FIN301 MONETARY POLICY

AND CENTRAL BANKING

Money, Banking & Interest Rate

Richard R. Devanadera, CPA

Learning objectives
At the end of our discussion youll be able
to:
Explain the economic functions of banks and
other depository institutions
Describe some financial innovations that have
changed the way we use money today
Explain how banks create money
Explain what determines the demand for money
Explain how interest rates are determined
Explain how interest rates influence expenditure
plans
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A recall: What is Money?

The items in M1 clearly meet the definition of money (Liquid);
the items in M2+ do not do so quite so clearly but still are quite
liquid.
Liquidity is the property of being instantly convertible into a
means of payment with little loss of value. It is the nearness
and velocity of an asset to be turned to CASH.
Checkable Deposits/Demand Deposit, Current/Checking Account
Deposits are money, but checks are not checks are instructions
to banks to transfer money.

not

Credit cards are

money. Credit cards enable the holder to
obtain a loan quickly, but the loan must be repaid with money.
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Depository Institutions
Incorporated Banks (Banks)
A incorporated bank is a private firm that is licensed
to
receive deposits and make loans.
A incorporated bank balance sheet summarizes its
business and lists the banks assets, liabilities, and
net worth.
The objective of a incorporated bank is to maximize
the net worth of its stockholders.
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Depository Institutions
To achieve its objective, a bank makes risky loans at an
interest rate higher than that paid on deposits.
But the banks must balance profit and prudence; loans
generate profit, but depositors must be able to obtain their
funds when they want them.
So banks divide their funds into two parts: reserves and loans.
Reserves are the cash in a banks vault and deposits at Bangko
Sentral ng Pilipinas.
Bank lending takes the form of liquid assets, investment
securities, and loans.

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Depository Institutions
A depository institution is a firm that accepts
deposits from households and firms and uses the
deposits to make loans to other households and
firms.
In the Philippines under RA 8791, known as "The
General Banking Law of 2000, the Monetary
Board of the Bangko Sentral was vested with
the power to authorize the organization of a bank
or quasi-bank subject to the conditions set forth in
the same law.
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Depository Institutions
Under the same law, the following have been authorized to accept
deposits, and as such are depository institutions, in the Philippines:
a) Universal banks (any type of deposits)
b) Commercial banks (any type of deposits)
Under the appropriate law, the following have been authorized to accept
deposits but limited to savings and time deposits, demand deposits
with conditions, and as such are depository institutions, in the
Philippines:
1.
a)
b)
c)

Thrift banks (RA No. 7906, also known as "Thrift Banks Act), composed
of:
Savings and mortgage banks,
Stock savings and loan associations, and
Private development banks, as defined in Republic Act No. 7906 (hereafter the
"Thrift Banks Act");

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Depository Institutions
2. Rural Banks (RA No. 7353, known as Rural
Banks Act of 1992)
3. Cooperative banks (Republic Act No. 6938,
know as the Cooperative Code)
Islamic banks (RA No. 6848, otherwise known
as the "Charter of Al Amanah Islamic
Investment Bank of the Philippines), like the
Universal and Commercial can accept any form
of deposits.
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How Banks Create Money

Reserves: Actual and Required
The fraction of a banks total deposits held as reserves
is
the reserve ratio.
The required reserve ratio is the fraction that banks are
required, by regulation, to keep as reserves. Required
reserves are the total amount of reserves that banks
are
required to keep.
Excess reserves equal actual reserves minus required
reserves.
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How Banks Create Money

Creating Deposits by Making Loans in a One-Bank
Economy
When a bank receives a deposit of currency, its reserves
increase by the amount deposited, but its required
reserves increase by only a fraction (determined by the
required reserve ratio) of the amount deposited.
The bank has excess reserves, which it loans. These
loans can only end up as deposits in our one and only
bank, where they boost deposits without changing total
reserves, which creates money.

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How Banks Create Money

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How Banks Create Money

Security Bank Deposit Liabilities
Source: Security Bank 2014 Annual Report

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How Banks Create Money

BPI Deposit Liabilities
Source: BPI 2014 Annual Report

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The Origins of the Money Supply

T-account for a typical bank
Asset - item of value owned
Liability - item of value owed / debt
Balance sheet - accounting statement
Left side: values of all assets
Right side: values of all liabilities & net worth

Net worth = assets liabilities

Assets = Liabilities + Net worth
(Shareholders or Stockholders Equity)

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Table 1
Balance sheet of Mahal Kita Banks as of December 31, 20014
Assets
Assets
Reserves
Loans outstanding
Total
Addendum: Bank
Reserves
Actual reserves
Required reserves
Excess reserves

Liabilities and Net Worth

Liabilities
P
Checking
1,000,000 deposits
P
4,500,000 Net Worth
P
Stockholders
5,500,00 equity
0
Total

P
5,000,000

P500,000
P
5,500,00
0

P
1,000,000
P
1,000,000
0

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Banks and Money Creation

Deposit creation process
Fractional reserve banking system
Turns Php 1 of bank reserves
Into several Pesos of bank deposits

Excess reserves
Reserves held in excess of legal minimum
Earn no interest
banks lent-out to earn

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Example 1
Mahal Kita Bank accepted a Php 100,000.00 deposit from Mr. Love Kita.

changes in Mahal Kita Banks balance sheet, due to the above transaction
Assets
Reserves
Addendum: Changes in
Reserves
Actual reserves
Required reserves
Excess reserves

Liabilities and Net

Worth
+P100,00
0
+P100,00
0
+P
19,000
+P
81,000

Checking
deposits

+P100,0
00

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Banks and Money Creation

Multiple money creation
Initial deposit Php 100,000
Increase reserves
Required reserves Php 19,000
Excess reserves Php 81,000

Extend more loans Php81,000

Increase deposits Php81,000
Increase reserves
Required reserves
Excess reserves

Extend more loans

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Example 1 (continued)
Mahal Kita Bank lent-out Php 81,000.00 as loan to Mrs. Forever.

Changes in Mahal Kita Banks balance sheet after the loan to Mrs. Forever
Assets

Liabilities and Net

Worth

Loans outstanding
Reserves

+P81,000
-P81,000

Addendum: Changes in
Reserves
Actual reserves
Required reserves
Excess reserves

-P81,000
No
change
-P80,000

No change

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Example 1 (continued)
Changes in Mahal Kita Banks balance sheet, after the deposit and loans
Assets

Liabilities and Net Worth

Reserves
Loans outstanding

+P19,000
+P81,000

Addendum: Changes in
Reserves
Actual reserves
Required reserves
Excess reserves

+P19,000
+P19,000
No
change

Checking
deposits

+P100,00
0

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Example 2
Youre the One Bank accepted a Php 81,000.00 deposit from Mrs. Forever.

Youre the One Bank lent-out Php 65,610.00 as loan to Mrs. Antonio.

Changes in Youre the One Banks balance sheet after the deposit and loan
Assets

Liabilities and Net

Worth

Reserves
Loans outstanding

+P15,390
+P65,610

Addendum: Changes in
Reserves
Actual reserves
Required reserves
Excess reserves

+P15,390
+P15,390
No
change

Checking
deposits

+P81,00
0

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Example 3
My Only One Bank accepted a Php 65,610.00 deposit from Mrs. Antonio.

My Only One Bank lent-out Php 53,144.10 as loan to Mrs. Jun.

Changes in My Only One Banks balance sheet after the deposit and loan
Assets
Reserves
Loans outstanding
Addendum: Changes in
Reserves
Actual reserves
Required reserves
Excess reserves

Liabilities and Net

Worth
+P12,465
.90
+P53,144
.10
+P12,465
.90

Checking
deposits

+P65,61
0

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Banks and Money Creation

Assumptions
Each bank
Holds exactly 19% required reserves per Bangko
Sentral, Office of the Governor Circular No. 830 s.
2014

Each loan recipient

Redeposits proceeds - next bank

Sum of infinite geometric progression

1
1 R R R ...
1 R
2

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Figure 1

The chain of multiple deposit creation

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Banks and Money Creation

Creating Deposits by Making Loans with Many
Banks
With many banks, one bank lending out its excess
reserves cannot expect its deposits to increase by the
full amount loaned; some of the loaned reserves end up
in other banks. But then the other banks have excess
reserves, which they loan.
Ultimately, the effect in the banking system is the same
as if there was only one bank, so long as all loans are
deposited in banks.
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Banks and Money Creation

Reserve ratio = m (=19% in the example)
R=1-m is loan ratio (=81% in the example)
Deposits
Expand by 1/m of each Php 1 of new reserves

Simplified Money multiplier (or The Deposit

Multiplier)
ratio of newly created bank deposits to new
reserves
Change in money supply=(1/m) Change in
reserves
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Money Multiplier
Money multiplier (or The Deposit
Multiplier)
The deposit multiplier is the amount by
which an increase in bank reserves is
multiplied to calculate the increase in
bank deposits.
The deposit multiplier = 1/Required
reserve ratio.
or =deposit / reserve
or = 1 / legal reserve
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Banks and Money Creation

Multiple contractions of money supply
Deposit destruction
Withdrawal Php 100,000
Decrease reserves Php100,000
Need Php80,000 to meet reserve requirement

Outstanding loans paid off Php80,000

Borrowers withdrawal Php80,000
Decrease reserves
Loans paid off

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Contractions of Money Supply

Reverse of money creation ends up (REFER TO FIGURE 1)
Deposit shrinks by Php 500,000
Loan falls by Php 400,000
Bank reserve decreases by Php100,000

Money supply (M1) falls by Php 400,000

This is why the several bank runs can trigger such a
huge financial crisis and spill over to the main street

Money-Creation Formula Is
Oversimplified

Oversimplified money multiplier

Accurate - very particular circumstances:

1. Every recipient of cash
Must redeposit cash to another bank
Doesnt hold cash

2. Every bank
Must hold reserves - legal minimum

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Money-Creation Formula Is
Oversimplified

If individuals & business firms

Hold more cash
Limited

Multiple expansion of bank deposits

Fewer pesos of cash

Available for use as reserves

Smaller money supply

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Money-Creation Formula Is
Oversimplified

If banks

Keep excess reserves

Limited
Multiple expansion of bank deposits

Smaller supply of money

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The Need for Monetary Policy

During a recession
Banks - reduce money supply
Increase excess reserves
Decrease lending
Less creditworthy applicants

Aggravate recession
Milton Friedman believed this is the cause of
Great Depression
Need government intervention

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The Need for Monetary Policy

During an economic boom
Banks expand money supply
Undesirable momentum to economy
Inflation

Need government intervention

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The Demand for Money

The Influences on Money Holding
The quantity of money that people plan to hold
depends on four main factors
The price level
The interest rate
Real GDP
Financial innovation

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The Demand for Money

The price level
A rise in the price level increases the nominal quantity of money
but doesnt change the real quantity of money that people plan to
hold.
Nominal money is the amount of money measured in Pesos.
The quantity of nominal money demanded is proportional to the
price level a 10 percent rise in the price level increases the
quantity of nominal money demanded by 10 percent.

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The Demand for Money

The interest rate
The interest rate is the opportunity cost of holding wealth in the
form of money rather than an interest-bearing asset.
A rise in the interest rate decreases the quantity of money
that people plan to hold.
Real GDP
An increase in real GDP increases the volume of expenditure,
which increases the quantity of real money that people plan to
hold.

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The Demand for Money

Financial innovation
Financial innovation that lowers the cost of switching between
money and interest-bearing assets decreases the quantity of
money that people plan to hold.

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The Demand for Money

The Demand for Money Curve
The demand for money curve is the relationship
between the quantity of real money demanded
(M/P) and the interest rate when all other
influences on the amount of money that people
wish to hold remain the same.

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Interest Rate Determination

An interest rate is the percentage yield on a financial
security such as a bond or a stock.
The price of a bond and the interest rate are inversely
related. If the price of a bond falls, the interest rate on
the bond rises. If the price of a bond rises, the interest
rate on the bond falls.
We can study the forces that determine the interest rate
in the market for money.
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Interest Rate Determination

Money Market Equilibrium
The BSP determines the quantity of money supplied and
on any given day, that quantity is fixed.
The supply of money curve is vertical at the given
quantity of money supplied.
Money market equilibrium determines the interest rate.

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Interest Rate Determination

Influencing the Exchange Rate
The exchange rate is the price at which the Philippine
pesos exchanges for another currency.
The exchange rate is determined by demand and supply
in the global foreign exchange market.
A rise in the Philippine interest rate
demand for the Philippine pesos and the
rise. A fall in the Philippine interest rate
demand for the Philippine pesos and the
fall.
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increases the
exchange rate
decreases the
exchange rate
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Questions.
Thank you for listening
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