CHAPTER 2

INTRODUCING MONEY AND INTEREST RATES

I. ROLE OF MONEY IN THE ECONOMY

➢ Money is any item or product that is widely recognized as a form of
payment for goods and services or as a means of debt reduction and acts
as an asset to its owner.
➢ Money is the oil that keeps our world's machines going.
➢ For thousands of years, money has played this critical role.
➢ In the Philippines, the Banko Sentral ng Pilipinas is a well-established bank
and institution.
II. CHARACTERISTICS OF MONEY
➢ The word "valuable" refers to something that has monetary value or
worth.
➢ Durable means that it will last a long time without losing its consistency or
value.
➢ Portable and standard - capable of being carried or transferred and
having a uniform quality or state
➢ Divisible means that it can be broken down into smaller parts.
➢ Money has a cap of Limited Availability.
➢ To be usable, it must be able to be used for payment.
III. THE KEY FUNCTIONS OF MONEY
➢ Store of value
➢ Item of worth
➢ Means of exchange
➢ Unit of account
➢ Standard of deferred payment
IV. THE EVOLUTION OF MONEY
➢ Bartering was the original method of exchanging surplus goods with one
another. Money emerged as a realistic alternative to the challenges of
 bartering hundreds of different items, even though the worth of each good
exchanged could be debated. Money has taken several forms over the
years, but regardless of its shape, whether as a coin, a note, or a digital
server, money still offers a fixed value to which any object can be compared.
➢ According to the law of supply and demand, as the price rises, the quantity
demanded decreases, and as the price falls, the quantity demanded rises.
The supply of a product is the single most important factor influencing its
price. Low supply will raise the price, while high supply will lower it.
V. THE SUPPLY AND DEMAND OF MONEY
➢ Key measures
▪ M1 is the smallest unit of the money supply. The use of money as a
medium of exchange
▪ M2: Money that is used as a store of value in addition to M1.
▪ M3: money used as a unit of account in addition to 2.
▪ L: This metric, in addition to M3, includes liquid and near-liquid
assets.
➢ The interest rate, and therefore the cost of borrowing money, would be
influenced by changes in the money supply. This would have an effect on
the economy's consumption and investment levels.
THE DEMAND OF MONEY
I. THE SOURCES OF DEMAND FOR MONEY
➢ Transaction Demand- the money we need to buy goods and services in our
daily lives.
➢ Precautionary Demand- the money we will need for unexpected purchases
or emergencies.
➢ Speculative Demand is the money we need to retain our money instead of
purchasing shares, assets, or risky investments.
II. THE IMPACT OF MONEY
 ➢ Interest- The amount of money you pay to borrow money or the amount
of money you earn as a result of lending money. The rate is expressed as
a percentage of the loan amount.
➢ A greater money supply reduces market interest rates, making borrowing
more affordable for consumers.
➢ Smaller money reserves tend to increase market interest rates, making
consumer loans more costly.
➢ If there is more money available, the interest rate is lower; if there is less
money, the interest rate is higher.
III. THE QUANTITY THEORY OF MONEY
➢ How interest rates are determined
▪ Investors- demand funds in order to fund capital assets that they hope
can boost performance and benefit.
▪ Customers- loanable funds with a positive rate of time preference are
in high demand. They would rather have earlier access.
▪ Lenders- provides lenders with an opportunity to cut back on their
current spending so that borrowers can spend or consume beyond their
means.
➢ Investment Funds- is a pool of money that many private investors
contribute to and use to invest in stocks and bonds collectively.
➢ A liquid asset is something you own that can be turned into cash
efficiently and easily while maintaining its market value.
➢ The rate at which the quantity of money demanded equals the quantity
of money supplied is known as equilibrium interest.
➢ People's willingness to retain capital for various reasons is known as
liquidity preferences.
➢ The nominal or money rate corresponds to the interest rate before
inflation is taken into account.
➢ The real rate of interest is calculated to exclude the influence of inflation
and represents the true value of a bond or loan.
➢ The rate at which the value of a currency falls and, as a result, the
overall cost of prices for goods and services rises is known as inflation.
➢ 3 components of money rate of interest on loan
• The real price of earlier availability is the pure interest
component.
• The component of a necessary return that compensates for
inflation risk is known as the inflationary premium
component.
• The extra yield above the risk-free rate that investors earn as
reward for investing in volatile assets is known as the risk-
premium component.