Financial Markets

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Central Banking and Monetary Policy

Week002: CENTRAL BANKING

AND MONETARY POLICY

• Central Banks: origins, structures, and functions

• International Monetary Policies and Strategies
• Supply and demand: monetary base

CENTRAL BANKS
Central banks are government-run agencies tasked with overseeing and controlling
commercial banking, money in circulation, interest rates, and currencies. The concept of
central banking has been around for millennia, with the earliest institutions opening in
China around a millennium ago, along with the first paper money issuance. The central
bank institution has progressed and grown over the years and decades of its existence to
reach the current stage of modern banking systems.
Central banks are among the most important and carefully watched policy-making
institutions in the world. They usually bear primary responsibility for accomplishing
macroeconomic goals through monetary policy.
Central banks are also the financial system's first line of defense against financial
turbulence and turmoil. Central banks, unlike other public institutions, have the ability to
create an unlimited amount of money either by issuing currency or, more importantly, by
crediting commercial bank accounts held with them. The central banks are the lifeblood of
a country's financial system, providing final settlement for the vast majority of financial
and non-financial transactions that occur every day.
According to the International Monetary Fund (IMF), central banks play a crucial role in
maintaining economic and financial stability. They use monetary policy to keep inflation
low and stable. Central banks have stretched their arms to deal with financial stability
threats and unpredictable exchange rates during the global financial crisis. To achieve their
goals, central banks require a complete policy framework. The efficiency of central bank
policies is improved by operational methods that are tailored to each country's
circumstances.

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Aside from these responsibilities, most central banks are responsible for overseeing
commercial banks and other major financial institutions. Central banks also provide a wide
range of financial services to financial institutions, commercial banks, governments, and, on
occasion, other central banks.
According to Samuelson, "Every central bank serves a single purpose. Its goal is to maintain
control over the economy, money supply, and credit." "The core definition of a central bank
is a banking system in which a single bank has either a total or residuary monopoly of note
issue," Vera Smith stated.
In addition, "a central bank may be characterized as an entity responsible with overseeing
the increase and contraction of the volume of money in the interest of general public
welfare," according to Kent.
"A Central Bank is the bank in any country to which has been given the function of
managing the volume of currency and credit in that country," according to the Bank of
International Settlements.

ORIGINS OF CENTRAL BANKS

In 1668, the Riksbank of Sweden was established, which was the first central bank. Later,
the most prominent of the central banks, the Bank of England, was established; the was
bank known as the Old Lady of Threadneedle Street and was commissioned in 1694 as a
private bank to function as the government’s bank and to help the government with its
financing, particularly during times of war. In time, it happens to be a bankers’ bank a bank
to other banks. The other commercial banks held balances with the Bank of England, and
the bank provided liquidity to them during times of pressure. This unique function came to
be known as the lender of last resort function.
As we know of it today, the monetary policy was not fully considered during this period
and came to be added to the list of central bank functions much later. In the early days of
central banking, the monetary system was a commodity gold standard. The amount of
money in circulation and interest rates were ruled by the workings of the gold standard.
There was limited coverage for the central bank's monetary authority to chase a goal apart
from the stability of the value of its currency in connection to gold. Chasing central banks'
goals today, price stability and, in some cases, high levels of employment was not fully
projected and would have required leaving this fixed-exchange-rate regime. Meanwhile,
central banks were introduced in other countries globally. For example, the Banque de
France was established in 1800, and also the Bank of Japan in 1882 was created. Central
banks were found to be beneficial for holding the government's fund and helping the
Government issuing and servicing its debt. The United States, on the other hand, was a
latecomer to central banking. The Federal Reserve, the Fed, was not created until 1913 and

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did not operate until 1914. Nonetheless, the Fed has become the leading central bank in the
world over the century since its establishment.

MAJOR FUNCTIONS OF CENTRAL BANK

The central bank does not transact directly with the general public. It performs its
functions through the help of various financial institutions, particularly commercial banks.
The central bank is responsible for protecting the financial stability and economic
development of a country. Aside from this, the central bank also plays a significant role in
avoiding cyclical fluctuations by directing money supply in the market. As stated by
Hawtrey, a central bank should mainly be the “lender of last resort.”
On the other hand, economists understand that maintaining the monetary standard's
stability is the vital function of central banking. The central bank's functions are largely
divided into two parts; these are traditional functions and developmental functions.
Central banks were certainly playing a vital role in building and developing a nation’s
economy. Below are the central bank's main traditional functions, if not all but common in
most countries worldwide.
• Bank of Issue
• Banker, agent, and adviser to government
• Custodian of Cash Reserves
• Custodian of Foreign Balance
• Lender of Last Resort
• Clearing House
• Controller of Credit
• Protection of Depositor’s Interest

TRADITIONAL FUNCTIONS
• Bank of Issue
In today's world, each country's central bank has a monopoly on note issuance. The central
bank's currency notes are acknowledged as unlimited legal tender throughout the country.
In the interests of uniformity, elasticity, better control, supervision, and simplicity, the
central bank has been given exclusive control over note-issuance. It will also deal with the
possibility of individual banks over-issuing.
As a result, central banks control the country's currency as well as the entire money supply
circulating throughout the economy. The central bank is required to hold gold, silver, or
other assets as collateral for the notes issued. The system for issuing notes differs from the
one used in the United States.

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➢ People’s confidence in the currency is maintained.

➢ The supply is adjusted to demand in the economy.
Therefore, keeping in mind the aims of uniformity, safety, elasticity, and security, the
system of note-issue has been changing from time to time.

• Banker, Agent, and Adviser to the Government

The Central bank, in general, performs the role of banker, agent, and adviser to the
government. The central bank acts as the government's bank because it is more suitable
and economical to the government and because of the direct connection between public
finance monetary affairs.
It originates and receives payments on behalf of the government as its primary banker. It
provides the government with short-term loans to help it overcome economic issues or
fund projects. On behalf of the government, it issues public loans and manages public debts.
After disbursements and remittances, it maintains the government's banking accounts and
balances. It advises the government on all monetary and economic affairs and dealings in
its capacity as an adviser to the government. Where majority exchange control is in place,
the central bank also acts as an agent for the government.
• Custodian of Cash Reserves
All commercial banks in a country maintain a part of their cash balances as deposits with
the central bank, which may be on account of convention or legal obligation. It can be
drawn during busy seasons and payback during relaxed seasons. Some of these balances
are used for clearing purposes. Other member banks look to it for direction, help, and
guidance in a time of need.
It has an impact on the member banks' cash reserve centralization. Any nation's banking
system benefits greatly from the concentration of currency reserves in the central bank. If
the same amount were shared across the numerous banks, centralized cash reserves could
at least serve as the foundation of a large and more elastic lending structure.
It is understandable that when bank reserves are pooled in one institution that is also
charged with safeguarding the national economic interest, such reserves can be used to the
fullest extent possible, and most effectively during periods of seasonal stress, financial
crises, or general emergencies. The centralization of cash reserves is beneficial to the
economy in terms of their use, as well as increased elasticity and liquidity of the banking
system and of the financial system as a whole.
• Custodian of Foreign Balances
The management of the gold standard, or if the country is on the gold standard, is reserved
to the central bank in order to maintain exchange rate stability.

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Central banks have been securing gold and foreign currencies as reserve note-issue since
World War I, and achieving an unfavourable balance of payment with other countries, if
there is one. The central bank's job is to keep the government's currency rate constant and
to administer exchange controls and other restrictions imposed by the government. As a
result, it becomes a guardian of the country's international currency reserves or foreign
balances.
• Lender of Last Resort
The central bank is also known as the lender of last resort because it can offer cash to its
member banks to help them increase their cash reserves by rediscounting first-class bills in
the event of a crisis or panic that leads to a bank run, or when there is seasonal stress.
Member banks can also make advances on the central bank's sanctioned short-term
securities to add to their cash balances as quickly as possible.
This type of facility, which allows them to convert their assets into cash at a moment's
notice, is extremely beneficial to them and improves the banking and credit system's
economy, flexibility, and liquidity. As a result, by acting as lender of last resort, the central
bank assumes responsible for meeting all reasonable requests for accommodation made by
commercial banks during a crisis.
According to De Kock, the central bank's lending of last resort function provides better
liquidity and elasticity to the entire credit structure of the country. According to Hawtrey,
the central bank's important role as lender of last resort is to compensate for cash
shortages among competing banks.

• Clearing House
Central bank also serves as a clearing house for the settlement of accounts of commercial
banks. A clearing house is an organization where common claims of banks on one another
are being offset, and the payment makes a settlement of the difference. The central bank is
a bankers' bank, holds the cash balances of commercial banks, and as such, it becomes easy
for the member banks to adjust or settle their claims against one another through the
central bank.
For example, there are two banks that draw cheques on each other. Suppose bank A has
due to it ₱3,000 from bank B and has to pay ₱4,000 to B. At the clearinghouse, mutual
claims are offset, and bank A pays the balance of ₱ 1,000 to B, and the account is settled.
Clearing house role of the central bank leads to a good deal of economy in cash, and much
of labor and inconvenience are evaded.

• Controller of Credit
Controlling or adjusting commercial bank loans is widely regarded as the central bank's
most important responsibility. Commercial banks created a lot of credit, which led to

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inflation in some circumstances. The most major causes of business instabilities are the
expansion or contraction of currency and credit. As a result, the necessity for credit control
is essential. It usually stems from the reality that money and credit are crucial in
determining income, output, and employment levels.
The basic job of a central bank, according to most economists and bankers, is to control and
modify credit. It is the function that encompasses the most essential piece of the puzzle,
one that raises problems about central banking policy and through which virtually all other
functions are merged and made to serve a common goal. As a result, the central bank is
known as a credit controller because of the supervision it exercises over commercial banks'
deposits.
• Protection of Depositors Interests
The central bank has to oversee the functioning of commercial banks so as to protect the
interest of the depositors and guarantee the development of banking on sound lines.
Therefore, the enterprise of banking has been acknowledged as a public service,
necessitating legislative safeguards to avoid bank failures.
The legislation was enacted to allow the central bank to inspect commercial banks in order
to maintain a sound banking system, which consists of strong individual units with
sufficient financial resources operating under the right management in accordance with
banking laws and regulations, as well as public and national interests
DEVELOPMENTAL FUNCTIONS
This refers to the functions that are connected to the promotion of the banking system and
economic development of the country. These are not obligatory functions of the central
bank.

• Developing specialized financial institutions

Refers to the central bank's primary responsibilities for a country's economic development.
The central bank established institutions to meet the credit needs of agricultural and other
rural businesses. These are referred to as specialized or dedicated institutions since they
cater to specific economic areas.

• Influencing money market and capital market

This means that the central bank assists in the regulation of financial markets' money
market and capital market transactions in short- and long-term credit, with the central
bank insuring the country's economic growth through management of these markets'
operations.
• Collecting statistical data

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The central bank collects and analyzes data on the banking, currency, and foreign exchange
positions of a country. Researchers, policymakers, and economists will find the data
extremely useful. These data can be used to develop various policies and make macro-level
judgments.

MONETARY POLICY
Central banks play an important role in monetary policy, ensuring price stability, low and
stable inflation, and assisting in the management of economic instability. The policy
frameworks within which central banks operate have undergone significant changes in
recent years.
Targeting inflation became the fundamental framework for monetary policy in the late
1980s. The central banks of Canada, Europe, the United Kingdom, New Zealand, and other
nations have set an explicit inflation target. Many low-income nations are likewise shifting
away from targeting a monetary aggregate that gauges the total amount of money in
circulation and toward an inflation-targeting strategy.
Monetary policy is implemented by central banks through adjusting the supply of money,
mostly through open market operations. A central bank, for example, could cut its money
supply by selling government bonds under a sale and repurchase arrangement and taking
money from commercial banks. Short-term interest rates are influenced by open market
operations, which in turn affect longer-term rates and total economic activity. The
monetary transmission mechanism in most nations, particularly low-income countries, is
not as successful as it is in wealthy economies. Countries must build a framework that
allows the central bank to target short-term interest rates before transitioning from
monetary to inflation targeting.
Following the global financial crisis, central banks in major economies eased monetary
policy by lowering interest rates until short-term rates were almost zero, limiting the
ability to slash policy rates even more, for example. With the risk of deflation increasing,
central banks employ unconventional monetary measures, such as purchasing long-term
bonds, to further cut long-term rates and relax monetary conditions, particularly in the
United States, the United Kingdom, the euro region, and Japan. Short-term rates have even
gone negative or below zero in several central banks.
Monetary policy also part of the central banks' variety of tools. The term monetary policy
denotes the central bank's activities to achieve control over the countries' monetary supply
within the country. The central bank can make decisions based on the economy's state,
adopt an expansionary policy or a contractionary policy, whereby money supply is
influenced through multiple methods.
In the time of economic slowdown, it is the central bank's regular choice to consider
adopting an expansionary policy. To start with, the monetary base is expanded, and

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interest rates are reduced. The purpose of the expansionary policy is that money is more
widely available to both banks and companies so that growth and development can be
boosted and sustained. The results targeted are an increase in the gross domestic product
(GDP) and a shrinking of the unemployment rate.
At times, following the era of rapid economic expansion, the economy heats up. Before that
occurs, or in the worst-case scenario when this happens, the Fed went to the adoption of a
contractionary policy. In doing that, the central bank reduces the monetary base and
increases the main interest rates. As a result, excess capital becomes scarcer or minimal,
and a higher premium is imposed on lending. Due to the smaller scale circulation of funds,
the economy is bound to launch a slowdown. During the contraction period, the GDP is
expected to slow down, and the rate of unemployment is expected to increase.

Foreign exchange regimes and policies

The selection of a monetary framework is intertwined with the selection of an exchange
rate regime. In comparison to a country with a more flexible exchange rate, a country with
a fixed exchange rate will have a smaller range for autonomous monetary policy. Although
some governments do not regulate the exchange rate, they do attempt to manage its level,
which may result in a price stability trade-off. An effective inflation-targeting system is
supported by a completely flexible exchange rate regime.

Macro-prudential policy
The global financial crisis demonstrated that countries must use dedicated finance policies
to manage financial system risks. Many central banks with a financial stability mandate
have improved their financial stability functions, particularly by adopting macroprudential
policy frameworks. To work successfully, macroprudential policy requires a strong
institutional framework. Because they have the competence and capability to examine
systemic risk, central banks are well-positioned to implement macroprudential policy.
Furthermore, they are frequently self-sufficient and autonomous. The macro-prudential
mission has been delegated to the central bank or a specific committee inside the central
bank in many nations.
Regardless of the model utilized to implement macro-prudential policy, the institutional
architecture must be strong enough to withstand criticism from the financial industry and
political forces, as well as conduct macro-prudential policy credibility and accountability. It
necessitates ensuring that policymakers are given clear objectives and the necessary
legislative authority, as well as encouraging cooperation among other supervisory and
regulatory bodies. To operationalize this new policy role by mapping an analysis of
systemic risks into macro-prudential policy action, a specific policy framework or process
is required.

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Effects of monetary policy on output and prices

Macroeconomists generally believe that central bank monetary policy effects the price level
or the rate of inflation in the long run, but does nothing to enhance output or employment.
The amount of labor and capital in the economy, resource productivity, and the efficiency
with which markets generate resources determine the latter. Other governmental policies,
such as those that help workers increase their skills or market flexibility, will boost output
and employment in the long run. The practically universal agreement that monetary policy
can influence these variables in the short and middle terms, despite its inability to
influence output and employment in the long run, is also noteworthy.
In normal conditions, an expansionary monetary policy will enhance aggregate demand
and, in the interim, push it to greater levels of output and employment, with little influence
on prices. However, the increased levels of output and employment will be reversed,
resulting in price increases. A contractionary monetary policy, on the other hand, will limit
aggregate demand, resulting in lower output and employment, but this effect will be
reversed once prices begin to relax.

The Goal of Price Stability

In light of these connections, the central bank in several nations has been tasked with
achieving a pricing goal: price stability or low inflation. Price stability is the principal
purpose of monetary policy, as stated in the central bank's charter. The microeconomic role
of relative pricing is expected to work more efficiently in allocating resources in a context
of stable prices, and firms and people will be more motivated to save and invest in
productive initiatives, supporting a better level of overall output and well-being.
Various macroeconomic goals are listed as supplementary goals of monetary policy in
other conditions, such as maintaining employment or producing production in a
sustainable manner. This enables the central bank to follow a strategy that supports the
economy while maintaining price stability. It does not, however, allow the central bank to
pursue such a strategy if it would compromise the price objective.
When conversing prices in the macroeconomic context, we usually deal with indexes of
prices that are created to represent the average price of things purchased. The most
commonly monitored indexes of prices are those for the prices that consumers pay. There
are also indexes for some other types of prices, particularly the index for the gross
domestic product (GDP), which is related to the average price of a unit of GDP. This
includes the likes of consumption goods and services, investment, government, and net
exports.
Consumer price indexes are based primarily on expenditure patterns for what consumers
actually buy. Price watchers around the country collect each item's prices appearing in a
typical basket of goods and services purchased by households. These are pooled with data

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on the share of the household budget spent on each item's weight in the budget. Each
item's price is then multiplied by its weight, and each of these computations is summed.
That sum, corresponding to the average price in this period, is then divided by the average
price during a base period to get the index number. The index number for the period in
question gives the average level of prices in that period relative to the average price in the
base period. An index number of 1.23, sometimes expressed as 123, indicates that prices
are 23 percent, on average, higher than in the base period. If the index were to increase to
1.27 in the next period, we would say that inflation had been 3.25 percent (0.04/1.23).
Due to food and energy prices fluctuating a great deal, the Fed and many other central
banks tend to focus on consumer price inflation measures that eliminate these volatile
components, so‐called measures of core inflation. For instance, a big spike in food prices
due to a bad harvest may alter the underlying pace of price increases, especially as the run‐
up in food prices likely will be reversed before long. Eliminating these components can give
a better reading of underlying inflation trends.

MONETARY POLICIES AFFECT AGGREGATE DEMAND

Aggregate demand (AD) is a macroeconomic concept that depicts an economy's total
demand for goods and services. This number is frequently used as a gauge of economic
health or growth. Both fiscal and monetary policy can affect aggregate demand because
they affect the parameters that are used to calculate consumer spending on goods and
services, company capital spending, government spending on services and infrastructure
projects, exports, and imports. Multiple trilemmas are frequently the result of it.
Fiscal policy affects aggregate demand through variations in government spending and
changes in taxation. Those factors impact employment and household income, which then
impact household spending and investment.
Monetary policy influence the money supply in an economy, which affects interest rates
and the inflation rate. It also impacts corporate expansion, net exports, employment, the
cost of debt, and the relative cost of consumption versus savings, all of which can directly
or indirectly affect aggregate demand.

The Formula for Aggregate Demand

To understand how monetary and policy influences aggregate demand, it's necessary to
first understand how aggregate demand (AD) is computed, which follows the same method
used to calculate GDP:
AD = C + I + G + (X – M)
Where:

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C=Consumer spending on goods and services

I=Investment spending on business capital goods
G=Government spending on public goods and services
X=Exports
M=Imports

Fiscal policy regulates government spending and tax rates. Expansionary fiscal policy,
normally enacted in response to recessions or employment blows, improves government
spending in infrastructure projects, education, and unemployment benefits.
Keynesian economics stated that these programs could avoid a negative shift in aggregate
demand by steadying employment among government employees and people involved
with stimulating industries. The theory is that prolonged unemployment benefits help to
stabilize the consumption and investment of individuals who become unemployed in times
of recession. This is similar to the theory that states that the contractionary fiscal policy can
be used to lessen government spending and sovereign debt or correct out-of-control
growth driven by rapid inflation and asset bubbles. In connection to the formula for
aggregate demand, the fiscal policy directly influences the government expenditure
component and indirectly impacts the consumption and investment component.
Central banks implement monetary policy by manipulating the money supply in an
economy. The money supply affects interest rates and inflation, both of which are major
determinants of employment, cost of capital, and consumption level. The expansionary
monetary policy involves a central bank either buying Treasury notes, reducing interest
rates on loans to banks, or decreasing the reserve requirement. All of these actions improve
the money supply and lead to lower interest rates.
This generates incentives for banks to loan and companies to borrow. Debt-funded
business expansion can completely affect consumer spending and investment through
employment, thus increasing aggregate demand. Expansionary monetary policy also
normally makes consumption highly attractive relative to savings. Exporters take
advantage of inflation as their products become relatively cheaper for consumers in other
economies.
The contractionary monetary policy is implemented to stop the exceptionally high inflation
rates or regulate expansionary policy effects. Narrowing the money supply discourages
business expansion and consumer spending and negatively affects exporters, reducing
aggregate demand.

Central Banks Can Increase or Decrease Money Supply

To enhance or decrease the amount of money in the financial system, central banks employ
a variety of methods. Monetary policy is the term used to describe these acts. While the
Federal Reserve Board, also known as the Fed or the central bank, has the authority to

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print paper currency at its discretion in order to increase the amount of money in the
economy, this is not the method employed in the United States.
The central, which is the governing body that manages the government reserve, oversees
all domestic monetary policy. This means they are generally held responsible for managing
inflation and managing both short-term and long-term interest rates. They make these
decisions to toughen the economy, and controlling the money supply is an important tool
they employ.

Modifying Reserve Requirement

The central bank can influence the money supply by altering reserve requirements, which
relate to the amount of money banks must retain against bank deposits. Banks can borrow
more money if reserve requirements are reduced, increasing the overall amount of money
in the economy. Similarly, the central bank can restrict the quantity of the money supply by
boosting bank reserve requirements.
Changing Short-Term Interest Rates
Changes in short-term interest rates can also be used by the central bank to alter the
money supply. The availability of money is effectively increased or decreased by cutting or
rising the discount rate that banks pay on short-term loans from the central bank. Lower
interest rates increase the money supply and boost economic activity; nevertheless, lower
interest rates feed inflation, thus the central bank must be cautious about lowering rates
too much for too long.
In the years following the 2008 economic crisis, the European Central Bank kept interest
rates either at zero or below zero for a longer time, and it negatively affected their
economies and their capability to grow healthily. Although it did not sink any countries in
economic disaster, it has been considered by many to be an example of what not to do after
a large-scale economic downturn.

The Demand for Money

People make decisions regarding how to hold their cash while selecting how much money
to keep. How much of one's wealth should be kept in cash and how much in other assets?
The answer to this issue depends on the relative costs and benefits of holding money
against other assets for a given level of wealth. The relationship between the amount of
money people wish to have and the circumstances that affect that amount is known as the
demand for money.
To make things easier, let's pretend there are just two ways to store wealth: cash in a
checking account or funds in a bond market mutual fund that buys long-term bonds on

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behalf of its investors. A bond fund is not the same as money. Although certain money
deposits pay interest, the yield on these accounts is typically smaller than that of a bond
fund. The advantage of checking accounts is that they have a lot of liquidity and may be
simply disposed of. We can think of money demand as a curve that represents the
outcomes of trade-offs between the increased availability of money deposits and the higher
interest rates available from owning a bond fund. The cost of storing money is the gap
between the interest rates provided on money deposits and the interest returns available
from bonds.

Interest Rates and the Demand for Money

People's amount of money to pay for transactions and satisfy preventive and speculative
demand is likely to differ with the interest rates they can earn from alternative assets such
as bonds. When interest rates rise compared to the rates earned on money deposits, people
hold lesser money. When interest rates are down, people hold more money. The logic of
these assumptions about the money people hold and interest rates depend on the people’s
motives for holding money.
The amount of money that households desire to keep varies depending on their income.
The interest rate, as well as various average amounts of money held, can meet their
transactional and precautionary money demands. To see why, assume a family of three
earns and spends $3,000 per month. Every day, it spends the same amount of money. That
works out to $100 each day for a month of 30 days. One option for the household to achieve
this spending would be to deposit the funds in a checking account that pays no interest. As
a result, when the month begins, the household will have 3,000 in the checking account,
2,900 at the end of the first day, 1,500 halfway through the month, and nothing at the end
of the month. We can calculate the amount of money the household requires by averaging
the daily balances. This kind of money management, dubbed the cash approach, offers the
advantage of simplicity, but the household will not receive any interest on its funds.
Consider a different money management strategy that allows for the same spending
pattern. The household deposits $1,000 in its checking account and the remaining $2,000
in a bond fund at the start of each month. Assume the bond fund pays 1% interest per
month, or a 12.7 percent annual interest rate. The money in the checking account is
depleted after ten days, and the household withdraws $1,000 from the bond fund for the
next ten days. The remaining $1,000 from the bond fund is deposited into the bank account
on the 20th day. The household has an average daily balance of $500 with this technique,
which is the amount of money it requires. Let's call this technique to money management
the bond fund approach.
BANKO SENTRAL NG PILIPINAS (BSP)

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Established on the 3rd of July 1993 based on the provisions of the 1987 Philippine
Constitution and the New Central Bank Act of 1993, the Republic of the Philippines' central
bank is the Bangko Sentral ng Pilipinas (BSP). The Philippines' Central Bank was
established on the 3rd of January 1949 and later replaced as Banko Sentral ng Pilipinas
(BSP). The BSP has fiscal and administrative independence from the Philippine
Government in accordance with its mandated responsibilities.

Creating a Central Bank for the Philippines

As early as 1933, a group of Filipinos had conceptualized a central bank for the Philippines.
It came up with the basics of a bill for establishing a central bank for the country after a
cautious study of the economic provisions of the Hare-Hawes Cutting bill, the Philippine
independence bill approved by the US Congress.
During the Commonwealth years (1935-1941), the discussion about a Philippine central
bank that would uphold price stability and economic growth continued. The country’s
monetary system then was managed by the Department of Finance and the National
Treasury. The Philippines was on the exchange standard using the US dollar, which was
supported by 100 percent gold reserve as the standard currency.
As required by the Tydings-McDuffie Act, in 1939, the Philippine legislature enacted a law
creating a central bank. As it is a monetary law, this required the approval of the United
States president. However, President Franklin D. Roosevelt rejected it due to strong
opposition from vested interests. Following the disapproval, a second law was passed in
1944 during the Japanese occupation, but the American liberalization forces' arrival
terminated its implementation.
As President Manuel Roxas assumed office in 1946, he instructed the Finance Secretary
Miguel Cuaderno, Sr. to develop a central bank charter. The founding of a monetary
authority became imperative a year after as a result of the findings of the Joint Philippine-
American Finance Commission headed by Mr. Cuaderno. The Commission, which planned
Philippine financial, monetary, and fiscal problems in 1947, suggested a shift from the
dollar exchange standard to a managed currency system. A central bank was then required
to implement the proposed shift to the new system.
Instantly, the Central Bank Council, which President Manuel Roxas created to prepare a
proposed monetary authority charter, develop a draft. It was submitted to Congress in
February 1948. By June of the same year, the newly-proclaimed President Elpidio Quirino,
who succeeded President Roxas, affixed his signature on Republic Act No. 265, the Central
Bank Act of 1948. The establishment of the Central Bank of the Philippines was a definite
step toward national sovereignty. Over the years, changes were introduced to make the
charter more responsive to the needs of the economy. On the 29th of November 1972,
Presidential Decree No. 72 adopted the Joint IMF-CB Banking Survey Commission's

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recommendations, which made a study of the Philippine banking system. The Commission
proposed a program designed to ensure the system's soundness and healthy growth. Its
most important recommendations were related to the Central Bank's objectives, its policy-
making structures, the scope of its authority, and procedures for dealing with problem
financial institutions.
Succeeding changes sought to improve the Central Bank's capability, in the time of a
developing economy, to enforce banking laws and regulations and respond to emerging
central banking challenges and issues. Thus, in the 1973 Constitution, the National
Assembly was mandated to establish an independent central monetary authority. Later, PD
1801 designated the Philippines' Central Bank as the central monetary authority (CMA).
Years after, the 1987 Constitution adopted the CMA provisions from the 1973 Constitution
that were intended to establish an independent monetary authority through enlarged
capitalization and greater private sector participation in the Monetary Board.
The administration that followed President Corazon C. Aquino's transition government saw
the turning of another chapter in Philippine central banking. In accordance with a
provision in the 1987 Constitution, President Fidel V. Ramos signed into law Republic Act
No. 7653, the New Central Bank Act, on the 14th of June 1993. The law provides for
establishing an independent monetary authority to be known as the Bangko Sentral ng
Pilipinas, with the maintenance of price stability explicitly stated as its primary objective.
This goal was only implied in the old Central Bank charter. The law also gives the Bangko
Sentral fiscal and administrative independence, which the old Central Bank did not have.
On the 3rd of July 1993, the New Central Bank Act was fully effective.
OVERVIEW OF FUNCTIONS AND OPERATIONS OF BANKO SENTRAL NG PILIPINAS
Objectives
The BSP’s main objective is to maintain price stability beneficial to a balanced and
sustainable economic growth. The BSP also aims to promote and preserve monetary
stability and the convertibility of the national currency.
Responsibilities
The BSP provides policy guidance in the areas of money, banking, and credit. It oversees
the operations of banks and exercises regulatory powers over non-bank financial
institutions with quasi-banking functions.
Under the New Central Bank Act, the BSP performs the following functions, all of which
relate to its status as the Republic’s central monetary authority.

• Liquidity Management: The BSP formulates and implements monetary policy to

influence money supply consistent with its primary objective to maintain price
stability.

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• Currency issue: The BSP has the exclusive power to issue the national currency. All
notes and coins issued by the BSP are fully guaranteed by the government and are
considered legal tender for all private and public debts.
• Lender of last resort: The BSP extends discounts, loans, and advances to banking
institutions for liquidity purposes.
• Financial Supervision: The BSP supervises banks and exercises regulatory powers
over non-bank institutions performing quasi-banking functions.
• Management of foreign currency reserves: The BSP seeks to maintain sufficient
international reserves to meet any foreseeable net demands for foreign currencies
in order to preserve the international stability and convertibility of the Philippine
peso.
• Determination of exchange rate policy: The BSP determines the exchange rate
policy of the Philippines. Currently, the BSP adheres to a market-oriented foreign
exchange rate policy such that the role of Bangko Sentral is principally to ensure
orderly conditions in the market.
As part of BSP’s other activities, the BSP functions as the banker, financial advisor and
official depository of the Philippines, its political units and instrumentalities and
government-owned and controlled corporations.

Source: BSP.gov.ph

Reference:

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Central Banking and Monetary Policy

Simpson, T. (2015). Financial Markets, Banking, and Monetary Policy, Monetary Policy: The
Basics, pp. 211 – 224
Saunders, A. and Cornett, M. (2016). Financial Markets and Institutions, The McGraw-Hill
Inc. New York

Online sources:
• https://www.imf.org/en/About/Factsheets/Sheets/2016/08/01/16/20/Monetary
-Policy-and-Central-Banking
• https://open.lib.umn.edu/principleseconomics/chapter/25-2-demand-supply-and-
equilibrium-in-the-money-market/
• https://findependence.org/monetary-policy-and-the-role-of-central-
banks/?gclid=EAIaIQobChMIr8-
HstG96wIVUdeWCh3RTwiQEAAYASAAEgIfpvD_BwE
• http://www.bsp.gov.ph/

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