Investment, Financial Systems and Monetary Policy

Economics 101 C. Arcilla

In this lecture. . .
We explain interest rates and money Money, money, money
function and brief history

We discover the economic role of the financial system

Financial Markets Financial intermediaries Central bank and monetary policy

Interest Monetary Policy

Investment
purchase of new capital goods
machines, equipment, buildings, or houses vs. financial investment (purchase of new financial assets)

money vs. capital

capital as value put into the production process to yield more value money as a store of value

Money, money, money

Money is the set of assets in an economy that people regularly use to buy goods and services from other people. Is the most liquid form of asset
Liquidity is the ease with which an asset can be converted into the economys medium of exchange.

Money, money, money

Functions of money As medium of exchange - an item that buyers give to sellers when they want to purchase goods and services. It can be anything that is readily acceptable as payment. A store of value is an item that people can use to transfer purchasing power from the present to the future. A unit of account is the yardstick people use to post prices and record debts.

A brief history of money

Barter an economy without money Commodity money takes the form of a commodity with intrinsic value.
Cattle, stone, cigarrettes, olive oil, beer/wine, gold, silver.

Fiat money is used as money because of government decree.

It does not have intrinsic value. Coins, currency, check deposits. E-money

Components of the Money Supply

Transactions/Narrow Money (M1)
money used for transactions currency (coins and paper currency) checks

Broad/ Near money (M2)

Money that cannot be used for all transactions M1 plus savings accounts and time-deposits

Financial system
The financial system is composed of financial institutions that coordinate the actions of savers and borrowers.
to match one persons saving with another persons investment.

Financial institutions can be grouped into two different categories: financial markets and financial intermediaries.

FINANCIAL INSTITUTIONS
Financial markets are the institutions through which savers can directly provide funds to borrowers.
Stock Market Bond Market

Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers.
Banks Mutual Funds

Financial Markets
The Bond Market
A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond.

The Stock Market

IOU

Stock represents a claim to partial ownership in a firm and is therefore, a claim to the profits that the firm makes. The most important stock exchanges Philippine Stock Exchange, New York Stock Exchange, the American Stock Exchange, and NASDAQ.

The Philippine Stock Exchange

The Philippine Stock Exchange, Inc. ("PSE" or the "Exchange") is a private organization that provides and ensures a fair, efficient, transparent and orderly market for the buying and selling of securities. PSE traces its roots from the country's two former bourses: the Manila Stock Exchange ("MSE") and the Makati Stock Exchange ("MkSE"). In December 23, 1992 the MSE and MkSE were unified to become the PSE. At present, PSE maintains two trading floors -- one in Makati City and another in its head office in Pasig City, where trading participants trade daily - from 9:30 a.m. to
12:10 p.m. except Saturdays, Sundays, legal holidays.

PHISIX
PSE Composite Index, commonly known previously as the PHISIX and presently as the PSEi, is the main stock market index of the Philippine Stock Exchange. The PSEi is the most watched index on the PSE and is also home to 30 major Philippine companies listed on the PSE. It is also one of the indicators on the general state of the Philippine economy.

Other Important Financial Markets

NASDAQ
The National Association of Securities Dealers Automated Quotations is an American stock exchange. Largest US electronic screen-based equity securities trading market. With approximately 3,800 companies and corporations, it has more trading volume per hour than any other stock exchange in the world

Other Important Financial Markets

Dow
Dow Jones Industrial Average also referred to as the Industrial Average, the Dow Jones, the Dow 30, or simply as the Dow; one of several stock market indices, created by Wall Street Journal editor and Dow Jones & Company cofounder Charles Dow. gauges the performance of the US industrial sector the average is computed by the stock prices of 30 of the largest and most widely held public companies in the US

Financial Intermediaries
Banks
is a business institution that accepts deposits from savers and use the deposits to make loans to borrowers for interest. help create a medium of exchange by allowing people to write checks against their deposits.

Financial Intermediaries
Mutual Funds
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors and invests it in stocks, bonds, shortterm money market instruments, and/or other securities. has a fund manager that trades the pooled money on a regular basis. The net proceeds or losses are then typically distributed to the investors annually. They allow people with small amounts of money to easily diversify.

Financial Intermediaries
Other Financial Institutions
Credit unions Pension funds Insurance companies Loan sharks Pawn shops

The banks of all banks

Bangko Sentral ng Pilipinas
restructured from the Central Bank of the Philippines in 1994 Its primary objective is to maintain price stability. Regulates the supply of money, and affects the level of interest rate

BSP's Organizational Structure (as of October 2008)

BSP governance
The Monetary Board exercises the powers and functions of the BSP, such as the conduct of monetary policy and supervision of the financial system. Its chairman is the BSP Governor, with five full-time members from the private sector and one member from the Cabinet. The Governor is the chief executive officer of the BSP and is required to direct and supervise the operations and internal administration of the BSP.

BSP Governance
A deputy governor heads each of the BSP's operating sector as follows:
Monetary Stability Sector takes charge of the formulation and implementation of the BSPs monetary policy, including serving the banking needs of all banks through accepting deposits, servicing withdrawals and extending credit through the rediscounting facility. Supervision and Examination Sector enforces and monitors compliance to banking laws to promote a sound and healthy banking system. Resource Management Sector serves the human, financial and physical resource needs of the BSP

BSP Policy Tools of Monetary regulation

Fiat money authority
To finance government borrowing during times of insufficient revenue, central bank prints new money. Like issuing a checking account to government. While this the easiest method to finance government expenditures, it most likely causes inflation. Government issues bonds to borrow new money from the general public.

Open market operation Discount rates

The central bank lends money to commercial banks for greater liquidity at a discount rate (interest rates to banks). BSP as the lender of last resort. Raising the reserve requirement reduces money supply through the deposit multiplier.

Reserve requirements

Interest
payment made to lender and cost of borrowing money Usually measured in peso per peso borrowed per year, or interest rate

Pt + n = (1 + i)n Pt
where P = principal n = maturity i = simple interest rate, annually

Nominal vs. Real i

Nominal i (money interest rate)
yield in peso per peso borrowed per year

Real i
measures the quantity of goods we get tomorrow for goods forgone today. used in highly inflationary periods

Real i = nominal i inflation rate

Interest rates
At the micro level, interest rates is affected by: terms or maturity
Length of time a loan is to be paid

risk
higher risk loans means higher interest

Liquidity
Loans on illiquid assets have higher interest

Administrative costs
higher administrative costs have higher interest

Central bank policies

Central bank determines the general level of interest rates

The Demand for Money

The Demand for Money, Md Levels of transaction demand
Depends on nominal income, $Y An increase in nominal income increases the demand for money.

Interest rates, i
An increase in interest rates decreases the demand for money.

Md = $Y L(i)
+ -

The Effects of an Increase in Nominal Income on the Demand for Money

Interest rate

i
1. An increase in the nominal
3

income . . .

Money demand
Money demand

Quantity of Money

Copyright 2004 South-Western

The Supply of Money

Determined by the BSP and commercial banks Our discussion will first assume no commercial banks for simplicity So, the supply of money is BSP sole responsibility through its monetary policy.

Money Supply, Money Demand, and the interest rate

Interest rate, i Money supply

Money demand 0

Quantity fixed by the BSP

Quantity of Money
Copyright 2004 South-Western

What happens to i
Increase in money supply (monetary injection)
Say because of a change in monetary policy

The Effects of Monetary Injection

Interest rate

MS1

MS2

1
1. An increase in the money supply . . . A

2. . . . decreases the interest rate

i1
i2

B Money demand M1 M2

Quantity of Money

Copyright 2004 South-Western

Next meeting. . .
Monetary policy of the BSP The macroeconomic role of commercial banks Money multiplier