Control
V. Financial Markets and Institutions
A. Definition of Terms
B. Why Financial Assets and Markets Exist
C. Financial Markets
VI. The Pricing of Financial Instruments
A. Riskless Assets and Computation of Asset Yields
B. Discounting and Compounding
C. Capital Asset Pricing Model (CAPM)
D. Risks and Portfolio Diversification
E. Credit Market Instruments
VII. Financial Intermediaries and Commercial Banking
A. Importance and Types of Financial Intermediaries
B. Structure and Regulation of Commercial Banking
VIII. The Central Bank
A. History and Structure of the Bangko Sentral ng Pilipinas
B. The Functions of the Central Bank
IX. Inflation
A. Causes of Inflation
B. Costs of Inflation
C. Why Policymakers Allow Inflation
D. Costs of Reducing Inflation
E. BSP Inflationary Measures
X. International Economy and Monetary Policy
A. Foreign Exchange Intervention
B. Exchange Rate Regimes and International Financial Systems
XI. Special Topics
3
POLICIES
Grading System
Pre-final Grade: 3 long exams = 75%
Quizzes = 15%
Stock Market Game = 5%
Participation = 5%
• Passing rate is 60%. Students with marks below 60% will take the final exam. Students
who already have passing marks may also take the final exam at their own risk. Pre-final
grade=60% and Final Exam=40%.
• If a student misses one exam, the final exam will be taken as a replacement. If a student
misses two exams, the student is automatically dropped from the course. Make-up
exams will be given only for excused absences (provide excuse slip from college
secretary).
• Attendance will be checked regularly. The maximum number of allowable absences is 7
meetings. A student who accumulates more than 7 absences will get either a DRP or a
5.0 mark, depending on the student’s performance. Students who arrive 20 minutes
after the start of the class will be marked as absent.
• Quizzes will be held every Tuesday at the start of the meeting. Latecomers will not be
given special quizzes.
• Participation is based on attendance. Every absence will incur a deduction of 0.5% on
participation.
• The Stock Market Game is online based and will start on January. The grades will be a
percentage of the score of the highest scorer of the game. The ultimate stock trader will
receive automatic 5% and a cash prize of P500.
• The ECON121 field trip will be required for this class. Details will be given later in the
semester.
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Chapter 1
Introduction
1.1. Overview of the Course Importance
• Why Study Monetary Economics?
a) Inherently interesting
b) Controversial issues are in the field of monetary economics
c) Facilitates analysis of policies that affect monetary and financial markets
1.2. What is Monetary Economics?
• Monetary Economics covers the following:
a) Role and functions of money in the economic system
b) Financial systems and the financial institutions
c) Effects of money and credit on the economic activity
d) Structure and functions of the Central Bank
1.3. Evolution of Monetary Economics
• Before 1929 – “money matters”
a) Changes in the money supply as the major cause of changes in the level of
economic activity – highlighting the role of monetary policy over fiscal policy
b) Economic activity represents – output (Y), balance of payments (BOP),
employment (N), and prices (P)
c) Monetary policy regarded as a powerful tool for economic stabilization
5
d) Quantity Theory of Money (QTM) – presupposes a stable market economy
which always tended toward full employment as long as competitive conditions
are met
e) Assumes very minimal government intervention
• 1930s to 1960s (Great Depression) “money does not matter”
a) Hyperinflation occurred and the financial system could not do anything to
stimulate the economy (50 – 100% inflation rates)
b) Stagflation – prices continue to increase and output is stagnant
c) Money does not matter; therefore monetary policy does not matter – highlights
the importance of fiscal policy over monetary policy
d) Keynesian Economics evolved which believed that fiscal policy was more
effective in changing economic activity - the economy was in a liquidity trap
e) Government as the lead actor in stabilizing the economy – the “self regulating
market” that reached socially desired outcome crumbled
• 1960 to present “money matters”
a) High inflation and high interest rates persist
b) Inability of Keynesian Economics to resolve the issue
c) Led to the return to the view that “money matters” in changing economic
activity
6
Chapter 2
Money and the Payment Mechanism
2.1 The Basic Definition of Money
Currency: “Do you have enough money for lunch?”
Income: “How much money do you make a month?”
Wealth: “Is she from a family with a lot of money?”
• Money is what money does – anything that performs the functions of money is
money! - anything that people are willing to accept in payment for goods and
services or pay off debts
• Money Supply vs. Asset
a. Asset – anything which serves as means to store value over a period of
time – E.g. real asset - land, house, machine, production equipment,
people; financial assets – claims against real assets or claims to future
income streams
b. Money supply – things generally acceptable in payment of debt, goods,
and services whatever its legal status may be
• Wealth vs. Income
a. Wealth – stock variable; market value of the total collection of assets
Example:
Assets Value
1. Car
2. House and Lot
3. Jewelry, Furniture, etc.
4. Cash Holdings
Total Wealth
500,000.00
5,000,000.00
50,000.00
50,000.00
5,600,000.00
7
b. Income – flow variable – measures an amount of value accrued over a
specified period of time. E.g. income is the P57,750 pesos per month basic
salary of the President of the Philippines.
2.2 General Functions of Money
• It acts as a medium of exchange - money refers to anything that is generally
accepted as payment for goods and services or in settlement of debts
• It is a unit of account – money refers to an item with which every good and service
can be quoted
• It is a store of value – money allows value to be stored for future use, however, the
acceptability of money in future transactions depends on it not losing its value over
time, e.g. due to inflation rate
• It is a standard of deferred payment – facilitates exchange at a given point in time –
money can separate the act of sale from the act of purchase
What can serve as MONEY and what makes a commodity suitable to be used as MONEY?
Important characteristics of a commodity or specie to perform the functions of money
(1) Nonperishable
(2) Divisible
(3) Widely accepted (in payment of goods and services and for settling other business
obligations)
(4) Easily standardized (i.e. homogenous)
(5) Portable
(6) Limited in supply
(7) Supply is relatively stable
(8) High in value (i.e. its physical size is small relative to its value)
(9) Not easily counterfeited
8
2.3 Monetary Aggregates
What’s included?
M1 M2 M3 L
Currency in circulation +
� Traveler’s check
� Demand
deposits
� Other checkable
deposits
M1 +
� Small denomination
time deposits
� Savings deposits
� Money market
deposit accounts
� Non-institutional
money market fund
shares
� Overnight
repurchase
agreements
M2 +
� Large-
denomination
time deposits
� Institutional
money market
fund balances
� Term repurchase
agreements
M3 +
Non-bank holdings of:
� Short-term
securities
� Commercial paper
� Savings bonds
� Banker’s
acceptance
M1
M2
M3
L
Narrow medium of
exchange
Broader medium of
exchange
Broader medium of
exchange and stores of
value
Short-term
stores of value
9
2.4. Classification of Money
• Bases of Classification
o physical characteristics of materials of which money is made
o nature of the issuer (government, CB, commercial bank)
o relationship between the value of money as money and the value of money as a
commodity
• Classification
a) Full Bodied Money / Commodity Money
• value as a commodity is equal to its value as money
• Precious metals – gold and silver – as medium of exchange
i. Value is related to its purity
ii. Need to check weight and purity of metals at each trade
iii. Metals were stamped and marked certifying weight and purity –
Royal emblems/insignia
iv. Difficult to transport, costly – and risky to carry gold bullions
b) Credit/Debt Money/Fiat Money
• value as money is greater than its value as commodity
• private institutions began to store commodity money and issue paper
certificates representing it
• Modern economies use paper currencies, token coins (issued by Central
Bank)
i. Money authorized by the central bank or governmental body is the
definitive money and does not need to be exchanged with
gold, silver or some other commodity
ii. Legal Tender – Ang Salaping Ito ay Bayarin ng Bangko Sentral at
Pinananagutan ng Republika ng Pilipinas
10
c) Check
• Paper money – expensive to transport for settling large commercial or
financial transactions
• Checks are promises to pay definitive money on demand and are drawn
on money deposited on financial institutions
i. Can be written in any amount and fraud free
ii. Involves information and waiting cost – “Check clearing”
iii. Less liquid and production involves cost
d) Electronic Funds
• Improvements in electronic communication resulted to efficiency of the
payment system – reduced clearing time and cost of paper flow for
making payments
• Money is stored electronically – settling and clearing transactions can be
done through computers in electronic funds transfer system –
computerized payment-clearing devises
• Includes debit/credit cards, automated teller machines (ATMs), stored-
value cards, electronic cards, electronic checks
i. Cuts down transactions cost
ii. Expensive to set-up and may have problems with record-keeping
iii. Security and privacy concerns (application requires full disclosure
of identity)
Q: Do you think that cash and checks will one day become obsolete and all payments
will be made electronically?
11
2.5. Evolution of Payment Mechanisms
a. Autarky
• In the absence of trade, family or tribal group produces goods and services equal
to their consumption
• Production output is shared according to the group’s distribution rules
• Money is not used
b. Barter System
• Money is not used
• Involves direct exchange of goods and services
• Requires a double coincidence of wants – an individual is willing to exchange
exactly the same goods and services (at the same quantity) that another is willing
to accept and vice versa
o Exchange ratios have to be established
o Searching for that person with whom you will have a double coincidence of
wants involves transactions costs. Once the search is completed – haggling or
bargaining cost pose additional burden
• Transactions Cost = Search Cost + Haggling Cost
• Waiting Cost – cost you incur when you delay in
transaction (WC = Subjective cost + Objective cost)
• Difficulty of storing value if commodities are perishable
12
Total Barter Cost – TC + WC
3 Types of Barter
• Isolated (IS) – means you have to search for your own business partners - high
transaction cost
• Fairground (FG) – have a common place for trading – minimum transactions cost and
search cost
• Trading Post (TP) – there is already a place for trading – minimum search cost
• Barter system necessitates a lot of cost – that is why we need money!! – monetary
economy (ME)
Transaction Period
TBC, WC, TC Total Barter Cost
Transaction
Cost
0 t1 t* t2
a
b
c
e
f
g
h
i
f – least cost
Waiting
Cost
13
c. Commodity Money
• Generally used uncoined metals – gold, silver, copper
• Overcame the inconveniences of the barter system, e.g. ease transport and
durability
• Problem of adulteration (impurities in content) and short weighing of content
d. Coinage
• Used coined metals – gold, silver, copper
• Solved the problem of adulteration and short weighing with the King’s seal
stamped on the metals for authentication
• Problems on storage, theft, costly, risky transport
e. IOUs
• Minimized the risk of transport since the coins were left to a reputable person
with a vault
• IOU means – “I owe you” – written on paper/receipt instead of going to the safe
keeper to transact
Transaction Period 0
IS, FG, TP, ME Cost Isolated
Fairground
Trading Post
Monetary Economy
14
f. Bank Note
• Involves a promise to pay a debt (IOU) which was evidenced by a piece of paper
backed by a specie
g. Specialized Bankers
• Evolved because not all people who “deposited” their money were demanding
payment at the same time – No need to hold all the gold/silver at the same time
• Idea of holding a portion of the entrusted money for a fee while holding on to
the rest for safe keeping
• Paved the way for fractional reserve banking
h. Electronic Funds Transfer System/Electronic Money
• Makes use of computer terminals for transactions and automated computers for
clearing
• Does away with the physical means of exchange
2.6. Monetary Transmission Mechanism and Channels of Monetary Influence
• Monetary Transmission Mechanism - The general conceptual framework within
which the analysis of monetary disturbances may be undertaken (Pierce and
Tysome, 1985)
• Process by which changes in monetary policies affect aggregate demand (Dornbush
and Fisher, 1984)
⇒∆ SM
Goal Variables (Prices, Output, Employment)
• Channels of Monetary Influence - The route through which these monetary
disturbances influence the goal variables (Pierce and Tysome, 1985)
15
Four Transmission Mechanisms
Let there be a change in the money supply - 0>∆ SM due to open-market purchase of bonds by
the government
• What is the ultimate effect of SM∆ when the new equilibrium is reached?
• How is the new equilibrium reached?
Assuming a closed/open economy with fixed exchange rate, the following have been identified
in the literature as important transmission mechanisms (TMs)
1. Portfolio Balance Transmission Mechanism
2. Wealth Transmission Mechanism
3. Credit Availability Transmission Mechanism
4. Expectations Transmission Mechanism
Link A ⇒
Link B
SM∆ and Portfolio Balance TM ⇒
Portfolio Adjustment and
goal variables
SM∆ and Wealth TM ⇒
Wealth and goal variables
SM∆ and Expectations TM ⇒
Expectations and goal
variables
SM∆ and Credit Availability TM ⇒
Credit availability and goal
variables
a. SM∆ and Portfolio Balance Transmission Mechanism
• Link A
o Portfolio – array of assets and debts which have different yields, risks,
maturities, and other characteristics (e.g. money, government bonds,
equities (stocks), debts, real estate)
16
o Portfolio composition depends on:
� Characteristics of assets – yields, risk, maturities
� Taste and preferences of wealth-holders
o Portfolio re-composition depends on:
� Changes in the market condition
� Assets’ characteristics
� Size of portfolio
� Wealth holder’s preferences
o Interrelationship of different assets depends on how wealth-holders view the
following
� Substitutability of assets
� Complementarity of assets
o Yield on financial assets reflect
� Money yield – e.g. interest, payments, dividends
� Liquidity – ease and speed with which they can be converted into
money
� Expected values
� Default risks
o Portfolio balance occurs when:
� j
j
i
i
P
MR
P
MR=
for all ji ≠
Where: MR – marginal returns on asset
P – Price of asset
i,j – 1,2,..n assets
17
o Demand for any assets
� Varies directly with its own yield
� Varies indirectly with the yield on other assets
� Depends on the yield-cross elasticity of demand
• Link B
o Portfolio Balance TM operates via aggregate demand
o Simple Keynesian Approach
� Assumptions
� 2 sector economy: private and public sector
� 3 assets: money, government bonds, and real assets
� 1 financial rate of interest: interest on bonds
� Demand for money and real assets are perfectly inelastic with
respect to yield on the other
� There is substitution between money and bonds and between
bonds and real assets
� There is no direct substitution between money and real assets
Let there be an open market purchase of bonds by government to increase money supply
( )SM↑ , resulting to: Cost of Capital Channel of Influence
18
↑ Money
Supply ⇒
↑ Demands for bonds ⇒ ↑ Price of bonds
↓ Interest on
bonds ⇒
↓ Opportunity cost of
investing in real capital
assets
⇒
↑ Size of optimum capital
stock
↑ Demand
for Capital
Assets
⇒ ↑ Flow of investment expenditures
o Monetarist Approach
� Assumptions
� Wide range of assets
� Direct substitution between money and real assets
� Interest rates also reflect that of real assets
� Cross price elasticity of demand for money with respect to yield
on any asset is likely to be low
� As interest rate on bond decreases as a result of portfolio adjustment
� There will be income and substitution effects on saving/dissaving
decision which may work in opposite direction
� As portfolio adjustments increase asset price
� Consumption expenditure may be influenced through windfall
capital gains
19
B) SM∆ and Wealth Transmission Mechanism
• Link A
o Keynesian View:
� If SM∆ goes to idle cash balances only, then bond prices will not be
affected and therefore, there will be no change in the interest rate on
bonds
� Implies that aggregate demand (AD) will not be affected, thus, there
will be no change in income (Y), prices (P), and employment (N)
o Neo-classical (>1960s)
↑ wealth ⇒ ↑ spending ⇒ ↑ aggregate demand ⇒ ↑ Y, ↑ P, ↑ N
• Link B
o Effects of increase in wealth on:
� Money market
� Assets market
� Goods and services market
(1) Money market
a. If the increase in wealth goes to idle cash balances, then there will be
no operational effects in the economy
(2) Assets market
a. People may use part of the wealth to buy additional earning assets
b. For Keynes: ↑ money ⇒ ↑ bonds
20
c. For Tobin and Other Monetarist: ↑ money ⇒ ↑ other assets
d. More loans can be available if people use part of the ↑ wealth for
lending, thus changing asset prices and yields
(3) Goods and services market
a. 2 channels of influence
i. Proportions in which current income is divided between
consumption and saving
ii. Effects depend whether the increase in money balances are
drawn on for increase consumption expenditure
C) SM∆ and Credit Availability Transmission Mechanism
• Link A
o Overall liquidity – more important monetary influence rather than level
monetary stock i.e. there are disgruntled borrowers because of scarcity of
loanable funds
o Empirical situations
� Market for loan is imperfect and loan rates are administered prices
(ceiling)
� Demand for loans are relatively inelastic and connotes the willingness
to borrow but not much loans are available - implying relative
importance of loan availability rather than costs
� Elastic supply of loan (responsive to changes in interest rate)
� There are marginal borrowers unable to get credit at ceiling rates
21
• Link B
o If ↑ money ⇒ ↑ stock of available credit, then the credit TM is operational
e.g. there will be an increase in expenditures on goods and services
o Changes in assets market could affect credit availability TM
D) SM∆ and Expectations Transmission Mechanism
• Link A
o Price expectations channel of influence
� Rational Expectations – perfect anticipation and adjustments to
expressed price due to past experiences e.g. ↑ money ⇒ ↑ prices
� Adaptive Expectations – based on current and immediate past
experience e.g. prices this year and last year
o Business Confidence
� Reactions of the business sector to the news of an increase in money
supply is ambiguous, it could be viewed as:
� More money for investment purposes
Loanable Funds 0
Interest rate
D
S0
i*
ic
S1
a
b
c
LF*
LF1
LF0
At iC, there will
be shortage of
LF equal to BC
To solve,
increase the
supply of LF to
S1
22
� More available money at a cheaper cost
� More household consumption expenditure
� Sign of tighter fiscal policy in the future
• Link B
o Price expectations
� Consumption
� Buy more now – accelerate expenditures
� Save now to stabilize future consumption
� Expectations of price increase may induce large wage claims by
workers to protect standard of living
� Producers may increase own prices of goods and services
o Business confidence
� Marginal efficiency of investments could be increased/decreased,
affecting desired flow of investment expenditure if there is an
improvement/deterioration of business confidence
23
Chapter 3
The Demand for Money
Recall: People hold on to money because it is a:
• Medium of exchange
• Store of value
• Unit of account
• Means of standard deferred payment
Question: How much money will households and businesses demand?
(A) The demand for money as for other assets reflects exchange and portfolio allocation
decisions
(B) People use money (currency, checkable deposits, and other close substitutes) mostly to
carry out transactions – money demand depends in part on the value of the transaction
3.1 Transactions Motives
• Arise from the use of money in making payments for goods and services – Money
generally makes transactions easy!!
• Households and businesses think about money holdings in real terms
o Adjusted for changes in the purchasing power – desired level of money
depends on the value of transactions
o Example: Consider the price of beef per kilogram now and 27 years ago:
2009: P200-250/kg 1982: P40 – 50/kg;
� Hence you need more money to buy beef now – your nominal money
balances would have to be more than 5 times as high!
o A higher price level leads to a proportionately higher nominal demand for
money
24
• Focus on the demand for real money balances - represents the purchasing power of
money holdings
• Real money balances
MRMB
P=
Velocity and Demand for Real Money Balances
o Irving Fisher (1900s) – analyzed the relationship between money balances and
transactions
o Velocity of Money – the average number of times a peso is spent each year on
purchases of goods and services in the economy
M
PYV =
1.Eq
V - Velocity of money P - Price level
Y - Aggregate output
representing the volume of real
transactions
M -Quantity of money
Example: M = 2M, GDP = 6M, What is V?
V=6M/2M = 3 - Peso is spent 3 times a year to purchase goods and services in the economy
o Multiplying both sides of equation 1 by M, we get the Equation of Exchange
PYMV = 2.Eq
Quantity of money times the velocity of money is equal to the nominal expenditure in the
economy (GDP)
25
o Fisher converted Eq. 2 into a behavioral theory of money demand, by assuming V to
be constant
YVP
M
= 1
3.Eq
If V is constant, then the demand for real money balances, M/P should be proportional to the
level of real transactions
• Equation 3 becomes the money demand function which relates the demand for real
money balances to the real volume of transactions
• This is the foundation of the Classical Quantity Theory of Money (QTM)
Does it make sense?
• Yes, in order to make transactions, households and businesses increase their
nominal money holdings as prices increase
• As the real incomes of household and businesses increase, they typically conduct
more transactions (resulting to higher velocity of money)
• Combining household and business: Public demand for money rises with the volume
of transactions; the quantity of real money balances rises with real income
� Fallbacks of the Classical Theory of Money
1. On the assumption that the velocity of money is constant
• Economists did not agree that velocity is constant – velocity could increase or
decrease in response to changes in money and non-money assets (Portfolio
allocation motives)
• Between the 1920s and 1930s (during the World War II) V decreased because of
economic downstream or recession
• Asian Financial Crisis in 1997 – global economic slowdown
• In the 1980s to present – the velocity of coins and demand deposits declined
significantly
o Payment system factors – financial innovations, paved way for the
development of money substitutes – ATMs, checking accounts,
debit/credit cards, merging of ATM services
o Unless financial innovations result to additional costs, e.g. high
production costs, which discourages its use
26
o Paying higher charges for using credit cards than paying in cash
2. Interest Rate Changes
• Classical theory of money did not include interest rates as a factor in the
transactions demand for money - Baumol and Tobin: Transactions motives
depend also on interest rate
• Increase in the interest rate increases the opportunity cost of holding money
balances for transactions purposes – individuals hold less money – increases
velocity
• Transactions demand is negatively related to interest rate where as velocity of
money for transactions is positively related to interest rate
Question:
What are the effects of the following on the demand for real money balances and the velocity of
M1?
a) BPI-Family Bank offer cash-management services to firms
b) Citibank credit cards become less widely used
� Cash management of BPI-Family Bank allows more investment portfolios to be in
non-money assets, the demand for real money balances ( )PM
falls, and V rises
because people have less need of money
� Because more cash is being used for transactions, the demand for real money
balances ( )PM
rises, and V falls
3.2 Portfolio Allocation Motives
• Determinants of asset demand
A. Income and wealth
B. Expected returns on money
C. Risk, Liquidity, and Information Costs
27
• Since the volume of transactions is not sufficient to explain movements in money
balances, use the portfolio allocation motives
A. Income and Wealth
• Rich and wealthy persons won’t hold the same proportion of assets in zero or
low yielding money balances like poorer households, e.g. richer households use
bank credit cards
• Larger firms may have lines of credit with banks to allow then to conduct
transactions with low cash or checkable deposit balances
• Demand for real money balances increases with real income but less
proportionately (i.e. low income elasticity)
B. Expected Returns
• When assessing money assets, households and businesses take into account
not only the interest paid on non-money assets but also “money’s
convenience yield” (MCY)
• MCY is the interest that household are willing to forego in return for low-
risk, transactions and information costs of holding money
• As interest paid on money balances (MCY) increases, demand for real money
balances (M/P) also increases
• As interest paid on money balances (MCY) decreases, demand for real money
balances (M/P) will decrease
• Conclusion: Households compare expected returns on non-money assets (i)
with expected returns on money (MCY).
C. Risk, Liquidity, and Information Benefit of Holding Money
• If the returns on alternative assets (bonds, stocks) fall or become risky, demand
for real money balances will increase – savers switch their holdings into money
• Innovations that allow easy movements of funds from less liquid to more liquid
forms (bonds, stocks to checking deposits) reduce the value placed on money’s
liquidity.
• The more liquid the assets become, the more savers focus on money’s explicit
interest (i) paid on M/P
28
• Some people place high value on holding currency for anonymity purposes (drug
trade, tax evasion, illegal activities)
• Demand for money becomes a function of changes in the volume of illegal
activity or tax code
Question:
Suppose that, of a total wealth of P250,000, Ms. Understood allocates P200,000 to treasury
bills (T-bills) yielding 8% and places the P50,000 left in a checking account yielding 5%
a) What value does Ms. Understood place on her checkable deposits?
b) What if the yield on T-bills rises to 10%?
� Implicitly, Ms. Understood values the liquidity services of her checkable
deposits at least as much as ( )( ) 500,1000,5003.0 PP = per year, the interest
forgone (opportunity cost)
� If the yield on T-bills rises to 10%, however, Ms. Understood may decide that
the liquidity benefits of checkable deposits is too expensive
( )( ) 500,2000,5005.0 PP = per year and may decide to reduce her checkable
deposit (money holdings) to, say, P40,000
3.3 Keynesian Approach to the Portfolio Allocation Theory
Building Blocks
o John Maynard Keynes – The General Theory of Employment, Interest and Money
• Recognized the importance of transactions motives – highlighted the sensitivity
of money demand on interest rate in his Liquidity Preference Theory
• Viewed the role of non-money assets in the money demand relationship in his
simplified portfolio allocation problem, referred to as speculative motives
(money vs. bonds, stocks)
• People hold on to money to pay for unexpected transactions – precautionary
motives
• Based on these three reasons: Money holdings depend on real income and
interest rate on non-money assets
29
• The Liquidity Preference Theory states that the demand for real money balances
is a function of liquidity, aggregate output, and interest rate:
( )iYLP
M,=
• Because the quantity of real money balances increases with income and
transactions, and increase in income leads to an increase in real money balances
– a positive relation
• However, the interest rate increases the opportunity cost holding money and
reduces quantity of money demanded, hence, an increase in the interest rate
leads decrease in real money balances – a negative relation
• Changes in the velocity based on the negative relationship of money demand
and interest rate.
( )
( )
( )
,
1
,
/ ,
ML Y i
P
PY
M L Y i
P Y Y YV
M M P L Y i
=
=
= = =
• Suppose that the interest on bonds rises, but aggregate income Y does not
change. Because opportunity cost of holding on to money has gone up, you
would use some of your money to buy bonds, reducing your demand for real
money balances.
• If M/P falls, velocity increases – implying that if interest rate fluctuates, velocity
fluctuates as well
30
3.4 Friedman’s Contribution to the Portfolio Allocation Theory
o Milton Friedman (1950) – Modified the Keynesian Theory
• Money demand depends on the average income over a lifetime for an individual
(*Y )
• *Y - permanent income, proportional to wealth
• Comparing the expected returns on money and non-money assets, demand for
money negatively depends on 2 measures of opportunity cost of money
a. The difference between expected returns on financial assets ( )i and
the return on money ( )mi
b. Difference between expected returns on durable goods by inflation
rate ( )eπ and the return on ( )mi ;
( )ee i−π
• Restating the demand for real money balances:
( )me
m iiiYLP
M −−= π,,*
(a) Demand for real money balances increases with increase in Y
(positive relationship)
(b) Demand for real money balances decreases with the opportunity
cost of holding money
Comparing Keynes and Friedman
• Both used the Portfolio Allocation Theory in money demand analysis
• Friedman: dM depends on ( )*Y - permanent income; hence dM
respond slightly
on short-run fluctuations in income and wealth
• Keynes considered only money and bonds while Friedman allowed for other
portfolio substitutes
• Keynes assumed the rate of return on money to be zero while Friedman’s rate of
return on money consist of both explicit interest payments on money and services
provided by financial institutions
31
Putting it all together: The Money Demand Function
,( , , )m e mM
L Y S i i iP
∏= − −
(a) An increase in real income ( )Y raises the quantity if real money demanded
P
MY ⇒↑↑
(b) An increase in the availability of money substitutes ( )S as means of payment
reduces the quantity of real money demanded
P
MS ⇒↓↑
(c) An increase in the opportunity cost of holding real money balances decreases the
quantity of real money demanded
( )P
MCostOppii m ⇒↓⇒↑−↑
(d) An increase in the expected inflation rate leads to an increase in the opportunity
cost of holding real money balances and hence decreases money demand
( )P
MCostOppim
ee ⇒↓⇒↑−⇒↑↑ ππ
Determinants of the Demand for Money
An Increase in Caused dM to Channel Reason
Price Level (P) Increase
proportionately
Transactions
demand
Doubling of price level doubles the needed
money for transactions
Real Income (Y) Increase less
proportionately
Transactions
demand
Increase in Y raises amount of transactions
and demand for liquid assets
Availability of money
substitutes (S) Decrease
Transactions
demand
Increase in the number of substitutes
causes HH and BS to economize on money
holdings
Interest rate on non-
money asset (i) Decrease
Transactions and
Portfolio
allocation
Greater return on alternative assets make
HH and BS to switch from money holdings
Interest on money
assets (im) Increase
Portfolio
allocation
Greater return on money makes HH and
BS more willing to hold on to money
32
Chapter 4
The Supply of Money
4.1 The Balance Sheet and T-accounts
Definition of Terms
• Balance Sheet
a) A statement showing an individual’s or a firm’s financial position at a particular
time
b) Lists the uses of acquired funds (assets) and the source of funds (liabilities or
capital account) and the difference between the two (net worth)
• Commercial Bank Assets - Lists types and values of everything owned by the bank
o Cash Balance
� Vault cash – the most liquid asset held by banks – cash on hand in the
bank, in deposit in other banks, and in deposit with the Central Bank
� Reserve accounts – consist of the vault cash and banks’ deposit with the
Central Bank – part of the regulation of the banking system in which CB
requires a bank to hold some of their deposits in non-interest bearing
accounts (reserve accounts) at the CB for liquidity purposes
� Cash item in the process of collection – a bank’s claims on other banks
for uncollected funds e.g. Your employer writes you a check drawn on
another bank (e.g. PNB) which you deposited in your bank (The Region
Bank)
o Securities
� Marketable securities – liquid assets that bank trade in securities market
– also known as secondary reserves
33
o Loans
� Commercial, real estate, and industrial loans - Relatively illiquid with
respect to securities and entails greater default risk and information costs
– hence interest rates on loans are higher than marketable securities
o Physical assets
� Equipments, buildings, inventories
� Collateral received from borrowers in default
• Commercial Bank Liabilities/Capital Account Side - Represents the funds acquired from
savers in order to make investments or loans to borrowers
o Checkable deposits
� Accounts that grant the depositor the right to write checks to individuals,
businesses ,or the government payable on demand
o Non-transaction deposits
� Savings account (passbook accounts)
o The most important type of non transaction deposits
o Before, 30 days notice may be required for withdrawal, but this
requirement was universally waived, making savings account, in
practice demandable
� Money market deposits
o Invested by banks and the interest paid to savers changes frequently
with short term yield in money market
� Time deposits
o Deposits with specified maturities ranging from a few months to
several years
o Significant penalty for early withdrawals (the saver forfeits part of the
accrued interest)
34
o Less than P250,000 – Small denomination time deposits and more
than P250,000 – Large denomination time deposits
o Not demandable and very risky for large denomination time deposits
– the PDIC (The Philippine Depositors Insurance Corporation) covers
only up to P250,000 insurance
o Borrowings
� Banks borrow money to make more loans available to investors and
consumers – earning interest in process – only if the interest rate the
bank pays to borrow this funds is lower than the interest it earns by
lending
o Includes short-term loans from CB funds market, loans from a bank’s
foreign branches, and loan from the Central Bank (discount loan)
� The CB funds market is the market for unsecured loans (often
overnight) between banks
� Repurchase agreements (RPs) – bank sell securities and agree
to repurchase them the following day – banks use RPs to
borrow funds from business firms or other banks using the
securities as collateral. The corporation that buys the
securities earns interest without any significant loss of
liquidity
• Commercial Bank Net Worth
o Assets are things of value that a bank owns whereas liabilities are things that of
value that a bank owes to others – the difference between the two is the bank
net worth or equity capital
Equity Capital = Assets - Liabilities
o Bank Net Worth – measures a banks remaining value after it has met all its
liabilities
35
� Depositors expose themselves to risk when they deposit money in a bank: if
the bank incurs losses from outside investments, they will lose part of their
deposits
� A bank with high net worth is relatively more appealing to savers because net
worth provides a buffer against the risk of losses - often the rationale behind
bank mergers
� Bank failure – when a bank cannot pay its depositors in full with enough
reserves left to meet its reserve requirement
o Regulators can close a bank when they deem its net worth to be too
low – the higher the bank holdings of reserves, marketable securities,
or equity capital, the less likely for the bank to fail
o Trade-off? bank safety vs. returns, being too conservative lowers
bank profitability, being too exposed to different transactions of
varying returns lowers bank safety
Balance Sheet of Commercial Banks
• Simple Commercial Philippine Commercial Bank System Balance Sheet
Total Assets 2000 2001 2002
Cash and due from banks 11.90 11.60 9.00
Loans 59.40 55.70 50.90
Investments 16.90 18.00 24.60
Other assets 11.80 14.70 15.50
Total 100 100 100
Total Liabilities and Capital 2000 2001 2002
Deposits 63.30 65.40 67.70
Borrowings 12.10 12.00 10.60
Other Liabilities 10.50 8.50 8.50
Capital accounts 14.10 14.10 13.20
Total 100 100 100
36
• Detailed Commercial Bank Balance Sheet
Assets Liabilities and Capital Assets
Cash Items
Cash items
Deposits with BSP
Balances with Financial Institutions
Accounts Receivable in the Process of
Collection
Total Cash
Loans
Commercial/Industrial
Agricultural
Real Estate
Consumer Credit to Financial Institutions
BSP Funds Sold and Securities Resale
Agreements
For Purchasing and Carrying Securities
Other Loans
Total Loans
Securities
Philippine Treasury
Other Philippine Government Agencies
National and Local Governments
Other Securities
Total Securities
Other Assets
Total Assets
Demand Deposits
Individual, Partnership, Corporation
Philippine Government
National Agencies and Local Government
Others
Total Demand Deposits
Time Deposits
Other Individual, Partnership, Corporation
Certificate of deposits
National and Local Government
Others
Total Time Deposits
Savings Deposits
Corporations
Other I,P, and C
National and Local
Total Savings Deposits
BSP Funds Purchased and Securities Sold
under repurchase agreements
Other Borrowed Funds
Miscellaneous Liabilities
Capital Accounts
Total Liabilities and Capital Account
37
Sample: LandBank of the Philippines (2007)
38
Basic Operation of A Bank: Using the T-Account
• T-Account
� Simplified Balance Sheet, with lines in the form of a T, that lists only the changes
that occur in the Balance Sheet items starting from some initial Balance Sheet
Position
� Used to illustrate effects of a single transaction in the Balance Sheet
o Example: On Gaining and Losing Reserves: Suppose Ms. Understood has heard
that Bank A provides excellent bank services, so she opens a checking account
with P100,000 bills. She now has P100,000 checkable deposits at Bank A, which
shows up as a P100,000 liability on the banks balance sheet. The Bank now puts
her P100,000 bill into its vault so that the bank’s assets rise by P100,000 in vault
cash. The T-account for the bank will be:
BANK “A”
∆Assets ∆Liabilities
Vault Cash +P100,000 Checkable
deposit
+P100,000
o Since vault cash is also part of the bank’s reserves, we can rewrite the T-account
as:
BANK “A”
∆Assets ∆Liabilities
Reserves +P100,000 Checkable
deposit
+P100,000
� Note that the opening of a checking account leads to an increase in the
bank’s reserves equal to the increase in Bank A’s checkable deposits – T-
Account must also Balance
39
o If Ms. Understood opens an account with a P100,000 check written on an
account at another Bank, say Bank B, we would get the same result. The initial
effect on the T-account of the Bank A is a follows:
BANK “A”
∆Assets ∆Liabilities
Cash items in the
process of
collection
+P100,000 Checkable
deposit
+P100,000
Suppose Bank A will now try to collect the funds that is owed from Bank B – the final balance
sheet position will be as follows:
BANK “A”
∆Assets ∆Liabilities
Reserves +P100,000 Checkable
deposit
+P100,000
BANK “B”
∆Assets ∆Liabilities
Reserves -P100,000 Checkable
deposit
-P100,000
� Therefore, when a bank receives additional deposits, it gains an equal
amount of reserves; when it loses its deposits, it loses an equal amount of
reserves
40
Example: On Rearranging the Balance Sheet: Suppose Bank A used the P100,000 to buy
Securities
BANK “A”
∆Assets ∆Liabilities
Reserves
Securities
-P100,000
+P100,000
Checkable
deposit
0
o Bank is being obliged by the CB to keep certain fraction of its deposits as
required reserves and maintain an excess reserve or the fraction of deposits
voluntarily keep in their vaults over and above the reserve requirement
o Reserve Requirements
o Excess Reserve
Suppose that the Reserve Requirement is 10%, the Balance Sheet of Bank A is as follows:
BANK “A”
Assets Liabilities and Capital
Account
Cash Reserves
Loans/Investment
Addenda:
Required Reserve
Excess Reserve
P10M
90M
P10M
0
Demand deposit P100M
41
o Given that Ms. Understood deposited P10,000 of currency in this bank and it was placed
under Bank A’s vault. T-account for the transaction is:
BANK “A”
∆Assets ∆Liabilities
Cash Reserves
Addenda
Required Reserve
Excess Reserves
+P100,000
+10,000
+90,000
Checkable
deposit
+P100,000
� But Bank A in this position is making a loss – reserves do not make interest – hence no
income to keep records, pay tellers, return cancelled checks, pay for check clearing and
so forth plus the interest on the deposits
� To solve this: assume that Bank A chooses not to hold any excess reserves but to make
loans instead. T-account then looks like:
BANK “A”
∆Assets ∆Liabilities
Required Reserve
Loans
+10,000
+90,000
Checkable
deposit
+P100,000
o Bank A is now making profit: it holds short term liabilities and uses the proceeds to buy
longer-term assets such as loans with higher interest - “Borrowing Short and Lending
Long Principle”
42
4.2 Deposit Creation
• To understand the creation of deposits, we have to first look into the mechanics of
processing the transfer of funds between depositing institutions
o Case 1: Suppose Jezreel and Nomer are both depositors of Land
Bank. If Jezreel gives P1,000 check to Nomer, Land Bank will just
deduct the amount from its deposit liability to Jezreel and increase
its deposit liability to Nomer. Thus, Land Bank’s Statement of Assets
and Liability does not change.
o Case 2: Suppose Jesehl writes check on Land Bank and gives it to
Jelai who deposits it at the Bank of the Philippine Island (BPI). BPI
will add P1,000 to its deposit liability to Jelai and send the check
back to Land Bank which will deduct the amount from its deposit
liability to Jesehl.
� Land Bank now owes BPI P1,000.
� To collect, BPI could send an armored van to Land Bank and
haul the money away – this is tedious and expensive if done
for every check
� Therefore the banks wait a bit before setting up so that things
can be averaged out, i.e. offsetting transactions that will
require Land Bank or some other banks to pay BPI
• There is this clearing process (by local clearinghouses or correspondent banks and
BSP) whereby financial institutions will check each other regarding payment due or
accruing and settle net payments.
o Case 3: Suppose we deal a unibank bank like the BPI and a private
domestic bank, Security Bank (SB)
� Assume that at the end of the business day:
o BPI customers deposited checks of P3M drawn on
negotiable order of withdrawal (NOW) accounts from
SB
o SB customers deposited checks of P1M drawn on
demand deposits from BPI
43
o BPI and SB rely on BSP to clear the checks
� What happens next?
o Both BPI and SB send received checks to BSP. BSP
compares 2 piles of checks and concludes the SB owes
BPI P2M
o Using computer terminals, BSP balances the books by
deducting P2M from SB’s account and credit’s BPI’s
account with P2M
Bank of the Philippine Island (BPI)
∆Assets ∆Liabilities
Deposit at BPI +P2M Demand deposits +P2M
Security Bank (SB)
∆Assets ∆Liabilities
Deposit at BPI -P2M Negotiable Order
of Withdrawal
-P2M
o Suppose BPI lends it out, the bank can create checkable deposits by
its act of lending
o Because checkable deposits are part of the money supply, the
bank’s act of lending has in fact created money
o By deducting the required reserves, BPI still has excess reserves so it
might want to make additional loans, since the bank would not
want to have excess reserves
44
• Deposit Creation on New Reserves
o Given a P1,000 deposit created by BPI’s loan is deposited at Far
East Bank and Trust Company (FEBTC) and that this bank and all
other banks have no excess reserves. Suppose the required reserve
is 10%. Far East Bank’s T-account will be:
Far East Bank and Trust Co.
∆Assets ∆Liabilities
Required Reserve
Excess Reserve
+P100
+P900
Checkable
deposits
+P1,000
o Because FEBT does not want to hold on to excess reserves as well, it will
make loans for the entire amount. Its loans and checkable deposits will
increase by P900
Far East Bank and Trust Co.
∆Assets ∆Liabilities
Required Reserve
Loan
+P100
+P900
Checkable
deposits
+P1,000
o If the money spent by the borrower to whom FEBT lent the P900 is
deposited in another bank, such as the Metrobank; Considering the 10%
reserve requirement, the T-account of Metrobank will be:
Metrobank
∆Assets ∆Liabilities
Reserve
+P900
Checkable
deposits
+P900
45
o The checkable deposits then in the banking system have increased by
another P900, for a total of P1,900 (P1,000 from FEBT and P900 from
Metrobank)
o Metrobank will modify its balance sheet further. It must keep 10% of P900
as required reserves and the rest in excess reserves and so can make loans of
this amount.
Metrobank
∆Assets ∆Liabilities
Required Reserve
Excess Reserve
+P90
+P810
Checkable
deposits
+P900
Metrobank
∆Assets ∆Liabilities
Required Reserve
Loan
+P90
+P810
Checkable
deposits
+P900
o The P810 spent by the borrower from Metrobank will be deposited in
another bank, say Philippine National Bank and consequently from the initial
P1000 increase in reserves in the banking system, the total increase of
checkable deposits in the system will be P1,000 +P900+P810 = P2,710
o Suppose Far East Bank and Trust Co. buys P900 worth of Securities, it writes
a P900 worth of securities, who in turn deposits the P900 at Metrobank,
Metrobank’s checkable deposits rise by P900, and the deposit expansion is
same as before.
• Whether a bank chooses to use its excess reserves to make loans or to purchase
securities, the effect on deposit expansion is the same for the whole banking system.
Why?
46
o A single bank can create deposits equal only to the amount of its excess reserves,
it cannot by itself generate multiple deposit expansion and a single bank cannot
make loans greater in amount than its excess reserves because the bank will lose
these reserves as the deposits created by the loan find their way to other banks
• But the banking system as a whole can generate multiple expansion of deposits - when a
bank loses its excess reserves, reserves will not leave the banking system, it will find its
way to another bank, which uses them to create additional loans and deposits, and on
to another bank and so on – the process is called the multiple expansion of deposits
o The process stops only when all excess reserves have been converted into
required reserves.
Creation of Deposits Assuming 10 percent Required Reserve and a P1, 000 Increase in Reserve
Bank Increase in Deposits Increase in Loans Increase in Reserves
BPI - 1,000.00 -
FEBTC 1,000.00 900.00 100.00
Metrobank 900.00 810.00 90.00
PNB 810.00 729.00 81.00
Bank 05 729.00 656.10 72.90
Bank 06 656.10 590.49 65.61
Bank 07 590.49 531.44 59.05
Bank 08 531.44 478.30 53.14
Bank 09 478.30 430.47 47.83
Bank 10 430.47 387.42 43.05
Bank 11 387.42 348.68 38.74
Bank 12 348.68 313.81 34.87
Bank 13 313.81 282.43 31.38
Bank 14 282.43 254.19 28.24
Bank 15 254.19 228.77 25.42
: : : :
: : : :
Total for all banks P10,000.00 P9,000.00 P1,000.00
47
Simple Deposit Multiplier
o The multiple expansion of deposits generated from the increase in the banking system’s
reserves can be attributed to the the simple deposit multiplier (dm)
o Deposit multiplier is equal to the reciprocal of the required reserve ratio (rr); expressed
as a fraction
1 110
0.10dm dm
rr= = =
• Deposit multiplier should be differentiated from the Keynesian multiplier (the multiplier
that relates an increase in income to an increase in investment whereas the simple
deposit multiplier relates an increase in deposits to an increase in reserves)
4.3 Multiple Expansion of Deposits
• The process of multiple expansion of deposits can be illustrated or expressed
mathematically
• Assumptions:
Banks do not hold on excess reserves (ER = 0)
Banks face the same reserve requirement (e.g. RR = 10%)
• Total Reserves (RE) = (Required Reserves (RR) + Excess Reserve (ER))
RE RR=
• The total amount of required reserves equals the required reserve ratio rr times
the total amount of checkable deposits
( )RR rr D=
48
• Substituting the second equation in the first equation, and dividing both sides by
rr , will give us:
1RR D
rr =
• Taking the change in both sides of the equation and using delta ( )∆ to indicate a
change:
1RE D
rr ∆ = ∆
• Note that the ratio 1
rr is the simple deposit multiplire (dm)
( )dm RE D∆ = ∆
• Hence, the total increase of deposits in the banking system will be equal to the
initial change in reserve times the deposit multiplier
Previous Example:
Reserve Requirement is 10%
Initial Increase in Reserve P1,000
What is the total change in deposit?
( )1
1,000 10,000.000.10
dm RE D
P
∆ = ∆
=
• This calculation provides a clear picture of the banking system as a whole rather
than one bank at a time
49
• This formula can also be used for multiple contraction of deposit. The process of
multiple deposit contraction is symmetrical to the process of multiple expansion of
deposit.
o Suppose that the BSP withdraws reserves from the banking system, e.g.
equal to P1,000.00
( )( )
1( 1,000) 10,000.00
0.10
dm RE D
P
−∆ = ∆
− = −
4.4 Determinants of Money Supply
• Four players that determines money supply:
o The BSP – the government agency that oversees the banking system and is
responsible for the conduct of monetary policy – the most important player
o Banks/Depository Institutions – the financial intermediaries that accepts
deposits from individuals and institutions and make loans - commercial banks,
savings and loan associations, mutual savings banks, and credit unions
o Depositors – individuals and institutions that hold deposits in the banks
o Borrowers – individuals and institutions that borrow from the depository
institutions, and institutions that issue bonds that are purchased by depository
institutions
(A) The Depositors and Borrowers (Public) Behavior
•••• Behavior can be represented by:
DCUM +=
where: M - monetary stock CU - currency in circulation
D - demand deposits
• Incorporating the effects of changes in the public’s holdings currency
50
D
CUcu =
(currency-deposit ratio)
cuCU
cuD
↑⇒↑↓⇒↑
(B) The Banks Behavior
• Behavior can be represented by:
RE RR ER= +
where:
RE - total reserves
RR - required reserves
ER - excess reserves
• Incorporating the effects of changes in the banks’ holdings of excess
reserves
D
REre =
- (Reserve - deposit ratio)
reRE
reRE
↓⇒↓↑⇒↑
Reserves are the assets held in bank to service/meet:
(a) demand of customers for cash
(b) payments for their customers made in checks which are deposited in other banks
51
Moreover:
/ /RE
re RR D ER D rr erD
= = + = +
Where rr = required reserve ratio; er = excess reserve ratio
(C) The BSPs Behavior
• Behavior can be represented by:
RECUH +=
where:
H - High powered money/ monetary base
CU - Currency in circulation
RE - Reserves
(D) The Money Multiplier
•••• Money multiplier can be represented by:
RECU
DCU
H
Mmm
++==
recall that:
DreRE
D
REre
DcuCUD
CUcu
==
==
;
;
52
( 1) 1 1
( )
M Dcu D D cu cu cumm
H Dcu Dre D cu re cu re cu rr er
+ + + += = = = =+ + + + +
1 cumm
cu rr er
+=+ +
(money multiplier)
if er mm
cu mm
re mm
↓ ⇒ ↑
↓ ⇒ ↑↓ ⇒ ↑
Example:
25.0
50.0
25.0
↓==
cuif
cu
re
⇒
50.250.0
25.01
00.275.0
50.01
2
1
=+=
=+=
mm
mm
Deposit Multiplier (general form)
( )ercurrDH
DerDcuDrrH
ERCURRH
++∆=∆∆+∆+∆=∆
∆+∆+∆=∆
1
/D Hrr cu er
∆ ∆ =+ +
(deposit multiplier)
Therefore:
( ); ( )D dm H M mm H∆ = ∆ ∆ = ∆
53
Complications of the Multiple Expansion of Deposit
Case 1: Simple Expansion of Deposits
Assuming the following:
ER or excess reserves = 0 Cash drain = 0
H∆ , change in the monetary base = 1,000 Required reserve ratio (rr) = 10%
D∆ , change in deposits
What happens to the money supply?
1
1/ 0.1 10
10(1,000) 10,000
10(1,000) 10,000
mm dmrr
mm
M
D
= =
= =∆ = =∆ = =
Case 2: Currency Drain from the System
Currency Drain – as deposits increase, public will prefer to take some of the proceeds and hold
them in the form of currency. This is because of institutional arrangements and public
preferences
Suppose:
10%
15%
0%
1,000.00
rr
cu
er
H P
==
=∆ =
Change in deposits:
( ) ( )1 11,000 4,000
0.25D H P
rr cu∆ = ∆ = =
+
Change in Money Supply:
54
( )1 1.151,000 1,000 4.6 4,600
0.25
cuM H P
cu rr
+ ∆ = ∆ = = = +
Case 3: With Excess Reserves
Suppose:
000,1%15
%5%10
=∆===
Hcu
errr
Change in Deposits:
1,000 1,0003,333.33
0.10 0.15 0.05 0.30
HD
rr cu er
∆∆ = = = =+ + + +
Change in Money Supply:
( )1 1.151,000 1,000 3.83 3,833.33
0.30
cuM H P
cu rr er
+ ∆ = ∆ = = = + +
55
Summary
Change in Money Supply: M mm H∆ = ∆
Change in Deposits: D dm H∆ = ∆
Complications Deposit Multiplier
( )dm
Money Multiplier
( )mm
Change in Money
Supply ( )M∆
None rr
1
rr
1
Hmm∆ or
Hrr
∆
1
Currency Drain curr +
1
curr
cu
++1
H
curr
cu ∆
++1
Excess Reserves ercurr ++
1
ercurr
cu
+++1
H
ercurr
cu ∆
+++1
• Factors affecting the currency deposit ratio ( )cu
o Payment habits of public – if all use cash or prefer credit
o Season (Christmas Season)
• Factors affecting the reserve deposit ration ( )re
o ( )γ,,, rriifre D=
� i market interest rate ( )− , opportunity cost of reserve
� Di discount rate ( )+
� rr reserve requirement ( )+
56
� γ , bank uncertainty ( )+ , the higher the risk, the more you should
have
Therefore:
HrriicufM
rriicufrecufmm
mmHM
D
D
),,,,(
),,,,(),(
γγ
===
=
4.5. Instruments of Monetary Control
• The Central Bank can control M via H and re.
1. Open market operations - This refers to the purchase and sales of bonds by the CB at
the open market.
• If the CB buys government bonds from the open market, then ↑M.
2. Re-discount rate - The CB lends to commercial banks through the rediscount window.
In doing so, they change an interest rate rd.
• Commercial Banks tend to use this instrument in times when it has a strong
demand for cash
↑rd → ↑er → ↓mm → ↓M
3. Required reserves: ↑rr → ↑re → ↓mm → ↓M
57
Chapter 5
Financial Markets and Institutions
5.1 Definition of Terms
� Financial Markets Places or channels for buying and selling newly issued or
existing bonds, stocks, foreign exchange contracts and other
financial instruments
� Financial
Institutions
Link between borrowers and savers such as banks,
insurance companies or pension funds
� Financial
Intermediaries
Institutions like commercial banks, credit unions, finance
and insurance companies among others which borrow funds
from savers and lend them to borrowers
� Savers Suppliers of funds; providing funds for borrowers in return
for promises of repayment of even more funds in the future
� Borrowers Demanders of funds for consumer durables, houses, or
business plant and equipment, promising to repay borrowed
based on their expectation of having income in the future
� Financial Liabilities Borrowers – their promises to pay; both the source of funds
and a claim against the borrowers’ future income
� Financial Assets Savers - the promises to pay of the borrowers; both the use
of funds and a claim against the borrowers’ future income
� Securities Financial assets exchanged in auction and over-the-counter
markets whose distribution is subject to legal requirements
or restrictions
Example:
� Your car loan is an asset (use of funds) for the bank and a liability (source of funds)
for you
� If you buy a house, the mortgage is your liability and your lender’s asset
58
� If a firm purchased Treasury bonds from the Philippine government, the bonds are
assets for the firm and liabilities for the Philippine government
5.2 Why do Financial Assets and Markets Exist?
FLOW OF FUNDS THROUGH THE FINANCIAL SYSTEM
• Recall: In equilibrium: Savings (S) is equal to Investments (I)
IS =
• Financial assets exists because savings (S) of economic units differ from their investments (I)
in real assets (S not equal to I)
IS ≠
• In a closed economy:
� If investments (I) in real asset by an economic unit is equal to savings (S) of that unit
for each investment ( )IS = , then there is no need for financial asset markets
Financial Intermediaries
Financial Markets
Borrower-Spenders Lender-Savers
FUNDS
FUNDS FUNDS
FUNDS FUNDS
Direct Finance
Indirect Finance
59
� If investments (I) in real assets by any economic unit is greater than savings of that
unit for each investment ( )SI > , then financial asset is created and financed by
borrowing, issuing securities, or money – usually being done by business firms for
capital formation
� If investments (I) in real assets by any economic unit is less than savings of that unit
for each investment ( )SI < , then savings surplus arise (particularly in the household
sector)
• The more diverse the pattern of investments (I) and savings (S) among economic units, the
greater the need for efficient financial markets. Why?
� To allocate savings (S) efficiently to ultimate users either for Investments (I) in real
assets or Consumption (C)
� Financial markets ensures capital formation and economic growth
� Allocate savings from surplus units to deficit units
If Financial Markets do not Exist...
� Case 1: Absence of financial assets (In the private sector)
o Assuming no financial assets (just money)
� Equality of Savings and Investments must be satisfied; it is important and
necessary to save to be able to invest
� Investments may be postponed till there is sufficient savings
o Implications
� May result to unproductive investments
� May result to misallocation of capital leading to decrease in I
� May result to lower growth since I is lower – leading to lower GDP to
lower living standards
60
� Case 2: Financial assets and money but without financial intermediaries
o Firms can invest in real assets more than it saves by:
� Decreasing money balances
� Selling financial assets
� Increasing financial liabilities or issuing of primary securities
o However, issuing primary securities requires finding other economic units willing
to purchase it (direct loan with interest)
o Direct loans however have several constraints
� May not be able to find one S-surplus unit to service the need; requires
double coincidence of wants
� Looking for small savers and negotiating with them entails transactions
cost
� May have to hire brokers (those who are in-charge of matching need for
funds with the supply of funds)
Example:
Without Financial Intermediaries
Borrower (Cost) Percentage Per Annum
Search cost
Interest rate charge
Total cost
1.00 %
10.0%
11.0%
Lender (Cost) Percentage Per Annum
Gross interest return
Less:
Search cost
Administrative cost
Total cost
Net Return
10.0 %
1.00%
5.00%
6.00%
4.00%
Overall Costs
(net costs)
11% less 4.00%
7.00%
61
With Financial Intermediaries
� 6 % to the Lender without any inconveniences on the lender’s part
o 6 % is greater than 4%, therefore relatively attractive to lenders
� Charge 9% to Borrowers
o 9 % is less than 11%, therefore relatively attractive to borrowers
� Overall costs: 9 % less 6 % = 3 %, therefore relatively more favorable than 7%
(3% < 7%)
5.3 Financial Markets
• Financial markets perform the essential economic function of channeling funds from
savers to borrowers
o Most important borrowers
� Government
� Businesses
o Most important savers
� Households
� Foreigners
• Price determination – financial markets provide the means by which prices for both newly
issued and existing stocks of financial asset are set
• Information Gathering and Communication - financial markets collect and process
information about values of financial assets and flow of funds from lenders to borrowers –
costly for savers and borrowers to do this on their own
• Risk sharing – most savers seek steady returns on their assets rather than erratic swings
between high and low earnings. Financial markets provide risk sharing by allowing savers to
hold many forms of assets and average out overall returns
• Liquidity – provide the holders of financial assets with more liquid savings or with the
opportunity to resell or liquidate assets
62
• Efficiency – financial markets allow for reduction of transactions, contracting and
information costs
• Divisibility, Flexibility, and Maturity – financial markets are able to transform funds of small
savers and primary securities into more attractive offers even for long term maturity
Structure of Financial Markets
• Debt and Equity Markets
o Debt instrument – a contractual arrangement by the borrower to pay the holder of
the instrument a fixed amount at regular time intervals (interest and principal
payment) until a specified date (maturity), when the final payment is made
� Maturity – the time (term) to that instruments’ expiration date
� Short-term – if its maturity is less than a year
� Long-term – if its maturity is ten years or longer
� Intermediate term – if its maturity is between 1 to 10 years
o Equity – claims to the share in the net income (income after expenses and taxes)
and the assets of the business
� Equities make periodic payments to their holders called dividends and are
considered long term securities because they have no maturity date
� Equity holder is a residual claimant – the corporation must pay all is debt
holders before it pays its equity holders
� Equity holders benefit directly from any increases in the corporations
profitability or asset value because equity confers ownership
Primary and Secondary Market
o Primary market –financial market in which new issues of a security, such as bonds or
stocks, are sold to initial buyers by the corporation or government agency borrowing
the funds
� Investment banks – an important financial institutions that assists in the
initial sale of securities in primary market
63
� Underwriting – guaranteeing a price for a corporation’s securities and then
sells them to the public
o Secondary market – financial market in which securities that have been previously
owned and sold can be resold
� The Stock Exchange is where previously issued stocks are trade
� Other examples include the bonds market, foreign exchange market,
futures market, and options market
� Securities brokers and dealers are crucial to a well-functioning secondary
market
• Brokers – agents of investors who match buyers with sellers of
securities – earning commission in the process
• Dealers – link buyers and sellers by buying and selling securities at
state price – the net of the buying and selling price is the gain
• Exchange and Over-the-Counter Market
o Secondary markets can be organized in 2 ways
� Organized exchanges – where buyers and sellers of securities (for their
agents or brokers) meet in one central location to conduct trade
� Over-the-Counter Markets – dealers at different locations with an inventory
of securities stand ready to buy and sell securities “over-the-counter” to
anyone who comes to them and is willing to accept their prices
• Money and Capital Market
o Money market – financial market in which only short term debt instruments are
traded
� Highly marketable, low risk, high degree of liquidity and funds move on the
basis of price and risk alone
o Capital market – markets in which longer-term debt instrument and equity
instruments are traded
� Government, corporate, municipal bonds, stocks, mortgages
64
Money Market Instruments
a. Treasury bills – short term debt instruments issued by the Philippine government in
3, 6, and 12 months maturities to finance deficits of the government
i. T-bills are the most liquid of all money market instruments because they are
the most actively traded
ii. Safest since there is no possibility of default – government can pay by raising
tax revenues or issue currency to pay off debts
iii. T-bills pay a set amount at maturity and have no interest payments
iv. Effectively pay interest by initially selling at a discount, that is a price lower
than the set amount paid at maturity
b. Certificate of Deposits – debt instrument sold by a bank to depositors that pays
annual interest of a given amount and at maturity pays back the original purchase
price
i. CD are non-negotiable; they could not be sold to someone else and could not
be redeemed from the bank before its maturity without paying a substantial
penalty
ii. Important source of funds for commercial banks, from corporations, money
market mutual funds, charitable institutions, and government agencies
c. Commercial Paper – short term debt instrument issued by large banks and well
known corporations to finance their immediate borrowing needs; in other words
they engage in direct finance
d. Banker’s Acceptance – market instruments created to carry out international trade
– a bank draft issued by a firm, payable at some future date, and guaranteed for a
fee by the bank that stamps it “accepted”
i. Firms issuing the draft are required to deposit the required funds into its
account to cover the draft
ii. Draft is more likely to be accepted when purchasing goods abroad because
foreign exporters know that even the firm importing goes bankrupt, the bank
draft will still be paid off
65
e. Repurchase Agreements – short term loans – usually with less than 2 weeks
maturity in which T-bills serves as collateral – which becomes an asset that the
lender receives if the borrower does not pay back the loan
i. RAs are important source of bank funds
ii. RAs are mostly issued by large corporations
f. BSP Funds – typically overnight loans between banks from their deposits at the BSP
i. These are loans made by banks to other banks, and not by the BSP
ii. BSP funds are being used by the bank to meet the requirement of regulators
– e.g. maintaining required reserves
Capital Market Instruments
• Capital market instruments are debt and equity instruments with maturities of
greater than one year
o They have far wider price fluctuations
o Considered fairly risky investments
a. Stocks – are equity claims on the net income and assets of a corporation;
represent the share of ownership of a corporation
i. Common Stock – no fixed rate of earnings, holders are “residual
claimants” receiving only a portion of the net corporate income
ii. Preferred Stock – preferred as to assets, dividends, or both;
holders have right to a fixed dividend and entitled to their receipts
before those holders of common stocks receive theirs
b. Mortgages – loans to household or firms to purchase housing, land, or other real
structures, where the structure or the land itself serve as a collateral
66
c. Corporate Bonds – long term bonds issued by corporations with very strong
credit ratings
i. Can be converted into a specified number of stocks at any time up
to the maturity date - convertible bonds
ii. Desirable to prospective buyers because it allows the corporation
to reduce its interest payments because these bonds can increase
in value if the price of stocks appreciates
d. Government Securities – long term debt instruments issued by the government
to finance budget deficits - widely traded bonds and the most liquid security
traded in the capital market
e. Government Agency Securities – long term bonds issued by various government
agencies in order to finance such items as mortgages, farm loans, or power-
generating equipments
f. National and Local Government Bonds – also called the municipal bonds, long
term debt instruments issued by the national and local governments to finance
expenditures on school, roads, and other large programs
i. Interest payments are exempted from income and other form or
taxes (e.g. withholding tax, VAT)
g. Consumer and Commercial Bank Loans – loans to consumers and businesses
made principally by banks and finance companies
67
Chapter 6
Pricing of Financial Instruments
6.1 Riskless Assets and Computation of Asset Yields
• Riskless Assets
Decisions facing investors are complex, there are so many alternatives
o Attributes of Debt Instruments
� Maturity – time that must elapse before borrower must repay debts in full
� Liquidity – capability of an asset to be converted into money easily and
without loss of value in terms of money
� Safety of Principal – freedom from risk that market value of debt
instrument will decrease
o Risk Associated With Loss of Principal
� Default risk – arise when borrowers simply do not repay the loan
� Market risk – risk that the market price of debt instrument will decrease
even in the absence of default risk; occurs when sharp rise in interest rates
occur
o Yield on Debt Instruments
� Yield – annual rate of return over cost with due consideration between
cost and sale value difference; also known as effective interest rate
o 3 Concepts in Computing Yield (e.g. on bonds)
� Coupon Yield – percentage of the par value or principal of the bond;
constant since par value and coupon remain fixed throughout the life of
the bond
� Defective because it ignores market value or price one pays for the
bond
68
� Current Yield – coupon payment (peso amount of interest per year) divided
by the market price of bond
� Inadequate as a measure of effective interest rate since it fails to
account for receipts accruing beyond a one year period
� Does not distinguish the differences between maturities of debt
instruments
� Does not treat potential capital gain or losses properly
� Yield to maturity – considers current market value, annual interest receipts
(coupon) and the relationship between current market value and par value
(value at which debt will be paid off at maturity)
� Assumes debt will be held to maturity
Numerical Example 1:
Consider a bond promising to pay a par value of P10,000 at the end of 10 years and P600 at the
end of each year (coupon). Assume that the market price of the bond is P9,000. What is the
effective interest rate?
� Using the Coupon Yield
%606.0000,10
600 ====ValuePar
couponYieldCoupon
Note: Capital gain of P1,000 was ignored
� Using the Current Yield
↑==== %7.6067.0000,9
600
ValueMarket
couponYieldCurrent
Note: Capital gain of P1, 000 was considered hence effective interest rate increase
Suppose market price = P11, 000.00 instead of P9, 000.00
↓==== %45.50545.0000,11
600
ValueMarket
couponYieldCurrent
69
Note: Capital loss of P1, 000 was considered hence effective interest rate decrease
Note: If maturity is one-year instead of 10 years, at the same par value and coupon, capital
gain of P1,000 can be realized or gained after one year instead of waiting at the end of the 10th
year.
Time Value of Money is not considered
Using the Yield to Maturity
)(lossgaincapitalcouponreturnTotal +=
If bond is purchased now for P9,000.00
%78.17000,9
600,1
000,9
1000600 ==+=
=InvestmentInitial
yearaafterreturnTotalMaturitytoYield
If bond is purchase now for P10,200.00
%92.3200,10
400
200,10
)200(600 ==−+=MaturitytoYield
Hence, given the coupon, the higher the market price of the bond, the lower the yield to
maturity of the effective interest rate
Numerical Example 2:
A government bond promised to pay a par value of P20,000.00 at the end of 5 years and P2,000
at the end of each year. Market price of bond is P15,000.00.
a) What is the coupon yield?
b) What is the current yield?
c) What is the Yield to Maturity?
Solutions:
• coupon yield =
%10000,20
000,2 ==valuepar
coupon
70
• current yield =
%33.13000,15
000,2 ==valuemkt
coupon
• yield to maturity =
%67.46000,15
000,5000,2 =+=+investmentinitial
gaincapitalcoupon
6.2 Discounting and Compounding
Present Value (PV) of Future Sum (FV) of Money
o This is the amount, which, if invested today, will grow as large as that future sum,
taking into account the interest that it will earn
ti
FVPV
)1( +=
where:
PV -Present Value FV -Future Value
i -Interest Rate t -time
Example: How much money will I invest now at 5% interest rate in order to receive P1,500
worth of bond after a year?
1,428.571)05.01(
500,11
=+
=PV
� I will be willing to pay 1,428.571 now for the bond whose future value is P1,500
at 5%
� The present value of a future value of P1,500 is P1,428.571 at 5%.
o Discounting – process of converting future income into an equivalent present value
by using a discount factor, reflecting the appropriate interest rate
o Compounding – the process of earning interest on the interest and as well as on the
principal
71
Example: What is the present value of a bond that pays P350 one year from now and P500 two
years from now at a constant 10% interest rate?
( ) ( )
40.731
22.41318.38
1.01
500
1.01
35021
PPV
PV
PV
=+=
++
+=
Example: If the interest rate is 10%, which of the following would you prefer to receive?
a) P75 one year from now
b) P85 two years from now
c) P90 three years from now
(a) ( )18.68
1.1
751
PPV == (b) ( )
25.701.1
852
PPV == (c) ( )
61.671.1
903
PPV ==
(b) would be chosen, it has the highest present value
Note: In the context where future income streams are certain, the following calculations show
how financial instruments can be valued. This valuation formula is especially relevant for
instruments like bonds issued either by the government or by well-known corporation. These
debt instruments have or no probability of default (riskless). Hence, the promised income
stream can be thought of as certain.
Example: Suppose that you bought a four-year, P10,000 coupon bond with a coupon rate
of 7% when the market interest rate is 7%. Immediately after you bought the bond, the market
interest rate falls to 5%. What happens to the value of your bond?
At the initial interest rate of 7%, the bond value is:
( ) ( ) ( ) ( ) ( )
000,10
95.628,703.53441.57141.61120.654
07.1
000,10
07.1
700
07.1
700
07.1
700
07.1
70044321
P
Value
=++++=
++++=
72
At the new interest rate of 5%, the bond value is:
( ) ( ) ( ) ( ) ( )
19.709,10
02.82789.57569.60492.63467.666
05.1
000,10
05.1
700
05.1
700
05.1
700
05.1
70044321
P
Value
=++++=
++++=
Therefore, the value of the bond rises as yields falls
Example: Suppose that you are considering the purchase of a coupon bond that has the
following future payments: P600 in one year; P600 in two years; P600 in 3 years; and P600 +
P10,000 in 4 years.
(a) What is the bond worth today if the market interest rate is 6%? What is the
bond’s current yield?
(b) Suppose that you have just purchased the bond, and suddenly the market
interest rate falls to 5% for the foreseeable future. What is the bond worth
now? What is its current yield?
(c) Suppose that one year has elapsed, you have received the first coupon payment
of P600 and the market interest rate is still 5%. How much would another
investor would be willing to pay for the bond? What is your total return on the
bond?
(a)
( ) ( ) ( ) ( ) ( )
%606.0000,10
600
00.000,10
94.920.726.47577.50300.53403.566
06.1
000,10
06.1
600
06.1
600
06.1
600
06.1
60044321
===
=++++=
++++=
YieldCurrent
P
Value
(b)
( ) ( ) ( ) ( ) ( )
%79.50579.060.354,10
600
60.354,10
02.227,862.49330.51822.54443.571
05.1
000,10
05.1
600
05.1
600
05.1
600
05.1
60044321
===
=++++=
++++=
YieldCurrent
P
Value
73
(c)
( ) ( ) ( ) ( )
[ ]%73.8
000,10
33.873
000,10
000,1033.273,10600Re
33.272,10
38.638,830.51822.54443.571
05.1
000,10
05.1
600
05.1
600
05.1
6003321
==−+=
=+++=
+++=
BondtheonturnTotal
P
Value
Example: Suppose Ms. Understood deposits P7,500 in a savings account at Star Bank
which offers 5% interest compounded annually, how much money will she have at the start of
the third year?
( )( ) 75.268,805.1500,7
12 P
iPVValueFuture t
==
+=
Suppose on the 4th
year, the interest rate increased by 1%, how much will she have at
the end of the 6th
year?
( ) ( )( ) ( )
62.340,1018.682,8
1910.118.682,81576.1500,7
06.118.682,805.1500,7 36
33
PP
VFFV
====
==
Example: Your instructor is planning to settle down upon completing his master’s degree, two
years from now. His would be in-laws required him to have a total of P1,000,000 in his bank
accounts. Terribly shaken by the terms, he looked into his two bank accounts – P500,000 in PNB
paying 6% compounded annually and P200,000 in Region Bank paying 5% compounded
annually. Can your instructor raise the required amount in due time and get married or stay
single a little bit longer?
( )( )
00.000,000,100.300,782
00.500,22005.1000,200
00.800,56106.1000,5002
2
PPTotal
PFV
PFV
RB
PNB
<===
==
Since that amount raised is less than P1M, your instructor will stay single a little bit
longer!!!
74
6.3 Capital Asset Pricing Model
o There are many assets whose future income streams are not certain
� For instance, stock has an income stream that varies with the
performance of the corporation which issues it – hence – there is
uncertainty or risk attached to the ownership of the stock
� How do we price such risky assets?
o The Capital Asset Pricing Model is the most widely used model for pricing risky
assets
� Expected return – the return that the saver anticipates for holding the
asset over the period t to t+1
� Risk of an asset – measured by the standard deviation of its rate of return
� Ceteris paribus, savers will prefer assets with low risk and high expected
return
� Upward sloping indifference curve represent preferences of savers for
risk-return trade-off (i.e., risk is a “bad”), thus higher risk must be
compensated by higher return
� Individual economic unit adjust its holding of assets, financial liabilities
and consumption on the basis of maximizing total utility
( )σ,RfUFA =
where:
FAU -utility derived from financial assets
R -expected return from financial asset
σ -risk involved in holding financial assets
∑=
=n
xxxPRR
1 where
75
R -expected return or expected value of probability
distribution
XR -return on the xth
possibility
XP -probability of occurrence of the event XR
n -total number of possibilities
Given a single financial asset:
( ) x
n
xx PRR
2
1∑
=
−=σ
where:
σ -standard deviation for one financial asset
-dispersion probability distribution
Note that the higher the σ , the higher the risk, therefore the lower the utility
Given a portfolio of financial assets:
∑∑= =
=m
j
m
kkjjkkj rAA
1 1
σσσ
where:
m -total number of financial assets
jA -proportion of total funds invested in asset j
kA -proportion of total funds invested in asset k
76
jkr -expected correlation between returns for j and k
kσ -risk involved in holding asset k
jσ -risk involved in holding asset j
o If 1+=r , returns from asset k and j vary directly, i.e., increase in kj RR → (e.g.
treasury bills vs. private bonds)
o If 1−=r , returns from asset k and j vary inversely
o If 0=r , returns from assets are not correlated
6.4 Risk and Portfolio Diversification
o Market (Systematic) Risk
� Common risk shared by all types of assets
� Risk that cannot be eliminated by diversification
� Unavoidable – e.g. recessions can decrease the value of stocks
collectively
o Idiosyncratic (Unsystematic) Risk
� Risk that is unique to a particular type of asset
� Can be eliminated by diversification
� Price of individual stocks can be influenced by factors such as discoveries,
strikes, lawsuits that influence the profitability of the firm and its share
value – risk can be eliminated simply by buying less or choosing from
other options
o Asset Risk = Market Risk + Idiosyncratic Risk
77
Graphically:
o Diversification – holding many risky assets reduced the overall risk an investor
faces
o Rule: DO NOT PUT ALL YOUR EGGS IN ONE BASKET
o Why?
� In real world, returns on assets do not move together perfectly because
their risks are not perfectly correlated
� The return on a diversified portfolio is more stable than the returns on
individual assets comprising the portfolio
� Diversification effectively allows investor to divide the risk into smaller
and therefore less potentially harmful pieces
� How does diversification reduce portfolio risk?
Example:
You would want to invest P1,000 in stocks and choosing between 2 investments - shares in
Bubbles PPG Inc. and Buttercup PPG Inc. whose returns vary with the economy’s performance
in opposite ways:
1
Idiosyncratic risk
Market risk
Average annual variability ( ),%σ
10 100 1,000
No. of stocks in portfolio
78
Suppose:
� Bubbles PPG Inc. does well half of the time and do not do well on the other half
� When economy improves, Bubbles PPG Inc. prospers and its share have a return
of 20%, and you earn P200
� When economy is weak, sales of Bubbles PPG Inc. products are poor, stock
return is 0%, and you earn nothing
Question:
� What is Bubbles PPG Inc.’s expected return?
10002
1200
2
1Re PturnExpected =
+
=
Therefore, if you invest only in Bubbles PPG, you can expect a rate of return of 10%
Suppose:
� Buttercup PPG’s return follow an opposite direction or pattern
� When the economy is weak, return on Buttercup PPG’s share is as high as 20%
� When the economy does well, you earn nothing (0%)
Question:
� What is Buttercup PPG Inc.’s expected return?
1000202
10
2
1Re PturnExpected =
+
=
Therefore, if you invest only in Buttercup PPG, you can expect a rate of return of 10%
Suppose:
� You invest equal amounts in Bubbles and Buttercup shares
� Compute for the total returns in good times and the total returns in bad times:
In good times:
� Bubbles’ return is 20%
79
� Buttercup’s return is 0%
( ) ( )
( ) ( )( ) ( ) 1000.050020.0500
%10%02
1%20
2
1
Re'2
1Re'
2
1Re
P
turnsButtercupturnBubblesturnTotal
=+=
=+=
+=
In bad times:
� Bubbles’ return is 0%
� Buttercup’s return is 20%
( ) ( )
( ) ( )( ) ( ) 10020.05000.0500
%10%202
1%0
2
1
Re'2
1Re'
2
1Re
P
turnsButtercupturnBubblesturnTotal
=+=
=+=
+=
Conclusion:
� You can earn same expected return as you would earn from investing in the shares of
only one of the companies
� But, you lessened the risk affecting you portfolio returns by limiting influence of one of
the source of variability: the economy
� Strategy of dividing risk by holding multiple assets ensures steadier income
o Summing up: On Diversification…
� Diversification is almost always beneficial to the risk-averse investor because it
reduces risk except in the extremely rare case where returns on securities move
perfectly together
� The less the returns on the securities move together, the more benefit (risk
reduction) there is from diversification
� The risk of a well-diversified portfolio is due solely to the systematic risk of assets
in the portfolio
80
Limits to Diversification
� Cost of acquiring information about alternative assets
� Transactions cost of buying and selling individual assets
� Legal restrictions on the number of assets that can be held by individual savers
or by certain financial intermediaries on their behalf
o Classification of Savers
� Risk averse savers - those who seek to minimize variability in the return on their
savings and prefer security in their investments
� Risk neutral savers - those who judge assets only on their expected returns;
variability is not their concern
� Risk loving savers - prefer to gamble by holding risky assets with the possibility of
maximizing returns or even maximizing loss
o Notes:
� Empirical evidence on returns from financial markets confirm risk averse
behavior of most investors
� Annual real rates of return on common stocks are greater than the annual rates
of return on long-term government bonds but larger investments can be found
in government bonds because of lower risk; equity investments involve higher
risk
81
6.5 Credit Market Instruments
Credit market instruments are being categorized according to the variations in the timing of
payments
1. Involves single payment of interest and principal
Simple loans
Discount loans
2. Involves multiple payments of interest and/or principal
Coupon bonds
Fixed-Payment loans
(a) Simple loans
The borrower receives from the lender an amount of funds called the principal and agrees to
repay the lender the principal plus an additional amount, the interest (fee for using the fund)
Example:
BPI makes a one-year simple loan of P10,000 at 10% interest to Cartoon Network Incorporated.
How much will Cartoon Network Incorporated pay and when?
(b) Discount Bond
Borrower pays the lender the amount of loan called face value (or par value), at maturity but
receives less than face value initially
Example
If Cartoon Network issued a one-year discount bond with a face value of P10,000 and an
implicit interest rate of 10%. It would receive approximately P9,091 and repay P10,000 after a
year.
CNI receives P9,091
from discount bond
CNI repays
P10,000
0 year 1 year
CNI receives
P10,000 loan from
BPI
CNI repays BPI
P11,000
0 year 1 year
82
(c) Coupon Bond
� Requires multiple payments on a regular basis e.g. annually, quarterly and the
payment of the face value at maturity
� Specifies maturity date, face value, issuer, and coupon rate
� Coupon rate is the yearly coupon divided by the face value
Example
ACME issued a P10,000, 20 year bond promising a coupon rate of 10%. It would pay P1,000 per
year, and a final payment of P10,000 at the end of the 20th
year.
(d) Fixed Payment Loan
� Requires borrower to make a regular periodic payment to lender
� Payment includes both the interest and principal, hence no lump-sum payment
at maturity
Example: STFAP grants a P10,000 – 10 years “student” loan with a 9% interest, compute for the
monthly payment.
monthsformonthP
months
yearx
yearsPaymentMonthly
PPPInterestincipal
PyearsxP
yearPxP
Interest
120/33.15812
1
10
000,19
00.000,19000,9000,10Pr
000,910900
/90009.0000,10
==
=+=+=
=
Borrower receives
P10,000
0 120
Borrower repays
158.33
158.33
158.33
158.33 158.33 158.33
119
1,000
Borrower receives
P10,000
0 20
CNI repays BPI
P10,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000 1,000
83
• Comparing Credit Market Instruments
Numerical Example:
Suppose you won P2 million pesos in lotto to be paid in P100,000 installments each year for 20
years. If interest rate is at 10% and expected to remain 10% for the next 20 years, are you still
rich as you think?
( )
( )
( )
00.492,936....48.131,75644,82909,90000,100
48.131,751.1
000,1004
00.644,821.1
000,1003
00.909,901.1
000,1002
000,1001
20
1
3
2
PPV
PP
year
PP
year
PP
year
Pyear
ii
th
rd
nd
st
=++++=
==
==
==
=
∑=
Numerical Example:
Suppose interest is 10% and you were offered either a discount bond paying P1,000 in five
years or a fixed payment loan paying you P150 per year for 5 years and for a price of P600.
Discount Bond
( )60092.620
1.1
000,15
PPPV >==
Fixed Payment Loan
( ) ( ) ( ) ( ) ( )60062.568
1.1
150
1.1
150
1.1
150
1.1
150
1.1
1505432
PPPV <=++++=
Because the present value of payments from the discount bond is greater than P600 and that
the payments on the fixed payment loan is less than P600 – you would be willing to buy the
discount bond at the P600 price offering
84
Chapter 7
Financial Intermediaries and
Commercial Banking
7.1 IMPORTANCE AND TYPES OF FINANCIAL INTERMEDIARIES
Financial
Intermediaries
Institutions like commercial banks, credit unions, finance and
insurance companies among others which borrow funds from
savers and lend them to borrowers
o Match savers and borrowers
� Funds channeled to the most productive investments
o Provide risk sharing, liquidity, and information services
o Purchase primary securities
o Issue own securities
� Transform direct claims (primary securities) to indirect claim (indirect
securities) that differ in form from direct claims
� Example: PhilAm – buy mortgages and bonds (direct claim) and issues life
insurance policies
o Financial intermediaries have to compete, thus the result is lower spread between
borrowing and lending rates
o Flow of funds via direct and indirect finance
Financial Intermediaries
Ultimate
Lenders
Ultimate
Savers Direct Finance
Indirect Finance
85
o The process of indirect finance – financial intermediation, is the primary avenue for
moving funds from lender to borrowers
TYPES OF FINANCIAL INTERMEDIARIES (4 BROAD GROUPS)
1. Securities Market Institutions
• Helps the securities market functions smoothly
• Not a real intermediary – because they do not acquire funds from savers to borrowers
but they assist in channeling funds from savers to borrowers and in providing risk
sharing, liquidity, and information services to both savers and borrowers
Examples:
(a) Investment banks - assist businesses in raising new capital in primary markets and
advice them on the best way to do so; issuing shares and structuring debt contracts
� Earn income through underwriting – the process of guaranteeing a price to
the issuing firm, selling issue at a higher price and keeping the difference as
profit or spread
� In exchange for spread, investment banks assumes risk of not being able to
resell securities to investors
� Syndicates – group of underwriters, file prospectors with the Securities and
Exchange Commission (SEC) disclosing information on long term issues of
publicly traded securities
o Merrill Lynch
o All Asia Fund, Incorporated
o Tibayan Group Investment Company Incorporated
(b) Brokers and dealers -assist businesses in raising new capital in secondary markets
� The SEC strictly regulates brokers and dealers to ensure disclosure of
information, prevent fraud, and restrict trading based on insider information
� Increased competition among brokers and dealers – investors pay lower
commissions
o Asian Capital Equities Incorporated
o BPI Securities Corporation
o Diversified Securities Corporation
86
(c) Organized Exchanges - securities may be traded in one of 2 ways – exchange or over
the counter markets
� Exchange is a physical location at which securities are traded
� Exchange act as an auction market for securities – assets are bought from the
offerer of the lowest price and sold to the bidder of the highest price
� Does not set the price but provide a way for buyers and sellers of financial
assets to trade anonymously, lowering information costs
� Specialists – a broker and a dealer on the floor of the exchange who makes a
market in one or more of stocks – can lead to a fragile market during a panic
“stock market crash”
o Philippine Stock Exchange (PSE)
o New York Stock Exchange (NYSE)
o American Stock Exchange (AMEX)
(d) Over the Counter – trading takes place over the phone or computer
� Traders keep track of the market by examining the activity of individual
issues on their computer shares
o National Association of Securities Dealer’s Automated Quotation
(NASDAQ)
2. Investment Institutions
o Raise funds to invest in loans and securities
Examples:
(a) Mutual Funds – financial intermediaries that convert small individual claims into
diversified portfolios of stocks, bonds, mortgages, and money market instruments by
pooling the resources of many small savers
� Obtain saver’s money by selling shares in portfolios of financial assets and
then using the funds of many savers to maintain and expand those portfolios
� Provide risk sharing benefits by offering diversified portfolio of assets and
liquidity benefits by guaranteeing to quickly buy back the saver’s share
� Reduce transaction costs of savers because savers can buy into all shares in
the fund with one transaction
87
� Money market mutual funds
o Hold high quality short term assets like T-bills, negotiable certificates
of deposits, and commercial paper
o Short term maturities, therefore asset value do not fluctuate as much
o Pay market interest rates since assets held are highly liquid
� Pag-ibig Mutual Fund
� Kabuhayan Mutual Fund
� ECC Money Market Func Inc.
(b) Finance Companies – raise funds in financial markets to lend to household and business
firms
� Finance companies must invest in gathering and monitoring information
about borrower’s default risk
� 3 main types
o Consumer finance – enable consumers to buy cars, furniture,
appliances, to finance home improvements, and to refinance
household debts – they have higher default risk hence they charge
higher interest
o Business finance – involved primarily in an activity called factoring –
purchasing account receivable of small firms at a discount and holding
them until maturity for a profit; to finance expensive business
equipments and then lease it to the business over a fixed length of
time
o Sales finance – affiliated with companies that manufacture or sell the
good – their purpose is to promote the business of the underlying
manufacturer or retailers
3. Contractual Savings Institutions
o Allow persons to pay money to transfer risk of financial hardship to someone
else (insurance) or to save in a disciplinal manner for retirement (pension
contribution)
Examples:
(a) Insurance companies – financial intermediaries specializing in writing contracts to
protect policy holders from risk of financial loss associated with particular events
� Insurer obtain funds by issuing promises to pay under certain conditions and
then lend money to borrowers
88
� People pay fees (premiums) to insurance companies to assume risk
� 2 Segments:
o Life Insurance Companies – sell policies to protect household against
loss of earnings from disability, retirement or death of insured person
� PhilAm Life
� Beneficial PNB Life
� Ayala Life Assurance, Incorporated
o Property and Casualty Insurance Companies – sell policies to protect
households and firms from risks of illness, theft, accidents
� UCPB General Insurance Company
� Prudential Guarantee
� RA Roco Insurance Agency
(b) Pension funds – investment contributions of workers and firms in stocks, bonds, and
mortgages to provide for pension benefits during worker’s retirement – do not act as a
deposit taking intermediary
� Private: Social Security Services
� Public: Government Service Insurance Corporation
� Ayala Pension Plans
4. Depository Institutions
o Accepts deposits and make loans, acting as intermediaries in savings- investment
process
Examples:
(a) Commercial Banks – financial intermediaries that offer risk-sharing, liquidity, and
information services that benefit savers and borrowers
� Savers obtain risk-sharing benefits from bank’s diversified portfolio of loans
� Borrowers can obtain needed funds to finance expenditures or investments
� Provide liquidity through checking account – which are available on demand
89
� Commercial banks are the largest single group of financial institutions in the
country, accounting for more than 90 percent of the combined assets of the
banking system (44 commercial banks serving the Philippines).
� Expanded Commercial Banks – also referred to as "universal banks"
empowered to engage in the activities of an investment house (underwriting,
securities dealership and equity investment) and to invest in other industries
other than those allied to the banking industry.
� Rizal Commercial Banking Corporation
� Bank of the Philippine Islands
� Philippine National Bank
� Metrobank
� Philippine Commercial International Bank (PCIBank)
� United Coconut Planters Bank
� Land Bank of the Philippines
� Citibank
� Commercial Banks
� ANZ Banking Group, Ltd.
� Asia United Bank Corporation
� Banco Santander Phils., Inc.
� Bank of America, N.A.
� Citibank, N.A. (Phils.)
� Export and Industry Bank
� International Exchange Bank
� Other banks - the remainder of the banking market is divided between thrift
banks, rural banks and a few specialized government institutions. As of
September 30, 2001, there were more than 100 thrift banks and 750 rural
banks serving the Philippines.
o Thrift banks include savings and mortgage banks, private
development banks, and stock savings and loan associations. Savings
banks serve primarily as thrift institutions, drawing funds from
household and individual savers.
o Rural banks specialize in small loans for agricultural purposes as well
as to retail traders. Their main sources of funds are savings and time
deposits.
90
o The following are government banks created for specialized
purposes:
� The Development Bank of the Philippines, established to
finance development projects in such areas as agriculture,
industry and low-cost housing. It also undertakes investment
banking functions.
� The Land Bank of the Philippines, established to assist the
government in the acquisition of landed estates under the
agrarian reform program. Under its charter, the Land Bank
functions as an expanded commercial bank.
� The Philippine Amanah Bank, established to provide financial
assistance to the Muslim communities of Mindanao.
� The Opportunity Micro-Finance Bank, established to fund,
monitor, service and screen Grameen-banking type
developmental loans to specified marginalized sectors of
Philippine society.
(b) SALAs – Savings and Loans Associations – originated as building and loan societies in
which individuals pool money to be loaned to members to build homes
� SALAs reduce problems of asymmetric information and default risk by
requiring down payment to make sure that borrowers maintain an economic
interest in the value of the house
� Take relatively short-term deposits to finance long term home mortgages,
thus prone to market risk
(c) Credit Unions – specified intermediary consumer lending, taking deposits from and
making loans to individuals known to each other
� UPLB Consumer Development Cooperative (CDC)
� Provident Funds
91
7.2 STRUCTURE AND REGULATION OF COMMERCIAL BANKING
1. Structure of Commercial Banks
o The most important among financial intermediaries in terms of asset size
o Major mover/channel of funds from savers to borrowers with productive
investment opportunities
o Important player in ensuring that the financial system and the economy run
smoothly and efficiently
Distribution of Banks in the
Philippines as of September
2008
Source: www.bsp.gov.ph
Type of Bank
Number
Universal and Commercial
Banks 4330
Thrift Banks 1331
Rural and Cooperative Banks 2150
92
Distribution of Commercial Banks on the Philippines as of September 2008
Source: www.bsp.gov.ph
Type of Bank Number
Universal Banks 3847
Private Domestic banks 3417
Government banks 415
Branches of foreign banks 15
Commercial Banks 483
Private Domestic banks 390
Subsidiaries of foreign banks 67
Branches of foreign banks 5
93
Philippine Commercial Bank Rankings based from Total Assets as of 30 June2008
(in Million Pesos)
Rank Bank Name Total Assets
1 Banco de Oro Unibank Inc. (BDO) 643,402
2 Metropolitan Bank and Trust Co. (Metrobank) 615,911
3 Bank of the Philippine Islands (BPI) 499,103
4 Land Bank of the Philippines (LandBank) 369,857
5 Development Bank of the Philippines (DBP) 322,749
6 Philippine National Bank (PNB) 241,880
7 Rizal Commercial Banking Corp. (RCBC) 216,008
8 Citibank NA 196,820
9 China Banking Corporation (ChinaBank) 185,625
10 Union Bank of the Philippines (Union Bank) 179,612
11 Allied Banking Corporation (Alied Bank) 128,992
12 Security Bank Corporation (Security Bank) 127,866
13 Hongkong & Shanghai Banking COrp. (HSBC) 112,342
14 United Coconut Planters Bank (UCPB) 97,670
15 Bank of Commerce (BoC) 86,917
16 Phil Trust Company 67,701
17 Standard Chartered Bank 66,923
18 Philippine Bank of Communications (PBCom) 50,405
19 Asia United Bank Corporation 42,462
20 East West Banking Corporation 41,608
21 Internationale Nederlanden Groep Bk 40,947
22 Philippine Veterans Bank 38,906
23 Deutsche Bank AG 34,070
24 Mizuho Corporate Bank Ltd-Manila Br 32,792
25 BDO Private Bank Inc. 28,721
26 The Bank of Tokyo-Mitsubishi UFJ Ltd 26,705
27 Chinatrust (Phils) CBC 24,371
28 JP Morgan Chase Bank National Assn 21,699
29 Maybank Philippines Inc. 20,124
30 ANZ Banking Group Ltd 19,829
Source: Pinoy Entrepreneurs - Philippine Bank Ranking in 2008 (Total Assets - Net)
94
2. General Principles of Bank Management
o Liquidity Management
� Keeping excess reserves
� If banks have ample reserves, a deposit outflow does not necessitate changes in
the other parts of its balance sheet
� Excess reserves are insurance against the cost associated with deposit outflows
� The higher the cost associated with deposit outflows, the higher the excess
reserves the banks will want to hold
� Calling in loan
� Selling of a financial security in a secondary market
� Borrowing in the interbank market
o Asset Management
� To maximize profit, a bank must simultaneously seek the highest returns possible
on loans and securities, reduce risk and make adequate provisions for liquidity.
How?
� Banks seek borrowers who will pay high interest and are unlikely to default
in their loan
� Purchase securities with high rates of returns and low risk
� Banks lower risks by diversifying – purchasing many different types of assets
and approving many types of loan to a number of customers
� Managing the liquidity of its assets so that it can satisfy its reserve
requirement without bearing huge costs – balancing its desire for liquidity
against the increased earnings
o Liability Management
� Interest rate competition
� Provide optimal interest rates to attract borrowers and savers
� Product differentiation
� Non-price competitions – promos, contests, heavy advertisements
95
o Capital Adequacy Management
� Banks have to make decisions about the amount of capital they need to hold for
three reasons:
� Bank capital helps prevents bank failure
• A bank maintains capital to lessen the chance of being insolvent - amount
of capital affects returns for the owners (equity holders) of the bank
• Given the return on assets, the lower the bank capital, the higher the
return for the owners of the bank
• To satisfy the minimum amount of bank capital (bank capital
requirements) required by the BSP
3. Bank Risk Management
o Managing Credit Risk – to make successful loans and reduce adverse selection and
moral hazards
a) Intensive screening – banks screen out the bad credits from the good ones so that
the loans are profitable
b) Specialization in Lending – specializing in lending only to local firms or to firms in a
particular agency
c) Monitoring and Enforcement of Restrictive Covenants – to reduce moral hazard,
borrowers are required to sign in loan contracts that restrict them from engaging in
risky activities
d) Long-term Customer Relationship – to obtain more information about their lenders
– closer ties between corporations and banks facilitates loan approval and
repayments
e) Loan Commitments – is a bank commitment to provide firm with loans up to a given
amount at an interest rate that is tied to some market interest rate – promote long-
term relationship with corporations and facilitates the gathering of information
f) Collateral and Compensating Balances - Banks require collateral for their loans
• Collateral – property promised to the lender as compensation if the borrower
defaults
• The borrower should keep a minimum “maintaining balance” in their checking
account as “compensating balance” in case of default
g) Credit Rationing – granting loans but not as large as what the borrower wants
• The larger your loan, you are likely to take actions that would increase risk and
96
o Managing Interest Rate Risks – to protect banks from fluctuating interest rates that
affect their earnings and returns – if a bank has more interest rate sensitive liabilities
than assets, a rise in the interest rates will reduce bank profits and a decline in interest
rates will raise bank profits
� Gap and Duration Analysis – the amount of rate sensitive liabilities is subtracted
from the amount of rate sensitive assets over a specified duration
4. Regulatory Environment
o For New Banks
a) The new banking organization must have suitable shareholders
b) Adequate financial strength
c) A legal structure in line with its operational structure
d) Management with sufficient expertise and integrity to operate the bank in a sound
and prudent manner
e) Where the proposed owner or parent organization is a foreign bank, the prior
consent of its home country supervisor should be obtained.
f) Capital Requirements
• Banks to be established shall comply with the required minimum capital
enumerated below or as may be prescribed by the BSP Monetary Board
(Philippine Case):
Revised Amounts Type of Bank
(In Million Pesos)
a. Universal Banks 4,950.0
b. Commercial Banks 2,400.0
c. Thrift Banks
- With head office within Metro Manila 325.0
- With head office outside Metro Manila 52.0
d. Rural Banks
- within Metro Manila 26.0
- Cities of Cebu and Davao 13.0
- In 1st
, 2nd
& 3rd
class cities and 1st
class
municipalities
6.5
- In 4th
, 5th
& 6th
class cities and in 2nd
, 3rd
&
4th
class municipalities
3.9
- In 5th
& 6th
class municipalities 2.6
97
o Reserve Requirement – 15 % to 20 % of total deposits
o Gross Receipts Tax – 2%
o 20 % tax on interest income (from trading government securities)
o Agricultural loans requirement should be 10 % or 25% invested in capital
investments
o Approximately 6 % and 2% of total loan portfolio set aside for small and medium
scale enterprises respectively – until August 2007
o Branching restrictions – BSP regularly approves more merges than putting or
setting up new branches
o Limited loans available for DOSRI (Directors, Officials, Stockholders, Related
Interest of banks)
Effects of Bank Regulations on Financial Intermediation
(a) Effect of Withholding Tax on Interest Income
Where:
i0 - the deposit interest rate before the tax
D0 - total deposits without the withholding tax
i1
- interest rate with tax
deposits
interest
rate
Supply D
Demand D
D0
i0
Supply T
i1
(1-t)i1
D1
98
D1 - total deposits after the tax
(1-t)i1 - net interest received by the depositors
Therefore, the withholding tax is to discourage investors
(b) Impact of Reserve Requirement on Banking System
i) LRRDD +=
where:
DD - demand deposits
RR - required reserves
L - loans
Suppose:
iD - deposit rate
iL - loan rate
rr - reserve requirement ratio
TC - total cost of banks
TR - total revenue of banks
ii) DDiTC D=
iii) ( )[ ]rrDDiTR
LiTRL
L
−==
1 :note that ( )rrDDrrDDDL
RRDDL
−=−=−=
1
99
iv) Computing for the profit
( )[ ]( )[ ]DL
DL
irriDD
DDirrDDi
TCTR
−−=
−−=−=
1
1
πππ
In the long run and under a perfectly competitive market 0, =∴= πTCTR
( )
( )rr
ii
irriD
L
DL
−=
=−
1
1
• The effect of the reserve requirement is to drive a wedge between deposits and
lending rates
• The higher the reserve requirement ratio, the higher the interest on loans
relative to interest on deposits – the rr acts as a tax on the banking system’s
output
Simplifying:
( )[ ]( )txQxPTR
rrDDiTR L
−=−=
1
1
where:
P is the price of their output
Q is the output of financial intermediation
t is the tax on the banking industry
(c) High reserve requirement and the Gross Receipt Tax
'DD -total deposits generated by the bank
rr -reserve requirement ratio
100
Li -loan rate
Di -deposit interest rate
Rt -tax on gross receipts
( ) '1 DDrr− -total available loans for lending
( )( ) '11 DDrri L −+ - total income of bank from lending
( )( )( ) '111 DDrrit LR −+− - net income of the bank after tax
Assuming a zero profit TR=TC
( )( )( ) ( )
( ) ( )( )( )rrt
ii
DDiDDrrit
R
DL
DLR
−−+=+
+=−+−
111
1
'1'111
• The effect of the rr and the gross receipts tax is to drive a wedge between the
deposit and loan rates
• Cost of intermediation are driven up by the high rr and the tax
• Therefore, banks have to charge a higher loan rate just to break even
o Large Banks = Monopoly??
• Is there substantial monopoly power over large banks?
• Why there is a structure of deposit rates on deposits of differing magnitude?
a) Small savings are paid 5 percent per annum - large depositors – P100,000 and more
can earn double the rate of small savings
101
b) If the banking system is competitive, deposit rates should not differ significantly
among big and small savers
c) Market differention suggest – IMPERPECT COMPETITION - top 5 universal banks
alone control approximately 55% of total assets and 30% of all deposits in the
banking industry
d) Large banks can take advantage of differences in the behavior of small and large
savers
• Example – large depositors have a large number of alternative uses or
investment opportunities for their savings while small savers have very little
option
• Then banks could lower interest rates to small depositors and raise interest
rates to large depositors
• Because of the better opportunities available to large depositors, they have a
higher reservation deposit rate than small savers
Banks have monopoly power and need to generate a fixed amount of deposits D
• To determine how much should be sourced from both small and large
depositors so as to minimize the cost of servicing those deposits - banks must
equalize the marginal resource cost (MRCs) for both type of savers. This
occurs when they service deposits of small savers and deposits of large
savers respectively, consequently determining the interest rates to be paid
Deposit rate Deposit rate
Deposit Deposit
iL
MRCL
Ssmall
MRCsmall
Slarge
MRClarge
DS
DL
Small Depositors Large Depositors
MRCS
iS
102
Rationale for Regulating Banks
• Given that risky banks in the economy cannot be weeded out efficiently, depositors
will always face a menu of risky prospectus - hence, regulation leads to less risky
outcomes, though one also has to consider the cost of regulation
• To make bank safe:
o Reserve requirements are safe
o Deposit insurance is required (PDIC)
o Size of bank capital is regulated
o Investments of banks are restricted
o BSP acts as a lender of last resort
103
Chapter 8
The Central Bank
8.1 History and Structure of the Bangko Sentral ng Pilipinas (BSP)
� Republic Act 265 – June 15, 1949
� Established the Central Bank of the Philippines
� Emphasis was to play a major role in rehabilitating the economy devastated by
World War II
� Administer the monetary and banking system of the Philippines
i. Maintain monetary stability of the economy
ii. Preserve the international value of the peso and convertibility of the
peso into other currencies
iii. Promote rising level of production, employment and real income in the
Philippines
� Republic Act 265 – Amended by Presidential Decree 72 – Nov. 29. 1972
� Administer monetary, banking, and credit system of the Philippines
i. Primary objective: To maintain internal and external monetary stability in
the Philippines
ii. Preserve international value of peso and its convertibility
iii. Foster monetary, credit, and exchange conditions conducive to a
balanced and sustainable growth of the economy
� Role shifted to being a participant in the international economy which had
generally experienced growth from 1950s to 1970s (development decades)
� Republic Act 7653 – June 14, 1993
� Established Bangko Sentral ng Pilipinas as the central and independent monetary
authority - restructuring of the old Central Bank of the Philippines (CBP),
established in 1949.
104
� Shall provide policy directions in the areas of money, credit, and banking
� Shall have supervision over the operations of banks and exercise such regulatory
powers and other pertinent laws over operations of finance companies (banks)
and non-bank financial intermediaries performing quasi-banking functions
i. Primary objective: To maintain price stability conducive to a balanced
and sustainable growth of the economy
ii. Promote and maintain monetary stability and convertibility of peso
� Bangko Sentral ng Pilipinas was a result of substantial deficits in the CBP’s
operations prior to 1993 that were incurred in connection with:
i. Certain quasi-fiscal activities conducted by the CBP consistent with
policies of the National Government at the time (i.e., foreign exchange
forward cover contracts and swaps entered into by the CBP with certain
banks and government-owned and -controlled corporations or GOCCs)
ii. CBP’s assumption of foreign exchange liabilities of certain GOCCs and
private sector companies during the Philippines’ foreign exchange crisis
in 1980s;
iii. development banking and financing by the CBP; and
iv. CBP’s conduct of open market operations and incurrence of high interest
expenses on the CBP’s domestic securities issued in connection with such
operations.
� Under the New Central Bank Act, the BSP was granted increased fiscal and
administrative autonomy from other sectors of the Government.
� The BSP no longer undertakes the quasi-fiscal activities described above, e.g.
the BSP is no longer permitted to engage in development banking or financing
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8.2 Functions of the Central Bank
Under the New Central Bank, the BSP performs the following functions, all of which relate to its
status as the Republic’s central monetary authority.
(1) Conducting Monetary Policy
� The BSP formulates and implements a monetary policy aimed at managing the
expansion or contraction of monetary aggregates consistent with the maintenance
of price stability
� This function is carried out primarily through open market operations, the
imposition of reserve requirements and rediscounting transactions
(2) Issuing Currency
� Bangko Sentral has the exclusive power to issue fully guaranteed national currency
and is considered legal tender for all private and public debts.
(3) Lending to other Banks and the Government
� Extend discounts, loans and advances to banking institutions to influence volume of
credit consistent with the objective of maintaining price stability.
� Extend commercial credits, advances against specified collateral, special credits or
loans for liquidity purposes and emergency loans and advances (consistent with its
function as the lender of last resort), which are subject to interest and other
appropriate charges.
(4) Managing Foreign Currency Reserves
� Maintain sufficient international reserves to meet demand for foreign currencies in
order to preserve the international stability and convertibility of the Peso.
� The BSP’s international reserves consist principally of gold and assets in foreign
currencies in the form of documents and instruments usually employed for the
international transfers of funds; demand and time deposits in central banks,
treasuries and commercial banks abroad; foreign government securities; and foreign
notes and coins.
(5) Supervision and Regulation of Financial Institutions.
� The BSP supervises and regulates banks and quasi-banks
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� Supervisory responsibilities include not only the issuance of rules, but also oversights
to ascertain that banks and quasi-banks comply with applicable regulations and
conduct their business on a sound financial basis.
� Exercises regulatory powers over operations of financial institutions without quasi-
banking functions, although certain of these powers were phased out and
transferred to the Philippine Securities and Exchange Commission (SEC).
� The BSP does not independently engage in any commercial banking activities
(6) Determination of Exchange Rate Policy
� The BSP determines the exchange rate policy of the Philippines. Currently, the BSP
adheres to a market-oriented foreign exchange rate policy such that the role of
Bangko Sentral is principally to ensure orderly conditions in the market.
(7) Other Activities
� The BSP functions as the banker, financial advisor and official depository of the
Government, its political subdivisions and instrumentalities and GOCCs.
� The BSP also provides the Government with opinions on the monetary implications
of any foreign and domestic borrowing operations. Foreign borrowing operations of
the Government require, in addition, the approval of the BSP. The BSP also
represents the Government in international financial institutions, such as the IMF
and the World Bank.
The BSP Monetary Board- The powers and function of Bangko Sentral are exercised by its
Monetary Board, which has seven members appointed by the President of The Philippines.
2 members from the Government
� The Governor of BSP – Chair
� A member of the Cabinet designated by the President of the Republic, which position is
currently held by the Secretary of Trade and Industry.
5 full time members from the private sector
� The old CB (1972) has the following composition of the Monetary Board
5 members from the Government
� Central Bank Governor – Chair
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� NEDA Director General
� Secretary of Finance
� Chair of DTI
� Secretary of Budget and Management
2 members from the private sector
� The old 1948 CB
All members from the Government
� Secretary of Finance – Chair , Governor of CB, President of the Philippine National Bank,
Chair of the Development Bank of the Philippines, and 3 members appointed by the
President
� Major Changes in the New BSP Act
Price stability is the primary objective
� P 50 billion capitalization fully subscribed by the Government vs. P 10B in old CB (1972)
and P10M in 1948
� Monetary Board composition and terms were changed
� Phase out fiscal agency functions
� BSP no longer in charge with issuance and servicing of Government securities – so that
BSP can concentrate on monetary management
� Phase-out of regulatory powers on the operation of finance companies without quasi-
banking functions – powers transferred to SEC
� Stronger regulation and supervision framework for banking institutions and quasi-banks
How Independent is the BSP?
� The BSP should be independent and free from political pressures from other
government agencies
o Limiting government participation in the Monetary Board, appointment is
non-renewable to eliminate incentives for the governor to carry favor of the
President or of the Congress
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o BSP operations have a substantial source of revenue from its holdings of
securities, returning bulk of earning to the Philippine treasury
� Earnings however are not controlled by the Congress through its
General Appropriations Act
o Government cannot audit the monetary policy or foreign exchange market
functions of the BSP
� However, the BSP is still subject to the control of the Congress
o The legislation structures is written by Congress and subject to change any
time
o When legislators are not satisfied with the performance of the BSP or with
their conduct of monetary policy, they frequently threaten to take control of
its finances
o The Congress also passes legislations to make the BSP accountable for its
actions
� The BSP is also being required to explain how their objectives are
consistent with the economic plans of the existing administration
o The President can also affect the BSP through Congressional legislation that
can directly affect its ability to conduct monetary policy
o The President can also appoint members of the monetary board and the
Governor of the BSP – though the term of the Chairman of the Board is not
concurrent with the President
Latest Developments in BSP
� The General Banking Law of 2000 – RA No. 2781 - an act providing for the regulation of
the organization and operations of banks, quasi-banks, trust entities and for other
purposes
� The Anti-Money Laundering Law – RA 9160 - an act defining the crime of money
laundering, providing penalties therefore and for other purposes
• Money laundering is a crime whereby the proceeds of an unlawful activity are
transacted, thereby making them appear to have originated from legitimate sources.
It is committed by the following:
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o Any person knowing that any monetary instrument or property represents,
involves, or relates to, the proceeds of any unlawful activity, transacts or
attempts to transact said monetary instrument or property.
o Any person knowing that any monetary instrument or property involves
proceeds from any unlawful activity, performs
o Any person knowing that any monetary instrument or property is required
under this Act to be disclosed and filed with the Anti-Money Laundering
Council (AMLC), fails to do so.
• Specific Regulations
o Customer Identification. - record the true identity of its clients based on
official documents, maintain a system of verifying the true identity of their
clients or organizational structure
� Anonymous accounts, accounts under fictitious names, and all other
similar accounts shall be absolutely prohibited
� Peso and foreign currency non-checking numbered accounts shall be
allowed. The BSP may conduct annual testing solely limited to the
determination of the existence and true identity of the owners of
such accounts.
o Record Keeping. - All records of all transactions of covered shall be
maintained and safely stored for five (5) years from the dates of transactions
including closed accounts
o Reporting of Covered Transactions - report to the AMLC all covered
transactions within five (5) working days from occurrence
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Chapter 9
Inflation
• Inflation refers to the economic condition characterized by a large and sudden
increase in the general level of prices of goods and services.
• More loosely, inflation is the rate of increase in the price level.
• Since people are usually more concerned with what is happening to the prices of
goods and services that they actually consume more often, it has become common
practice to measure inflation as the annual percentage change in the Consumer
Price Index (CPI).
What is the Consumer Price Index?
• The CPI is the measure of the average price of a standard "basket" of goods and
services consumed by the typical household.
o Determined from the Family Income and Expenditure Survey (FIES) periodically
conducted by the National Statistics Office (NSO) on a nationwide basis.
o The standard basket contains hundreds of different consumption items. It is the
actual movement in the prices of each of these items that is monitored to
determine the overall change in CPI, or in short, inflation.
What Comprises the CPI Basket?
• The bulk of the Philippine CPI basket is accounted for by food items (58.5 percent),
including beverages and tobacco.
o Rice, the country's main staple, accounts for about 13 percent of the basket.
o Non-food items comprising the rest of the basket include the following:
housing and repairs, 13.3 percent; services, 10.9 percent; fuel, light and water,
5.4 percent; clothing, 4.3 percent; and miscellaneous items, 7.6 percent.
o Price movements in the food, beverages and tobacco sector have large effects
on the overall price changes. Since 1994, food items have contributed more
than 50 percent to overall inflation
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9.1 Causes of Inflation
Structuralist Approach to Inflation: An Alternative to Monetarism
A. Using the Equation of Exchange
• Recall the equation of exchange: Connecting nominal money supply, price level
and output
PYMV = (1)
• Since inflation represents rate of change of prices, we can express the equation of
exchange in percentage form
% % % %M x V P x Y
m v y
m v y
∆ ∆ = ∆ ∆+ = ∏++ = Π +
(2)
• Rearranging the equation to focus of the determinants of inflation
m v yΠ = + − (3)
• Therefore, inflation = the growth rate of money supply + growth of velocity less
the growth of real output
112
B. Using the AD-AS Model
• If the growth rate of AS (y) is less than the growth rate of nominal AD (m+v) -
inflation must occur [ ]Π=< ADAS
• Short term inflation
o To assess the potential causes of short-term inflation, determine if
AD(m+v) >AS(y) over a short period of time
o From Equation 3, there are 3 possible causes of short term inflation
� Nominal AD ↑ due to ↑ in nominal money supply ( )m ↑
� Nominal AD ↑ due to ↑ in velocity because of ↑ in G, ↑ C, or ↑ I
- ( )v ↑
� Even if changes in ΔAD = 0, AS can ↓
Simulations:
(i) Response to MONETARY POLICY
• Assumptions:
o In both the New Classical and Keynesian approaches, SR AS is upward
sloping
o In the New Classical Approach, unexpected changes in the price level may
cause producers to change output, thus actual level of output can > or <
the output level consistent with the LR full employment
o In LR, AS at full employment output is vertical
• What is the effect of an unexpected ↑ in SM on P ?
o New Classical Proponents
� Unexpected YPADM S ↑⇒↑⇒↑↑ ,
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� During the adjustment process, actualF YY < - gaps puts
upward pressure on P leading AS↓ until FY is reached
again
� In the LR, money is neutral, therefore on P↑ and Y
o Keynesian Proponents
� Some prices are sticky in the SR - Price adjustments process is
slower with respect to output but similar to new classical
� From the FY , expected
YPADM S ↑→↑⇒↑↑,
� AD↑ puts upward pressure on wages and prices, thus
decreasing AS↓ gradually
Graphically:
Price Level
Current Output Y YF
AD0
SRAS0
AD1
Y’1
P0
P’1
SRAS1
P1
LRAS
0
E
E’
E’’
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• Unexpected SM↑ shifts AD from
10 ADAD ⇒ , moving equilibrium from
0EE ⇒
• In the SRAS0 , FYY >1'
• Upward pressure on prices shifts AS from SRAS0 to SRAS1, new intersection of the SRAS
and AD at E’’
• A one time PM S ⇒↑↑
, 10
PP ⇒↑ in the SR
• In the LR, only price is affected because money is neutral
CONCLUSION: Unexpected increase in Aggregate Demand increases Output and Prices in the
Short Run
(ii) Response to OTHER CHANGES IN THE AGGREGATE DEMAND
• How do factors such as changes in the G, C. and I affect Π ?
o Consider a one-time unexpected increase in ↑ G (massive defense expenditures)
� ↑ G → ↑ AD → ↑ P ↑ Y – Π results in the SR
� Y’ – YF gaps put pressure only on prices in the LR, leaving Y
unchanged
(iii) Response to SUPPLY SHOCKS
• Example of SUPPLY SHOCKS that can cause short term Π
i. Changes in raw material prices
ii. Changes in worker’s wage demands
• How does an adverse supply shocks, e.g. one-time increase in oil prices, affect P?
� Increase Poil → ↑ Pinputs → ↓ AS
� If Ms, G, and T are constant AD will be constant
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� ↓ AS and constant AD → ↑ P ↓ Y – inflationary in the SR
� At the new equilibrium, YA < YF over time and ↓ P until old equilibrium
is reached
Graphically:
CONCLUSION: Supply shocks can cause short term Π but not long term Π
General Conclusions:
� A one time increase in the Ms, SR increase in AD, supply shocks can lead to short run
Π
� But, of more concern are repeated increases in P level over a long period of time
Price Level
Current Output Y YF
AD0
SRAS0
Y’1
P0
SRAS1
P1
LRAS
0
E
E’
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Long term inflation Π
o Long term Π arises whenever growth rate of the AD > growth rate of the
AS over sustained periods of time
� Causes of long term Π
o Some notes:
� One time changes in G or T cannot by themselves produce long
term Π
� G spending and size of government are limited by the fact that G
cannot exceed GDP (total production) and practical limitation on
spending is imposed on political process (same for taxes)
� Given a fixed Ms, expansionary fiscal policy (increase G and reduce
T) alone cannot produce Π for a long period of time
� What causes long term Π ?
o Sustained growth in the nominal Ms at a faster rate than v&
and y&
(new
classical and new Keynesian)
o Suppose household and business firms expect growth rates of v and y to be
0%, and Ms to increase steadily by 5% each year
� Expected Ms ↑ ⇒ AD ↑ ⇒ ↑ Y ↑ P
� Because YA > YF creates an upward pressure on P leads to decrease
in SRAS until old YF reached
� Repeated Ms ↑ ⇒ leads to further AD ↑ , decrease ↓ AS and
P ↑ for a long period of time without changing Y since money is
neutral in the long run
117
Graphically:
o In LR, money is neutral, i.e. sustained growth in Ms does not affect real
output in the LR but does lead to sustained Π
o From empirical studies, countries with low average rates of
Π experienced slow average growth rate of nominal Ms
� Does government budget deficit causes Π ?
o In the SR, budget deficit can increase AD ↑ ⇒ AD ↑ ⇒ ↑ Y or ↑ Π
o This is because government may increase G or decrease T and this leads to
an increase in AD
o In the LR, government budget deficit can be inflationary if BSP expands
monetary base to acquire government bonds
o Thus more rapid growth of monetary base increases growth rate of
Ms ↑ ⇒ Π
Price Level
Current Output Y YF
AD0
SRAS0
Y’1
P0
P’1
LRAS
0
AD1 E
E’1
SRAS1
P1 E
1
AD2
P’2 E’2
SRAS2
P2 E
2
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8.2 Costs of Inflation
� Concerns of households, business firms, and policy makers about inflation implies that
there must be cost to the economy from Π
� Expected Inflation ( )EΠ
o Π places a tax on money balances when those balances pay less that the
market interest rate (tax on purchasing power)
� Example: If you hold P1,000 in currency in 2002 when the inflation rate is
6 %, you already lost P 60 of purchasing power over the year
� Since Π is a tax on money balances, public’s demand for real money
balances decreases
� Cost of Expected Inflation ( )EΠ
o Shoe-Leather Costs
� Costs to households and business firms of making more trips to the bank
to avoid holding significant amounts in pesos or of shifting funds from
interest bearing assets into money
o Bracket Creep
� Progressive tax system (higher income – higher tax rate) of the
Philippines are not fully indexed against inflation
� Higher nominal income can lead to higher tax burden relative to income.
Failure of tax code to adjust values of inventories plus value of
depreciation allowances for Π also increase corporate tax burden
� It can also distort financial decisions because lenders pay taxes in
nominal instead to real returns
o Menu Cost
� Costs to firms of changing prices (reprinting pricelists, informing
customers)
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� Because firms face different menu costs, not all firms change prices at the
same time, therefore, price changes brought about by the Π are not
synchronized throughout the economy
� Expected Π can change relative price in the SR and affect allocation of
resources
Unexpected Inflation ( )UΠ
EAU Π−Π=Π - have redistributive effect
where:
UΠ - unexpected inflation
AΠ - actual inflation EΠ - expected inflation
Redistributive Effect: Example 1
Ms. Understood borrowed from Ms. Take a one-year P10,000 simple loan at 4% interest rate.
Suppose both of them expects that 0=Π
� Regardless of the Π rate for the year, Ms. Take will receive ( )( ) 400,1004.1000,10 PP =
at the end of the year
� If AΠ= 7%, The lender, Ms. Take’s real return is:
%3%7%4 −=−=Π−= NR iR
� The borrower, Ms. Understood real interest payment
%3%7%4 −=−=Π−= ANR ii
%7
%0%7
=Π−=Π−Π=Π
U
EAU
Transferred P700 of real purchasing power from lender to borrower (Redistribution)
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Redistributive Effect: Example 2
� When UΠreduces real wages for employees with nominal wage
contracts
� Implications of the UΠare more difficult to assess than those of EΠ
,
because there are both gainers and losers. For the risk averse persons,
UΠ’s redistribution possibility can distort behavior
o Example: Suppose there are 4 individuals: Ara, Boobah, Rica, and Maui:
� Ara borrowed money at a fixed nominal interest rate
� Boobah lent money at a fixed nominal interest rate
� Rica borrowed money at a variable interest rate (indexed for Π )
� Maui lent money at a variable interest rate (indexed for Π )
o Suppose inflation rises:
� Who gains the most? Ara
� Who looses the most? Boobah
o Why?
� Lender and borrowers incorporate EΠinto agreed upon interest rate.
When interest rate is fixed, additional or unexpected inflation
redistributes purchasing power from lenders to borrowers
Inflation Uncertainties
o Inflation uncertainties can introduce the most serious costs of inflation
o In market economy, price acts as signals for resource allocation
� An increase in XPrelative to YP
would mean
1. Production of good X would increase
2. Consumer increase consumption of good Y
121
� Increase in the stock market prices relative to general level of prices is signal for good
investment for business firms
� Relative prices, not individual prices, provide signals. When Π fluctuates significantly,
relative prices may change in response to general price level changes.
� Signals from the market will be distorted
� Uncertain Π causes households and business firms to waste resources investigating
price differences
o Hyperinflation
� Extreme case of uncertain inflation
� Rate of inflation is hundreds or thousands or more percentage points per year for a
significant period of time
Example:
o Hyperinflation in Germany after WW 1 – government ignited inflation because of the
burst of money creation resulting in an increase in price level by a factor more than 10B
between August 1922 and November 1923
o Hyperinflation in Bolivia – first half of 1985, inflation rate was running at 20,000
percent and rising – e.g. price of a movie ticket often rose while the people wait in line
to buy it
o Zimbabwe - inflation peaked at an annual rate of 89.7 sextillion percent
(89,700,000,000,000,000,000,000%) in mid-November 2008. The peak monthly rate was
79.6 billion percent, which is equivalent to a 98% daily rate. At that rate, prices were
doubling every 24.7 hours
Costs of hyperinflation
� Households and firms minimize currency holdings
� Firms must pay employees frequently
� Employees must spend money quickly or convert it to more stable foreign
currencies before prices increase further
Conclusion on hyperinflation
� Price signals are confusing
� Merchants changes prices as often as possible
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� Price changes fail to direct resource allocation
� Government’s tax collecting ability decreases because people tend to delay tax
payments to reduce real tax burden
9.3. Why do Policy Makers Allow Inflation to Occur?
� To achieve goals such as target full employment income, policy makers may use
inflationary monetary policy
� Significant GDP growth and decreases in unemployment rate increase reelection
chances of incumbent administrators and other candidates
Three (3) types of Inflationary Pressure (associated with long term inflation)
Cost-push Inflation
� A type of inflation characterized by the rise in prices resulting from increases in the cost
of production without corresponding increases in output.
� Examples of this would be wage increases not matched by increased productivity of
labor, hikes in international oil prices, higher cost of capital, higher interest rate,
increases in prices of imported raw materials, and hikes in rental rates.
� Shortage in supply due to natural calamities and disasters leading to higher prices
provides the other source of cost-push inflation.
� Just as a shortage of goods tends to push prices up, an oversupply of commodities tends
to induce the opposite effect on prices.
� If policy makers were committed to maintain full employment output even in the short
run, expansionary fiscal policies would follow increase prices and wages – leading to
increase AD and increase in P
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Cost-Push Inflation
Demand-pull Inflation
� Inflation caused by higher demand compared to the available supply of goods and
services.
� Usually when people, businesses or the government receive more income, realize
capital gains or obtain easier access to credits, the overall demand for goods and
services may increase.
� This would lead to increased prices, assuming the supply of goods and services is not
able to adjust quickly enough to meet the higher demand.
Price
Y
LRAS
YF
AD0
SRAS0
P0
SRAS1
Y1’
AD1
P1
P1’
E0
E’1
E1
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Demand Pull Inflation
Structural Inflation
� Persistent inflation caused by deficiencies in certain conditions in the economy such as a
backward agricultural sector that is unable to respond to people's increased demand for
food, inefficient distribution and storage facilities leading to artificial shortages of goods,
and production of some goods controlled by some people.
9.4 Cost of Reducing Inflation
� New Classical Approach: Reducing Inflation through Cold Turkey
• Assumption: Wages and Prices adjust quickly to changes in expectations
• Solution: Lower expectations about the future money supply increase and
inflation will fall all at once
• Effects:
o Shift SRAS to original level, given the fixed money supply, AD falls to
original level
o Since the wages and P adjust quickly, inflation decreases with little or no
loss in the output or jobs
Price
Y
LRAS
YF
AD0
SRAS0
P0
SRAS1
Y1’
AD1
P1
P1’
E0
E’1
E1
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• However, T. Sargent, stressed the importance of changing the expectations in
order to decrease inflation while keeping the cost to output and jobs low. How?
Announce budget reforms and cessation of increases in money supply – rational
expectations
� New Keynesian Approach: Reducing Inflation Gradually
• Argument: Long term nominal wage contracts and costs of changing prices slow
the adjustment of P level to changes in the expectations. Even with rational
expectations, not all prices adjust immediately to changes in expectations about
the future inflation
• Cold turkey will still lead to loss of Y and jobs – only over time will the economy
return to full employment
• Solution: Keynesian support Gradualism, slow and steady decrease in money
supply so that inflation rate can adjust to with smaller losses in Y and jobs
o Announce disinflationary policies
o BSP Credibility – convince public of true commitment
• Effect: Overall costs to the economy will be smaller
9.5 BSP Measures to Combat Inflation
� Section 3 of R.A. 7653 or the New Central Bank Act states that the primary objective of
the BSP is to maintain price stability conducive to a balanced and sustainable growth of
the economy
i. BSP monitors the movements in prices, analyzes their causes and
undertakes necessary measures to ensure that money supply is managed
in a manner that does not contribute to inflation.
ii. Keeping the amount of money circulating in the economy significantly
within program ceilings
iii. Too much money in circulation is often one of the basic causes of
inflation but, and this is very important, not all inflation should be
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addressed by monetary policy. An obvious example is inflation triggered
by weather-related food supply shortages
iv. BSP has a well-planned monetary program precisely geared to regulating
money supply consistent with the anticipated level of economic activity
that is believed to be sustainable
v. Reduction in the reserve requirement which greatly accounts for the
intermediation costs of banks, thus influencing the cost of money
vi. Improving public access to banking system facilities and credit at
competitive interest rates to encourage savings and investments
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Chapter 10
International Economy and Monetary
Policy
10.1 Foreign Exchange Intervention
� Recall that the Ms is determined by the behavior of the BSP, banks, and the public
� But the international financial markets are linked, thus, actions of foreign Central Banks,
banks and the public affect the domestic Ms
� International financial transactions affect Ms when CBs or governments try to influence
the foreign exchange values of their currencies
� To understand the connection:
o Examine how the foreign market interventions affect BSP’s holding of
international reserves
o Determine how changes in holdings of international reserves affect monetary
base
Definitions
(a) Foreign Exchange Market Intervention – deliberate actions of BSP to influence
exchange rate
(b) International Reserves – assets denominated in foreign currencies and used in
international transactions
Example 1
� Suppose BSP buys P1B of foreign assets, say short-term securities issued by the Japanese
government
Question: What happens to BSP’s international reserves? Assets?
BSP’s international reserves increase by P1B worth of yen. Assets will also increase by P1B
worth of yen
� If BSP pays for foreign assets by writing a check for P1B
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Question: What happens to BSP’s liability in terms of banks’ deposits at the BSP? To the
reserves of the banking system?
Banks’ deposits at BSP increases, reserves of the banking system also increases
Using a T-Account for the above transactions:
Bangko Sentral ng Pilipinas
Assets Liabilities
Foreign Assets
(international
reserves)
+ P1B Bank deposits at
BSP (reserves)
+P1B
Question: If BSP pays for foreign assets with P1B of currency, what happens to BSP’s
liabilities?
BSP liabilities (currency in circulation) increase by P1B
Bangko Sentral ng Pilipinas
Assets Liabilities
Foreign Assets
(international
reserves)
+ P1B Currency in
circulation
+P1B
Question: What are the effects of the amount foreign assets acquired?
Recall that the monetary base equals the sum of currency in circulation (CU) and the banking
systems reserves (RE), therefore the monetary base rises by the amount of foreign assets
acquired, regardless of how the BSP pays for them
It would have the same effect as open market purchase of government bonds
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Example 2
� Suppose BSP sells P1B of foreign assets to buy P1B of domestic assets
Question: What happens to BSP’s international reserves?
BSPs international reserves decrease by P1B
� If buyers of foreign assets sold by BSP pay with checks drawn on domestic banks
Question: What happens to banks’ reserves at BSP?
Banks’ reserves at BSP decrease by P1B
Bangko Sentral ng Pilipinas
Assets Liabilities
Foreign Assets
(international
reserves)
- P1B Banks’ deposits at
BSP
- P1B
CONCLUSION
� If nothing else changes, when the BSP buys foreign assets, international reserves and the
monetary base increase by an amount of foreign assets acquired
� When the BSP sells foreign assets, international reserves and the monetary base falls by an
amount of foreign assets sold
Foreign Exchange (FOREX) Intervention and the Exchange Rate
Definition:
� Foreign Exchange Rate – the price of one currency in terms of another
� Foreign Exchange Market – financial markets where exchange rates are determined
� Appreciation – when a currency increases its value against another currency
� Depreciation – when a currency decreases its value against another currency
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Peso-Dollar Exchange Rate Determination
• What causes the depreciation of the peso against the U.S. dollar?
o A commodity (US dollar) becomes more expensive, or its price increases, when
more of it is demanded than what can be supplied in the foreign exchange
market
o Value of the peso against the US dollar goes down, weakens or depreciates when
the supply of dollars falls. This means that the dollar becomes more expensive
relative to the peso.
o There are various sources of dollar supply in the Philippines. (1) Exports; (2)
remittances from overseas Filipino workers; (3) tourism; and (4) foreign
investments
• What supply-side factors are influencing the fluctuations in the exchange rate?
o First, the slowdown in the U.S. and Japanese economies has contributed
significantly to the decline in Philippine exports (US and Japan as the country’s
major export destination) - global slump in IT – reduced exports of
semiconductors
o Second, OFW remittances have been on a general downtrend, particularly those
coming from the U.S. and some European countries
� The economic slowdown in these labor-importing countries and the
Increased tendency among OFWs to hold back converting their dollars
into pesos in anticipation of a higher exchange rate
o Third, foreign exchange receipts from tourism have declined due to the yet
unresolved series of kidnappings and insurgencies
o Fourth, foreign investments coming into the Philippines have been adversely
affected by global issues such as the threat of a possible US-Iraq war
• What demand-side factors are influencing the exchange rate?
o First, the demand for dollars increased due to high importation of goods
indicating high import payments
o Second, the constraints on dollar supply have given rise to the perception that
the peso would depreciate further against the dollar prompting companies to
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purchase more dollars as quickly as possible to avoid paying a higher rate in the
future.
o Third, there has been an increase in the demand for dollars by speculators
whose sole objective is to make a profit from changes in the value of the dollar
against the peso
• Determination of Foreign Exchange Rate
Exchange rate depends on the ability of investors to move funds among international markets
easily
Changes in the domestic interest rate
� For domestic assets, expected rate of return, in dollar terms equals R which is equal
to the interest rate, while the expected return on foreign assets in dollar terms is Rf
� Graph of R against the peso/dollar exchange rate is simply the vertical line because
the return on Philippine assets in dollar terms is the same regardless of exchange
rate
� At E*, interest rate is i*, which is equal to the interest rate for foreign assets, no
appreciation or depreciation is expected, investors will be indifferent between
foreign and domestic assets, exchange rate stabilizes at EX*
Exchange
Rate
($/P)
Expected Rate of
return (i) in $
0
R= i
EX*
i*
E*
E’
E’’
i’ i’’
EX’
EX’’
Rf
132
Suppose the interest rate increased from i* to i’
o Higher returns on domestic assets encourage investors to increase their
demand for peso to buy domestic assets
o The domestic currency appreciates from EX* to EX’: the exchange rate rises
Suppose the interest rate decreased from i* to i’’
o Lower returns on domestic assets encourage investors to reduce demand for
domestic and increase demand for foreign assets, respectively.
o The domestic currency depreciates from EX* to EX’’: the exchange rate falls
Changes in the foreign interest rate
� Suppose the foreign interest rate increased
o Shifts Rf to the right from Rf* to Rf ‘ - the exchange rate falls; the domestic
currency depreciates
Exchange
Rate
($/P)
Expected Rate of
return (i) in $
0
R= i
EX*
i*
E*
E’
E’’
EX’’
EX’
Rf
Rf’
Rf’’
133
� Suppose the foreign interest rate decreased
o Shifts Rf to the left from Rf* to Rf ‘’ – the exchange rate rises; the domestic
currency appreciates
FOREX Intervention
2 Types of Intervention
o Unsterilized Forex Intervention
• A transaction in which BSP allows the monetary base to respond to
the sale or purchase of domestic currency
• Suppose BSP sells P1B foreign assets. If there is no offsetting, the MB
↓ by P1B
o Sterilized Forex Intervention
• A transaction in which a forex intervention is accompanied by
offsetting domestic market operations to leave MB unchanged
• Suppose BSP sells P1B of foreign assets. At the same time, it engages
in open market purchases of P1B of government bonds to eliminate
decrease in MB
• Using a T-Account
Bangko Sentral ng Pilipinas
Assets Liabilities
Foreign Assets
Securities
- P1B
+P1B
Monetary base
(CU+RE)
P 0B
134
Effects of FOREX Intervention on Exchange Rate
� Unsterilized Intervention
o To increase exchange rate, BSP must buy domestic currency, losing international
reserves and decreasing monetary base
o Domestic short-term interest rate increases, therefore the expected rate of
return of domestic assets also increases. This causes FOREX to increase because
investors increase their demand for domestic assets and currency
o Ceteris paribus, unsterilized intervention in which BSP sells foreign assets to buy
pesos lead to reduction in international reserves, decrease money supply, and
depreciation of the domestic currency
o To lower the exchange rate, the BSP must sell domestic currency, gaining
international reserves and increasing the monetary base
o Domestic short-term interest rate decreases, therefore the expected rate of
return of domestic assets falls. This causes FOREX to decrease because investors
reduce their demand for domestic assets and currency (See Figure in Page 122)
� Sterilized Intervention
o In the unsterilized intervention, domestic and foreign currency are assumed to
be perfect substitutes (have similar liquidity, risk, and info characteristics)
o Because sterilized intervention does not affect money supply (Ms), it will not
affect domestic interest rates or expected appreciation or depreciation of
domestic currency – therefore, rate of return on domestic assets and expected
return on foreign assets do not shift, hence, no effect on exchange rate
o But if domestic and foreign assets are not perfect substitutes, sterilized
intervention can affect exchange rates
� Source of liquidity difference can be capital controls or government
imposed barriers to foreign savers investing in domestic assets and vice
versa
� If domestic and foreign assets are not perfect substitutes – an increase in
the supply of domestic assets implies higher exchange rate risk
135
� Higher exchange rate risk means higher premiums for expected rate of
return on domestic assets leading to a fall in the exchange rate
o Empirical evidence shows that:
� Sterilized intervention has no effect on interest rate
� Domestic and foreign assets are imperfect substitutes
o Therefore, if BSP wants intervention, use unsterilized intervention
Reasons for FOREX Intervention
Question: If FOREX intervention affects money supply, why does BSP intervene?
Answer: Because BSP (and government) worries about the effects of exchange rate
depreciation and appreciation
� Depreciation – decrease in a currency’s value against another currency
o Effect: Raises cost of foreign goods and may lead to inflation
o BSP buy own currency in the FOREX market (sell $)
� Appreciation – increase in currency’s value against another currency
o Effect: Causes domestic goods to be uncompetitive in the world market
o BSP sell own currency in the FOREX market (buy $)
10.2 Exchange Rate Regimes and the International Financial System
� Fixed Exchange Rate System - Exchange rates are set at levels determined and
maintained by the government
o Advantage
� Promote international trade by lowering transactions costs of buying and
selling goods and assets and reducing uncertainty about prices of goods
and services caused by exchange rate fluctuations
136
o Disadvantage
� Countries have little control of monetary policies because gold flows
dominated monetary base
� Gold discoveries and production strongly influenced changes in money
supply
� Countries with gold outflows and trade deficits experienced deflations
(recessions)
The Bretton Woods System (1945-1971)
o As WW II was about to end, representatives of the Allied governments gathered
at Bretton Woods, New Hampshire, to design new a international monetary and
financial system
o This was intended to reinstate the fixed exchange rate system but permit
smoother economic adjustments in the short run than the gold standard did
o Foreign CBs would be able to convert US$ into gold at price of $35 per ounce,
thus, foreign currencies were defined in terms of dollar ($) terms and $ were
convertible to gold by US at official price of $35 per ounce
o The dollar has come to be known as reserve currency
o Exchange rates were supposed to shift only when the country experienced
fundamental disequilibrium e.g. persistent BOP deficits/surplus at fixed
exchange rate
o To help countries in short run economic management:
� International Monetary Fund (IMF)was created to:
• Act as the lender of last resort
• Encourage domestic policies consistent with exchange rate
stability
• Monitor member countries
� The World Bank (WB) was also created to:
• Make long term loans to developing countries
137
• Give loans to infrastructure to aid economic development
• Sell bonds in international capital market to raise loanable funds
Question: How were the FOREX under the Bretton Woods System maintained?
Answer: CBs intervene in yhe FOREX market to buy and sell dollar assets; Exchange rates
could vary at greater than or less than 1% of fixed exchange rate before countries were
required to intervene to stabilize them
Example:
� If foreign currency appreciated relative to the dollar, sell own currency for
dollars (buy $) to drive exchange rate back to fixed rate
� If foreign currency depreciated relative to the dollar, buy own currency by selling
dollar assets to push exchange rate back to fixed rate
� CBs ability and willingness to buy and sell amounts of its own currency was
necessary to maintain fixed exchange rate
Question: If CBs international reserves are exhausted, how it can defend fixed exchange
rate? (BOP deficits)
Answer: It would have to implement restrictive economic policies to decrease imports
and trade deficits or abandon policy of stabilizing the exchange rate against the dollar
� Devaluations and Revaluation: Alternatives to defending fixed exchange rate
(a) Devaluation
o The lowering of the official value of a country’s currency relative to the dollar (or
other currencies), thereby resetting the exchange rate
o Done when currency is overvalued relative to the dollar
(b) Revaluation
o The raising of the official value of a country’s currency relative to the dollar (or
other currencies)
o Done when currency is undervalued relative to the dollar
138
� Speculative Attack
o When market participants believe that government is unable or unwilling to
maintain the exchange rate, they may sell a weak currency or buy a strong
currency
o These actions force devaluation or revaluation of the currency and could result
to international financial crisis
o Devaluation – forced when CB is unable to defend FOREX
o Revaluation – forced when CB is unwilling to defend FOREX
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