Central Banking

Module 1

by
Mr. Nilo N. Iglesias, CPA, REA, MBA
Conceptual Framework
of Central Banking
Conceptual Framework of Central
Banking
“ That shall function and operate as
an independent and accountable
body corporate in the discharge of its
mandated responsibilities to provide
policy directions in the area of
money, banking and credit”.
Conceptual Framework of Central
Banking
“ … to maintain price stability conducive
to a balanced and sustainable growth of
the economy …”

“…to promote and maintain monetary

stability and the convertibility of the
peso”.
Conceptual Framework of Central
Banking

What do we associate
Central Bank with?
Money
 Definition of Money

• By function
• By Composition or
“Nearness” to cash (Liquidity)
 By Function

1. Unit or Measure of Value

2. Medium of Exchange
3. Store of Value
4. Standard of Deferred Payment
 By Function
Unit or Measure of Value
A sort of common denominator
through which the exchange value of all
goods and services can be expressed
without any difficulty.
Medium of Exchange
Intermediary instrument use to
facilitate the sale, purchase or trade
goods between parties.
 By Function
Store of Value
It can be saved and exchanged a
later time and be predictably useful
when retrieved.
Standard of Deferred Payment
A function of being widely accepted
way to value a debt, thereby allowing
goods and services to be acquired now
and paid for in the future.
 Righteous Cycle of Money

• Money can perform its 4 functions

because it is acceptable
• And it is acceptable because it
performs its functions
 By Composition or Nearness to Cash
1. M1- Narrow Money
a) Currency in Circulation
b) Demand Deposits
2. M2 – Broad Money
a) M1 +
b) Quasi-Money
i. Savings Deposits
ii. Time Deposits
 By Composition or Nearness to Cash
3. M3 – Domestic Liquidity
a) M2 +
b) Deposits substitutes ( securities other
than shares)
4. M4 – Total Liquidity
a) M3 +
b) Transferable and other deposits in
foreign currency (FCDs) by residents
 Money by ORIGIN
1. Money of Domestic Origin
Loans and credit of the central bank and
banks (net domestic assets)
2. Money of foreign origin (inflows abroad)
Exports proceeds, remittances, foreign
direct investments, foreign financial
portfolio investments, loan proceeds
 Money Supply Theories
1. Quantity Velocity Approach
• Price level show changes because of the changes in
quantity (demand and supply) of money.
• Quantity of money comprises cash (M) and its
velocity (V).
• The velocity of circulation of cash depends on
various factors, such as frequency of transactions,
trade volume, type of business conditions, price
levels, and borrowing and lending policies.
• An increase or decrease in the price level would
occur due to increase or decrease in the quantity of
money.
• Hence, the price level and quantity of money are
directly proportional to each other.
 Money Supply Theories
2. Cash Balances Approach
• This approach is a modification of quantity approach and
is based on national income approach and considers the
concept of liquidity.
• The value of the money depends on the demand and
supply of cash balances for a given period of time.
• The demand for money is not only dependent on the
quantity of goods and services that would be exchanged,
but also on the time period at which the transaction
takes place.
• Thus, if an economy individuals are habitual for holding
money for overcoming their expenditure for a longer
period of time, then the demand for money would be
more.
• In such a case, only small part of income is held and the
rest of the amount is invested.
 Money Supply Theories
3. Income - Expenditure Approach
• This approach view that changes in price level are
brought by the changes in national income rather then
quantity of money.
• The approach is based on the concept that the main
reason for the change in the price level is the changes
that occur in the aggregate income or expenditure.
• Change in the quantity of money can only bring changes
in the price level when it can change the aggregate
expenditure with respect to the supply output.
• If there is no rise in the expenditure, then the demand for
goods would not rise and consequently, the price level
would not increase.
• In case, the expenditure rises but the supply of output is
fairly elastic, then also the price level would not rise.
Demand, Supply and Equilibrium in the Money Market
Changes in money demand or money supply are related to
changes in the bond market, in interest rates, in aggregate
demand, and in real GDP and the price level.
Demand for Money
• In deciding how much money to hold, people make a
choice about how to hold their wealth.
• For a given amount of wealth, the answer will
depend on the relative costs and benefits of holding
money versus other assets.
• The demand for money is the relationship between
the quantity of money people want to hold and the
factors that determine that quantity.
Demand, Supply and Equilibrium in the Money Market

Motives for Holding Money

• People hold their assets as money so that they can
purchase goods and services for every transactions
and to pay for goods and services they anticipate
buying.
• The money people hold for contingencies represents
precautionary demand for money that include bank
account balances kept for possible house repairs,
health-care needs.
• People also hold money for speculative purposes
such as investment in securities.
Demand, Supply and Equilibrium in the Money Market

Interest Rates and the Demand for Money

• The quantity of money people hold for transactions
and to satisfy precautionary and speculative demand
is likely vary with the interest rates they can earn
from alternative assets such as bonds.
• When interest rates rise relative to the rates that can
be earned on money deposits, people hold less
money.
• When interest rates fall, people hold more money.
• The logic of these conclusions about the money
people hold and interest rates depends on the
people’s motive for holding money.
Demand, Supply and Equilibrium in the Money Market

Other Determinants of the Demand for Money

• Real GDP - A household with an income of P50,000
per month is likely to demand a larger quantity of
money than a household with an income of P5,000
per month. That relationship suggests that money is
a normal good: as income increases, people demand
more money at each interest rate, and as income
falls, they demand less.
• The Price Level – The higher the price level, the more
money is required to purchase a given quantity of
goods and services. All other things unchanged, the
higher the price level, the grater the demand for
money.
Demand, Supply and Equilibrium in the Money Market

Other Determinants of the Demand for Money

• Expectations –
✓The speculative demand for money is based on
expectations about bond prices.
✓All other things unchanged, if people expect bond
prices to fall, they will increase their demand for
money.
✓Expectations about future price levels also affect the
demand for money.
✓The expectation of a higher price level means that
people expect money they are holding to fall in value.
✓Given that expectation, they are likely to hold less of it
in anticipation of a jump in prices.
Demand, Supply and Equilibrium in the Money Market

Other Determinants of the Demand for Money

• Transfer Costs –
✓For a given level of expenditures, reducing the quantity of
money demanded requires more frequent transfers
between nonmoney and money deposits.
✓As the cost of transfers rises, some consumers will choose
to make fewer of them.
✓They will therefore increase the quantity of money they
demand.
✓In general, the demand for money will increase as it
becomes more expensive to transfer between money and
nonmoney accounts.
✓The demand for money will fall if transfer costs decline.
Demand, Supply and Equilibrium in the Money Market

Other Determinants of the Demand for Money

• Preferences –
✓Some people place a value on having a considerable
amount of money on hand.
✓For others, this may not be important.
✓Household attitudes toward risk are another aspects of
preferences that affect money demand.
✓As seen, bonds pay higher interest rates than money
deposits, but holding bonds entails a risk that bonds prices
might fall and issuer will default in payment.
✓People’s attitudes about trade-off between risk and yields
affect the degree to which they hold their wealth as
money.
Demand, Supply and Equilibrium in the Money Market
Equilibrium in the Market for Money
• The money market is the interaction among institutions
through which money supplied to individual, firms and
other institutions that demand money.
• Money market equilibrium occurs at the interest rate at
which the quantity of money demanded is equal to the
quantity of money supplied.
• A shift in money demand or supply (effects of changes
in the Money Market) will lead to a change in the
equilibrium interest rate.
• Decrease in transfer cost, change in expectations, or
change in preferences, we can see interest rates also
changes.
 What have we learned?
• We learned the Conceptual Framework of Central
Banking and what do we associate with it.
• We explained the definition of money by functions
and by composition.
• We recognized the origin of money.
• We explained the money supply theories.
• We described the relationship of demand, supply
and the equilibrium in the money market.

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