Monetary Policy Reviewer PDF

I INTRODUCTION TO MONETARY POLICY Interest Rates AND CENTRAL BANKING The central bank may change the interest rates or the required collateral...

I INTRODUCTION TO MONETARY POLICY Interest Rates AND CENTRAL BANKING The central bank may change the interest rates or the required collateral that it demands. In the U.S., this rate is Monetary Policy - set of tools used by a nation's central bank to known as the discount rate. control the overall money supply and promote economic growth Banks will loan more or less freely depending on this and employ strategies such as revising interest rates and interest rate. changing bank reserve requirements. Reserve Requirements KEY TAKEAWAYS – Monetary Policy Authorities can manipulate the reserve requirements, the Monetary Policy is a set of actions to control a nation's funds that banks must retain as a proportion of the overall money supply and achieve economic growth. deposits made by their customers to ensure that they can Monetary policy strategies include revising interest rates meet their liabilities. and changing bank reserve requirements. Lowering this reserve requirement releases more capital Monetary policy is commonly classified as either for the banks to offer loans or buy other assets. Increasing expansionary or contractionary. the requirement curtails bank lending and slows growth. The Federal Reserve commonly uses three strategies for monetary policy including reserve requirements, the ROLE OF CENTRAL BANK discount rate, and open market operations. Central bank plays a critical role in every transaction, business and daily activities, whether it is Economic activity TYPES OF MONETARY POLICY or Individual activity (saving schemes or return matters) 1. Contractionary – increases interest rates and limits the Central banks monitors the purchase and repurchase so outstanding money supply to slow growth and decrease that loss would not be there in the exchange rates. inflation, where the prices of goods and services in an Central bank gives money to commercial banks in the time economy rise and reduce the purchasing power of money. of crises to avoid panic life situations in the markets. Reserves are just like savings help to fall back upon from 2. Expansionary – during times of slowdown or a recession, an difficult or contingent situations. expansionary policy grows economic activity. By lowering Banks itself has no money, for this there are some interest rates, saving becomes less attractive, and consumer legislations required, that are issued in the form of spending and borrowing increase. Prudential regulations by central bank for determining credit policy. GOALS OF MONETARY POLICY The central bank has a number of policy instruments that 1. Inflation can affect the major objectives of monetary policy: Contractionary monetary policy is used to temper inflation and 1. Stability of prices reduce the level of money circulating in the economy. 2. Stability of exchange rate Expansionary monetary policy fosters inflationary pressure and Central banks can focus increases the amount of money in circulation. 1. Quantitative monetary policy: central banks regulate monetary base 2. Unemployment 2. Qualitative monetary policy: central banks An expansionary monetary policy decreases unemployment as a regulate market interest rate and provide higher money supply and attractive interest rates stimulate monetary base which respond to money demand business activities and expansion of the job market. OBJECTIVE OF MONETARY POLICY 3. Exchange Rates To maintain price stability is the primary objective of the The exchange rates between domestic and foreign currencies monetary policy. Ensuting price stability is the most important can be affected by monetary policy. With an increase in the contribution that monetary policy can make to achieve a money supply (EXPANSIONARY), the domestic currency favourable economic environment and a high level of becomes cheaper than its foreign exchange. employment. TOOLS OF MONETARY POLICY MONETARY POLICY INSTRUMENTS Open Market Operations The main monetary policy instruments available to central bank In open market operations (OMO), the Federal Reserve open market operation, Bank buys bonds from investors or sells additional bonds bank reserve requirement, to investors to change the number of outstanding interest-rate policy, government securities and money available to the economy re-lending and re-discount (including using the term as a whole. repurchase market), and The objective of OMOs is to adjust the level of reserve credit policy (often coordinated with trade policy). balances to manipulate the short-term interest rates and that affect other interest rates. Direct, administrative instruments: Tight Monetary Policy –Credit limits Central bank contracts the money supply in response to –Interest rates limits fears of rising prices. The lower money supply increases –Liquidity rules interest rates. The result of a tighter monetary policy is –Investment regulation lower investment and decrease in the nation’s output. Indirect, market instruments: –Open - Market Operations The monetary transmission mechanism – represents the way –Legal Reserve Requirements by which changes in the supply of money are translated into –Discount Rate Policy changes in output, employment, prices and inflation. Legal Reserve Requirements Exchange Rate – accordingly there are certain exchange All banks are required to hold a minimum percentage of requirements to influence the money supply, some Central deposits as reserve. Banks may require that some or all foreign exchange receipts Changes in required reserve ratios can have an important generally from exports be exchanged for the local currency ,the influence on the money supply. rate that is used to purchase local currency may be market Changes in reserve requirements are made sparingly based or arbitrarily set by bank. because they present too large change in monetary policy. Open - Market Operations Capital Requirement Open-market operations represent purchases or sale of All banks are required to hold a certain percentage of their government securities and treasuries to influence the assets as capital. money supply. A rate which may be established by the Central bank or These operations are a central bank the most important banking supervisor. stabilizing instruments. Open market operations serve the purpose of managing Capital Adequacy interest rate, the liquidity situation in the market and Capital adequacy is important, it is defined and regulated by signaling the stance of monetary policy. the Bank for International Settlements, and central bank in Through open market operations, a central bank influences practice generally apply strict rules. the money supply in an economy directly. Each time it buys To enable open market operations, a central bank must hold securities, exchanging money for the security, it raises the foreign exchange reserves. money supply. - EXPANSIONARY It will often have some influence over any official or Conversely, selling of securities lowers the money supply. - mandated exchange rates: Some exchange rates are CONTRACTIONARY managed, some are market based (free float) and many are Buying of securities thus amounts to printing new money somewhere in between ("managed float" ). while lowering supply of the specific security. Temporary lending of money for collateral securities Reserve Requirement ("Reverse Operations" or "repurchase operations", Another significant power that Central bank hold is the otherwise known as the "repo" market). ability to establish reserve requirement for other banks. These operations are carried out on a regular basis, with The other requirement is that a percentage of liability is fixed maturity time periods. being held as cash or deposited with the Central bank or other agency, limits are set on the money supply. THE MONEY Discount Rate Policy Money – refers to all things that are generally acceptable as a Discount rate is the interest rate at which the central bank means of payment for good and services (medium of exchange) stands ready to lend reserves to commercial banks. and as a payment. There are the three key interest rates for the banks: 1. The interest rate on the main refinancing FUNCTIONS OF MONEY operations. 1. Money as a unit of account - means that the value of goods 2. The rate on the deposit facility, which banks may and services are store and services are expressed or quoted use to make overnight deposits. with the use of a single item, usually a country’s currency. 3. The rate on the marginal lending facility, which offers overnight credit to banks. 2. Money as a medium of exchange - means that you can trade your money in the market and in return, get the Expansionary Monetary Policy goods and services that you want to purchase because When the central bank raises the money supply interest money is generally accepted as a means of payment. rates fall. The economy moves down the money demand schedule. Lower interest rates reduces the costs of The prerequisite of the barter system is called the double investment; thus higher investment raises aggregate coincidence of wants. demand curve. 3. Money as a store of value or standard of deferred Money supply is determined by the behavior of three payment - means that you can keep or save money now principal actors, the public, the bank, and the BSP. and then spend it at a future date because its capacity to buy the same amount of goods and services is not lost or THE ROLE OF MONETARY INSTITUTIONS IN THE ECONOMY diminished over time. The Bangko Sentral ng Pilipinas The Central Bank of the Philippines (CB) was established on EVOLUTION OF MODERN PAYMENT SYSTEM IN THE PHILIPPINE June 15, 1948 by virtue of Republic Act No.265. Its primary From a period of autarky or no trade system where the objectives then were: much older generation of Filipino families produced a) To maintain the monetary stability in the country; commodities for their own consumption, the mode of b) To preserve the international value of the peso; and transaction often cited was the barter system. c) To promote rising level of production, employment, and Followed by the use of commodity money were people real income in the Philippines. used commodities such as salt, carabao, shells that serves as a medium of exchange. On June 14, 1993 , through R.A. 7653, the Bangko Sentral ng Pilipinas (BSP) was put up as a central monetary authority. Its Face value refers to the amount of goods and service that primary objectives were still to maintain price stability (or fight can be bought with the use of the paper bills. inflation) conductive to a balanced and sustainable growth of Example: if you have a one thousand peso bill, then it is the economy as well as promote and maintain monetary possible for you to purchase goods and services worth stability and convertibility of the peso. of a thousand pesos at the maximum. BSP likewise called lender of the last resort. From whom Specialized bankers offered businessmen and traders the ailing or bankrupt banks can borrow if other banks in the particular service of safekeeping their surplus money for a financial system cannot provide them with the necessary fee. Overtime, bankers discovered that they can also lend a funds portion of the traders’ surplus money to other people who needed funds and then charged as an interest in return. Financial Institutions With the vast developments in commerce and industry, the The Philippine financial or monetary system is a network system of fractional reserve banking also evolved. of markets and institutions that transfer funds from individuals and groups who save money to individuals and THE DEMAND OF MONEY groups who want to borrow money. The demand for money for real balances or purchasing Banks Classified as: power, i.e., the amount of goods and services money can a) universal and commercial buy. b) rural bank c) thrift bank – which include: According to John Maynard Keynes, there are 3 motives for 1. Savings and mortgage banks holding money: 2. private development banks 1. Transaction motive - refers to the holding of money to 3. micro-finance institutions enable people and firm to pay off their daily transaction 4. stock savings such as paying for electricity, telephone bills, house rent, 5. loan associations education, food, clothing, etc. Non banks institutions are: 2. Precautionary motive - for holding money arises because a) Contractual savings institutions – such as: household and firms cannot predict exactly their level of 1. Insurance companies expenditure per unit time and the inflow of income as well. b) Investment institutions 3. Speculative or portfolio allocation motive - refers to the c) Securities market institution holding of money for purpose of taking advantage of 1. Securities brokers and dealers. market opportunities. 2. Lending investors 3. Organized exchanges THE SUPPLY OF MONEY d) Credit card companies The supply of money may be viewed in terms of monetary e) Pawnshops aggregates: M1 – this refers to the narrow definition of money which Financial or monetary institutions are important because of the consists of currency (e.g., paper bills and coins) in following major roles: circulation plus demand or checking deposits; a) they allocate or channel saving efficiently from savers to M2 – this refers to M1 plus savings and small time deposits; borrowers. M3 – this refers to money supply, peso savings, time b) they provide information, liquidity, and risk-sharing deposits, plus deposit substitutes of money-generating services. banks, and negotiable order of withdrawal (NOW) accounts. c) they provide flexibility and divisibility of funds for the users RM – this is the reserve money which represents liabilities and sources of this funds of the BSP to the public sector in the form of currency in d) they are essential for ensuing capital formation and circulation and to banking sector in the form of cash economic growth. reserve. SIMPLE MONEY CREATION Money - any item or medium of exchange that is accepted by Money Multiplier - is the factor by which money supply will people for the payment of goods and services, as well as the change given a change in monetary base or deposit. repayment of loans. Formula of the Money Multiplier: mm = 1 / rr Money makes the world go 'round. Economies rely on Formula of the Change in Money Supply: M = mm x MB money to facilitate transactions and to power financial growth. Typically, it is economists who define money, where Monetary Policy can either be expansionary (increasing money it comes from, and what it's worth. Here are the supply) or contractionary (decreasing money supply) multifaceted characteristics of money. The following is a list of important instruments of monetary Key takeaways control used by the Monetary board: Money is a medium of exchange; it allows people and a) Reserve requirement – is the percentage of deposits that businesses to obtain what they need to live and thrive. banks are mandated to keep in their vaults for safekeeping Bartering was one way that people exchanged goods for by the BSP. other goods before money was created. b) Rediscount Rate – is the interest charged by the banks to Like gold and other precious metals, money has worth wish to borrow from it. because for most people it represents something valuable. c) Open Market Operation – in simplistic terms, refer to the Fiat money is government-issued currency that is not buying and selling of government securities by the BSP. backed by a physical commodity but by the stability of the Open market purchase, means buying of government issuing government. securities (e.g., bonds) from private individuals or firms by Above all, money is a unit of account - a socially accepted the BSP. Open market sale refers to the sale of government standard unit with which things are priced. securities to private individuals or firms by the BSP. Medium of Exchange INTERNATIONAL MONETARY INSTITUTIONS AND THE Before the development of a medium of exchange—that is, PHILIPPINE MONETARY SYSTEM money—people would barter to obtain the goods and services Even prior to financial liberalization and globalization of they needed. Two individuals, each possessing some goods the markets in the recent past, the Philippine monetary system other wanted, would enter into an agreement to trade. has been affected by international monetary institutions particularly by the International Monetary Fund (IMF) and The lack of transferability of bartering for goods is tiring, the World Bank (WB). confusing, and inefficient. But that is not where the problems end; even if the person finds someone with whom to trade meat International Monetary Fund was created to: for bananas, they may not consider a bunch of bananas to be a) Act as lender of last resort; worth a whole cow. Such a trade requires coming to an b) Encourage domestic economic policies consistent with agreement and devising a way to determine how many bananas foreign exchange rate stability; and are worth certain parts of the cow. c) Monitor the financial activities of member countries. Commodity money solved these problems. Commodity money World Bank was also created to: is a type of good that functions as currency. In the 17th and a) To make a long term loans available for developing early 18th centuries, for example, American colonists used countries beaver pelts and dried corn in transactions. b) Give loans for infrastructure to aid economic development c) Sell bonds in international capital market to raise loanable Possessing generally accepted values, these commodities were funds. used to buy and sell other things. The commodities used for Composed of five (5) institutions: trade had certain characteristics: they were widely desired and, 1. International Development Association (IDA) therefore, valuable, but they were also durable, portable, and 2. International Bank for Reconstruction and Development easily stored. (IBRD) 3. International Finance Corporation (IFC) HOW IS MONEY USED? 4. Multilateral Investment Guarantee Agency (MIGA) Money primarily functions as the good people use for 5. International Center for Settlement of Investment Disputes exchanges of items of value. However, it also has secondary (ICSID) functions that derive from its use as a medium of exchange. The World Bank also encourages member counties to give Money as a Unit of Account priority to programs for good governance and transparency, Due to money's use as a medium of exchange for buying and environmental protection and sustainable development. selling and as a value indicator for all kinds of goods and These programs are envisioned as potential solutions to services, money can be used as a unit of account. eradicate poverty in member nations. Washington, D.C. (District of Columbia)  That means money can keep track of changes in the value For example, if the cost of printing a $100 bill is only $10, of items over time and multiple transactions. People can the government will earn a $90 profit for each bill it prints. use it to compare the values of various combinations or However, governments that rely too heavily on seigniorage quantities of different goods and services. may inadvertently debase their currency. Money as a unit of account makes it possible to account for profits and losses, balance a budget, and value the total 3. Fiat Currency (Fiat Money) assets of a company. Many countries issue fiat currency, which is currency that does not represent any type of commodity. Instead, fiat Money as a Store of Value money is backed by the economic strength of the issuing Money's usefulness as a medium of exchange in government. It derives its value from supply and demand transactions is inherently future-oriented. As such, it and the stability of the government. provides a means to store a monetary value for use in the future without having that value deteriorate. 4. Money Substitutes and Fiduciary Media So, when people exchange items for money, that money To reduce the burden of carrying large quantities of retains a particular value that can be used in other currency, merchants and traders sometimes exchange transactions. This ability to function as a store of value money substitutes such as written statements of debt that facilitates saving for the future and engaging in can be redeemed later. These statements can themselves transactions over long distances. adopt some of the properties of money, particularly if traders use them in lieu of actual currency. Money as a Standard of Deferred Payment For example, ancient banks issued bills of exchange to their To the extent that money is accepted as a medium of depositors, stating the amount that had been deposited exchange and serves as a useful store of value, it can be and the terms for redemption. Rather than withdraw used to transfer value over different time periods in the money from the bank to make payments, depositors would form of credits and debts. simply trade their bills, allowing the recipient to redeem or One person can borrow a quantity of money from someone trade them at will. else for an agreed-upon period of time, and repay a This use of money substitutes can increase the portability different agreed-upon quantity of money at a future date. and durability of money, as well as reduce the cost of storage. However, there are risks involved with money TYPES OF MONEY substitutes. Banks may print more bills than they have 1. Market-Determined Money money to redeem, a practice known as fractional reserve Money can originate out of the spontaneous order of banking. If too many people try to make withdrawals at the markets. As traders barter for various goods, some goods same time, the bank may suffer from a bank run. will prove more convenient than others because they have Fiduciary media are types of money substitutes introduced the best combination of the five properties of money listed into circulation that aren't fully backed by the base money above. held to back money substitutes. Over time, these goods may become desirable as objects of For example, paper checks, token coins, and electronic exchange, rather than for practical use. Eventually, people credit represent contemporary examples of fiduciary media. may come to desire a good solely for future trading. Historically, precious metals such as gold and silver were Cryptocurrencies As Money often used as market-determined monies. They were highly In recent years, digital currencies that do not exist in prized across many different cultures and societies. Today, physical form, such as Bitcoin, have been introduced. Unlike people in cashless economies frequently turn to cigarettes, electronic bank records or payment systems, these virtual instant noodles, or other nonperishable goods as a market- currencies are not issued by a government or other central determined money substitute. body. Cryptocurrencies have some of the properties of money and are sometimes used in online transactions. 2. Government-Issued Currency Although cryptocurrencies are rarely used in everyday When a certain type of money is widely accepted transactions, they have achieved some utility as a throughout an economy, government bodies may begin speculative investment or a store of value. Some regulating it as a currency. They may issue standardized jurisdictions have recognized cryptocurrencies as a payment coins or notes to further reduce transaction costs. medium, including the government of El Salvador. A government may also recognize some money as a legal tender, meaning that courts and government bodies must What Are the 4 Types of Money? accept that form of money as a final means of payment. Money can be something determined by market participants to have Issuing money allows the government to benefit from value and be exchangeable. Money can be currency (bills and coins) issued by a government. A third type of money is fiat currency, which is seigniorage, the difference between the face value of a fully backed by the economic power and good faith of the issuing currency and the cost to produce it. government. The fourth type of money is money substitutes, which are anything that can be exchanged for money at any time. For example, a check written on a checking account at a bank is a money substitute. What is the Difference Between Hard and Soft Money? In any functional economy, economic resources are limited, Hard money is money that is based on a valuable commodity, with individuals having unlimited wants and desires. This such as gold or silver. Since the supply of these metals is limited, problem, referred to as scarcity, is one of the significant these currencies are less susceptible to inflation than soft drivers of an economy. However, it challenges an economy money such as printed banknotes. With no guarantee that extra in determining when, where, to whom to distribute its notes will not be printed, soft money may be considered risky by resources. Consequently, it resulted in a financial system some. structure capable of efficiently allocating economic resources to stimulate growth. Also, it allows participants to Is Cryptocurrency Money? benefit by: Cryptocurrency has many of the properties of money and is Providing a way of making payments (banks) sometimes used as a medium of exchange for transactions. Giving participants a way of earning interest in the Many governments consider cryptocurrency to be a taxable form of time value (investment institutions) asset, but very few give it the same legal treatment as a foreign Protecting them against financial risks(insurance) currency. Some jurisdictions, notably El Salvador, have embraced Collecting and distributing financial cryptocurrency. information(credit agencies) Governing regulations to maintain stability (central banks and governments) FINANCIAL SYSTEMS Maintaining liquidity and converting investments into cash (banks and financial institutions) A financial system is an economic arrangement wherein financial institutions facilitate the transfer of funds and assets The money or funds flow from the lender to the borrower in between borrowers, lenders, and investors. Its goal is to one of two ways: efficiently distribute economic resources to promote economic 1. Market-Based growth and generate a return on investment (ROI) for market 2. Centrally Planned participants. In a market-based economy, borrowers, lenders, and Financial Intermediaries are system that allows the transfer of investors can obtain funds by trading securities, such as money between savers and borrowers stocks and bonds in the financial markets. The law of supply Entities that channel funds from people savers to and demand will determine the price of these securities. borrowers/investors With a centrally planned economy, governing authority or Banks, Mutual Funds, Pension Funds, Financial Companies, central planner makes the investment decisions. In most Credit Unions instances, there will be a mix of both types of economies. The market participants may include investment banks, Components of Financial Systems stock exchanges, insurance companies, individual 1. Financial Institutions investors, and other institutions. It functions at corporate, Financial institutions act as intermediaries between the lender national, and international levels and is governed by various and the borrower when providing financial services. These rules dictating the eligibility of participants and the use of include: funds for different purposes. Banks (Central, Retail, and Commercial) Aside from financial institutions, financial markets, Insurance Companies Investment Companies Brokerage financial assets, and financial services are the components Firms of the financial system. 2. Financial Markets Key Takeaways These are places where the exchange of assets occurs with A financial system consists of individuals like borrowers and borrowers and lenders, such as stocks, bonds, derivatives, lenders and institutions like banks, stock exchanges, and and commodities insurance companies actively involved in the funds and Financial markets help businesses to grow and expand by assets transfer. allowing investors to contribute capital. Investors invest in It gives investors the ability to grow their wealth and company stock with the expectation of it producing a assets, thus contributing to economic development. return in the future. As the business makes a profit, it can It serves different purposes in an economy, such as then pass on the surplus to the investors. working as payment systems, providing savings options, bringing liquidity to financial markets, and protecting 3. Financial Instruments investors from unexpected financial risks. Tradable or financial instruments enable individuals to trade A specific set of rules drafted under different government within the financial markets. These can include cash, shares of policies is required for a stable financial system operating at stock (representing ownership), bonds, options, and futures. corporate, national, and international levels. 4. Financial Services TYPES OF INTEREST RATES Financial services provide investors a way of managing assets 1. Fixed Interest Rates and offer protection against systemic risk. These also ensure The interest rate is fixed throughout the loan’s repayment individuals have the appropriate amount of capital in the most period. efficient investments to promote growth. Banks, insurance It is usually decided on an agreement basis between the companies, and investment services would be considered lender and the borrower when the loan is granted. financial services. 2. Variable Interest Rate Currency (Money) Here the interest rate fluctuates with time. Variable-rate A currency is a form of payment to exchange products, services, interest is generally linked to the movement of the base and investments and holds value to society. level of interest rate, which is also called the prime rate of interest. Functions of Financial Systems 1. Payment System – An efficient payment system allows 3. Annual Percentage Rate businesses and merchants to collect money in exchange for Yearly Interest rate charged on a loan or earned through an their products or services. Payments can be made with investment expressed as percentage cash, checks, credit cards, and even cryptocurrency in Here the annual rate of interest is calculated as the amount certain instances. of the total sum of interest pending, which is expressed on the total cost of the loan. 2. Savings – Public savings allow individuals and businesses to invest in a range of investments and see them grow over 4. Prime Interest Rate time. Borrowers can use them to fund new projects and This rate is generally lower than the usual increase future cash flow, and investors get a return on lending/borrowing rate. It is generally linked to the Federal investment in return. Reserve lending rate, the rate at which different banks borrow and lend. 3. Liquidity – The financial markets give investors the ability to reduce the systemic risk by providing liquidity. It thus allows 5. Discounted Interest Rate for easy buying and selling of assets when needed. This interest rate does not apply to the common public. This rate is generally applicable for Federal Banks to lend money 4. Risk Management – It protects investors from various to other financial institutions financial risks through insurances and other types of On a short-term basis, which can be as short as a single day. contracts. Banks may opt for such loans at a discounted rate to cover up their lending capacity, rectify liquidity problems, or 5. Government Policy – Governments attempt to stabilize or prevent a bank from failing in a crisis. regulate an economy by implementing specific policies to deal with inflation, unemployment, and interest rates Suppose, at times when the loans/lending becomes more than deposits in a single day, a particular bank may approach the Federal Bank to grant loans at a discounted REVIEW OF INTEREST RATES rate to cover up their liquidity or lending position for the day. Interest Rate The amount a lender charges a borrower and is percentage of a 6. Simple Interest principal which is the amount loaned is a bank’s rate of interest for charging its customers. The calculation is basic and generally expressed as the The Pros of Rising Interest Rates multiplication of principal, interest rate, and the number of More interest for savers. periods. Payouts increase. Inflation may subside 7. Compound Interest Rate A stronger dollar. Calculated on the initial principal and also on accumulated interest from previous periods. The Cons of Rising Interest Rates Compound Interest methodology is called interest on New loans will cost more interest. Banks generally use the calculation to calculate the Payments will go up on adjustable-rate loans bank rates. It is based on two key elements: the interest of Home equity may decline the loan and the principal amount There’s a higher chance of a recession Here banks will first apply the interest amount on the loan Stock market volatility may continue balance, and whatever balance is pending will use the same amount to calculate the subsequent years interest payment.