Chapter 6

Money and Monetary Policy

Learning Outcomes: At the end of this chapter, students are expected to:
1. Explain the role of money in the economy.
2. Discuss the money market
3. Analyze the nature and functions of the Philippine Financial System
4. Evaluate the different monetary policies to stabilize the economy

Concept and Functions of Money

Money is fundamental in the functioning of the economy. It facilitates the exchange of

goods and services and reduces the amount of time and effort to carry out a trade transaction.
Money is able to perform this role of facilitating the exchange of goods and services through the
functions that it performs, namely: (1) as a medium of exchange, (2) as a unit of account, (3) as
a store of value, and (4) as a standard for deferred payments.

1. Medium of exchange

Money can be used for buying and selling goods and services. If there were no
money, goods would have to be exchanged through the process of barter (goods would
be traded for other goods in transactions arranged on the basis of mutual need).

The use of money for transactions and trading of goods and services could also
mean faster economic activity. As money is available through cash, cheques, or electronic
cards, purchases can be done easily.

2. Unit of Account

Money is the common standard for measuring the relative worth of goods and
services. It serves as a unit at which goods and services are valued in terms of the given
currency. The main reason for this is to standardize the value of goods and services. In
the Philippines, the value of goods and services is expressed in terms of a given price per
unit of measurement, such as P35.00 per kilo of rice and P9.00 for a relatively short
jeepney ride.

3. Store of value

Money may be affected by the price level because the “value of money is fixed in
terms of the price level”. If prices increase, the value of money will decline, which means
that the cost of holding one’s cash or money will mean fewer goods that can be bought
after the price increase.

4. Standard for deferred payments

Money facilitates transactions that involve loans in the form of cash or goods.
Money value trends enable lenders to estimate how much interest they should charge on
loans and consigned goods. Money provides a fixed and stable standard for measuring
future payments.

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Demand for Money

1. Transactions Demand. The transactions motive for demanding money arises form the fact
that most transactions involve an exchange of money.
2. Precautionary Demand. People often demand money as a precaution against an uncertain
future.
3. Speculative Demand. People hold money for speculative purposes, keeping the money
so that one can respond to financially attracttive opportunities like the purchase of stocks
and bonds.

Composition of Money Supply

The Bangko Sentral ng Pilipinas (BSP) defines money on the following basis of its
components namely:

Philippine Financial System

The Philippine financial system is composed of the banking system, and the non-bank
financial institutions.

The Philippine banking system consists of duly licensed and registered banking entities
engaged in the lending of funds obtained in the form of deposits. These institutions include
universal banks, commercial banks, thrift banks, rural banks and cooperative banks.

Non-bank financial institutions (NBFIs) refer to all financial institutions, other than banks,
engaged principally in the provision of a wide range of financial services. NBFIs are engaged in
a variety of financial services, which include those performed by pawnshops, lending investors,
stock brokers, money brokers, investment houses, financing companies, insurance companies,
and intermediaries, performing quasi - banking functions. Meanwhile, non-bank financial
institutions with quasi-banking functions are authorized to issue deposit substitutes similar to
deposit taking activity,

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Bangko Sentral ng Pilipinas

The primary mandate of the BSP is to maintain price stability conducive to a balanced
and sustainable economic growth. Recognizing the importance of an effective banking system to
growth, the BSP provides policy directions in the areas of money, banking, and credit. It
supervises operations of banks and exercises regulatory powers over non-bank financial
institutions with quasi-banking functions.

Under the New Central Bank Act, the BSP performs the following functions, all of which
relate to its status as the Republic’s central monetary authority.

• Liquidity Management. The BSP formulates and implements monetary policy aimed at
influencing money supply consistent with its primary objective to maintain price stability.

• Currency issue. The BSP has the exclusive power to issue the national currency. All
notes and coins issued by the BSP are fully guaranteed by the Government and are
considered legal tender for all private and public debts.

• Lender of last resort. The BSP extends discounts, loans and advances to banking
institutions for liquidity purposes.

• Financial Supervision. The BSP supervises banks and exercises regulatory powers over
non-bank institutions performing quasi-banking functions.

• Management of foreign currency reserves. The BSP seeks to maintain sufficient

international reserves to meet any foreseeable net demands for foreign currencies in order
to preserve the international stability and convertibility of the Philippine peso.

• Determination of exchange rate policy. The BSP determines the exchange rate policy
of the Philippines. Currently, the BSP adheres to a market-oriented foreign exchange rate
policy such that its role is principally to ensure orderly conditions in the market.

• Other activities. The BSP functions as the banker, financial advisor, and official
depository of the Government, its political subdivisions and instrumentalities, and
government-owned and -controlled corporations.

Monetary Policy Instruments

Measures or actions by the central bank to regulate the supply of money in the economy
constitute what is called monetary policy. Monetary policy actions of the BSP are aimed at
influencing the timing, cost and availability of money and credit, as well as other financial factors,
for the purpose of influencing the price level. This is in line with the primary mandate of the BSP
under RA7653, otherwise known as the New Central Bank Act, to maintain price stability
conducive to a balanced and sustainable growth of the economy

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1. Open Market Operations(OMO) OMO involves the buying or selling of government
securities from banks and financial institutions of the BSP in order to expand or contract
the supply of money. An open market purchase of securities by the BSP results in an
increase in reserves and an increase in the supply of money. Moreover, an open market
sale of securities by the BSP results in a decrease in reserves and a decrease in the
supply of money.

2. Rediscounting

This refers to transactions whereby the BSP extends credit to a bank collateralized
by its loan papers with customers. This instrument plays a dual role; as a tool to allocate
credit to preferred sectors of the economy and as an instrument to influence the supply of
money and credit. Rediscounting rate is the interest rate charged by the BSP to the banks
that borrow from them. Rediscounting affects banks’ reserves and therefore their ability to
extend credit. If an individual borrowed 1,000,000 pesos from the land bank of the
Philippines at 10% using his title of land as a collateral, he will only receive 900,000 pesos.
Consequently, the LBP’s cash on vault is reduced by 900,000 pesos. If LBP avails 5%
rediscount rate, by passing the collateral to BSP, period, LBP will receive 950,000 pesos.
Without waiting for a month-long period, it earned 50,000 pesos. By availing of this, the
bank can use that money for another client and earn more.

3. Reserve Requirement

This is the minimum amount of reserves that bank must hold against deposits.
Let’s say Mr. Rafael deposits P100,000 with land bank of the Philippines. The BSP
requires LBP to keep 10% of deposits. For instance, in its reserves. Therefore, LBP can
use only P90,000 of Mr. Rafael’s money for its loans and investments while if BSP imposes
20% reserve requirement. LBP can use only P80,000 for its activities. The reserve
requirements which are held by banks as cash in their vaults and deposits with the BSP,
help to control money and credit by affecting the demand for money reserves and the
money multiplier. Moreover, it serves as a prudential safeguard for depositors.

4. Direct Controls

These consist of quantitative and qualitative limits on the ability of banks to

undertake certain activities. The most common types of direct controls include limitations
on aggregate bank lending, selective limitations on certain types of bank lending, and
interest rate regulations. These controls are prescribed to promote specific sectors and to
focus more on developmental financing. Under the new charter, the BSP has abandoned
direct controls with its pursuit of more market-oriented and deregulated policies.

5. Moral Suasion

The BSP persuades banks to make their lending policies responsive to the needs
of the economy. Thus, the BSP may persuade banks to tighten their credit programs in
times of inflation and to loosen them in times of recession

Course Materials:
Read: Payumo, C., et al, (2012), Understanding Economics
Watch: https://www.youtube.com/watch?v=Dugn51K_6WA Money and Finance: Crash course
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