Monetary Policy PDF

MODULE 1: Holding deposits from other banks, they The Bank began to follow Bagehot’s rule, INTRODUCTION TO CENTRAL BANK served as banks for bankers and facilitated which was to lend freely on the basis of any...

MODULE 1: Holding deposits from other banks, they The Bank began to follow Bagehot’s rule, INTRODUCTION TO CENTRAL BANK served as banks for bankers and facilitated which was to lend freely on the basis of any interbank transactions. sound collateral offered—but at a penalty Central Bank- responsible for managing a country's Over time, due to their large reserves and rate (that is, above market rates) to prevent money supply and credit through monetary policy networks, they became lenders of last moral hazard. tools like open market operations, discount window resort, providing emergency funds to other No financial crises occurred in England for lending, and reserve requirements. banks during financial crises. nearly 150 years after 1866. The U.S. had earlier failed experiments The three key goals of modern monetary policy TRANSITION with central banking in the 19th century due ★ Price Stability: Maintaining a low and The Federal Reserve System emerged in to distrust of concentrated financial power. stable inflation rate. the early 20th century, representing a later Between 1836 and the onset of the Civil ★ Stable Real Economy: Ensuring high wave of central banks created to War—a period known as the Free Banking employment and sustainable economic consolidate currency instruments and Era—states allowed virtual free entry into growth while smoothing the business cycle provide financial stability. banking with minimal regulation. and mitigating economic shocks. Many were created to manage the gold This led to a period of financial instability ★ Financial Stability: Ensuring an efficient standard, which prevailed until 1914. This until the creation of the Federal Reserve in and reliable payments system and required central banks to maintain large 1913 to provide a stable currency and serve preventing financial crises. gold reserves to ensure currency as a lender of last resort. convertibility. The 1907 financial crisis was a key catalyst BEGINNINGS To maintain the gold standard, central banks for the establishment of the Federal Origins of central banking date back to the would raise interest rates to attract foreign Reserve to address the recurrent banking 17th century, with the founding of the first investment and boost gold reserves. panics that plagued the U.S. during the 19th recognized central bank - the Swedish The gold standard acted as a nominal century. Riksbank in 1668. anchor, constraining money supply growth Early central banks were established in the and determining the price level. The Genesis of Modern Central Banking Goals late 17th and 18th centuries, such as the Central banks at this time focused more on Bank of England in 1694 and the Banque price stability than economic growth. Before World War I, central banks were de France in 1800. Central banks also learned to act as primarily focused on maintaining the gold These early central banks were often "lenders of last resort" during financial standard and external stability, rather than private, joint-stock companies that were crises, providing emergency liquidity to the domestic economic stability. chartered to serve functions like lending to banking system, as exemplified by the Bank 1920s as central banks began to also focus the government, acting as a clearinghouse, of England. on internal goals like controlling prices, and issuing private banknotes that The Bank of England. (and other European output, and employment. However, the gold circulated as currency. central banks) would often protect their own standard still dominated their priorities. Despite their role in government finance, gold reserves which led to severe criticism The Federal Reserve's adherence to the these central banks were also private of the Bank. flawed "real bills doctrine" contributed to the entities that performed typical banking In response, the Bank adopted the severity of the Great Depression by functions. “responsibility doctrine,” proposed by the leading to overly tight monetary policy. economic writer Walter Bagehot.  After the Great Depression, the Federal Depression, exposed the limitations of this New financial products and practices can Reserve was reorganized and its approach. create opacity and increase risks independence from the Treasury was In response, countries established Central banks need to stay on top of these restored in 1951 under William McChesney comprehensive financial safety nets developments to maintain stability Martin. including deposit insurance and increased During the 1950s, the Fed was able to regulation of the banking sector, which 3. Explicit inflation targeting vs. dual mandate successfully implement countercyclical prevented major banking crises for several Adopting an explicit inflation target can policies to stabilize the economy, likely decades. simplify policy and enhance credibility aided by the credibility of the Bretton Woods This stability was disrupted in the 1970s as But it may be difficult to combine with the system's nominal anchor. financial innovation and deregulation led to Fed's dual mandate of price stability and However, in the 1960s the Fed shifted a resurgence of banking instability, with high employment priorities towards boosting employment over central banks often resorting to bailouts of controlling inflation, leading to the "Great "too big to fail" institutions. 4. Accounting for global and supply-side factors Inflation" of the 1970s when the nominal Regulatory reforms like the Basel Accords beyond central bank control anchor was lost. aimed to encourage more prudent bank Factors like globalization, political instability, It was not until Paul Volcker's policy of behavior by requiring higher capital buffers. and commodity shocks can affect domestic monetary tightening in 1979-1982 that high Another challenge has been managing prices inflation expectations were finally broken. asset price booms and busts, with central Since the 1990s, the Fed has pursued an banks typically choosing to react to bursts 5. Considering a shift to price-level targeting implicit inflation targeting regime, regaining rather than attempt to preemptively deflate Potential benefits include avoiding base drift credibility akin to the gold standard era. the booms for fear of triggering recessions. and reducing long-term price uncertainty Central bank independence has been a key Overall, maintaining financial stability has But concerns about the risks of deflation factor, with the Fed regaining independence become a core function of modern central make this unlikely in the near future from the Treasury in 1951 after being banking, requiring a range of policy tools nationalized and losing independence and approaches to address the evolving BANGKO SENTRAL NG PILIPINAS earlier in the 20th century. nature of financial risks. HISTORY OF BANGKO SENTRAL NG PILIPINAS- Financial Stability Challenges for the Future Chronology of Events​ Ensuring financial stability has become an 1. Balancing the three policy goals increasingly important responsibility for ★ Price stability (low inflation) - Requires 1900- Act No. 52 was pas​sed by the First Philippine central banks over time. credibility and clear communication Commission placing all banks under the Bureau of In the gold standard era, central banks ★ Macroeconomic stability and growth - Treasury. The Insular Treasurer was authorize​d to developed a "lender of last resort" function Temporary policy easing to offset supervise and examine banks and banking to provide emergency liquidity to the recessions activities. banking system during crises, following the ★ Financial stability - Providing liquidity principles outlined by Walter Bagehot. during crises, then removing excess liquidity February 1929- The Bureau of Banking under the However, widespread banking crises in the Department of Finance took over the task of banking interwar period, especially the Great 2. Keeping up with financial innovations that can supervision. undermine stability 1939- A bill establishing a central bank was drafted the promotion of economic development in addition Vision by Secretary of Finance Manuel Roxas and to the maintenance of internal and external The BSP aims to be recognized globally as the approved by the Philippine Legislature. However, monetary stability. monetary authority and primary financial system the bill was returned by the US government, without supervisor that supports a strong economy and action, to the Commonwealth Government. November 1972- RA No. 265 was amended by promotes a high quality of life for all Filipinos. Presidential Decree No. 72 to make the CBP more 1946- A joint Philippine-American Finance responsive to changing economic conditions. Mission Commission was created to study the Philippine To promote and maintain price stability, a strong currency and banking system. The Commission PD No. 72 emphasized the maintenance of financial system, and a safe and efficient payments recommended the reform of the monetary system, domestic and international monetary stability as the and settlements system conducive to a sustainable the formation of a central bank and the regulation of primary objective of the CBP. Moreover, the CBP’s and inclusive growth of the economy. money and credit. authority was expanded to include not only the - The charter of the Central Bank of Guatemala supervision of the banking system but also the was chosen as the model of the proposed central regulation of the entire financial system. Bangko Sentral as Bank of Issue bank charter. The Bangko Sentral is the only bank January 1981- Further amendments were made authorize to manufacture and issue money. As the August 1947- A Central Bank Council was formed with the issuance of PD No. 1771 to improve and bank of issue, it has the monopoly of note issue. to review the Commission’s report and prepare the strengthen the financial system, among which was Thus, anyone who makes money without the necessary legislation for implementation. the increase in the capitalization of the CBP from authority given by the Bangko Sentral is guilty of P10 million to P10 billion. counterfeiting. February 1948- President Manuel Roxas submitted Counterfeiting is the manufacture of to Congress a bill “Establishing the Central Bank of 1986- Executive Order No. 16 amended the money without due authority. This is a criminal the Philippines, defining its powers in the Monetary Board membership to promote greater offense and is therefore punishable by law. administration of the monetary and banking system, harmony and coordination of government monetary amending pertinent provisions of the Administrative and fiscal policies. Bangko Sentral as Lender of Last Resort Code with respect to the currency and the Bureau of In case banks need funds for lending to Banking, and for other purposes. 3 July 1993- Republic Act No. 7653 was passed their clients, they may avail of the rediscount establishing the Bangko Sentral ng Pilipinas (BSP), facilities of the Central Bank. Through the rediscount 15 June 1948- The bill was signed into law as replacing CBP as the country's central monetary window of the Central Bank, banks may borrow Republic Act No. 265 (The Central Bank Act) by authority. funds by using their notes and having them President Elpidio Quirino. rediscounted. 14 February 2019- Republic Act No. 11211 was The Bangko Sentral charges interest on 3 January 1949- The Central Bank of the passed amending RA No. 7653. The charter money lent to borrowing banks. When banks are Philippines (CBP) was inaugurated and formally amendments bolster the capability of the BSP to distressed, the Bangko Sentral comes to their opened with Hon. Miguel Cuaderno, Sr. as the first safeguard price stability and financial system rescue by lending to them extraordinary loans as to governor. stability. prevent banks from losing the confidence of the The broad policy objectives contained in RA general public. No. 265 guided the CBP in the implementation of its Vision and Mission of BSP duties and responsibilities, particularly in relation to Bangko Sentral as Fiscal Agent As a fiscal agent of the government, the Bangko readiness to seize challenges and high standards of ethics and performance it Sentral has the following functions: opportunities that rise over the horizon holds. ❖ Talons represent the strong will, resolve, ❖ two-tone midnight blue background is To be the official representative of the and the monetary and financial tools that evocative of the honor, dignity, and noble government to financial entities; the central bank uses in discharging its character of the Filipino people, and the To be the depository banker of the mandates. BSP's unwavering commitment to serve the government; 2. SHAPE. The logo is contained within a nation. To be the financial adviser of the ❖ Perfect circle—without sides, a beginning, government; and or an end OBJECTIVES OF THE BSP To manage public debts. ❖ Accentuated by a bold border, to convey The primary objective of the Bangko Sentral the singular and integrative nature of the is to maintain price stability conducive to a balanced The BSP Logo BSP and its impartial approach to holistic and sustainable growth of the economy and The Bangko Sentral ng Pilipinas (BSP) has growth and development. employment maintain monetary stability and the introduced a new logo last 2020 in keeping with the convertibility of the peso. changing times. 3. GOLDEN STARS. The Bangko Sentral shall promote financial In contrast to the stylized eagle profile ❖ Three golden stars- represent the three stability and closely work with the National design of the current logo, the new one features a pillars of central banking (price stability, Government. full-bodied Philippine eagle rendered in gold, taking stable banking system, and a safe and The Bangko Sentral shall oversee the inspiration from various wildlife photographs of efficient payments and settlements system), payment and settlement systems in the actual Philippine eagles. as well as the BSP's commitment to Philippines in order to promote sound and The use of the Philippine eagle in the new promote and sustain a high quality of life for prudent practices consistent with the logo is intended to represent the BSP as well as the all Filipinos, across Luzon, Visayas, and maintenance of financial stability. Filipino people which it serves. Mindanao. RESPONSIBILITIES OF THE BSP The BSP Logo : Design Elements 4. CORPORATE TEXT. The different functions of the Bangko Sentral ng GOLDEN PHILIPPINE EAGLE ❖ The name of the Bangko Sentral ng Pilipinas (BSP) includes: The logo employs a photorealistic rendering of a Pilipinas is rendered in gold, Philippine eagle in flight, signifying the strength of ❖ using a clean sans-serif font, to signify the 1. Monetary policy leadership and foresight that the BSP provides in Bank's operational efficiency, clarity of 2. Monetary Operations the financial sector and the economy. vision, and single-mindedness of purpose. 3. Systemic Risk Management ❖ Eagle's outstretched wings and tail 4. Financial Supervision feathers symbolize the BSP's balanced, 5. DOMINANT COLORS. 5. Payments and Settlements System Oversight inclusive approach to growth and Yellow gold and midnight blue dominate the new 6. Currency Management development, while also conveying the logo’s color scheme to evoke the BSP’s stature as a 7. Inclusive Finance central monetary authority's mastery over its premier government agency. 8. Loans and Credit Operations field. ❖ The yellow gold foreground elements 9. International Reserves Management ❖ Eagle's head and eyes face east, represent the BSP's aim to promote 10. International Operations expressing the BSP's vigilance and economic growth and prosperity, and the 11. International Economic Cooperation 12. Economic Education  Payment systems are essential to the effective but in ensuring that these services truly enhance the Monetary policy functioning of financial systems worldwide. well-being of their users. The primary objective of BSP's monetary policy is to They provide the channels through which funds are When people are financially included and realize promote a low and stable inflation conducive to a transferred among banks and other institutions to their stake in national prosperity, they are balanced and sustainable economic growth. discharge payment obligations arising from empowered to make better, informed choices when economic and financial transactions across the it comes to their financial welfare and future. Monetary Operations refer to the entire economy. In turn, they are able to make sound implementation of monetary policy. To ensure that An efficient, secure and reliable payment system decisions that raise their productivity and standard the monetary policy decision is transmitted to the reduces the cost of exchanging goods and services, of living. financial market and the economy in general, the and it is an essential tool for the effective BSP uses its suite of monetary instruments to implementation of monetary policy, and the smooth Loans and Credit Operations influence the underlying demand and supply functioning of money and capital markets. The BSP extends discounts, loans and conditions for central bank money. It is this key role played by payment and settlement advances to banking institutions in order to influence system (PSS) in the smooth functioning of an the volume of credit consistent with objective of Systemic Risk Management economy in general and its financial and monetary price stability and maintenance of financial stability. The promotion of “financial stability” is a system in particular that gives the central bank (CB) It also grants loans or advances to banking formal mandate that is uniquely ascribed to the a strong incentive for ensuring that an effective, institutions in precarious financial condition or under bangko sentral ng pilipinas (bsp). reliable and secure payment and settlement system serious financial pressures, subject to certain The objective of “financial stability” is to enhance is in place. conditions. the resilience of the financial system, in its totality The BSP's rediscount facilities have two and in its components, from shocks. Currency Management categories, namely Peso Rediscount Facility and This is done by managing systemic risks Exporters' Dollar and Yen Rediscount Facility, which that could affect the financial system so that finance The BSP has the exclusive power and authority to are administered by the Department of Loans and continues to be a value proposition to consumers in issue the national currency. Credit (DLC). normal times while remaining resilient when BSP’s notes and coins are issued against, and in disruptions do arise. amounts not exceeding, the assets of the BSP. International Reserves Management All notes and coins issued by the BSP are fully The BSP maintains a healthy level of international Financial Supervision guaranteed by the government and are considered reserves to provide liquidity support in times of The Bangko Sentral has supervision over the legal tender for all private and public debts. volatility in the exchange rate and balance of operations of banks and exercises such regulatory payments. powers as provided in the New Central Bank Act Inclusive Finance and other pertinent laws over the operations of Financial inclusion is a state wherein there International Operations finance companies and non-bank financial is effective access to a wide range of financial The BSP’s mandate on international operations institutions performing quasi-banking functions. services for all, especially the vulnerable sectors. under the purview of the International Operations Financial inclusion lays the groundwork for Department is to support the promotion and sustainable and equitable national development. maintenance of price stability, external sustainability, Payments and Settlements System The goal of financial inclusion does not end and the integrity and value of the Philippine peso Oversight in providing universal access to financial services through the effective management of external debt, foreign investments and other foreign exchange (FX) transactions. Economic Education The BSP’s Economic Education Portal provides the general public a guided access on the BSP’s collection of information on economic education for them to better understand and appreciate the role of the BSP, as the country’s central bank, in the Philippine economy. As the portal strategically presents the BSP’s available learning materials, it aims to develop and strengthen the public’s knowledge on economic concepts that could eventually guide them in making sound economic and financial decisions. Composition of the Monetary Board of the Bangko Sentral ng Pilipinas Governor of the Bangko Sentral An appointed Cabinet member of the President Five(5) Full-time members from the Private sector The BSP Monetary Boar​d Chairman Eli M. Remolona, Jr. Member Ralph G. Recto Benjamin E. Diokno Romeo L. Bernardo Rosalia V. De Leon Walter C. Wassmer  MODULE 2 generally decreases unemployment because the Commercial banks can’t use the reserves to higher money supply stimulates business activities make loans or fund investment into a new FRAMEWORK OF MONETARY that lead to the expansion of job market businesses. Since its constitute a lost POLICY Currency exchange rates. Using its fiscal opportunity for the commercial banks, central banks pay them interest on the reserves. The authority, a central bank can regulate the exchange rates between domestic and interest in known as IOR or Interest on Monetary policy Reserves is a central bank's actions and communications foreign currencies. that manage the money supply. Example: the central bank may increases the 3. Open market operations. The central bank can Central Banks use monetary policy to prevent monetary supply by issuing more currency. In such either purchase or sell securities issued by the inflation, reduce unemployment and promote a case, the domestic currency becomes cheaper government to affect the money supply. moderate long-term interest rates. relative to its foreign counterparts. Monetary policy increases liquidity to create Example: central banks can purchase government bonds. As a result, banks will obtain more money to economic growth and reduces liquidity to Tools of Monetary Policy increase the lending and money supply in the prevent inflation. Central banks use various tools to implement economy. Central banks use interest rates, bank reserve monetary policies. The widely utilized policy tools requirements, and the number of government include: bonds that banks must hold. Expansionary vs. Contractionary The money supply includes forms of credit, 1. Interest rate adjustment. A central bank can cash, checks, and money market mutual funds. Monetary Policy influence interest rates by changing the discount Credit includes loans, bonds, and mortgages. Depending on its objectives, monetary policies can rate. The discount rate (base rate) is an interest In a recession, central banks might combat high be expansionary or contractionary. rate charged by a central bank to banks for unemployment by giving banks more money. short-term loans. 1. Expansionary Monetary Policy Banks in turn lower interest rates, which allows business to hire more employees. Example: if central bank increases discount rate, the This is a monetary policy that aims to cost of borrowing for the banks increases. increase the money supply in the economy by Subsequently, the banks will increase the interest decreasing interest rates, purchasing government Objectives of Monetary Policy rate they charge to their customers. Thus, the cost securities by central banks, and lowering the The primary objectives of monetary policies are the of borrowing in the economy will increase and reserve requirements for banks. An expansionary management of inflation or unemployment and money supply will decrease. policy lowers unemployment and stimulates maintenance of currency exchange rates. business activities and consumer spending. The 2. Change reserve requirements. Central banks Inflation. Monetary policies can target overall goal of the expansionary monetary policy is usually set up the minimum amount of reserves that inflation levels. A low inflation is considered to fuel economic growth. However, it can also must be held by a commercial bank. By changing healthy and if inflation is high, a contrary possibly lead to higher inflation the required amount, the central bank can influence policy can address this issue the money supply in the economy.If monetary 2. Contractionary Monetary Policy. Unemployment. Monetary policies can authorities increase the required reserve amount, influence the level of unemployment in the commercial banks find less money available to lend The goal of a contractionary monetary economy. their clients, and thus money supply decrease policy is to decrease the money supply in the Example, an expansionary monetary policy economy. It can be achieved by raising interest rates, selling government bonds, and increasing the important things. It would also mean that consumers Sentral ng Pilipinas on imposing monetary policy reserve requirements for banks. The contrary policy will be able to settle their monthly payments argue that, during recessions, not all consumers is utilized when the government wants to control regularly - a win-win situation for creditors, would have the confidence to spend and take inflation levels. merchandisers and property investors as well advantage of low interest rates, making it a disadvantage. 4. It can promote low inflation rates. Advantages of Monetary Policy One of the biggest perks of monetary policy is that it 2. It is not that useful during global recessions. 1. It can bring out the possibility of more can help promote stable prices, which are very Proponents of expansionary monetary investments coming in and consumers spending helpful in ensuring inflation rates will stay low policy state that even if banks lower interest rates more. throughout the country and even the world. As for consumers to spend more money during a global In an expansionary monetary policy, where inflation essentially makes an impact on the way we recession, the export sector would suffer. If this is banks are lowering interest rates on loans and spend money and how much money is worth, a low the case, export losses would be more than what mortgages, more business owners would be inflation rate would allow us to make the best commercial organizations could earn from their encouraged to expand their ventures, as they would financial decisions in life without worrying about sales. have more available funds to borrow with affordable prices to drastically rise unexpectedly. interest rates. Plus, prices of commodities would 3. Its ability to cut interest rates is not a also be lowered, so consumers will have more 5. It promotes transparency and predictability. guarantee. reasons to purchase more goods. As a result, A monetary policy would oblige Though a monetary policy is said to allow businesses would gain more profit while consumers policymakers to make announcements that are banks to enjoy lower interest rates from the Central can afford basic commodities, services, and even believable to consumers and business owners in Bank when they borrow money, some of them might property. terms of the type of policy to be expected in the have the funds, which means that there would be future. insufficient funds that people can borrow from them. 2. It allows for the imposition of quantitative easing by the Central Bank. 6.It promotes political freedom. 4. It can take time to be implemented. The Bangko Sentral ng Pilipinas can make With things expected to be done immediately in Since the central bank can operate separately from use of a monetary policy to create or print more these modern times, implementing a monetary can the government, this will allow them to make the money,allowing them to purchase government certainly take time, unlike other types of policies, best decisions based upon how the economy is bonds from banks and resulting to increased performing doing at a certain point in time. Also, the such as a fiscal policy, that can help push more monetary base and cash reserves in banks. This money into the economy faster. According to banks would operate based on hard facts and data, also means lower interest rates and, eventually, experts, changes that are made for a monetary rather than the wants and needs of certain more money for financial institutions to lend its policy might take years before they begin to take individuals. Even the Bangko Sentral ng Pilipinas borrowers. can operate without being exposed to political place and make changes felt, especially when it comes to inflation. influences. 3. It can lead to lower rates of mortgage payments. 5.It could discourage businesses to expand. As monetary policy would lower interest rates, it Disadvantages of Monetary Policy With this policy, interest rates can still would also mean lower payments homeowners increase, making businesses not willing to expand would be required for the mortgage of their houses, 1. It does not guarantee economy recovery. their operations, resulting to less production and leaving homeowners more money to spend on other Economists who criticize the Bangko eventually higher prices. While consumers would not be able to afford goods and services, it would corporations make in commercial banks. spending to cool down the economy. take a long time for businesses to recover and even Fiscal policy is often contrasted with monetary cause them to close up shop. Workers would then 4.Liquidity Trap policy, which is enacted by central bankers and lose their jobs. not elected government officials. A liquidity trap is when interest rates are Fiscal policy is largely based on the ideas of close to zero and savings rates are high, rendering Limitations of Monetary Policy monetary policy ineffective. In a liquidity trap, British economist John Maynard Keynes (1883-1946). He argued that economic Monetary policy has quite a number of shortcomings consumers choose to avoid purchasing treasury recessions are due to a deficiency in the and, as such, usually does not reach expectations. securities and keep their funds in savings because consumer spending and business investment of the prevailing belief that interest rates will soon 1. Case of Deflation components of aggregate demand. rise. A rise in interest rates will cause a decrement Keynes believed that governments could in bond prices. Compared to inflation, deflation is usually stabilize the business cycle and regulate hard to control. During deflationary periods, central 5.Case of the Government Reducing the Money economic output by adjusting spending and tax banks reduce their policy rates to as low as zero. Supply policies to make up for the shortfalls of the The economy therefore, cannot be stimulated private sector. beyond this point. We've recently seen in which If a government decreases the money His theories were developed in response to the have ever opted for negative rates. supply, for example, with higher taxes, individuals Great Depression, which defied classical would expect low future inflation. This could render economics' assumptions that economic swings 2. Case of Banks Decreasing the Money They an expansionary monetary policy ineffective. were self-correcting. Lend In Keynesian economics, aggregate demand or Bond Market Vigilantes spending is what drives the performance and Sometimes when the money supply banks Vigilantes are individuals who participate in growth of the economy. Aggregate demand is can have' excess reserves, making the short-term the bond market, which can reduce their demand for made up of consumer spending, business rates decrease. This is mostly a result of the long-term bonds, thus raising their yields. The rise in investment spending, net government spending, business environment yields can easily make it difficult for any and net exports. 3.Uncertainty About How the Economy Reacts to expansionary monetary policy to be effective. Expansionary and Contractionary Policy TYPES OF FISCAL POLICY Expansionary Fiscal Policy and Tools Uncertainty about the effect of a policy puts Fiscal Policy Expansionary fiscal policy is usually the economy and prices on a complicated path. Fiscal policy refers to the use of government characterized by deficit spending. Deficit Some economies might over or underreact to spending and tax policies to influence economic spending occurs when government central bank policies. It is imperative to note that conditions, especially macroeconomic expenditures exceed receipts from taxes and economists often disagree on the policies central conditions. These include aggregate demand for other sources. In practice, deficit spending tends banks should use. goods and services, employment, inflation, and to result from a combination of tax cuts and economic growth. higher spending. Every attempt of central banks to During a recession, the government may lower manipulate the supply of money within an economy tax rates or increase spending to encourage Contractionary Fiscal Policy and Tools does not always work. This is due to their lack of demand and spur economic activity. Conversely, In the face of mounting inflation and other capacity to control the deposits households and to combat inflation, it may raise rates or cut expansionary symptoms, a government can  pursue contractionary fiscal policy, perhaps The basic reasons for the market failure in the reduce it. This suggests that budgetary effects on even to the extent of inducing a brief recession provision of social goods are: firstly, because demand increase as the level of expenditure to restore balance to the economic cycle. consumption of such products by individuals is non increases and as the level of tax revenue The government does this by increasing taxes, rival, in the sense that one person's partaking of decreases. reducing public spending, and cutting public does not reduce the benefits available to others. sector pay or jobs. The benefits of social goods are extemalised. 4) Economic Growth Where expansionary fiscal policy involves Secondly, the exclusion principle is not feasible in spending deficits, contractionary fiscal policy the case of social goods. The application of Moreover, the problem is not only one of is characterized by budget surpluses. This exclusion is frequently impossible or prohibitively maintaining high employment or of curtailing policy is rarely used, however, as it is hugely expensive. So, the social goods are to be provided inflation within a given level of capacity output. The unpopular politically. by the government. effects of fiscal policy upon the rate of growth of potential output must also be allowed for. Fiscal Public policymakers thus face differing incentives policy may affect the rate of saving and the relating to whether to engage in expansionary or 2) Distribution Function willingness to invest and may thereby influence the contractionary fiscal policy. Therefore, the preferred rate of capital formation. tool for reining in unsustainable growth is usually a Adjustment of the distribution of income and wealth contractionary monetary policy.. Monetary policy to assure conformance with what society considers Capital formation in turn affects productivity involves the Bangko Sentral ng Pilipinas raising a 'fair' or state of distribution. The distribution of growth, so that fiscal policy is a significant factor in interest rates and restraining the supply of money income and wealth determined by the market forces economic growth. and credit in order to rein in inflation. and laws of inheritance involve a substantial degree of inequality. Tax transfer policies of the government play an important role in reducing the inequalities in COORDINATING FISCAL AND FISCAL FUNCTIONS income and wealth in the economy. MONETARY POLICIES Although particular tax or expenditure Monetary policy refers to central bank activities that measures affect the economy in many ways and 3) Stabilization Function are directed toward money and credit in an may be designed to serve a variety of purposes, economy. influencing the quantity of money and Fiscal policy is needed for stabilization, since full several more or less distinct policy objectives may credit in an economy employment and price level stability do not come be set forth. They include: automatically in a economy. Without it the economy By contrast, fiscal policy refers to the government's tends to be subject to substantial fluctuations, and it decisions about taxation and spending. 1) Allocation Function suffer from sustained periods of unemployment or Both monetary and fiscal policies are used to inflation. Unemployment and inflation may exist at regulate economic activity over time. They can be The provision for social goods, or the the same time. Such a situation is known as used to accelerate growth when an economy starts process by which total resource use is divided stagflation. to slow or to moderate growth and activity when an between private and social goods and by the mix of The overall level of employment and prices in the economy starts to overheat. In addition, fiscal policy social goods is chosen. This provision may be economy depends upon the level of aggregate can be used to redistribute income and wealth. termed as the allocation function of budget policy. Social goods, as distinct from private goods, cannot demand, relative to the potential or capacity output be provided for through the market system. valued at prevailing prices. Government expenditures add to total demand, while taxes  MODULE 3 V is increased by 6 P= 2 theory integrates the monetary theory with the T is decreased by 2,000,000 P = 1.8 general theory of values. MONETARY THEORY M is decreased by 300,000 P = 1.05 V is decreased by 6 P = 1 THE VALUE OF MONEY MONETARY THEORY T is increased by 6,000,000 P = 1 KEYNESIAN THEORY OF MONEY ✔ explains the role of money in the economic ✔ In his famous 1936 book the "General theory of system with this existence the workings of the 2. CASH BALANCE APPROACH- it is not the Employment", Interest and Money, John economic system are better understood. total money but that portion of the cash balance Maynard Keynes abandoned the quantity ✔ The value of money is the quantity of goods that people spend which influences the price theory view that velocity is a constant developed and services in general that will be exchanged levels. Most people hold a cash balance in their a theory of money demand that emphasized the for a unit of money. hands rather than spending the entire amount importance of interest rates. ✔ indicates its purchasing power, the quantity of all at once. ✔ In his theory of the demand for money, which he goods and services that a unit of money can Formula: M=PKT called the liquidity preference theory, Keynes purchase Where: presented three motives behind the demand M = The money supply for money: QUANTITY THEORY OF MONEY P= pre level 1) the transaction motive ✔ Framework to understand price changer of T= total volume 2) the precautionary motive money relation to the in an economy supply K= demand per money 3) the speculative motive reflects the idea that the quantity of money (money supply) available grows at the same Assuming that M = 1,000,000; K = 1/6; and T = Keynesian Theory of Money rate as price e do in the long run. 12,000,000, what will be the P? P =.5 1. TRANSACTIONS MOTIVE ✔ the value of money is determined by the Now, considering the original assumption, what will ✔ In the quantity theory approach, individuals amount of money available in an economy. be P, if there is a change in either (or both) of the are assumed to hold money because it is a following (other factors remaining the same or medium of exchange that can be used to TWO APPROACHES TO ANALYZE THE constant): carry out everyday transactions. QUANTITY THEORY OF MONEY K is increased to 1/3 P =.25 ✔ Keynes initially accepted the quantity 1. FISHERS THEORY - explains the relationship T is increased to 15,000,000 P =.4 theory view that the transactions component between the money supply and price level K is decreased to 1/24 P = 2 is proportional to income. Later, he and According to Fisher: FORMULA: MV = PT T is decreased to 6,000,000. P =1 other economists recognized that new where: methods of payment, referred to as M- total money supply payment technology, could also affect the V-The velocity of circulation QUANTITY OF MONEY- John Maynard Keynes demand for money. P- price level or the average price of the GNP ✔ Keynes reformulated the Quantity theory of ✔ For example, credit cards enable T- the total National Output money. According to him, money does not consumers to make even very small -Through this equation, Fisher showed that the directly affect the price level. Also, a Change in purchases without needing to hold money. relationship between money supply and the the quantity of money can lead to a change in Electronic payments that can be made from price level is direct and proportional the rate of interest. investors' brokerage accounts also reduce ✔ Further, with a change in the rate of interest, the money demand Example volume of investment can change. Also, this ✔ In Keynes's view, as payment technology Assuming that M = 1,000,000; V = 18; and T = change in investment volume can lead to a advanced, the demand for money would be 12,000,000 what will be the P? 1.5 change in income. Output and employment likely to decline relative to income. Now, considering the original assumption, what will along with a change in the cost of production. 2. PRECAUTIONARY MOTIVE be P, if there is a change in either of the following ✔ Finally, all these factors will lead to a change in ✔ Keynes also recognized that people hold (other factors remaining the same or constant): the prices of goods and services. In simple money as a cushion against unexpected M is increased by 200,000 P = 1.8 words, the keynesian version of the Quantity opportunities.  ✔ Suppose you have been thinking about ⮚ Nominal interest rate- The actual interest Inflation-Adjusted Future Expenses = Php 500,000 x buying a Xbox gaming console and now see rate observed in the market or the interest (1+0.05)25 that it is on vale at 25% off. If you are rate stated on a financial instrument (such Inflation-Adjusted Future Expenses Php. holding money as a precaution for just such as a bond or a savings account). 1,693.177.47 an occurrence, you can immediately buy it. ⮚ Expected inflation rate- The anticipated So, you would need approximately Php. ✔ Keynes argued that the precautionary rate at which prices are expected to 1,693.177.47 annually to maintain the same money balances people would want to hold increase in future. standard of living you have today. would also be proportional to income. 3. SPECULATIVE MOTIVE Fisher Effect Formula: Calculate Real Interest Applications of the Fisher Effect ✔ Keynes also believed that people choose to Rate ✔ The Fisher Effect has several practical hold money as a store of wealth which he Nominal Interest Rate (Investment Return) = 8% applications in the finance industry, called the speculative motive. Expected Inflation Rate (Ph. historical average) = particularly in interest rates, investments, ✔ Because the definition of money in Keynes's 5% and inflation. analysis includes currency (which earns no Real Interest Rate (Fisher Effect) = Nominal interest) and checking account deposits Interest Rate - Expected Inflation Rate Here are some real-life examples of how the (which typically earn little interest), he Real Interest Rate = 8%-5% = 3% Fisher Effect is applied assumed that money earns no interest and After accounting for expected inflation, the real 1) Interest Rate Setting- Central banks and hence its opportunity cost relative to holding interest rate is 3%. monetary authorities use the Fisher Effect to other assets, such as bonds, is the nominal set nominal interest rates based on their interest rate on bonds, i. Fisher Effect Formula: Calculate Future Value of inflation targets. For example, if a central ✔ As the interest rate i rises, the opportunity Investments bank has an inflation target of 2% per year, cost of money rises (it becomes more costly Let's assume you have Php 1,000,000 saved for they may adjust nominal interest rates to to hold money relative to bonds), and the retirement. Using the compound interest formula, ensure that real interest rates are aligned quantity of money demanded falls. you can estimate the future value of your with their target. The Fisher Effect investments in 25 years: 2) Bond Pricing- Investors use the Fisher ✔ It is a financial concept that helps us Future Value Present Value x (1 + Real Interest Effect to estimate the real return on bonds. understand the relationship between interest Rate) Number of Years When purchasing bonds with fixed nominal rates and inflation. =>Php. 1,000,000 x (1+0.03)25 interest rates, investors factor in their ✔ In simpler terms, it tells us how interest rates ≈ Php. 2,093,777.93 expectations of future inflation to determine and the cost of living are connected. Your investments will grow to approximately Php the actual return they will earn after adjusting ✔ The Fisher Effect formula is a financial and 2,093,777.93 over the next 25 years, assuming an for inflation. economic equation that relates nominal 8% nominal return and a 5% inflation rate. 3) Investment Decision-Making- Investors interest rates, real interest rates, and expected consider the Fisher Effect when making inflation rates. Fisher Effect Formula: Account for investment decisions. For instance, if they ✔ Formula: Real Interest Rate (Fisher Effect) Inflation-Adjusted Income Needs expect higher inflation in the future, they may = Nominal Interest Rate - Expected Inflation Suppose your current annual expenses amount to seek investments that offer higher nominal Rate Php 500,000. To maintain your purchasing power in returns to compensate for the eroding Where: retirement, you must adjust this amount for purchasing power of their money. ⮚ Real interest rate- The actual purchasing expected inflation in the Philippines. Using the 4) Interest Rate Setting- Central banks and power of money and is the rate of return Fisher Effect, you can estimate your future monetary authorities use the Fisher Effect to adjusted for inflation. It is also considered expenses: set nominal interest rates based on their the rate of interest an investor or lender Inflation-Adjusted Future Expenses Current inflation targets. For example, if a Loan receives after accounting for the erosion of Expenses x (1 + Expected Inflation Rate) Number of Pricing Financial institution uses the Fisher their purchasing power due to inflation. Yours Effect to price loans and mortgages. Lenders consider the expected and real inflation rates  when determining the interest rates they charge borrowers. 5) Currency Markets- In foreign exchange markets, traders use the Fisher Effect to assess the impact of interest rate differentials between countries. If one country has higher expected inflation than another, it can affect the relative strength of their currencies.  MODULE 4 IMPACT: OMOs are a primary tool for controlling monetary policy stance. For instance, a lower short-term interest rates and managing liquidity in discount rate encourages banks to borrow more and MONETARY POLICY OPERATION the banking system. expand lending, stimulating economic activity. Central Banking Operations By influencing interest rates, OMOs also affect In the Philippines, the BSP’s lending facility offers Central banks play a critical role in inflation and economic growth. short-term funds to banks, playing a key role in managing a country’s monetary policy. In the context of the BSP, OMOs are crucial in managing liquidity while promoting financial stability. They use several tools to influence liquidity, stabilizing inflation within its target range, which interest rates, inflation, and overall economic supports the BSP’s mandate to maintain price RESERVE REQUIREMENTS stability. stability and sustainable economic growth. Reserve requirements refer to the minimum amount of reserves that commercial banks must Primary operations of central banking DISCOUNT WINDOW LENDING hold with the central bank, expressed as a open market operations (OMOs), Discount window lending refers to the percentage of their deposit liabilities. discount window lending, and process by which commercial banks borrow funds reserve requirements. directly from the central bank, typically to meet PURPOSE: Reserve requirements are designed to short-term liquidity needs. control the amount of money banks can create OPEN MARKET OPERATIONS (OMOS) through lending. By adjusting reserve requirements, Open Market Operations (OMOs) involve PURPOSE: Discount window lending is intended to central banks can influence the supply of money in the buying and selling of government securities provide short-term liquidity to banks facing the economy and overall credit conditions. (such as treasury bonds and bills) by the central temporary cash flow shortages. This tool is ADJUSTMENTS: bank in the open market to influence the money especially useful during financial crises or periods of Increasing reserve requirements: When the supply and interest rates in the economy. market stress. central bank increases the reserve ratio, banks must PROCESS: Banks borrow money from the central hold a larger proportion of their deposits as Purchasing government securities: When the bank at a specified discount rate (or overnight reserves. This reduces the amount of money central bank buys government securities, it injects lending rate in the BSP's case). This lending is available for lending, tightening credit conditions and money into the banking system. This increases the secured by collateral, usually in the form of slowing economic activity. This tool is often used to reserves of commercial banks, encouraging lending high-quality assets, such as government securities. curb inflation. and investment. Consequently, interest rates tend to The central bank, through discount window lending, Decreasing reserve requirements: Lowering the fall, making borrowing cheaper and stimulating serves as a lender of last resort, ensuring that banks reserve ratio frees up more funds for banks to lend, economic activity. have access to funds when the interbank lending expanding the money supply and stimulating Selling government securities: When the central market is tight or when they are facing liquidity economic growth. This is typically done in response bank sells government securities, it pulls money out challenges. to a slowdown in the economy or during periods of of the banking system, reducing the reserves of low inflation. commercial banks. This leads to a contraction in IMPACT: lending, which can help control inflation by reducing Stabilizes the banking system: By providing IMPACT: the amount of money circulating in the economy. liquidity to banks, the central bank can prevent bank Money supply and credit: Reserve requirements Interest rates usually rise as a result, making runs and maintain confidence in the financial directly affect the amount of funds banks can lend borrowing more expensive and slowing down system. out, influencing the money supply in the economy. A excessive growth. Influences short-term interest rates: Changes in higher reserve ratio restricts credit availability, while the discount rate can signal the central bank’s a lower ratio increases it. Interest rates and inflation: Reserve requirement rates depends largely on their expectations Unanchored or volatile inflation expectations adjustments can influence interest rates indirectly by about future rates. can lead to unpredictable economic altering the availability of credit. For example, higher If firms expect interest rates to rise in the behavior, making it harder to control inflation reserve requirements can push interest rates up, future, they may invest sooner to avoid and stabilize the economy. dampening inflationary pressures. Conversely, lower higher borrowing costs, stimulating reserve requirements can lead to lower interest economic activity in the present. Rational Expectations rates, supporting economic growth. Conversely, if consumers and businesses the rational expectations hypothesis In the Philippines, the BSP uses changes in reserve expect rates to fall, they might delay suggests that individuals make decisions requirements sparingly but effectively as a tool to investment and spending, slowing economic based on all available information, including manage liquidity and credit growth in the banking activity. central bank policies. system, complementing its other monetary policy This means that the public’s expectations instruments. Forward Guidance about future monetary policy are crucial in Many central banks use a tool known as determining the effectiveness of current ROLE OF EXPECTATIONS IN MONETARY POLICY forward guidance to influence expectations. policy measures. Expectations play a crucial role in the By communicating their future policy effectiveness of monetary policy. intentions, such as signaling that interest Managing expectations is essential for Central banks rely heavily on shaping public rates will remain low for an extended period, central banks to achieve their goals of price stability, expectations about future inflation, interest rates, central banks can influence economic full employment, and economic growth. and economic conditions to achieve their policy behavior today. By influencing expectations, central banks goals. This can encourage more spending and can guide economic behavior in ways that support investment if people believe that borrowing their policy objectives. Inflation Expectations costs will stay low. One of the main objectives of monetary policy is to maintain price stability by Self-Fulfilling Prophecies controlling inflation. Expectations can sometimes become Public expectations of future inflation can self-fulfilling. If businesses and consumers influence current inflation. expect economic growth, they may increase If people expect higher inflation in the investment and spending, contributing to future, they are likely to demand higher actual growth. wages and increase prices for goods and On the other hand, negative expectations services, which could lead to actual can lead to reduced investment and inflation. consumption, dampening economic activity Central banks try to manage these even if fundamentals are sound. expectations to keep inflation stable Anchoring Expectations Interest Rate Expectations A key challenge for central banks is to Central banks use interest rates as a key anchor expectations around desired targets, tool in monetary policy. The way businesses especially for inflation. and consumers react to changes in interest