Review for Licensure Examination for Agriculturist ADEL S. LAURETO, Ph.D.

MACROECONOMICS

 is concerned with performance of the economy as a whole or with large sectors of it,
such as government, business firms, and households.
 it attempts to explain why the economy’s total output of goods and services fluctuates
overtime, giving the time to the business cycle with its accompanying upward and
downward movements in the unemployment and inflation rates.

The Circular – Flow Diagram

REVENUE SPENDING
Markets for
Goods &
G& S Services G&S
Sold Bought

FIRMS HOUSEHOLDS

Factors of Labor, Land

Production Markets for Capital
factors of
Production
WAGES, RENT, INCOME
PROFIT

1.1 NATIONAL INCOME ACCOUNTING

 it provides us with aggregate measures of what is happening in the economy.

There are at least three reasons why national income accounting is important:

1. It allows us to keep finger on the economic pulse of the nation.

2. By comparing national income accounts over a number of years, we can track the
long-run course of the economy and see whether it has grown, been steady, or
stagnated.
3. Information supplied by national income accounts provides a basis for formulating,and
applying public policies to improve the performance of the economy.
Two ways of measuring economy’s output:
1. Gross National Product (GNP)
2. Gross Domestic Product (GDP)
Both Measure the total market of all final goods and services product in the economy in
one year. They are closely related, differing only in how the “economy” is defined.

Gross National Product (of the Philippines)

 consists of the total output produced by land, labor, capital and entrepreneurial talent
supplied by Filipinos, whether these resources are located in the Philippines or abroad. It
is defined as the total market value of all final goods and services produced by a nation’s
economic resources over a given period of time.

Gross Domestic Product (of the Philippines)

 comprises the value of the total goods and services produced within the boundaries of
the Philippines, whether by Filipinos or foreign-supplied resources.

GDP = GNP – Net factor income from the rest of the world (NFIRW) (1)
Net factor income from the rest of the world (NFIRW)

 is the difference between the earnings of Filipinos from activities overseas and the
earnings of foreigners in the Philippines.
 if earnings of Filipinos from overseas activities exceeds those of the foreigners in the
Philippines then we can expect NFIRW to be positive. Consequently, GNP will be higher
than GDP, if the reverse is true then GNP will be lower than GDP.

 Approaches to GNP/GDP Measurement

1. The Final Expenditure Approach:

In this approach, the GNP/GDP is computed by getting the sum of the final
expenditures of the four major sectors of the economy. These major sectors include the
following:

a) Household – personal consumption expenditure (C)

b) Businesses – private domestic investment (I)
c) Government – government expenditures (G)
d) Foreign Sector – net exports (X-M)

To summarize, the GNP computed using the final expenditure approach is simply the sum of C, I,
G, and (X-M). This can be expressed mathematically as:
GNP/GDP = C + I + G + (X-M) (2)
2. The Factor Income Approach
The GNP is viewed as payments or income to the owners of all the inputs that contribute to its
production. This consists of wages (w), interests (i), rents (r), or profits (p). In addition, a portion is
provided for capital consumption allowance or depreciation and indirect business taxes. In
symbols:
GNP/GDP = NI + IBT + D (3)
where: NI = w + i + r + p
IBT = indirect business taxes net of subsidies
D = depreciation or capital consumption allowance
Components of National Income (NI) as found in the National Accounts of the Philippines:
a) compensation of employees (salaries and wages)
b) Net Operating Surplus is a composite of profits, rents, and interest

IBT account for items like taxes on the use and purchase of goods and services and grants
from government to firms.
Depreciation represents the consumption or the wear and tear of capital stock. It is added
because it is stated as the business expense.
3. Value-added Approach
In this approach, GNP/GDP is computed by adding the gross value-added of all the major
industries in the economy such as:
GNP/GDP = GVA1 + GVA2 + GVA3 + …….+ GVAn + IBT (4)
GNP/GDP = NNP + IBT (5)
where: NNP = net national product
1….n = industry 1 up to n
Value added is computed as the difference between the sales of the firm and its spending on
goods produced by other firms or
Value added = Sales – Purchases from other firms (6)
Why are the three approaches equivalent?
The equivalence between the approaches lies in the fact that each is just a different way of
viewing a transaction. For the equivalence of the income and expenditure approaches, it is
 sufficient to note that the “spending of one person is the income of another” (as illustrated in the
circular flow diagram).

GNP/GDP BY FINAL EXPENDITURE APPROACH (in million peso)

TYPE OF EXPENDITURE 2008 2009 2010
1. Household Final Consumption
Expenditure 5,739,592 5,993,427 6,442,033
2. Government Final Consumption Expenditure 681,893 791,403 875,291
3. Capital Formation 1,489,212 1,331,662 1,849,380
A. Fixed Capital 1,518,168 1,526,098 1,847,748
1. Construction 737,901 785,427 949,406
2. Durable Equipment 582,028 541,642 692,519
3. Breeding Stock &
Orchard Dev't 171,039 168,960 173,494
4. Intellectual Property Products 27,199 30,069 32,328
B. Changes in Inventories -28,955 -194,436 1,632
4. Exports 2,849,943 2,587,015 3,133,507
A. Exports of Goods 2,152,099 1,799,714 2,259,876
B. Exports of Services 697,845 787,301 873,632
5. Less : Imports 3,039,737 2,677,363 3,296,732
A. Imports of Goods 2,511,963 2,104,793 2,635,752
B. Imports of Services 527,774 572,570 660,980

GROSS DOMESTIC PRODUCT 7,720,903 8,026,143 9,003,480

Net Primary Income from the Rest of the World 2,055,282 2,626,323 2,992,597
GROSS NATIONAL INCOME 9,776,185 10,652,466 11,996,077
Source: National Statistical Coordination Board

GNP/GDP BY VALUE ADDED APPROACH (in million peso)

INDUSTRY 2008 2009 2010
1. AGRI., HUNTING, FORESTRY AND FISHING 1,022,515 1,049,874 1,108,718
2. INDUSTRY SECTOR 2,538,461 2,545,104 2,932,279
a. Mining & Quarrying 95,410 106,396 128,727
b. Manufacturing 1,760,890 1,706,391 1,930,779
c. Construction 419,402 460,426 551,230
d. Electricity, Gas and Water Supply 262,758 271,892 321,543
3. SERVICE SECTOR 4,159,928 4,431,165 4,962,483
a. Transport, Storage & Communication 548,856 561,093 586,197
b. Trade and Repair of Motor Vehicles,
Motorcycles Personal and Household Goods 1,316,070 1,359,500 1,563,786
c. Financial Intermediation 499,925 544,526 622,404
d. R. Estate, Renting & Business Activities 816,548 884,131 979,129
e. Public Administration & Defense;
Compulsory Social Security 285,860 323,605 372,304
f. Other Services 692,669 758,310 838,663

GROSS DOMESTIC PRODUCT 7,720,903 8,026,143 9,003,480

Net Primary Income from the Rest of the World 2,055,282 2,626,323 2,992,597
GROSS NATIONAL INCOME 9,776,185 10,652,466 11,996,077

Source: National Statistical Coordination Board

 Real and Nominal GNP (or GDP)

Nominal GNP/GDP

 measures the value of output in a given period in the prices of that period, or, as it is
sometimes put, in current pesos. Thus, 2010 nominal GNP measures the value of the
goods produced in 2010 at the market prices prevailing in 2010.
 changes from year to year for two reasons. First, the physical output of goods and
services changes and the second is that the market prices change.

Real GNP/GDP or GNP/GDP at constant prices

 measures changes in physical output in the economy between different time periods by
valuing all goods produced in the two periods at the same prices, or in constant pesos.
Calculated as follows:

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝑁𝑃/𝐺𝐷𝑃
Real GNP/GDP =
𝐺𝑁𝑃/𝐺𝐷𝑃
𝑥 100 (7)

𝑅𝑒𝑎𝑙 𝐺𝑁𝑃
Real GNP per capita/per capita GNP = (8)
𝑝𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛
PER CAPITA: GDP, GNP, and Personal Consumption Expenditure (in Peso)
TYPE OF EXPENDITURE 2008 2009 2010

A. Estimates in current pesos

1. GROSS DOMESTIC PRODUCT 85,319 86,972 95,736
2. GROSS NATIONAL INCOME 108,027 115,436 127,570
3. HOUSEHOLD FINAL CONSUMPTION
EXPENDITURE 63,425 64,953 68,502
B. Estimates in constant (2000) pesos
1. GROSS DOMESTIC PRODUCT 57,881 57,411 60,634
2. GROSS NATIONAL INCOME 72,832 75,744 80,420
3. HOUSEHOLD FINAL CONSUMPTION
EXPENDITURE 41,232 41,376 41,958
C. Population* 362 369 376
(million persons)
Source: National Statistical Coordination Board

 Problems of GNP (or GDP) Measurement

1. Some outputs are poorly measured because they are not traded in the market. Specific
example includes government services, nonmarket activities such as volunteer work, and do-it-
yourself activities in the home.
2. It is difficult to account correctly for improvements in the quality of goods. This has been the
case particularly for computers, whose quality has improved dramatically, which their price has
fallen sharply.
3. Some activities measured as adding to real GNP in fact represent the use of resources to
avoid or contain “bads” such as crime or risks to national security.

 Macroeconomic Equilibrium: Simple Income Determination

The economy is in equilibrium when : GNP (or Y) = C + I + G + X – M (9)

The left-hand side of the equation represents the level of aggregate supply (or income),
while the right-hand represents the level of aggregate demand.

If we assume an economy with no government and no external relations (no foreign

trade), then the economy is in equilibrium when

Y=C+I (10)
 Where: Y = national income

C = aggregate consumption

I = aggregate investment

The income received can be used in two ways: it can be spent on consumer goods (C),
or saved (S), S includes both personal and business savings. This can be indicated as:

Y=C+S (11)

Rearranging equations (10) and (11), we have : Y – C = I (12)

Y–C=S (13)

Therefore, S=I (14)

Another way of expressing the equilibrium condition is shown in equation (14) which
states that measured savings always equals measured investment.

1.2 CONSUMPTION, SAVINGS AND INVESTMENT

1. Consumption Function

It was Keynes who made the consumption function the basic element in the income-
expenditure approach to national income determination. This function is the principal building
block in the multiplier analysis. Assuming a linear relationship between consumption and
disposable income, the consumption function can be written as:

C = a + bYd, where: a>0, b<1. (15)

In this equation, a is the vertical intercept, b is the slope of the function, which is called
the marginal propensity to consume (MPC), and Yd is the residual after deducting taxes from
income that is, Yd = Y –T (16)

The savings function shows the relationship between savings and income. This can be
written as : S = Yd – C

S = Yd – (a + bYd)

S = - a + (1– b)Yd (17)

In this equation, -a is the negative vertical intercept and (1 - b) represents the marginal
propensity to save (MPS). Note that MPC + MPS = 1 or b + (1 – b) = 1. (18)

C C = a + bYd
O
N
S
U
M
20 S = - a + (1– b)Yd
P
T
I 45 0
O 0
N
- 20
NATIONAL INCOME

Figure 1. The Consumption and Savings Function

The Average Propensity to Consume (APC)

 is the function of total income spent on consumption, C/Yd.

 The slope of a line drawn from the origin to any point on the consumption function.
obviously, the average propensity to save S/Yd is equal to 1 – (C/Yd).

The Marginal Propensity to Consume (MPC)

 relates a change in consumption ∆C, to the change in income, ∆/Yd, that causes it.
 is symbolically indicated as ∆C/∆Yd, it is equal to the slope of the consumption function
– dC/dYd.

 Simple Income Determination

Assuming that there are no government and external relations (that is, no foreign trade),
the GNP can be written as: Y=C+I (19)

Assume further that the consumption function is : C = 20 + 4/5 Yd (20)

And investment (I) = P 100 billion

Substituting equation (19) with equation (20) yields:

Y = 20 + 4/5 Yd + 100; Yd = Y (21)

Simplifying: Y – 4/5 Yd = 120

1/5 Y = 120

National Income : Y = 600 billion

Aggregate Consumption : C = 20 + 4/5 (600) = 480 billion

Aggregate saving : S = Y – C = 600 – 480 = 20 billion

Condition for equilibrium : I = S

20 billion = 20 billion

The concept of Investment Multiplier

The investment multiplier measures the increase in the equilibrium income for 1 peso
increase in investment spending. Mathematically, this represented by the following:

1
Investment Multiplier (αI) = (22)
1 −𝑀𝑃𝐶
1
Since, MPC = b (in the consumption function) , then, αI = (23)
1−𝑏
In the present consumption function : C= 20 + 4/5 Yd, the investment multiplier is equal
to 5. This means that as investment increases by 100, equilibrium income increases by 500.

 Factors affecting the level of aggregate consumption

a. taste and preferences g. Someone else’s expenditure patterns

b. Current and expected process h. Liquid assets

c. The availability of goods i. Debts

d. Advertising j. Real wealth

e. Interest rates k. Availability of consumer installment credit

f. Expected future earnings

1.3 INFLATION AND UNEMPLOYMENT

Inflation – refers to the increase in the general price level (GP) or prices as a whole.
Analyst typically examine inflation by observing the inflation rate using the following formula:

𝑮𝑷 (𝒑𝒆𝒓𝒊𝒐𝒅 𝒕)– 𝑮𝑷 (𝒑𝒆𝒓𝒊𝒐𝒅 𝒕−𝟏)

Inflation rate = 𝑮𝑷 (𝒑𝒆𝒓𝒊𝒐𝒅 𝒕−𝟏)
𝒙 𝟏𝟎𝟎 (24)

Two measures of the inflation rate:

a) headline inflation rate – uses the Consumer Price Index (CPI) as a measure of the general
price level. This the traditional and most common index inflation.

𝐶𝑃𝐼 (𝑝𝑒𝑟𝑖𝑜𝑑 𝑡)−𝐶𝑃𝐼 (𝑝𝑒𝑟𝑖𝑜𝑑 𝑡−1)

Headline Inflation rate = 𝑥 100 (25)
𝐶𝑃𝐼 (𝑝𝑒𝑟𝑖𝑜𝑑 𝑡−1)

b) core inflation rate – uses a price index which excludes the prices of commodities that are
deemed to be volatile. It is viewed as a better measure of the long term movements in prices for
a country.

Consumers Price Index – is a weighted average of the cost of a bundle goods that is purchased
by a typical household. it is an index which expresses the costs of a bundle of goods in one year
relative to the base year.

Consumer Price Index

Headline Inflation Rate
2006 = 100
2012
February 128.1 2.7
January 128.1 4.0
2011 126.2 4.8
2010 120.4 3.8
Source: National Statistics Office (NSO).

Unemployment implies that the productive resources are not being fully utilized in the
economy. A person is considered unemployed if he/she is a member of the labor force but is
not engaged in work or business. The term “labor force” refers to people of a certain age (15
years and above in the case of the Philippines) who are:

a) working or are engaged in the business; and

b) not working or engaged in business but are actively looking for work
Since the population of the Philippines and consequently its labor force changes from
year to year, it is sometimes difficult to assess the employment situation by simply looking at the
number of people who do not have work. To overcome this difficulty, we examine an indicator
known as the unemployment rate (u) which can be calculated using the following formula:

𝐔𝐧𝐞𝐦𝐩𝐥𝐨𝐲𝐞𝐝 𝐦𝐞𝐦𝐛𝐞𝐫𝐬 𝐨𝐟 𝐭𝐡𝐞 𝐥𝐚𝐛𝐨𝐫 𝐟𝐨𝐫𝐜𝐞

u= 𝐱 𝟏𝟎𝟎 (26)
𝐓𝐨𝐭𝐚𝐥 𝐥𝐚𝐛𝐨𝐫 𝐟𝐨𝐫𝐜𝐞

It is important to note that not all employed persons are able to work as much as they
want . Some of these people may be working less than the standard 40-hour workweek. Others
may be working 40 hours a week but still want to work longer hours. These employed
individuals are considered underemployed. The proportion of employed individuals who want
to work longer hours is known as underemployment rate which can be calculated using the
following formula:

𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑜𝑝𝑙𝑒 𝑢𝑛𝑑𝑒𝑟𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑

Underemployment rate = 𝑥 100 (27)
𝑇𝑜𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡
 Household Population 15 Years Old and Over by Employment Status
Labor Force Employment Unemployment Underemployment
Period
Participation Rate Rate (In %) Rate (In %) Rate (In %)
Jan 2012 64.3 92.8 7.2 18.8
Jan 2011 63.7 92.6 7.4 19.4
Jan 2010 64.5 92.7 7.3 19.7
Jan 2009 63.3 92.3 7.7 18.2
Source: National Statistics Office (NSO).

 Effects of Unemployment and Inflation

1. Debtors and profit-earners benefit from inflation. Creditors and fixed income individuals on the
other hand, lose from inflation.

2. People who put their money in savings accounts in a bank can earn say, 6% per year interest
income. If prices rose by greater than 10%, their savings are reduced in value. If interest income
is not higher than the rate of price inflation, savers with fixed interest income suffer from
inflation, the real value of this saving falls.

 Measures to address inflation

The control of inflation depends on the management or control of the level of the: a) money
supply and credit, b) government spending; and c) taxation

The Philippine Financial System

CENTRAL BANK

Expanded Banking Institutions Non-Bank Financial Non-Bank Thrift

Commercial Banks
Institutions
(Universal Banks) Mutual
Building &
Investment Loan
Houses Associatio
n
Commercial Thrift Rural Specialized Finance
Banks Banks Banks Banks Companies Non-Stock
SLAs
DBP Securities
Stock SLAs Dealers/Brokers
s Aside from being Pawnshops
commercial banks these Savings & LBP
banks can also undertake Mortgage
the functions of thrift banks, Banks Fund Managers
PAB
non-bank financial institutions
& non-bank thrift institutions Private Lending Investors
Development
Banks
Private Insurance
Companies

Specialized Non-Banks

Source: Economics by Sicat G.P. GSIS SSS ACA MIDC

 1.4 MONETARY AND FISCAL POLICY

1.4.1 Monetary Policy

 The Central Bank

 is principally an institution designed to regulate the monetary and financial systems. It
has a policy abroad which serves as the monetary authority.
 provides the staff to supervise and implement policies enunciated by monetary
authority.

1.4.2 Fiscal Policy

The “fiscal system” is a collective term for the combined operation of public expenditure,
taxation and debt. The term “public finance” refers in particular to the subject of financing public
expenditures. Public finance is approximately a study of the fiscal system. The fiscal operations
are reflected in the government budget.

 Component of national budget

1. Total Revenue : Taxes in income, Taxes in international trade, Exercise and sales tax, other taxes and
non-tax revenue

2. Current Operation Expenditures: Personal Services, Maintenance, Interest, Transfer to corporations

and Allotment local governmen

3. Capital Outlays: Infrastructure, Other capital, Capitalization (equity contributions), and Net lending

4.Overall deficit: Foreign borrowing (net), Borrowing from banking system, and Other domestic
borrowing

5. Current operation surplus

Business Cycle

Business cycles refer to long periods of changes in economic activities in contrast with
seasonal cycles, which are reflected in the changes that may be observed within a given year.
The business cycle has four distinct phases namely: expansion phase, peak phase, recession
phase and depression phase.

peak

B C
U O peak
S N
I D
N I recession
E T
S I
trough
S O
N
expansion trough

Figure 3. Business Cycle

TIME
 MONEY, CENTRAL BANKING, AND MONETARY POLICY
Assets – are defined as anything which serves as means to store value over a period of time.

 real assets – are physical in nature like lands, houses, cars, DVD players, computers,
phone gadgets, etc.

 financial assets – are financial in nature like savings or time deposits, as well as
shares of stocks in a particular company.

Money – refers to all things that are generally acceptable as means of payment for goods and
services (medium of exchange) and as payment of debts (standard or deferred payment).

Functions of Money

1. Unit of Account

 means that the value of goods and services are expressed or quoted with the use of a
single item, usually a country’s currency.
 In our case we have the Philippine peso (Php). In the United States, it is the US dollar
while in the United Kingdom, it is the pound sterling. Each country, therefore, uses its
own monetary unit in the domestic market to express the value of its commodities and
services.

2. Medium of Exchange

 means that you can trade your money in the market and in return, get the goods and
services that you want to purchase because money is generally accepted as a means of
payment.
 this is what happens when you pay Php 15 in exchange for a small glass of taho from a
vendor or when you give the supermarket cashier Php 500 in exchange for a small bag
of groceries. Schools accept your cash or checks as payment for tuition fees.

 double coincidence of wants (in the case of barter system) – a requirement in barter
wherein trading will take place only if one individual finds another who is willing to accept
exactly the same kind and amount of goods and services that the first is willing to
exchange and vice-versa.

3. Store of Value or Standard of deferred payment

 means that you can keep or save money now and then spend it at a future date because
its capacity to buy the same amount of goods and services is not lost or diminished over
time.
 the underlying assumption here is that inflation will not occur in between time periods of
saving and spending the money.

The Demand for Money

The demand is a demand for real balances or purchasing power, i.e., the amount of
goods and services that the money can buy.

Motives for holding money according to John Maynard Keynes

1. Transaction Motive – refers to the holding of money to enable people and firms to pay off
their daily transactions such as paying for electricity and telephone bills, house rent, education,
food, clothing, etc. Business firms need money to pay their workers, utilities, raw materials,
office space, and so on. Thus, the transactions motive may be related to the function of money
as a medium of exchange.

2. Precautionary Motive – for contingency purposes or unforeseen circumstances. This motive

may be related to the function of money as a store of value.
3. Speculative or portfolio allocation motive – also related to the role of money as a store of
value. It refers to the holding of money for the purpose of taking advantage of market
opportunities such as buying shares of stocks in a company or investing in bonds or treasury
bills and other assets that yield additional earnings for the households and firms.

The Supply of Money

The supply of money may be viewed in terms of monetary aggregates:

M1 – refers to the narrow definition of money which consists of currency (e.g., paper bills and
coins) in circulation plus demand or checking deposits;
M2 – refers to M1 plus savings and small time deposits;

M3 – refers to money supply, peso savings, time deposits, plus deposit substitutes of money
generating banks, and negotiable order of withdrawal (NOW) accounts.
RM – is the reserve money which represents liabilities of the BSP to the public sector in the
form of currency in circulation and to the banking sector in the form of cash reserves.

Money supply is determined by the behavior of three principal actors – the public, the
banks, and the BSP.

THE ROLE OF MONETARY INSTITUTIONS IN THE ECONOMY

The Bangko Sentral ng Pilipinas

 was established on June 15, 1948 by virtue of Republic Act No. 265 or R.A. 265
 its objectives were: (a) to maintain the monetary stability in the country; (b) to preserve
the international value of the peso ; and (c) to promote rising level of production,
employment, and real income in the Philippines.
 it was also established to play a major role in the rehabilitation of the economy
devastated by World War II. Its role then shifted to being a participant in the international
economy which had generally experienced growth from the 1950s to the 1970s.
 on June 14, 1993, through R.A. 7653, the Bangko Sentral ng Piipinas (BSP) was put as
a central monetary authority. Its primary objectives were still to maintain price stability (or
fight inflation) conducive to a balanced and sustainable growth of the economy as well
as promote and maintain monetary stability and convertibility of the peso.
 likewise called the lender of the last resort from whom ailing or bankrupt banks can
borrow if other banks in the financial system cannot provide them with the necessary
funds.

Financial Institutions

The Philippine financial or monetary system is a network of markets and institutions that
transfer funds from individuals and groups who save money to individuals and groups who want
to borrow money. These financial institutions consist of banks and non-bank institutions.

Banks are classified as:

1. universal and commercial banks;

2. rural banks; and
3. thrift banks which include savings and mortgage banks, private development banks,
microfinance institutions, stock savings, and loan associations

Examples of non-banks institutions:

1. contractual savings institutions such as insurance companies and pension funds like the
Social Security System (SSS) and Government Service Insurance System (GSIS);

2. investment institutions like mutual funds and finance companies; and

3. securities market institutions which comprises securities brokers and dealers, lending
investors, and organized exchanges like the Philippine Stock Exchange (PSE). In a strict sense,
they are not financial intermediaries because they do not acquire funds from savers in order to
lend to borrowers, but they assist financial markets in channeling funds from savers to
borrowers and in providing risk-sharing, liquidity, and information services to savers and
borrowers.

In 2003, credit card companies were also included, as well as pawnshops to the list of
non-bank financial institutions since they give credit to individuals who turn in their valuables
(e.g., jewelry) in exchange and then retrieve such valuables when they have raised the mount
that they borrowed plus the interest charged.

Financial or monetary institutions are important in an economy because of the following major
functions or roles:

1. they allocate or channel savings efficiently from savers to borrowers;

2. they provide information, liquidity, and risk-sharing services;
3. they provide flexibility and divisibility of funds for the users and sources of these funds; and
4. they are essential for ensuing capital formation and economic growth.

SIMPLE MONEY CREATION

Multiple expansions of deposits

When you deposit one peso, only a fraction of that peso is kept by the bank in its vault
for safekeeping. The rest of the money is made available for loans and other investments. In
very simple terms, banks earn a spread (i.e., profit) from the difference in the deposit rates that
they give to their depositors and the lending rates that they charge to their borrowers.

Reserve Requirement – the percentage of deposits that banks are mandated by BSP to keep as
reserves for the purpose of servicing day-to-day withdrawals and unexpected heavy withdrawals
during bank runs or in times of other emergencies. Thus , if the BSP mandates a reserve
requirement of 10%, this means that 10 centavos for every one peso deposit must be kept in
bank’s vault for safekeeping and 90 centavos will be available for lending. In certain
circumstances, banks may deem it necessary to keep in their vaults an additional percentage of
their deposits which is above the reserve requirement. This is called excess reserves.

The level of reserve requirement set by the BSP varies from time to time depending on
the performance of the economy and the subsequent monetary policy that must be adopted.
Historically, though, reserve requirements averaged between 10% - 13%.

The simple money creation process Reserve requirement: 10%

FUNDS
REQUIRED
BANK DEPOSIT AVAILABLE FOR
RESERVE
LENDING
9,000
Zest 10,000 1,000
8,100
Golden Rule 9,100 900
7,290
Patience 8,100 810
.
. . .
.
. . .
.
. . .
24,390
Total, first 3 banks 27,100 2,710
.
. . .
.
. . .
.
. . .
65,610
Other banks’ turn 72,900 7,290
Grand Total 100,000 10,000 90,000

The reason behind this multiple expansion of deposits from an initial 10,000 pesos to a
grand sum of 100,000 pesos is the concept of the money multiplier. Money multiplier is the
factor by which money supply will change given a change in monetary base, or in our example,
given a change in deposits. The money multiplier which is denoted by mm, is just a reciprocal of
the reserve requirement, rr as shown by the following formula:

mm = 1/rr
 From our example, with a reserve requirement of 10% (or 0.10), the money multiplier will
be equal to 10. Notice that if the reserve requirement increases, say from 10% to 20%, the
money multiplier will decrease from 10 to 5. This inverse requirement has an important
implication on the money supply. The change in money supply (M) is equal to the product of the
money multiplier (mm) and the change in monetary base (MB) or deposits. Hence,

M = mm ∙ MB

The change in money supply due to the expansion of deposits brought about by a
system of banks is equal to 10 multiplied by 10,000 pesos or 100,000 pesos. Given the same
initial deposit of 10,000 pesos, if the reserve requirement increases to 29%, the money
multiplier is reduced to 5 and the change in money supply will now only be 50,000 pesos
instead of 100,000 pesos. Thus, the reserve requirement is an important tool used by the BSP
in controlling money supply.

MONETARY POLICY

Why is there a need to control money supply?

 In layman’s terms, we do not wish to have too much or too little money circulating in the
economy.
 If there is too much money held by households and firms, then this can result in
overspending and if manufacturers of goods and services cannot catch up with the
increase in consumption, inflation can occur since the only way by which firms can
allocate the remaining inventories is to sell these at higher prices.
 If there is too little money circulating, then, unemployment of resources can occur
because firms will not be receiving as much revenues to pay off their costs of operations
and they will be forced to cut down on their production.

Monetary Policy can either be: a) expansionary (increasing money supply) or b) contractionary
(decreasing money supply). The following is a list of important instruments of monetary control
used by the Monetary Board of the BSP:

1. Reserve Requirement – is the percentage of deposits that the banks are mandated to keep in
their vaults for safekeeping by the BSP

 if the BSP wants to contract money supply (or “mop up excess liquidity”) tyen it has to
increase the reserve requirement. This implies that lesser funds will then be available for
lending.
 if BSP wants to expand money supply, then it has to lower or decrease the reserve
requirement. This means that a smaller fraction of deposits will be kept in the banks’
vaults and more funds will be available for lending.

2. Rediscount Rate – is the interest charged by BSP to banks who wish to borrow from it

 to contract money supply, the BSP has to increase the rediscount rate to discourage
banks from borrowing at higher interest rates. This way less funds will be available for
lending.
 as an expansionary monetary policy, the BSP must decrease the rediscount rate to
encourage banks to borrow funds from it thereby allowing more money to be available
for lending.

3. Open Market Operations – refer to the buying and selling of government securities by the
BSP

 open market purchase, means buying of government securities (e.g., bonds) from
private individuals or firms by BSP. If BSP wants to to expand money supply, it has to
 engage in open market purchase of securities – BSP gets the public’s bonds and “gives”
them money or cash in return.
 open market sale refers to the sale of government securities to private individuals or
firms by the BSP. If BSP wants to contract money supply, it has to engage in open
market sale of government securities. This way the BSP sells securities to the public and
“gets” their money in return. Hence, lesser money will be circulating in the economy
because people are holding bonds instead of cash.

INTERNATIONAL MONETARY INSTITUTIONS AND THE PHILIPPINE MONETARY SYSTEM

As World War II was about to end in 195, representatives of allied governments

gathered at Bretton Woods, New Hampshire, to design a new international monetary and
financial system. To help countries in short run economic adjustment, the International
Monetary Fund was created to:

1. act as lender of last resort;

2. encourage domestic economic policies consistent with foreign exchange rate stability; and
3. monitor the financial activities of member countries

The IMF is composed of more than 100 member counries. It is like a “hyper” bank whose
depositors and borrowers are the banks of the world.

World Bank was also created to:

1. make long-term loans available for to developing countries;

2. give loans for infrastructure to aid economic development; and
3. sell bonds in international capital market to raise loanable funds

It is composed of five institutions: the International Development Association (IDA) which

is the “concessional lending window” of the World Bank; the International Bank for
Reconstruction and Development (IBRD); the International Finance Corporation (IFC); the
Multilateral Investment Guarantee Agency (MIGA) and the International Center for Settlement of
Investment Disputes (ICSID). The World Bank also encourages member countries to give
priority to programs for good governance and transparency, environmental protection, and
sustainable development. These programs are envisioned as potential solutions to eradicate
poverty in member nations.

As member country of IMF, the Philippines has been receiving loans from this
international institution and has likewise been monitored particularly with respect to the
domestic economic policies that government and related financial institutions engage in affect
exchange rate stability. Our country has also been a recipient of various World Bank long-term
loans to aid us in economic development.