Professional Documents
Culture Documents
Money
Currency
Bonds 150
100
+ 50 + 50
Foreign assets 50
Total
Total 150
150
200 200
but Its liabilities also
its assets increase by rise because of the new
the value of the bonds currency it must issue to
it acquires pay for them.
Open-market operations
When the central bank buys bonds from the
public, it issues new currency to pay for
them. Both its assets and liabilities
(currency) rise. Money supply expands.
When the central bank sells bonds to the
public, it takes in their money as payment.
It reduces its liabilities (currency) as well
as its assets. Money supply contracts.
Suppose exporters and OFWs
exchange their dollars for pesos
BSP
BSPLIABILITIES
ASSETS
Currency
Bonds 150
100
+ 25
Foreign assets 50
+ 25
Total
Total 150
150
175 175
but Its liabilities also
CB assets increase by rise because of the new
the peso-value of the currency it must issue in
dollars it acquires exchange.
Exports and loans
When earners of foreign exchange (e.g.,
exporters) or borrowers of foreign loans
exchange their dollar proceeds for pesos, the
Central Bank effectively expands the currency:
foreign assets rise, liabilities increase.
When demanders of foreign-exchange buyers
exchange their pesos for dollars, the Central
Bank accepts reduces its foreign assets and
also reduces its liabilities. Money supply
contracts.
4.3 Interest rates and
money demand
Interest rates and bonds
Controlling the money supply will depend on
whether the Central Bank can persuade
the public to hold more or fewer bonds
(i.e., more or less currency) in their
portfolio.
This will depend on the rate of interest.
Interest rates and bonds
The interest rate i is the return on different forms of financial
wealth other than money.
E.g. debt (IOUs) issued by the government (T-bills) or by private corporations promise a
percentage annual return.
Hence i can also be defined as the cost of holding money
instead of these other assets.
Holding P100 in cash rather than a bond that promises
P110 a year from now means foregoing 10% per annum.
James, Inc.
Total
Total 150
150
200 200
but Its liabilities also
KB assets increase rise because it owes
by the value the depositor.
of the deposit
When the public deposits P50 with a KB
KB
KBLIABILITIES
ASSETS
Checking deposits
Cash in vault 200 110
Loans 90
Total
Total 200
200
The money-multiplier
So, both KB assets and liabilities increase by P50.
But if the required-reserve ratio is 1/5, the bank needs
to keep only 20% of the deposited amount.
So it needs only to keep P10 in the vault and can lend
out P40 by creating a checking account for the
borrower.
Suppose the P40 is deposited with the bank again (or
some other bank); then it need keep only P8 in the
vault and lend out P32, and so on
Initial deposit of Z and
required-reserve ratio of h
LendDeposit
out as CA
Round 1: Z (1 h)Z
Round 2: (1 h) (1Z h)(1 h)Z
Round 3: (1 h)2Z (1 h)3Z
Round N: (1 h)N (1
1
Z Zh)NZ
..
The money-multiplier
Let (1 h) = v. What is the total amount of current accounts
created from an original deposit of Z?
The answer is:
Z + vZ + v2Z + v3Z + = ZV,
where V = (1 + v + v2 + ) = (1 + v( 1 + v + v2 + ))
V = (1 + vV), or (1 v)V = 1
V = 1/(1 v) = 1/(1 1 + h) = 1/h.
So, ZV = Z/h; the initial cash deposit can support current
accounts equal to a multiple 1/h of itself.
The money-multiplier
Example: If the public deposits an original P100, and the
required-reserve ratio is 12%, the commercial banking
system can create checking accounts equal to a
maximum of
P100 0.12 = P100 8.33 = P833,
or credit equal to P733.
Obviously, if the BSP reduces the required-reserve ratio,
KBs could create even more credit and money supply.
So raising or lowering the required-reserve ratio is
another tool of monetary policy.
Another tool of the BSP
Sometimes it is inevitable that KBs run short of cash for their
depositors.
They can then borrow from the BSP at some interest rate,
called the rediscount rate, to pay off their depositors. This
reduces liabilities to depositors but increases liabilities to
the BSP. (So total liabilities remain the same.)
By doing this, KBs dont have to call in the loans they made to
borrowers.
But if the rediscount rate is high, KBs might find it better to call
in loans (or to be more conservative in lending). So a higher
rediscount rate reduces money supply.
Monetary tools of the BSP
To summarise, the tools the central bank can
use to control the money supply are:
1. open-market orperations;
2. changing the reserve-requirement of KBs;
3. changing the rediscount rate, or other rates at
which the KBs can borrow or lend money with
the BSP.
End of chapter