FinMar-1-MONEY-AND-INTEREST

MONEY AND INTEREST
Topic 1
ROLE OF MONEY IN THE ECONOMY
Money is an item or commodity that is

generally accepted as a means of payment
for goods and services or for repayment of
debt and that serves as an asset to its
holder.
ROLE OF MONEY IN THE ECONOMY
In the Philippines, the Bangko Sentral ng

Pilipinas controls the country’s economy.
While government still print and guarantee
money, in today’s world it no longer needs
to exist as physical bills or coins, but can be
found also in digital form.
Characteristics and Key Functions of
Money
1. Store of value
2. Items of worth
3. Means of exchange
4. Unit of Account
5. Standard of deferred payment
Money
1. Store of value
Money acts as a means by which people can store their
wealth for future use. It must not, be perishable, and it
helps if it is of a practical size that can be stored and
transported easily.
2. Item of worth
Most money originally has an intrinsic value, such as
that of the precious metal that was used to make a coin.
This in itself acted as some guarantee that it would be
accepted.
Money
3. Means of exchange
It must be possible to exchange money freely and widely for
goods, and its value should be as stable as possible. It helps if
that value is easily divisible and if there are sufficient
denominations so change can be given.
4. Unit of account
Money can be used to record wealth possessed, traded or
spent personally and nationally. It helps if only one recognized
authority issued money. If anybody could issue it, then trust in
its value would disappear.
Money
5. Standard of deferred payment

Money is also useful because of its ability to
serve as a standard of deferred payment. Money
can facilitate exchange at a given point by
providing a medium of exchange and unit of
account.
THE EVOLUTION OF MONEY
People originally traded commodities with each

other in a process known as bartering. The
value of each good traded could be debated,
however, and money evolved as a practical
solution to the complexities of bartering
hundreds of different things.
Barter
Barter involves the exchange of an item for one

or more of a perceived equal value.
Barter
Advantages of barter
1. Fosters strong links between partners.
2. Physical goods are exchanged.
Disadvantages of barter
1. Bothe parties must want what other offers.
2. Hard to establish a set value on items.
3. Goods may not be easily divisible.
4. Large-scale transactions can be difficult.
THE SUPPLY AND DEMAND FOR MONEY
Money facilitates the flow of resources in the circular

model of macro economy. Not enough money will
slow down the economy, and too much money can
cause inflation because of higher price levels.
Monitoring supply and demand of money is vital for

the economy’s central bank’s monetary policy, which
aims to stabilize price levels and to support
economic growth.
The Money Supply: Key Measures
M1. The narrowest measure of the money

supply. It includes currency in circulation held
by the nonbank public, demand deposits, other
checkable deposits, and traveler’s checks.M1
refers primarily to money used as a medium of
exchange.
M2. In addition to M1, this measure includes

money held in savings deposits, money market
deposit accounts, non-institutional money
market mutual funds and other short-term
money market assets. M2 refers primarily to
money used as a store of value.
M3. In addition to M2, this measure includes the

financial institutions. M3 refers primarily to
money used as a unit of account.
L. In addition to M3, this measure includes

liquid and near-liquid assets.
The Demand of Money: Sources
1. Transaction demand. Money demanded for

day-to-day payments through balances held by
households and firms. This kind of demand
varies with GDP; it does not depend on the rate
of interest.
2. Precautionary demand. Money demanded as a

result of unanticipated payments. This kind of
demand varies with GDP.
3. Speculative demand. Money demanded

because of expectations about interest rates
in the future. This means that people will
decide to expand their money balances and
hold off on bond purchases if they expect
interest rates to rise.
The rate of interest is the price paid in the money

market for the use of money. The rate is a percentage of
the amount borrowed.
Changes in factors will lead to shifts in the demand
curve for money. Increases in the economy’s price level
will increase the demand for money. If the real GDP
increases, the demand for money increases because of
the higher demand for products. When banks develop
new money products that allow easier, low-cost
withdrawal, the demand for money will decrease
The Impact of Money
The BSP’s monetary policy has an immediate,

short-run impact on the economy. Higher
interest rates will decrease investment because
it becomes more expensive to borrow money,
and will also decrease consumption because
consumers will tend to, save more as interest
rate returns increase.
The Impact of Money
In addition, a higher Philippine interest rates

increase the demand for pesos on the foreign
exchange markets, the higher pesos will
decrease exports by making them increasingly
expensive. This means that real GDP growth
and the inflation rate slow when the BSP raises
the interest rate. The reverse occurs when the
interest rate is lowered.
The Impact of Money
Monetary policy can be applied in the short-run

when the economy faces an inflationary gap. The
BSP may then pursue a policy to avoid inflation by
decreasing the quantity of money and raising the
interest rate. The higher interest rate decreases
investment, consumption and, net export. This
decrease in aggregate demand will decrease, real
GDP and lower the price level. In the macroeconomic
long-run, prices are assumed to be fully flexible, and
this will move real GDP toward potential GDP.
The Impact of Money
If the economy is at its long-run equilibrium and

the BSP increases the money supply, it will
increase aggregate demand. Consequently, the
price level goes up, as well as the real GDP.
THE QUANTITY THEORY OF MONEY
The quantity theory of money holds that changes in the

money supply (MS) directly influences the economy’s
price level. This theory follows from the equation of
exchange:
MxV=PxY
Where: M = quantity of money
V = velocity of money
P = price level
Y = real GDP
THE QUANTITY THEORY OF MONEY
The quantity theory of money states that

velocity is not affected by the quantity of money
and is considered constant. Additionally, real
GDP is not affected by quantity of money and is
considered constant.
Time Value of Money
Interest is defined as the cost of using money

over time. Interest represents the time value of
money.
The concept of present value is based on the

notion that a peso of cash flow paid one year
from now is less valuable than a peso paid now.
INTEREST RATES
The interest rates link the future to the

present.it allows individuals to
evaluate the present value of future
income and costs.
INTEREST RATES
In the viewpoint of a borrower, the interest rate

is the premium that must be paid in order to
acquire goods sooner and pay them later. From
the lender’s viewpoint, interest is a reward for
supplying other with current purchasing power.
The interest rates allow the lender to calculate
the future benefit of extending a loan or saving
funds today.
Determination of Interest Rates
Interest rates are determined by the demand for

and supply of loanable funds.
The amount of funds demanded by borrowers is

inversely related to the interest rate.
Higher interest rates give people willing to save

the ability to purchase more goods in the future
in exchange for sacrificing current consumption.
As the interest rate rises, the quantity of funds

supplied to the loanable funds market will
increase.
1. Investment funds. The rate of interest balances the

demand for funds and the supply of funds. Household
delay consumption by saving depending on their time
preference and the rate of interest. Saving percentages
can differ significantly from one nation to another.
2. Liquid assets. Households and businesses may have

reasons to hold assets in liquid form. Because borrowers
require cash in the long-term, they are willing to
compensate lenders for giving up liquidity.
The Nominal or Money Rate versus the
Real Rate of Interest
Real rate of interest rate refers to the interest rate

before taking into account the effect of inflation.
Inflation reduces the purchasing power of a loan’s
principal. When inflation is common, lenders will
recognize they are repaid with pesos of less
purchasing power. Unless they are compensated for
the anticipated inflation by an upward adjustment in
the interest rate, they will supply fewer funds to the
loanable funds market.
The Nominal or Money Rate versus the
Real Rate of Interest
A nominal rate of interest is an interest rate

adjusted for inflation reflecting the real cost of
funds to the borrower and the yield to the
lender. It reflects the real burden to borrowers
and payoff to lenders in terms of their being
able to buy goods and services.
INTEREST RATES AND RISK
Interest rates in the loanable funds market will

differ mainly because of differences in the risks
associated with the loans. The risk also
increases with the duration of the loan. The
longer the time period of the loan, the more
likely it is that the borrower’s ability to repay
the loan will deteriorate or market conditions
changes in an highly unfavorable manner.
Three components of money interest
1. Pure-interest component – is the real price one

must pay for earlier availability
2. Inflationary premium component – reflects the
expectation that the loan will be repaid with
pesos of less purchasing power as a result of
inflation.
3. Risk-premium component – reflects the
probability of default.
Three components of money interest
NR = RR + IP + RP
Where: NR – nominal rate

RR – real rate
IP – inflation premium
RP – risk premiums
Impact of Changing Interest Rates
Higher interest rates make loans less affordable,

while high interest on savings accounts
encourages savings rather than spending. As
spending decreases, so does the economy, with
demand for goods and services decreasing.
Impact of Changing Interest Rates
Lower interest rates make it cheaper to take out

loans, and hence to spend more money. Saving
becomes less attractive as interest rates are low.
With more money in circulation, demand for
products and services rise, stimulating
businesses and increasing employment.
End of Topic 1

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MONEY AND INTEREST

Money is an item or commodity that is

In the Philippines, the Bangko Sentral ng

5. Standard of deferred payment

People originally traded commodities with each

Barter involves the exchange of an item for one

Money facilitates the flow of resources in the circular

Monitoring supply and demand of money is vital for

M1. The narrowest measure of the money

M2. In addition to M1, this measure includes

M3. In addition to M2, this measure includes the

L. In addition to M3, this measure includes

1. Transaction demand. Money demanded for

2. Precautionary demand. Money demanded as a

3. Speculative demand. Money demanded

The rate of interest is the price paid in the money

The BSP’s monetary policy has an immediate,

In addition, a higher Philippine interest rates

Monetary policy can be applied in the short-run

If the economy is at its long-run equilibrium and

The quantity theory of money holds that changes in the

The quantity theory of money states that

Interest is defined as the cost of using money

The concept of present value is based on the

The interest rates link the future to the

In the viewpoint of a borrower, the interest rate

Interest rates are determined by the demand for

The amount of funds demanded by borrowers is

Higher interest rates give people willing to save

As the interest rate rises, the quantity of funds

1. Investment funds. The rate of interest balances the

2. Liquid assets. Households and businesses may have

Real rate of interest rate refers to the interest rate

A nominal rate of interest is an interest rate

Interest rates in the loanable funds market will

1. Pure-interest component – is the real price one

Where: NR – nominal rate

Higher interest rates make loans less affordable,

Lower interest rates make it cheaper to take out

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