Monetary Economics
• Why study monetary economics?
The Role of Money in
the Economic System
Money Supply and Inflation
Linkages (lecture Notes)
– Inherently interesting
– Most of the controversial socio-
socio-economic issues deal with
monetary policy (eg(eg:
eg: unemployemnt,
unemployemnt, international finance
incomes, etc)
– Affects all of us! Incomes, Livelihood, Jobs and choice of
careers
• What is monetary economics? Includes the ffg concepts
– The role and functions of money in the economic system
(the lubricant of the economy)
– Role of the Bangko Sentral ng Pilipinas
– Effects of Money and Credit into Monetary Policy
– Financial System itself where money is traded that
includes all institutions that influence total amount of
money and credit
• Q: What is money?
– Very difficult to define
– “Anything that is generally accepted in payment for goods
and services and as payment for debts”
– Take note that money is defined by its funtion,
funtion, rather
than its form.
– Thus, money can be from sheeps to checques to prepaid
cards.

Functions of Money
• Unit of Account
– Represents an item with which every good or
service cab be quoted (eg
(eg:
eg: Philippine Peso is the
basic unit of account in which the value of
everything that is traded in the market can be
expressed.
• Medium of Exchange
– Accepted means of payment for g/s
• Store of Value
– Money is the “Temporary abode of purchasing
power”
– Money is also “Repository of purchasing power”
– Inflation decreases the ability of money to act as
store of value and deferred payment.
MONEY SUPPLY MEASURES/ AGGREGATES
• M1
most liquid (most commonly used as medium of
exchange) and demand deposits
• M2
M1+ small time deposits
• M3
M2+Money supply, peso savings, negotiable order
of withdrawal
• RM
Represents the liabilities of the BSP to the public
sector in form of cash reserves
Evolution of the Money
Payment Mechanism
• Autarky
– A family or tribal group, in the absence of trade, produces
the level of goods and services equal to their
consumption: Qd=Qs.
Qd=Qs.
– The output is then shared according to the group’s
distribution rules.
– Is money used?
• Barter System
– Trading of goods and services
– “Double coincidence for barter to exist”
– Trading is only possible if the g/s that one individual is
willing to accept is exactly the same g/s that another is
willing to accept and vice versa.
– Disticnt pairs of items to be traded!
– Is barter system effcient?
effcient?
– NO! very costly

costly
Transaction Costs, Search Costs
(transpo,
transpo, etc), Waiting Costs (opp
(opp cost of waiting for that
g/s),
g/s), Subjective Costs (loss of satisfaction, umay),
umay),
objective cost (cost of storage between exchange and
foregone income on earning assets by not bringing the
goods into the market) etc.
– THREE TYPES OF BARTER:
• Isolated-”To each on his own”
• Fairground-Bringing transactors in one place
• Trading Pots-Fairground + Trading post for each good
(reduced search costs)
USE OF MONEY LOWERS TRANSATION COSTS!!!!
 Evolution of the Money Important Characteristics
Payment Mechanism (p2) of Money

• Commodity Money • Money is

– Uncoined metals like copper, silver or Gold. They are also
durable and easily transported – Imperishable
– Adulteration and short weighing occurred. – Divisible
• Coinage – Widely accepted
– Certfication from the king re: weight and purity level. – Easily standardized
– Danger of theft in storage or transport, absence of interest or
return on money – Portable
• IOUs – Limited in supply
– Coins were left to a reputable person with vault or safekeeping – Supply is relatively stable
means. IOUs were written on paper instead of gpoing to the
safekeeper for transaction.
– High in value
• Bank Notes – Not easily counterfeited
– Similar to IOU, evidenced by a piece of paper backed by a specie • Money supply
amount of money used in
• Deposit Credit the entire economic system
– “the order to pay someone”, deposit claims
– Affects other economics variables most
• Specialized Bankers
especially prices
– Similar to those mentioned above only that some portion of the
deposit where lent out

out
banking was born – If MS increases, prices increases
• EFTS/Electronic Funds Transfer System/ E-Money – If MS decrease, prices decrease
– Use of Computer Terminals for transactions and automated • How? Thru the BSP
discountrate

clearing houses using no physical medium of exchange.
interest rate
people would either save in
• Credit card, debit cards.
banks or withdraw their money.
WHAT DO WE HAVE IN THE FUTURE????
Inflation (Π)
• Inflation: measured in terms of changes
in price index, spec the CPI
– How do we compute inflation rate?
• Thru the CPI:
• Two types of inflation (based on time
frame)
– Short Term Inflation
• Increase in nominal MS
• Increase in G,C, and I
• Response to supply shocks (changes in
prices of raw materials, changes in workers’
wage demands) Ex: Oil
– Long Term Inflation
• Sustained rapid growth in MS
• Costs of Inflation
– Concern of households, business firms and
policy makers implies that there are costs to
the economy because of inflation
– Two Kinds: Expected and Unexpected Inflation
Expected Inflation
• Inflation that is anticipated
• Example: If you hold PhP100 of currency in 2006
when inflation rate is 9%, you lost PhP9 of purchasing
power over the year
• Costs of Expected Inflation
– Shoe leather Cost
• Cost to households and business firms of
making more trips to the banks to avoid
holding significant amount of pesos or
shifting funds from interest bearing assets
to money.
– Bracket Creep
• Tax rate is defined in nominal terms, and
individual income tax is progressive and
fully indexed against inflation
• Example: Inflation also increases in wage,
thus higher tax rates and higher prices
– Who benefits? Corporations and lenders do.
– Menu Cost
• Cost to firms because of changing prices
(reprinting price list, informing customers0
• Prices are not synchronized in the whole
 Unexpected Inflation
• ΠU= ΠA- ΠE
– Where: ΠU is unexpected inflation, ΠA is
expected inflation, ΠE is actual inflation
• Money contracts in labor, goods and services are
written in nominal terms and take into account ΠE.
• Causes Income redistribution
– Channel 1
• Suppose borrower and lender expect
Π=0 and agree to one year P10,000
simple loan at 4% interest.
– Regardless of the Π rate, lender receives

(P10,000)(1.04)=P10,400 at the end of the
year.
– If ΠA=is 7%, lender’s real return is RR=iN-
Π=4%-7%=-3% for the lender.
– IR=iN- ΠA
– IR=-3%
– Thus ΠU= ΠA- ΠE, 7%-0%=7%. Transferred P700 of
purchasing power from lender to borrower.
– Channel 2: Πu decreases real wages for employees
with nominal wage contracts. Less Purchasing
power!
Inflation Uncertainty
• Can introduce the most serious costs of inflation
• Know the concept of relative prices
acts as signals to the
economy
– An increase in PBEEF relative to chicken:
– An increase in PSEi higher than CPI is s a signal for good
investment
• Hyperinflation
– Extreme case of uncertain Π
– rate of increase in prices is hundreds or thousands of
times more percentage per year.
• Costs of Hyperinflation
– Households must minimize currency holdings
– Firms must pay employees frequently
– Employees spend more quickly or convert it to more stable
currencies before prices increase further.
• Speculative attack on the peso
• Short-selling
one way to profit while there is still economic
downturn (reading on George Soros, The economist)
• Conclusions:
– Price signals are actually confusing
– Merchants change prices ASAP
– Prices fail to reflect resource allocation
– The government’s tax collecting ability decrease because people
tend to delay tax payment to reduce real tax burden.