Chapter Two

[Money] is a machine
FISCAL AND MONETARY POLICY for doing quickly and
commodiously what
would be done, though
less quickly and
commodiously, without
it.

JOHN STUART MILL

 What is money?

●Money is anything generally accepted as a

medium of exchange.

●Without money, you would have to use

barter to get items you want.

●Barter is the direct exchange of one good

for another, without the use of money.

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 Nature of Money

●Barter versus Monetary Exchange

♦A barter system (with no money) would be
awkward and extremely inefficient.
♦Money greases the wheels of exchange thus,
makes the whole economy more productive.
♦Money comes in the form of tokens (coins and
paper money) that have value established by a
commonly recognized authority.

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 Nature of Money

●The Conceptual Definition of Money

♦The functions of money:
■Medium of exchange
■Store of value
■Standard of value

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 Nature of Money

●What Serves as Money?

♦Commodity money (metallic form)
♦Credit money (promissory note)
♦Paper money
♦Fiat money (value fixed by government edict
or decree/ declared legal tender by a
government, e.g. U.S. Dollars)

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 How money is created?

●Most of the money is created by banks

through the process of credit (lending)

●What is the purpose of a bank?

♦Safe-keeping
♦Funds economic activity, such as, investment
projects
♦Creates money for transactions in the economy
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
 How money is created?

●The actors in this process are:

♦The agents
■Provide deposits to banks and take out loans
♦The banking system
■Take deposits from agents and make loans to agents
♦The central bank
■Regulates the banking system
■Provides “base money”
■Acts as a lender of last resort to banks

Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

 How money is created?
Central Bank ● The amount of
money M supplied
Supplies base by the banks is
Interbank money B larger than the base
(interbank
market money B supplied
liquidity)
by the central bank
M>B
Bank A Bank B Bank C
● There is a net
creation of money !
Supplies money M
Deposits and loans to the economy

Agents

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 How money is created?
●First, let’s examine the balance sheet of a bank
Bank A
Assets Liabilities
Reserves Deposits
Loans

●Liabilities: in the form of the deposits of money made to

the bank by agents
●Assets:
♦ Reserves: held against depositor claims
♦ Loans: made to 3rd parties, they earn interest

Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

 How money is created?
●Creation of money through credit
Bank A
Assets Liabilities
P200 P1000
P800

● A bank receives a P1000 deposit in cash

● We assume a 20% reserve ratio against deposits
♦ Bank A has to hold P200 in reserve
♦ It can loan P800
● This P800 loan is new money, created by the bank!

Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

 How money is created?
●Creation of money through credit
Bank A Bank B
Assets Bank A Liabilities Assets Bank B Liabilities
Assets
200 Liabilities
1000 Assets Liabilities
800
200
800 1000 800
800
● Assume the 800 loan is deposited in Bank B
● Total deposits in the economy are now 1800
● Given the reserve ratio of 20%:
♦ Bank B has to hold 160 in reserve
♦ It can loan 640

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 How Money Supply is
Measured
●There is no single, obvious place to draw the line
between “money” and “near money.”

●M1 (standard monies) = coins and paper money

in circulation and demand deposits
●M2 (money equivalents) = M1 + money
market instruments

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 How Money Supply is
Measured
●M3 (net performance approach) = PSC + GSC + FSC
●Private sector contribution
♦ Total loans granted – total private sector deposits
●Public sector or the government contribution
♦ Total government expenditures – total government
deposits
●Foreign sector contribution
♦ Total foreign loans – total foreign deposits

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 How Money Supply is
Measured
A. Consider the following currencies in an economy:

Coins P 200,000
Total private deposit P 600,000
Paper money P 800,000
Total government expenditures P 600,000
Demand deposit P 400,000
Total government deposits P 500,000
Money market P 200,000
Total foreign loans P 900,000
Total private loans P 800,000
Total foreign deposits P 300,000

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 How Money Supply is
Measured
QUESTIONS:

●How much is the supply of money using the

standard monies approach (M1)?

●How much is the supply of money using the money

equivalent approach (M2)?

●How much is the supply of money using the net

performance approach (M3)?

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 R.A 7653 : a constitutional provision
creating the Bangko Sentral ng
Pilipinas

●BSP is mandated to:

■ maintain domestic stability of Philippine peso and
its convertibility into foreign currencies
■ manage money supply or money aggregate at a
certain level
■ monitor tendencies of inflation and deflation

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 The Banking System

●How Banking Began

♦Fractional reserve banking began when
goldsmiths realized they could profitably lend
out a portion of the gold that had been
deposited with them for safekeeping.
♦The “Goldsmith Tale”

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 The Banking System

●Principles of Bank Management:

Profits versus Safety
♦To make a profit, a banker must take risks.
♦But because the business is risky, the same
banker must also emphasize safety.
♦The heart of banking is to be torn between the
two principles.

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