Money and the Economy 86. What are the basic functions of money?

Money functions as a medium of exchange, standard of value and store of value. 87. What is the computation of money supply? The narrow definition of money supply includes (a) Coins and currency (b) Demand deposits (c) Checking deposits (including travelers checks) The broad definition of money supply includes (d) Other non-checking savings (e) Time deposits (f) Money market accounts and money market mutual funds 88. How is supply of money determined? Supply of money is determined by the monetary authorities (Bangko Sentral ng Pilipinas). 89. How is demand for money determined? Demand for money is determined by transactions demand and asset demand. Transactions demand arises from the need to use money as a medium of exchange. It varies directly with nominal GDP. Asset demand reflects moneys role as a store of value. Money is the most liquid and least risky of assets. However, holding money entails an opportunity cost because it does not provide a return. Thus, asset demand is inversely related to the level of interest rates. 90. What is the relationship between the supply and demand for money? The supply of money (fixed in the short run) and the demand for money give money market equilibrium and determine interest rate (price of money). Varying the supply of money alters the interest rate, affecting investment in society. For example, increasing the supply of money moves one down and to the right along the demand curve. This decreases the interest rate and increases the amount of investment in the economy. 94. Discuss briefly the significance of monetary policy. The overriding concern of economic policy, especially in underdeveloped economies, is to generate and sustain economic growth and development to raise the levels of employment and output and, at the same time, stabilize prices and the exchange rate.

While the Banko Sentral ng Pilipinas (BSP) has no direct control over any of these important variables, it influences the level of economic activity in a country by having over the supply of money and credit necessary to conduct these activities. The tools to exercise monetary policy become the means by which the BSP controls money supply. The tools are used to increase or decrease the amount of money and credit available, and may be used to distribute credit available on a selective basis among different areas of investment based on certain criteria. 95. What are the tools of monetary policy in regulating total money supply? The tools of monetary policy in regulating total money supply are: (a) reserve requirements; (b) amount and rate of rediscounting; and (c) open market operations. Monetary authorities also have other tools that are non-global in character: (a) selective credit controls, (b) maximum interest rates, (c) moral suasion. (1) Major tools (a) Reserves. The legal reserve ratio is the percentage of deposits that must be kept on hand. (i) Lowering the percentage is expansionary (allowing banks to put more of their excess reserves into circulation through loans) (ii) Raising the percentage is contractional (iii) This tool is not frequently used because it has very powerful effects on the economy. (b) Changing the discount rate. This rate is the interest rate at which member banks may borrow from the BSP. (i) Lowering the rate encourages borrowing and increases the money supply. (ii) Raising the rate discourages borrowing and increases saving, and decreases the money supply. (iii) Changing the funds rate is another way in which the BSP affects Interest rates, the money supply, and economic activity. (c) Open market operations. Purchase and sale of government securities is the primary mechanism of monetary control. (2) Minor tools (a) Selective credit controls. For example, the BSP may require a certain percentage of down payment on durable good purchases. (b) Margin requirements. The margin is the percentage of the purchase price

of securities that cannot be borrowed. It determines the down payment requirements on the stock purchases. (c) Moral suasion. Jawbone control entails merely asking banks to hold down rates. Inflation 96. What is inflation? Inflation is a sustained and general increase in price in all or nearly all of the markets in an economy. Inflation would not have any adverse effect if all income earners are able to retain their position after inflation. However, this is not usually the case. Inflation losers are usually the fixed-income earners like retirees, wage-earnings, and creditors. Inflation gainers are the speculators, those with flexible incomes, and debtors. There seems to be a trade-off between inflation and employment. Finally, inflation seems to have a native effect on long-term growth. 97. What are commonly used indices for inflation measurement? The commonly used indices for inflation measurement are 1. Consumer price index (CPI) This measures inflation by a monthly pricing of items on a typical household shopping list. The current index uses a base year as a reference point. The price in the current year of a market basket of goods and services is determined relative to the same basket for the base year. Price of market basket in a given year _________________________________________ Price of the same market basket in the base year 2. The wholesale price index (WPI) This measures increases in price at the wholesale level. It is often accepted as a proxy for future inflation.

100

98.

What are the costs or adverse effect of inflation?

a. Negotiating long-term contracts may be difficult. b. The efficiency of business relationships is reduced. c. Usury laws may prevent borrowing if interest rates are too high. d. The rate is difficult to predict. e. Breach of existing contracts is encouraged. f. Creditors, fixed-income groups and savers are placed in a disadvantage position. 99. What are the different types of inflations? The basic types of inflation are: 1. Demand-pull inflation This is generated by excess aggregate demand for goods and services. This arises when the economy approaches full employment and demand continues to increase. A fiscal policy increase in purchases designed to be expansionary can lead to demand-pull inflation. 2. Cost-push inflation This is generated by increasing production costs which are passed on to consumers in the form of higher prices. Demands of labor unions are often considered the source of these increased costs. 3. Structured inflation This arises from bottlenecks in the economic system due to inadequacy of social overhead capital (e.g, power, transportation and communication) deficiency in tax system, low agricultural production and inadequate exchange supply. Structural inflation is usually experienced by developing countries.

100.

What are the means of combating inflation? Combating inflation is no easy task since in many instances inflation may result as a combination of different factors, each one reinforcing the other. General approaches can still be discussed and applied. Firstly, the type must first be identified: a. Demand-pull inflation is attacked with demand management policies. b. Cost-push inflation is fought with supply-side policies, particularly, rapid imporvements in productivity. c. Structural inflation. This can be eased up by correcting the structural deficiencies of the economy.

Unemployment

101.

Discuss the theoretical and policy definition of unemployment. Theoretical definition: Full employment exists when all individuals willing to work at prevailing market wages are employed at tasks appropriate for their skills. Policy definition: Because of the normal workings of the market, full employment exists even though some members of the labor force are unemployed. The full-employment or natural rate of employment equals the sum of frictional and structural unemployment. This rate varies over time because of demographic and institutional changes in the economy.

102.

Explain the different types of unemployment (a) Frictional unemployment is the amount of unemployment caused by the normal workings of the labor market. This definition acknowledges that some unemployment exists at any given time as workers search for jobs or wait to take jobs in the near term. (b) Structural unemployment exists when aggregate demand is sufficient to provide full employment, but the distribution of the demand does not correspond precisely to the composition of the labor force. (c) Cyclical unemployment is caused by insufficient aggregate demand. During economic downturns, unemployment will occur due to lack of demand.

103.

What are the costs of unemployment? Economic cost can be measured in terms of the forgone output, i.e., the gap between potential GDP under full employment and actual GDP. Non-economic costs of unemployment, such as the individual and social degradation implicit in the loss of meaningful employment and income, are equally important.

104.

Describe briefly the role of government in the pursuit of economic growth. 1. The government as an economic entity plays the five roles which any individual plays in the economy: income-earner, consumer, saver, borrower, and investor. The difference is that the government is a giant in the economy, for its activities involve trillions of pesos. 2. Its main source of income is taxation. A major share of total taxes collected is accounted for by taxes on the sale of goods and services. This is an indirect tax since the seller passes the tax burden to the ultimate consumer. This is also regressive since both poor and rich pay the same amount for the goods and services they purchase. 3. The government earns income in order to maintain itself and perform the function inherent to its nature. A big share of its revenues goes to current or consumption

expenditures which include social services, national defense, debt-servicing and general operations. Whenever its income from taxation is greater than current expenditures, the government considers the difference as savings, a source of funds for capital expenditures. 4. Whenever savings are not sufficient to meet capital expenditures, the government engages itself in public debt. It can borrow from commercial banks, private individuals, the BSP, foreign institutions and foreign individuals. Parts of its current income are spent on interest payments and debt repayments. Public debt exerts a strong influence on the economic pace of the nation since it can be as was frequently the case, inflationary in character. 5. Government savings and borrowings are spent on capital outlays and investments which include public works and construction. These expenditures are expected to improve the lot of the economy in general and business in particular. 6. The economic role of the government cannot be underestimated. Any of its economic decisions can create tiny ripples which can pick up into giant waves and affect lives of every individual. Thus the need for fiscal policies to guide it in the performance of its significant task. 105. Explain briefly how government expenditures and taxation serve as tools of fiscal policy. 1. Government expenditures and taxation as tools of fiscal policy are aimed at certain socially acceptable goals (level of income, unemployment, distribution of income, etc.) 2. The new equilibrium when the government sector is included is now Savings (S) + Taxes (T) = Investments (I) + Government Spending (G). Taxes may be conceived as depending on the level of income. Therefore, we came up with the concept of marginal propensity to tax (MPT) which is the change in the level of tax collections that accompanies a change in the level of income. Taxation 1. The principle of taxation are (a) Benefits received. Individuals should pay tax based on the benefits received from the services (e.g., paying the use of a public park or swimming pool). (b) Ability to pay. Consumers should pay taxes based on their ability to pay them (e.g., taxes on income and wealth) 2. Three classifications of taxes that may or may not reflect ability-to-pay principles. (a) Progressive. With a higher income, individuals pay a higher percentage of their

income in taxes (e.g., income tax). Forcing people into higher tax brackets as they earn more in a contractionary automatic stabilizer. (b) Proportional. At all levels of income, the percentage paid in taxes is constant (e.g., sales tax) (c) Regressive. As income increases, the percentage paid in taxes is decreases (e.g., payroll or excise taxes.) Example: An excise tax is regressive because its burden falls disproportionately on lower-incom persons. As personal income increases, the percentage of income paid declines since an excise tax is a flat amount per quantity of the good or service purchased. 3. Taxes also may be classified as either direct or indirect. (a) Direct taxes are imposed upon the taxpayer and paid directly to the government, e.g., the personal income tax (b) Indirect taxes are levied against other and thus, only indirectly on the individual taxpayer, e.g., excise specific tax, documentary stamp tax, amusement tax, etc. 4. In the recent years, many major industrial nations have adopted a tax based on consumption a value-added tax. The tax is levied on the value added to goods by each business unit in the production and distribution chain. (a) The amount of value added is measured by the difference between a firms sales and its purchases. (b) Each firm in the chain collects the tax on its sales, takes a credit for taxes paid on purchases, and remits the difference to the government. (c) The consumer ultimately bears the incidence of the tax through higher prices. (d) A value added tax encourages consumer saving because taxes are paid on consumption only, not on savings. Because the value-added tax is based on consumption, people in the lower income groups would spend a greater proportion of their income on taxes. The value-added tax is therefore regressive. (e) Only those business that make a profit have to pay income taxes. Under the valueadded tax, however, all business have to pay taxes, regardless of income. 106. What are the sources and uses of public funds? Sources of Public Funds include

1. Tax revenues 2. Borrowings 3. Other income (service income, income from GOCC) 4. Remittance to local government All sources Uses of Public Funds include Economic development Social development National defense General public service including debt services All uses

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