A theory of money needs a proper place for financial intermediaries.

Financial institutions are

able to create money, for example by lending to businesses and home buyers, and accepting
deposits backed by those loans. The amount of money created by financial intermediaries
depends crucially on the health of the banking system and on the presence of pro table investment opportunities in the economy.1
Since intermediation involves taking on some risk, a negative shock to productive agents also
hits intermediary balance sheets. Intermediaries' individually optimal response is to lend less
and accept fewer deposits. Hence, the amount of inside money in the economy shrinks.
Because money serves as a store of value and the total demand for money changes little, the
value of outside money increases inducing deflationary pressure. More specifically, in our model
the economy moves between two cases: in one case the financial sector is well capitalized: it
can overcome financial frictions and is able to channel funds from less productive agents to
more productive agents. Financial institutions through their monitoring role enable productive
agents to issue debt and equity claims. The value of money is low. In contrast in the other case,
in which the financial sector is undercapitalized, funds can only be transferred via outside
money. Whenever an agent becomes productive he buys capital goods from less productive
households using his outside money, and vice versa. That is, outside money allows de facto
some implicit borrowing and lending. In this case outside money steps in for the missing
financial intermediation. The value of money is high. A negative shock to productive agents
lowers the financial sector's risk bearing capacity and hence brings us closer to the second case
with high value of money. First, they are exposed to productivity shocks on the asset side of the
balance sheet. Second, their liabilities grow after a negative shock as the value of money
increases. This amplies the initial shock even further, absent appropriate monetary policy.2

Monetary policy is the monitoring and control of money supply by a central bank, such as the Federal Reserve
Board in the United States of America, and the Bangko Sentral ng Pilipinas in the Philippines. This is used by the
government to be able to control inflation, and stabilize currency. Monetary Policy is considered to be one of the two
ways that the government can influence the economy the other one being Fiscal Policy (which makes use of
government spending, and taxes). Monetary Policy is generally the process by which the central bank, or
3
government controls the supply and availability of money, the cost of money, and the rate of interest.
Money supply indicators are often found to contain necessary information for predicting future behavior of prices and
assessing economic activity. Moreover, these are used by economists to confirm their expectations and help forecast
trends in consumer price inflation. One can predict, to a certain extent, the government's intentions in regulating the
economy and the consequences that result from it. For example, the government may opt to increase money
supply to stimulate the economy or the government may opt to decrease money supply to control a possible mishap
in the economy. These indicators tell whether to increase or decrease the supply. Measures that include not only
4
money but other liquid assets are called money aggregates under the name M1, M2, M3, etc.

M1: Narrow Money

1

http://scholar.princeton.edu/sites/default/files/i_theory_0.pdf
Ibid.
3
http://en.wikipedia.org/wiki/Monetary_policy_of_the_Philippines
4
Ibid.
2

M1 includes currency in circulation. It is the base measurement of the money supply and includes cash in the hands
of the public, both bills and coins, plus peso demand deposits, tourists checks from non-bank issuers, and other
checkable deposits. Basically, these are funds readily available for spending. Adjusted M1 is calculated by summing
all the components mentioned above.

M2: Broad Money

This is termed broad money because M2 includes a broader set of financial assets held principally by households.
This contains all of M1 plus peso saving deposits (money market deposit accounts), time deposits and balances in
retail money market mutual funds.

M3: Broad Money Liabilities

Broad Money Liabilities include M2 plus money substitutes such as promissory notes and commercial papers.

M4: Liquidity Money

These include M3 plus transferable deposits, treasury bills and deposits held in foreign currency deposits. Almost all
short-term, highly liquid assets will be included in this measure.

Open Market Operations consist of repurchase and reverse repurchase transactions, outright transactions, and
foreign exchange swaps.

Repurchase and Reverse Repurchase

This is carried out through the Repurchase Facility and Reverse Purchase Facility of the Bangko Sentral ng
Pilipinas. In Purchase transactions, the Bangko Sentral buys government securities with a dedication to sell
it back at a specified future date, and at a predetermined interest rate. The BSPs payment increases
reserve balances and expands the monetary supply in the Philippines. On the other hand, in Reverse
Repurchase, the government acts as the seller, and works to decrease the liquidity of money. These
transactions usually have maturities ranging from overnight to one month.

Outright Transactions
Unlike the repurchase or reverse repurchase, there is no clear intent by the government to reverse the
action of their selling/buying of monetary securities. Thus, this transaction creates a more permanent effect
on our monetary supply. When the BSP buys securities, it pays for them by directly crediting its
counterpartys Demand Deposit Account with the BSP. The reverse is done upon the selling of securities.

Foreign Exchange Swaps

This refers to the actual exchange of two currencies at a specific date, at a rate agreed upon the deal date
and the reverse exchange of the currencies at a farther ate in the future, also at an interest rate agreed on
.
deal date

What do banks do?

Banks are financial intermediaries.6

- Savers need a safe place to store their money and borrowers need credit; banks try to earn
profit serving both groups.
5
6

Ibid.
http://business.baylor.edu/tom_kelly/2307ch14.htm

Savers generally want to save relatively small amounts. Borrowers want to borrow relatively
larger amounts. Savers and borrowers also want to save and borrow for varying lengths of
time. Banks repackage the small savings into larger amounts for borrowers and offer
desirable durations to borrowers and savers.

2. Banks cope with Asymmetric Information.

Asymmetric Information Unequal information known by each party to a transaction; borrowers
usually have more information about their credit-worthiness than do lenders
-

Lenders must identify borrowers who are willing to pay interest and are able to pay back
their loans.
Borrowers know more about their ability to pay back than lenders. Borrowers have incentive
not to report history correctly if it is bad.
Because of experience and expertise, banks are better able to deal with asymmetric
information.

The economy is more efficient because banks develop expertise in evaluating borrowers,
structuring loans, and enforcing loan contracts.
3. Banks reduce risk through diversification.
By developing a diversified portfolio of assets rather than lending funds to a single borrower,
banks reduce the risk to each saver.7

MADAAAAM, IM SO SORRY FOR THE LATE SUBMISSION. O.o

Ibid.