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FIN301 monetary policy and central bankingRichard R. Devanadera, CPAMoney, Banking & Interest Rate

Learning objectivesAt the end of our discussion youll be able to:Explain the economic functions of banks and other depository institutionsDescribe some financial innovations that have changed the way we use money todayExplain how banks create moneyExplain what determines the demand for moneyExplain how interest rates are determinedExplain how interest rates influence expenditure plans2Colegio de San Lorenzo,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.

Credit cards are not money. Credit cards enable the holder to obtain a loan quickly, but the loan must be repaid with money.2Colegio de San Lorenzo,Depository InstitutionsIncorporated Banks (Banks)A incorporated bank is a private firm that is licensed toreceive 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.2Colegio de San Lorenzo,Depository InstitutionsTo 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, investmentsecurities, and loans.2Colegio de San Lorenzo,Depository InstitutionsA 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.

2Colegio de San Lorenzo,Depository InstitutionsUnder the same law, the following have been authorized to accept deposits, and as such are depository institutions, in the Philippines:Universal banks (any type of deposits)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:

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");2Colegio de San Lorenzo,Depository InstitutionsRural Banks (RA No. 7353, known as Rural Banks Act of 1992)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.

2Colegio de San Lorenzo,How Banks Create MoneyReserves: Actual and RequiredThe fraction of a banks total deposits held as reserves isthe reserve ratio.The required reserve ratio is the fraction that banks arerequired, by regulation, to keep as reserves. Requiredreserves are the total amount of reserves that banks arerequired to keep.Excess reserves equal actual reserves minus requiredreserves.

2Colegio de San Lorenzo,How Banks Create MoneyCreating Deposits by Making Loans in a One-BankEconomyWhen a bank receives a deposit of currency, its reservesincrease 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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Colegio de San Lorenzo,How Banks Create Money2

Security Bank Deposit LiabilitiesSource: Security Bank 2014 Annual Report

Colegio de San Lorenzo,How Banks Create Money2

BPI Deposit LiabilitiesSource: BPI 2014 Annual Report

Colegio de San Lorenzo,The Origins of the Money SupplyT-account for a typical bankAsset - item of value ownedLiability - item of value owed / debtBalance sheet - accounting statementLeft side: values of all assetsRight side: values of all liabilities & net worthNet worth = assets liabilitiesAssets = Liabilities + Net worth (Shareholders or Stockholders Equity)14Colegio de San Lorenzo,Balance sheet of Mahal Kita Banks as of December 31, 20014Table 115Assets Liabilities and Net WorthAssetsReservesLoans outstandingTotalAddendum: Bank ReservesActual reservesRequired reservesExcess reservesP 1,000,000P 4,500,000P 5,500,000

P 1,000,000P 1,000,000 0 LiabilitiesChecking deposits

Net WorthStockholders equityTotal P 5,000,000

P500,000 P 5,500,000Banks and Money CreationDeposit creation processFractional reserve banking systemTurns Php 1 of bank reservesInto several Pesos of bank depositsExcess reservesReserves held in excess of legal minimumEarn no interestbanks lent-out to earn16Colegio de San Lorenzo,changes in Mahal Kita Banks balance sheet, due to the above transaction

Example 117Assets Liabilities and Net WorthReserves Addendum: Changes in ReservesActual reservesRequired reservesExcess reserves+P100,000 +P100,000+P 19,000 +P 81,000 Checking deposits+P100,000Mahal Kita Bank accepted a Php 100,000.00 deposit from Mr. Love Kita.

Banks and Money CreationMultiple money creationInitial deposit Php 100,000Increase reservesRequired reserves Php 19,000Excess reserves Php 81,000Extend more loans Php81,000Increase deposits Php81,000Increase reservesRequired reservesExcess reservesExtend more loans18Colegio de San Lorenzo,Changes in Mahal Kita Banks balance sheet after the loan to Mrs. ForeverExample 1 (continued)19Assets Liabilities and Net WorthLoans outstandingReserves Addendum: Changes in ReservesActual reservesRequired reservesExcess reserves+P81,000-P81,000

-P81,000No change-P80,000 No changeMahal Kita Bank lent-out Php 81,000.00 as loan to Mrs. Forever.

Changes in Mahal Kita Banks balance sheet, after the deposit and loans

Example 1 (continued)20Assets Liabilities and Net WorthReservesLoans outstanding Addendum: Changes in ReservesActual reservesRequired reservesExcess reserves+P19,000+P81,000

+P19,000+P19,000 No changeChecking deposits+P100,000Changes in Youre the One Banks balance sheet after the deposit and loanExample 221Assets Liabilities and Net WorthReservesLoans outstanding Addendum: Changes in ReservesActual reservesRequired reservesExcess reserves+P15,390+P65,610

+P15,390+P15,390 No changeChecking deposits+P81,000Youre 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 My Only One Banks balance sheet after the deposit and loan Example 322Assets Liabilities and Net WorthReservesLoans outstanding Addendum: Changes in ReservesActual reservesRequired reservesExcess reserves+P12,465.90+P53,144.10

+P12,465.90+P12,465.90 No changeChecking deposits+P65,610My 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.

Banks and Money CreationAssumptionsEach bankHolds exactly 19% required reserves per Bangko Sentral, Office of the Governor Circular No. 830 s. 2014Each loan recipientRedeposits proceeds - next bankSum of infinite geometric progression

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Colegio de San Lorenzo,The chain of multiple deposit creationFigure 124

Banks and Money Creation25Creating 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.Colegio de San Lorenzo,Banks and Money CreationReserve 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 reservesSimplified Money multiplier (or The Deposit Multiplier)ratio of newly created bank deposits to new reserves Change in money supply=(1/m) Change in reserves

26Colegio de San Lorenzo,Money MultiplierMoney 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 requirement (m)Colegio de San Lorenzo,Banks and Money CreationMultiple contractions of money supplyDeposit destructionWithdrawal Php 100,000Decrease reserves Php100,000Need Php80,000 to meet reserve requirementOutstanding loans paid off Php80,000Borrowers withdrawal Php80,000Decrease reservesLoans paid off28Colegio de San Lorenzo,Reverse of money creation ends up (REFER TO FIGURE 1)Deposit shrinks by Php 500,000Loan falls by Php 400,000Bank reserve decreases by Php100,000Money 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 streetContractions of Money Supply

Money-Creation Formula Is OversimplifiedOversimplified money multiplierAccurate - very particular circumstances:Every recipient of cashMust redeposit cash to another bankDoesnt hold cashEvery bankMust hold reserves - legal minimum30Colegio de San Lorenzo,Money-Creation Formula Is OversimplifiedIf individuals & business firmsHold more cashLimitedMultiple expansion of bank depositsFewer pesos of cashAvailable for use as reservesSmaller money supply31Colegio de San Lorenzo,Money-Creation Formula Is OversimplifiedIf banksKeep excess reservesLimitedMultiple expansion of bank depositsSmaller supply of money32Colegio de San Lorenzo,The Need for Monetary PolicyDuring a recessionBanks - reduce money supplyIncrease excess reservesDecrease lendingLess creditworthy applicantsAggravate recessionMilton Friedman believed this is the cause of Great DepressionNeed government intervention33Colegio de San Lorenzo,The Need for Monetary PolicyDuring an economic boomBanks expand money supplyUndesirable momentum to economyInflationNeed government intervention34Colegio de San Lorenzo,The Demand for Money35The Influences on Money HoldingThe quantity of money that people plan to hold depends on four main factors

The price level The interest rate Real GDP Financial innovationColegio de San Lorenzo,The Demand for Money36The 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.Colegio de San Lorenzo,The Demand for Money37The interest rateThe 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 moneythat people plan to hold.

Real GDPAn increase in real GDP increases the volume of expenditure, which increases the quantity of real money that people plan to hold.Colegio de San Lorenzo,The Demand for Money38Financial innovationFinancial innovation that lowers the cost of switching between money and interest-bearing assets decreases the quantity of money that people plan to hold.Colegio de San Lorenzo,The Demand for Money39The 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.Colegio de San Lorenzo,Interest Rate Determination40An 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.Colegio de San Lorenzo,Interest Rate Determination41Money Market Equilibrium

The BSP determines the quantity of money supplied andon 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.Colegio de San Lorenzo,Interest Rate Determination42Influencing the Exchange Rate

The exchange rate is the price at which the Philippinepesos exchanges for another currency.

The exchange rate is determined by demand and supplyin the global foreign exchange market.

A rise in the Philippine interest rate increases the demand for the Philippine pesos and the exchange rate rise. A fall in the Philippine interest rate decreases the demand for the Philippine pesos and the exchange rate fall.Colegio de San Lorenzo,Questions.Thank you for listening

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