Chapter Two

[Money] is a machine
FISCAL AND MONETARY POLICY for doing quickly and
commodiously what
would be done, though
less quickly and
commodiously, without
it.

JOHN STUART MILL

 MONEY

● Standard medium of exchange in business

transactions
● Refers to the currency and coins which are
in circulation and legal tender

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 Nature of Money

● Barter versus Monetary Exchange

♦A barter system (with no money) would be
awkward and extremely inefficient.
♦Money greases the wheels of exchange thus,
makes the whole economy more productive.
♦Money comes in the form of tokens (coins and
paper money) that have value established by a
commonly recognized authority.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

 Nature of Money

● The Conceptual Definition of Money

♦The functions of money:
■Medium of exchange
■Unit of account
■Store of value
■Means of deferred payment

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 Nature of Money

● Characteristics:
♦ General acceptability (legal tender)
■ Note: Denominations of P .10 to P 1.00 not to exceed P 50.00 when used for payment
Denominations of P .05 not to exceed P 20.00 when used for payment

♦ Stability of value (purchasing power)

♦ Portability
♦ Cognizability
♦ Durability
■ Note: Peso bill has a circulating life of 3 months

♦ Divisibility
♦ Malleability
♦ Convertibility

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 Nature of Money

● What Serves as Money?

♦Commodity money (metallic form)
♦Credit money (promissory note)
♦Paper money
♦Fiat money (value fixed by government edict
or decree)

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 How Money Supply is
Measured
● There is no single, obvious place to draw the line
between “money” and “near money.”
● M1 (standard monies) = coins and paper money
in circulation and demand deposits
-includes those monies that are very liquid such as cash, checkable
(demand) deposits, and traveler’s checks
● M2 (money equivalents) = M1 + money market
instruments
-less liquid in nature and includes M1 plus savings and time
deposits, certificates of deposits, and money market funds
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
 How Money Supply is
Measured
● M3 (net performance approach) = PSC + GSC + FSC
● Private sector contribution
♦ Total loans granted – total private sector deposits
● Public sector or the government contribution
♦ Total government expenditures – total government
deposits
● Foreign sector contribution
♦ Total foreign loans – total foreign deposits

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 How Money Supply is
Measured
A. Consider the following currencies in an economy:

Coins P 200,000
Total private deposit P 600,000
Paper money P 800,000
Total government expenditures P 600,000
Demand deposit P 400,000
Total government deposits P 500,000
Money market P 200,000
Total foreign loans P 900,000
Total private loans P 800,000
Total foreign deposits P 300,000

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 How Money Supply is
Measured
QUESTIONS:

● How much is the supply of money using the

standard monies approach (M1)?

● How much is the supply of money using the money

equivalent approach (M2)?

● How much is the supply of money using the net

performance approach (M3)?

Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

 How Money Supply is
Measured
B. Given the following information:

Reserve deposit P 500,000

Reserve ratio 5 percent

● Using the fractional reserve banking system, how much can

be loaned out to borrowers?

● How much is the change in the total money supply if the

initial change in deposit is P 500,000?

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 Limits to Money Supply

● R.A # 7653 Section 53

♦ Whenever money aggregates or level of credit
increases by more than 15% or the cost of living
index increases by more than 10% in relation to the
level of existing at the end of preceding period or
when the circumstances so warrant…, the Monetary
Board shall make changes in money limits to provide
a more stable peso and Philippine economy

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 Fiscal and Monetary Policy

● R.A 7653 : a constitutional provision

creating the Bangko Sentral ng Pilipinas
● BSP is mandated to:
■ maintain domestic stability of Philippine peso and its
convertibility into foreign currencies
■ manage money supply or money aggregate at a certain
level
■ monitor tendencies of inflation and deflation
■ implement fiscal and monetary policies

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 The Banking System

● How Banking Began

♦Fractional reserve banking began when
goldsmiths realized they could profitably lend
out a portion of the gold that had been
deposited with them for safekeeping.
♦The “Goldsmith Tale”
Short video
presentation

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The Fractional Banking System

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 The Banking System

● How Banking Began

♦Three important features of the fractional
reserve banking system:
■Bank profitability
■Banks discretion over the money supply
■Exposure to bank runs

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 The Banking System

● Principles of Bank Management:

Profits versus Safety
♦To make a profit, a banker must take risks.
♦But because the business is risky, the same
banker must also emphasize safety.
♦The heart of banking is to be torn between the
two principles.

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 The Banking System

● Bank Regulation
♦Deposit insurance
■ Eliminates the motive for customers to withdraw funds
because of bad news regarding the bank’s finances
♦Moral hazard
■ When an individual is insured against risk, he/she puts
forth little effort to avoid risk
■ Deposit insurance could make the banking system less
safe

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 The Banking System

● Bank Regulation
♦Bank Supervision
■Needed to reduce moral hazard problem
■Ensures banks take only sensible, defensible risks
■Controls the money supply
♦Reserve Requirements
■Helps control the money supply

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 The Origins of the Money
Supply
● How Bankers Keep Books
♦Banks keep balance sheets
■Assets = liabilities + net worth
♦Assets include:
■Reserves
■Loans
♦Liabilities include:
■Deposits owed to customers.

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TABLE 1: Balance Sheet of Bank-a-mythica
Dec. 31, 2004

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 Banks and Money Creation

● The Limits to Money Creation by a Single

Bank
♦Banks can lend money in their vault that is
above the minimum required reserve ratio.
♦In doing so, they create new money.

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TABLE 2: Balance Sheet of Bank-a-mythica’s
Jan. 2, 2005

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 Banks and Money Creation

● Multiple Money Creation by a Series of

Banks
♦When all banks make loans with funds they
have that are above the required reserve ratio,
the society’s money supply expands.

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 The Need for Monetary
Policy
● Left uncontrolled, banks would:
♦Reduce the money supply in a recession
♦Increase the money supply during boom
periods
● Changes in the money supply would exacerbate
the business cycle.
● One reason for monetary policy, therefore, is to
prevent this behavior on the part of banks.

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 Money  Store of value
 Barter  BSP
 Economy  Payment
 Medium of exchange  Cognizability
 Inflation  R.A. 7653
 Fiat money  Money supply
 Commodity money  Portability
 Monetary board  Credit money
 Paper money  Philippine peso
 Money market  Deflation
instruments  Monetary policy
 Durability  Money aggregates
 Legal tender  Cost of living index