Monetary policy of the Philippines

Monetary policy is the monitoring and control of moneysupply by a central bank, such as the Federal ReserveBoard in the United States of America, and the BangkoSentral ng Pilipinas in the Philippines. This is used bythe government to be able to control inflation, and stabi-lize currency. Monetary Policy is considered to be one ofthe two ways that the government can influence the econ-omy – the other one being Fiscal Policy (which makes useof government spending, and taxes).[1] Monetary Policyis generally the process by which the central bank, or gov-ernment controls the supply and availability of money, thecost of money, and the rate of interest.

1 Money Supply Indicator

The New Generation Philippine Banknotes

Money supply indicators are often found to contain neces-sary information for predicting future behavior of pricesand assessing economic activity. Moreover, these areused by economists to confirm their expectations and helpforecast trends in consumer price inflation. One can pre-dict, to a certain extent, the government’s intentions inregulating the economy and the consequences that resultfrom it. For example, the government may opt to increase

money supply to stimulate the economy or the govern-ment may opt to decrease money supply to control a pos-sible mishap in the economy.[2]

These indicators tell whether to increase or decrease thesupply. Measures that include not only money but otherliquid assets are called money aggregates under the nameM1, M2, M3, etc.

1.1 M1: Narrow Money

M1 includes currency in circulation. It is the base mea-surement of the money supply and includes cash in thehands of the public, both bills and coins, plus pesodemand deposits, tourists’ checks from non-bank issuers,and other checkable deposits.[3] Basically, these are fundsreadily available for spending. Adjusted M1 is calculatedby summing all the components mentioned above.[2]

1.2 M2: Broad Money

This is termed broad money because M2 includesa broader set of financial assets held principally byhouseholds.[2] This contains all of M1 plus peso savingdeposits (money market deposit accounts), time depositsand balances in retail money market mutual funds.[3]

1.3 M3: Broad Money Liabilities

Broad Money Liabilities include M2 plus money substi-tutes such as promissory notes and commercial papers.[3]

1.4 M4: Liquidity Money

These includeM3 plus transferable deposits, treasury billsand deposits held in foreign currency deposits. Almostall short-term, highly liquid assets will be included in thismeasure.[3]

1.5 Implications

If the velocity of M1 and M2 money stock has been low,this indicates that there is a lot of money in the hands ofconsumers andmoney is not changing hands frequently.[4]

Generally we would expect that when money supply indi-cators are growing faster than interest rates plus growth

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2 3 PHILIPPINE MONETARY POLICY

rate or inflation, whichever is higher, interest rates shouldpossibly be increased. This should only generally applywhen broad measures of money supply growth are higherthan narrow measures, to rule out some of the measure-ment error issues that could emerge.[5]

2 Monetary Policy Instruments

2.1 Open Market Operations

Open Market Operations consist of repurchase and re-verse repurchase transactions, outright transactions, andforeign exchange swaps.

• Repurchase and Reverse Repurchase

This is carried out through the RepurchaseFacility and Reverse Purchase Facility of theBangko Sentral ng Pilipinas. In Purchasetransactions, the Bangko Sentral buys govern-ment securities with a dedication to sell it backat a specified future date, and at a predeter-mined interest rate.[6] The BSP’s payment in-creases reserve balances and expands the mon-etary supply in the Philippines. On the otherhand, in Reverse Repurchase, the governmentacts as the seller, and works to decrease theliquidity of money. These transactions usuallyhave maturities ranging from overnight to onemonth.

• Outright Transactions

Unlike the repurchase or reverse repurchase,there is no clear intent by the government to re-verse the action of their selling/buying of mon-etary securities. Thus, this transaction createsa more permanent effect on our monetary sup-ply. “When the BSP buys securities, it paysfor them by directly crediting its counterparty’sDemand Deposit Account with the BSP.”[6]The reverse is done upon the selling of secu-rities.

• Foreign Exchange Swaps

This refers to the actual exchange of two cur-rencies at a specific date, at a rate agreed uponthe deal date and the reverse exchange of thecurrencies at a farther ate in the future, also atan interest rate agreed on deal date.[7]

2.2 Acceptance of Fixed-Term Deposits

To expand its liquidity management, the Bangko Sentralintroduced this method in 1998. In the Special Deposits

Account, or SDA, consists fixed terms deposits by banksand institutions affiliated with the BSP.[6]

2.3 Standing Facilities

To increase the volume of credit in the financial system,the Bangko Sentral ng Pilipinas extends loans, discounts,and advances to banking institutions. “Rediscounting is astanding credit facility provided by the BSP to help banksmeet temporary liquidity needs by refinancing the loansthey extend to their clients.” There are two types of redis-counting in the BSP: the peso rediscounting facility andthe Exporter’s dollar and Yen Rediscount Facility.

2.4 Reserve Requirements

In banking institutions, there are required amounts thatbanks cannot lend out to people. They always need tomaintain a certain balance of money, which are called"reserves". Once these reserve requirements are changedand are varied, changes in the monetary supply will beobserved greatly.[8]Two Forms:

1. Regular or Statutory Reserves

2. Liquidity Reserves

3 Philippine Monetary Policy

3.1 Bangko Sentral ng Pilipinas

The Bangko Sentral ng Pilipinas or BSP is the centralmonetary authority of the republic of the Philippines. Itprovides policy directions in the areas of money, bankingand credit and exists to supervise operations of banks andexercises regulatory powers over non-bank financial insti-tutions. It keeps aggregate demand from growing rapidlywith resulting high inflation, or from growing too slowly,resulting in high unemployment.[9]

The primary objective of BSP’s monetary policy is to pro-mote price stability because it has the sole ability to influ-ence the amount of money circulating in the economy. Indoing so, other economic goals, such as promoting finan-cial stability and achieving broad-based, sustainable eco-nomic growth, are given consideration in policy decision-making.[10]

3.2 Philippine Monetary Framework I:1980s to early 1990s

In the past, the BSP followed the monetary aggregate tar-geting approach to monetary policy. This approach is

3.4 Current Approach: Inflation Targeting 3

based on the assumption that there is a stable and pre-dictable relationship between money, output and infla-tion.In particular, all money aggregates, with the exception ofreserve money, are incorporated with output and inter-est rate. This means that there is a long-run relationshipbetween money on one hand and output and interest rateon the other so that even if there are shocks in the econ-omy, the variables will return to their trend equilibriumlevels.[11]

This means that changes in money supply (on the assump-tion that velocity is stable over time) are directly relatedto price changes or to inflation. Thus, it is assumed thatthe BSP is able to determine the level of money supplythat is needed given the desired level of inflation that isconsistent with the economy’s growth objective. In ef-fect, under the monetary targeting framework, the BSPcontrols inflation indirectly by targeting money supply.[12]

3.3 Philippine Monetary Framework II:June 1995 to Present

The BSP employs a modified framework beginning thesecond semester of 1995 in attempt to enhance the effec-tiveness of the monetary policy by complementing mon-etary aggregate targeting with some form of inflation tar-geting, placing greater emphasis on price stability.Certain key modifications include:

• Allows base money levels to go beyond target as longas the inflation rates are met

• An excess of one or more percentage points of infla-tion over the program induces mopping up operationby the BSP to bring down base money to the previ-ous month’s level[12]

Under an aggregate targeting framework, the BSP fixesmoney growth so as to minimize expected inflation. Onthe other hand, under the new framework, BSP sets mon-etary policy so that price level is not just zero in expecta-tion but is also zero regardless of latter shocks.[12] More-over, the framework was changed because BSP wanted toaddress the fact that aggregate targeting did not accountfor the long-run effects of monetary policy on the econ-omy.With this approach, the BSP can exceed the monetarytargets as long as the actual inflation rate is kept withinprogram levels and policymakers monitor a larger set ofeconomic variables in making decisions regarding the ap-propriate stance of monetary policy.[11]

3.4 Current Approach: Inflation Target-ing

As mentioned earlier, Inflation Targeting requires a pub-lic announcement of an inflation rate that a country willtarget for the coming years, or in a given period of time. Itfocuses on maintaining a low level of inflation, that whichis considered to be optimal, or at least would allow thecountry to have ample economic growth. Its main desireis to achieve price stability as the ultimate end goal of themonetary policy.[11] The Philippines formally adopted In-flation Targeting as the framework for Monetary Policyon January 2002.The Philippines’ inflation target is measured through theConsumer Price Index (CPI). For 2009, inflation targethas been set to be 3.5 percent, having a 1% tolerancelevel, and 4.5 percent for 2010, also having 1% tolerance.Also, the Monetary Board of the Philippines announceda target of around 4±1 percent from 2012 to 2014.[13]

4 Monetary Policy Issues

4.1 Exchange Rate

Exchange rates play a significant role in monetary trans-mission mechanism and at the same time, it can havea large impact on inflation rates. Although the BSPhas adopted the inflation targeting approach, it may betempted to inexplicitly target exchange rate to achieve itslow inflation target. The issue here is the extent of theexchange rate pass-through or ERPT to domestic pricessince higher ERPT would require the BSP to shift its at-tention to exchange rate movements to stabilize prices.[14]

4.2 Role of Monetary Aggregates

Since the shift to inflation targeting, BSP has alreadyabandoned monetary aggregates because its informa-tion content has apparently declined in the recent years.Moreover, it is also assumed that a shift of approach wasnecessary because money aggregates are normally notgood indicators of future economic policy requirementsdue to unreliability of measurement.[14]

4.3 Measurement of Inflation and Liquid-ity Trap

Since inflation targeting leads to lower and stable inflationrates, more improvement should then be given to themea-surement of the consumer price index since few percent-age points have greater repercussions when rates are low.Errors in CPI measurement could lead to ineffective andunsuitable monetary policy response by the BSP whichdefinitely result to detrimental effects to the economy.[14]

4 5 REFERENCES

Another issue arising from monetary policies is theliquidity trap. This happens when inflation rate declinestoo much leading to a threat of deflation. Liquidity trapis defined as a situation in which there are zero nominalinterest rates, persistent deflation and deflation expecta-tions. In the event this occurs, bonds and money earn thesame real rate of return thus making people indifferentto holding bonds or excess money.[14]

4.4 Budget Deficit and External Debts

Given high budget deficits, the government is concernedabout two closely related issues: it does not want to payvery high interest on its borrowings and it does not wantto crowd out the market. Ideally, the government couldraise tax revenues to avoid borrowing huge sums from themarket. However, the government opted to borrow fromthe international capital market and though rates are low,these have shorter maturity and country’s outstanding ex-ternal debt has continued to move towards a less idealposition.[14]

4.5 Fiscal Dominance

According to the fiscal theory of the price level, it is notthe non-interest bearing money but the total nominal li-abilities including interest bearing notes and future fiscalsurpluses that matter for price-level determination. In theabsence of fiscal discipline, an independent central banksuch as the BSP cannot guarantee a stable nominal an-chor. In other words, for the BSP to successfully focuson price stability, there must be a credible commitmenton the part of the National Government to reduce totalfiscal deficits by a meaningful amount.[15]

5 References[1] “Monetary Policy”. Retrieved May 19, 2011.

[2] Bheda, Disha. “An Overview of Key Money Supply Indi-cators - M0, M1, and M2”. Data360. Retrieved May 18,2011.

[3] “Monetary Policy - Glossary and Abbreviations”. BangkoSentral ng Pilipinas. Retrieved May 18, 2011.

[4] “Other Money Supply Indicators”. Data360. RetrievedMay 18, 2011.

[5] “Money Supply- (27.06.04)". Retrieved May 19, 2011.

[6] “Inflation Targeting: The BSP’s Approach to MonetaryPolicy”. Retrieved May 19, 2011.

[7] “Currency Swap Definition”. Retrieved May 19, 2011.

[8] “FRB: Reserve Requirements”. Archived from the origi-nal on 2010-02-19. Retrieved May 19, 2011.

[9] “MANDATE”. Retrieved May 20, 2011.

[10] “Primer on Inflation Targeting” (PDF). Department ofEconomic Research. Retrieved May 19, 2011.

[11] “Primer on Inflation Targeting” (PDF). Department ofEconomic Research. Retrieved May 20, 2011.

[12] Gochoco-Bautista, Maria Socorro. “What Drives Mone-tary Policy?". University of the Philippines Diliman. Re-trieved May 18, 2011.

[13] “Inflation Targeting: The BSP’s Approach to MonetaryPolicy”. Retrieved May 18, 2011.

[14] Lamberte, Mario. “Central banking in the Philippines:Then, Now and the Future” (PDF). Philippine Institutefor Development Studies. Retrieved May 19, 2011.

[15] Mariano and Villanueva, Robert and Delano. “Monetarypolicy approaches and implementationin Asia: the Philip-pines and Indonesia” (PDF). Retrieved May 20, 2011.

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