Chapter 5: Financial System and Monetary Policy

8/10/2019 Chapter 5: Financial System and Monetary Policy

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CHAPTER 5THE FINANCIAL SYSTEM

AND MONETARY POLICY


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The Financial System

Every economy has its own financial system, whetherbig or small, whether its a sovereign country or agroup of sovereign countries, like the European union.

The primary function of every financial system is toensure sufficient liquidity in the economy so thatbusiness and financial transactions happen smoothly.

Technically, a financial system may be defined as a setof laws, rules, regulations and guidelines that govern,guide and support the unhampered flow of financialtransactions in an economy.


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The most elaborate financialsystem in the world is that ofthe United States. This is themodel that others look up towith awe and respect. Other

more respected financialsystems are those of Japan,England, and the EuropeanUnion.

A central bank is the mostimportant player in anyfinancial system as it is its defacto overseer. Some of themost important functions of a

central bank are as follows:

1. Issue currency for circulation

2. Withdraw damaged currencyfrom circulation

3. Clear checks4. Issue banking regulations

5. Lend to bank

6. Conduct monetary policy


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The most important and most prestigious central bank in the worldis the Federal Reserve System of the United States. It is composedof 12 Federal Reserves banks representing the 12 Federal Reservedistricts throughout the country.

The three largest Federal Reserves banks in terms of assets arethose of New York, Chicago, and San Francisco. Together, they holdover 50% of the assets of the Federal Reserve System.

A seven-member Board of Governor heads the Federal Reserve

System. Its headquarters is in Washington D.C. The president of theUnited States appoints every member of the board for a 14-yearnon-renewable term after confirmation by the Us Senate. Thechairman of the Board of Governors is chosen from among them,and seats for a 4-year term with reappointment.


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The Philippine Financial System

Just like that of the UnitedStates, the Philippines has its owncentral bankthe Bangko Sentralng Pilipinas (BSP). It acts as theoverseer of the Philippinefinancial system.

The Bangko Sentral ng Pilipinaswas created through theenactment of Republic Act No.7653 (The New Central Bank Actof 1993). The BSP replaced the

old central bank (Republic Act No.265) of 1949. The monetaryboard or Central MonetaryAuthority (CMA) heads the BSP.

It has six members including theBSP governor who acts as thechairman of the board. Eachmember of the CMA appointedby the Philippine President andconfirmed by the Commission on

Appointments for a six-year term.

The Bangko Sentral ng Pilipinas isheadquartered at the BSPcomplex in Roxas Boulevard,Manila, and has regional offices

on Dagupan, Cebu and Davao


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Structure of the

Philippine Financial System The BSP, the banking system, and the non-bank-quasi-bank (NBAB) financial intermediaries

comprise the Philippine Financial System.

BSP (Philippine Central Bank)

Banking System

1. Commercial Bank

a. Universal Banksb. Ordinary Commercial

2. Savings Banks

a. Savings and Mortgage

b. Stocks Savings and Loans

c. Private Development Banks

3. Government Banks

a. Land Bank of the Philippines

b. Development Bank of the Philippines

c. Philippine Islamic Bank


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Structure of the

Philippine Financial System NBQBs Financial Intermediaries

1. Insurance Companies

2. Investment House

3. Investment Companies

4. Building and Loan Associations

5. Pawnshop6. Non-stock Savings and Loans

7. Trust Companies

8. Venture Capital Corporation

9. Securities Dealers and Brokers

10. Lending Investment

11. Financing Companies

12. Credit Unions

13. Government NBQBs Financial Intermediaries

a. Social Security System

b. Government Service Insurance System


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The Banking System

The Philippine Banking system plays a principalrole in financial intermediation. Banks are thefinancial intermediaries that the average person

interacts with most frequently. A person, whoneeds a loan to buy a car, a piece of real estate,or appliances, usually goes a bank to obtain thatloan. Most of us keep a large proportion of our

cash in banks in the form of savings account orchecking account, or even in the form of timedeposits.


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Commercial Banks

These financial intermediaries raise fundsprincipally by creating deposits liabilities inthe form of demand deposits, saving deposits,

and time deposits. They use these funds tomake commercial, consumer and mortgageloans, and to buy government securities andbonds. As a group, commercial banks are the

largest financial intermediaries and have themost diversified portfolios of real and financialassets.


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Monetary Policy

Monetary policy may define as a set of guidelines and plans ofaction designed to achieve stability and reliability of financialsystem so that it automatically responds and adjusts to changes anddynamics of an economy.

In the United States, the Federal Reserve System exercise authorityin the conduct of the American monetary policy. In the Philippines,the Bangko Sentral ng Pilipinas is the authority.

The primary objective of monetary policy is to provide financial

stability that promotes growth and development of the economywithin minimal inflation. This is achieved by maintaining a level ofmoney supply that is sufficient enough to facilitate business andfinancial transactions in the economy.


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Monetary Policy

The success indicator of monetary policy is the rate of inflation. Thismeans that low inflation rate 9single0digit) indicates that the BSPsmonetary policy is successful. On the other hand, a regime of highinflation (double-digit) indicates that the current monetary policy isnot working, therefore, need to be altered. This is called inflation

rate targeting.

Prior to 2001, BSPs success indicators are base on monetaryaggregates. In other words, its focus was on the level of moneysupply, M1, M2 and M3.

The shift to inflation rate targeting has effectively aligned our ownmonetary policy indicator tot those of the more advancedeconomies, principally the United States. Between the two,inflation targeting is more direct and responsible indicator.


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Monetary Policy

Market for Money

Money Supply: This is set by the Central Bank using money policyinstrument.

M5=M0

Money Demand: Interest rate is opportunity cost of holding money.Transaction demand depends on real GDP, Y and on the level ofprinces, P, in the economy.

Md= P x L(r.Y)

Equilibrium: Keynesian Theory of Liquidity Preference says realinterest rate moves to equate demand and supply at any level ofreal GDP, Y.

M0

P=L(r,Y)


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Effects of Unanticipated Expansionary

Monetary Policy

1. Real Output, Y. SRIncrease in Real GDP, LR

Return to LRAS

2. Inflation Rate, D.SRPrice (Inflation) rise,

LRPrices (Inflation) rise

3. Real Interest Rate, r.SRDecrease in r, LR

Return to original level


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Effects of Monetary Policy

In Interest Rates, Output, and Employment

The anticipated effects of monetary policy can reduce the policys effectiveness.

As they exert little impact on real activity, only nominal variable changes.

Expectation of inflation will affect nominal interest rates quickly, keeping realinterest rate constant, and reduces impact on Aggregate Demand.

Escalator clauses in wages automatically raise costs, shifting Short Run AggregateSupply, and economy is more quickly to go back to Long Run Aggregate Supply.

The impact of monetary policy on major economic variables in the SR and LR,when the effects are wither anticipated or anticipated:

When policies are anticipated, short run effects are less and long run effectsoccur more rapidly.


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Quantity Theory of Money and Its Implication

To the Determinants of Inflation

The Quantity Equation states MV = PY or in growth m + v = p + y

Y = real GDP y = growth of real GDP

P = implicit GDP price deflator p = inflation

M = money supply m = growth rate of money supply V = velocity (number of time per year P1 used to buy output)

In the Long Run, monetary policy affects only price level and inflation,

assuming velocity is constant or it varies predictably. Real output, Y, is

determined by other factors.

p = my or inflation equals growth rate of money in excess

of growth rate of real GDP.


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Important Monetary Policy Rules

MV = PY

1. Money Growth Target. Money growthdetermined by quantity theory.

2. Nominal GDP Target. Money adjusted to hit

nominal GDP target growth rate.

3. Price Level Target. Money growth used to

keep price level within target growth rate.


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Foreign Exchange Parity Relations

1. It explains how exchange rates are determined in a flexible orfloating exchange rate system.

a. Demand for foreign currency from domestic individuals buyinggoods, service, or assets.

b. Supply of foreign currencyfrom foreign individuals buying goods,

services or assets in domestic economy.

Equilibrium: Flexible Exchange Rate System. Demand and supply of foreign

currency determine exchange rate (value of foreign currency in termsof domestic currency.

Fixed Exchange Rate System. Government sets exchange rate andthen fixes this level by intervening to buy or sell foreign currencydepending on demand/supply at the fixed rate.


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2. It also explains the role of each component of the balance-of-paymentsaccounts.

Balance of Payments = Current Account + Capital Account

a. Current Account

Merchandise Trade Balance = Exports of GoodsImports of Goods

Balance on Services = Exports of ServicesImport of Services

Income from Investments = Net Income From-To Foreigners

Unilateral Transfers = Net Gifts From-To Foreigners

Balance on Current Account = Sum of items 1-5

b. Capital Account Net changes in Ownership of Assets To-From Foreigners

c. Official Reserve Account Official Reserve Assets held in form of foreign currencies, gold, and Special Drawing Rights

(SDRs) held at IMD


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3. It also explains how current deficits or surpluses and financial account deficits orsurpluses affect an economy.

Current account balance reflects primarily trade in goods and services. Currentaccount deficit means nation is buying more goods and services from the rest ofthe world than the rest of the world is buying from it.

a. Current Account Deficit must be financed.

b. For a Current Account Deficit to be sustained in over some period of time, itmust be accompanied by an offsetting Financial Account Surplus, i.e. capitalinflowing into the country from the rest of the worldthink the UnitedStates.

c. For a Current Account Surplus to be sustained in over some period of time, itmust be accompanied by an offsetting Financial Account Deficit, i.e., capitalflowing out of the country to the rest of the worldthink Japan.

d. Be careful about causality Account Deficit may cause capital inflows(Financial Account Surpluses), or capital inflows may cause Current AccountDeficits. This latter is likely true for the U.S. in the recent years.


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If a nation is running a Current Account Deficit but has nooffsetting Financial Account Surplus, then its currency will fall invalue against the rest of the world.

a. A trade deficit will reduce the countrys international reserves.

b. This should lead to depreciation in the value of the local currency,as the government will be unable to support its currency in theForeign Exchange market as its international reserves dwindle.

c. This deprecation makes the countrys goods and services cheaperto the rest of the world. This will increase the countrys exports

d. Depreciation makes imported goods more expensive, thusreducing imports.

e. Net result is an increase in the trade balance until trade deficit isreserved.


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4. It also describes the factors that cause a nations currency to appreciateor depreciate.

Factors Causing Nations Currency to Appreciate (Strengthen)

a. Slow growth of domestic income relative to trading partners causes

exports to increase more than imports (decrease in demand for FX)b. Inflation rate lower than trading partners will cause foreign goods tobecome expensive (demand for FX falls, supply for FX rises). As a result,foreign currency weakens; its goods become competitive.

c. Domestic real interest rates higher than trading partners will attractinflows of foreign capital, increasing demand for domestic currency

(demand for FX falls, supply for FX rises).

Factors Causing Nations Currency to Depreciate (Weaken) (Opposite of the factors above for appreciation of domestic currency)


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5. And finally, it explains how monetary and fiscal policies after

the exchange rate and balance-of-payments components.

Monetary Policy Expansionary Restrictive

Real Interest Rates

Decline

Rise

Exchange Rate

Depreciates

Appreciates

Flow of Capital

Outflow

Inflow

Current Account

Move to surplus

Move to deficit

Fiscal Policy

Expansionary

Restrictive

Real Interest Rates

Rise

Decline

Exchange Rate

Uncertain but likely appreciate

Uncertain but likely

depreciate

Flow of Capital

Inflow

Outflow

Current Account

Move to deficit

Move to surplus


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6. It describes a fixed exchange rate and a peggedexchange rate system.

Fixed Exchange Rate System

a. When a nation is absolutely fixes its exchange ratebetween its own currency and the currency of othercountry or region.

Example: Countries such as Hong Kong that have a currency board

that exchange HS$ for US$ at a fixed rate.


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Pegged Exchange Rate

a. When a nation sets desired level and band around that level forthe exchange rate between its currency and the currency of othercountry or region.

b. Key difference between a fixed exchange rate regime and a

pegged exchange rate regime is that, in pegged system thenations exchange rate can vary within the bands without BangkoSentral intervention.

Example:

Many European countries prior to the euro belonged to the ExchangeRate Mechanism (ERM). Each nation in the ERM sets its exchange ratewith the Deutschemark (DM) but allowed their exchange rate with Mto fluctuate within established band.


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7. It discusses absolute purchasing power parity and relativepurchasing power parity.

Absolute Purchasing Power Parity

a. Basic idea is the Law of One Price, i.e., the real price of good

should be the same in all countries at any point in time;otherwise, arbitrage opportunities exist through trade

b. Absolute PPP relates overall price indexes for two countries to thelevel of the nominal exchange rate. PDC= Price level for the domestic country

PFC= Price level for the foreign country S = spot Exchange rate between DC and FC in FC/DC units.

Let S be the indirect quoted exchange rate. Then the Absolute PPPrelationship is then written as: S= PFC/ PDC


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Relative Purchasing Power Parity (PPP)

a. Focuses on the general relationship between inflation rates in twocountries and the movements in the exchange rate necessary tooffset the effects of differential inflation on goods prices.

b. Relative PPP reflectsrelates overall inflation rates in two countries

to change in the nominal exchange rate. IDC = Inflation rate for the domestic country

IFC= Inflation rate for the foreign country

S0 = spot exchange rate at the beginning of the year between DC andFC in DC/FC units

S1 = spot exchange rate at the end of the year between DC and FC inDC/FC units

Relative PPP relationship is then written as S1

S0= 1+IFC

1+IDC


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Approximation for Relative Purchasing Power Paritya. Useful approximation for Relative PPP (especially on CFA exams) is to re-arrange above in terms

of change in exchange rate, i.e.,

b. Relative PPP becomes

c. Under Relative PPP, the approximate change in the exchange rate is equal to the differencebetween foreign and domestic inflation rates (the inflation differential)

If Relative Purchasing Power Parity holds, then real returns on an asset are the same for investors

in any country, as the change in the real exchange rate offsets any inflation differential betweencounties.

Relative PPP does not necessarily hold in the short run but should provide a guide for exchangerate movements over the longer term. Absolute PPP does not, in general, hold in their either shortrun or long run.

s =S1 S0( )S0

s =S1 S0( )S0

=

S1

S0 1 IFC IDC


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Measures of Money Supply

Money supply is measured in three levels:

1. M1, which is also called narrow money, is comprised ofmoney in circulation plus demand and saving deposits.

2. M2, which is also called the broad money, is comprised ofmoney in circulation, demand and savings deposits, plustime deposits.

3. M3, which is also called the expanded money, iscomprised of money in circulation, demand and savingsdeposits, plus deposit substitute (investments in securitiesand bonds).


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Theory of Monetary Policy

The principles of

monetary policy as we

know it today is based

principally onCambridge Universitys

Alfred Marshalls and

Yales Irving Fischers

treaties on incomevelocity and quantity

theory of prices.

Income velocity of

moneyis the ratio of

total nominal GDP to

the stock of money.Velocity measures the

rate of turnover of the

stock of money relative

to the total income oroutput of an economy.


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This relationship is mathematically expressed

as follows:V =

GNP

m=P1q1+P2q2+...Pnqn

m=PQ

m

Therefore,

V =PQ

mormv = PQ

Where :

P = Averagepricelevel

Q = RealGNP

m = stockofmoney


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In this equation, velocity maybe defined as the amount ofnominal GNP each yeardivided by the stock of money,intuitively, income of velocityof money may also be definedas the speed at which moneychanges hands in theeconomy.

For example, assuming that aneconomy produces only onceproduct, cloth, and GNPconsists of 500 million yards ofcloth, selling at 10 per yard,hence, GNP = P * Q= 500million yards * 10/yard =P5billion a year.

If money supply is 500million, then, income velocity

(V) is equal IO, meaning thatmoney turns over then times ayear, as earnings are used tobuy cloth almost monthly (5/6times a month)


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Quantity theory of prices is anextension of the income velocityof money. In this theory, theconcept of velocity is used toexplain the movements in theoverall price level. The key

assumption being that thevelocity of money is relativelystable and predictable. Accordingto monetary economists,(monetarists), the reason forstability is that velocity mainlyreflects underlying patterns in the

timing of income and spending.

If people receive their pay twice amonth (15thand 30th) and spendtheir income evenly betweenpaydays, income velocity will beequal to 24. Regardless whereincome, prices, and GNP may

change, but with an unchangedspending pattern, the incomevelocity of money will notchange.


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With this insight, we can explain the movement in prices in relationto money supply.

Rewriting the equation: P = MV/Q

But since V/Q tends to be constant, then the equation can berewritten as P = km, k being the constant ratio V/Q. As we can seefrom the equation, if k were constant, then the price level willproportionately move with supply of money.

We can suggest, therefore, that a stable money will produce stableprices and an increasing money supply over and above what isnecessary will produce inflation, and in some cases in the past,hyper-inflation


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Tools of Monetary Policy

In the Philippines, the Bangko Sentral ng Pilipinas (BSP) exercises authority in theimplementation of monetary policy. It uses three principal tools in implementingmonetary policy as follows:

1. Open Market Operation. This is BSPs main tool in increasing and decreasingmoney supply. This is implemented through the selling and buying ofgovernment securities to and from the banking system.

When the BSP wants to reduce money supply, it sells government securities tothe banks; hence, recusing liquidity in the financial system, thereby tighteningmoney supply. This policy results to tight credit situation and therefore, higherinterest rates on loan and deposits. This encourage saving and discouragesinvestments.

On the other hand, when BSP wants to increase money supply, it buys backpreviously sold government securities from the banks, thereby, releasingadditional liquidity in the financial system, and loosening up the creditsituation. This policy results to easier credit for business and consumption byeffectively lowering interest rates on loans and deposits. This encouragesinvestments and discourage saving.


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2. Rediscount Facility.The rediscountfacility of BSP is the lendingwindow of Central Bank tocommercial banks.

It works like this: for example San MiguelCorporation applies for a loan fromMetrobank in the amount of P200 million. Ifthe project for the loan applied for qualifiesfor rediscounting, Metrobank may opt to lendP 100 million of its own fund and borrow fromthe BSP the other P100 million through BSPrediscounting facility to complete the requiredP 200 million for lending to San Miguel, thenMetrobank gains profit o 6% from thetransaction on the P100 million portion of the

loan without even using its own funds in thisportion of the loan. In this transaction,Metrobank will use the loan documents withSMC as collateral for the loan from the BSP.

If the Central Bank wants to injectmore liquidity into the system, it willlower its rediscount rate and increasethe list of projects, which may qualifyfor rediscounting. On the other hand,if it wants to reduce liquidity, it willincrease the rediscount rate and

shorten the list of projects that mayqualify, or alter together close itsrediscounting window.


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3. Reserve Requirements. Themost powerful tool of monetarypolicy is the reserverequirement variation. Reserverequirement is that portion ofbank deposits set-aside by

banks, and therefore, notavailable for lending. Forexample, if the reserverequirement is 15%, it meansthat for every P1000 of bankdeposit, P150 is set-aside;hence, only P850 may be lend

out or invested by bank. Statedin another way, it may alsomean that a P150 reserve cansupport P1000 of bank deposits.

If the BSP requires to reducemoney supply because of a treatof inflation, then, it will increasethe banks reserve requirementso that there will be less loanablefunds from banking system,

hence, effectively reducingmoney supply.

On the other hand, if the BSPwant to stimulate businessactivity and consumer demand, it

will reduce the reserverequirement, thus, freeing morefunds for lending and investment,which in effect increase moneysupply.


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Moral Suasion

Aside from the three global tools of monetary policy, there are instanceswhen the person of the Central Bank governor would prefer to use hismoral authority in persuading banks to follow a certain behavior.

For example, at the height of the Asian Financial Crisis (1997-1999), thedepreciation of the Philippine peso was exacerbated by the speculation

attack on the local currency. It was then perceived that some banks areactively participating in this act. In its midst, the Central bank governors inthose times, Gabriel Singson and later Rafael Buenaventura called for ameeting of all bank CEOs to persuade them to stop this destructivepractice, as it will ruin the economy if not stopped. And to put teeth intothis appeal, threats of legal sanctions were also suggested.

This exercise of moral suasion effectively halted the speculative attack onpeso.


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Effects of Monetary Policy

The immediate effect of monetary policy implementation is on interestrates. If the BSPs objective is to stimulate the general level of demand,interest go down.

History, however, has shown that the effectiveness of monetary policyhas its own limitations. As an economic policy tool, it has been proven that

is more effective in contacting inflation that in stimulating economic andbusiness activities. This observation has been validated during the greatdepression (1929-1936) and even in the Philippines in the aftermath ofAsian Financial Crisis. It has been shown that even in interest rates werebrought down, demand goes not go up for long as long as business andconsumer confidence remain low.

As Keynes had observed, even if observed, even if the interest rates gogown, if there is no one who wants to borrow, demand will remain low.

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Chapter 5: Financial System and Monetary Policy