Monetary System and Central Banking

Money is the stock of assets used to facilitate transactions – a medium of exchange.
Without money, transactions require a double coincidence of wants, where each party has something the other desires, which is inefficient.
Money facilitates trade by eliminating the need for this coincidence.

Medium of Exchange: Facilitates trade, avoiding the double coincidence of wants.
Unit of Account: A standard measure of value, e.g., prices measured in pesos.
Store of Value: An asset that transfers purchasing power from the present to the future.

Commodity Money: Money with intrinsic value (e.g., gold coins, cigarettes in prisons).
Fiat Money: Money without intrinsic value, declared legal tender by government decree (e.g., peso).

Banks keep a fraction of deposits as reserves and lend out the rest.
Reserve Requirement: The minimum percentage of deposits banks must hold as reserves, set by the central bank (BSP).
Reserve Ratio: The fraction of deposits banks hold as reserves.
Example: Before April 3, 2020, reserve requirement for big commercial banks was 14%.

Scenario 1: No Banks
- Currency in circulation = 1,000
- Demand deposits = 0
- Money supply = 1,000
Scenario 2: 100% Reserve Banking
- Banks hold 100% of deposits as reserves. If households deposit 1,000, currency in circulation becomes 0, and demand deposits become 1,000. Money supply remains 1,000.
- Balance Sheet (T-accounts) of Banku Uno:
  - Assets: Reserves = 1,000
  - Liabilities: Deposits = 1,000
Scenario 3: Fractional Reserve Banking
- Banks hold a fraction of deposits as reserves (e.g., 20%). The remainder can be loaned out.
  - Households deposit 1,000 in Banku Uno.
  - Banku Uno keeps 200 as reserves and loans out 800.
- Balance Sheet of Banku Uno:
  - Assets: Reserves = 200, Loans = 800
  - Liabilities: Deposits = 1,000
- Money supply increases to 1,800 (1,000 in demand deposits + 800 in currency held by borrowers).
The process repeats as loans are deposited in other banks (Bankodos, Bankot Tres, etc.), which then loan out a fraction of their deposits.

The total money supply is the original deposit times the money multiplier.
\text{Money Multiplier} = \frac{1}{\text{Reserve Requirement}}
If the reserve requirement is 20% (0.2), the money multiplier is 5.
- \frac{1}{0.2} = 5
An initial deposit of 1,000 can generate a total money supply of 5,000.
- 1000 \times 5 = 5000

Fractional reserve banking creates money but does not create wealth.
Loans create new money but also create debt; a household's wealth does not increase because the new money is offset by new debt.

An entity that oversees the banking system and regulates the money supply.
Conducts monetary policy to set the money supply.
In the Philippines, the central bank is the Bangko Sentral ng Pilipinas (BSP).
Monetary policy decisions are made by the Monetary Board, composed of appointees from the private sector and government, chaired by the BSP governor.

Open Market Operations:
- Buying bonds increases the money supply.
- Selling bonds decreases the money supply.
Reserve Requirement:
- Lowering the reserve requirement increases the money supply.
- Raising the reserve requirement decreases the money supply.
Standing Liquidity Facilities:
- Loans to banks at a special interest rate (RRP rate + 50 basis points = discount rate).
- Lowering the RRP rate increases the money supply.
- Raising the RRP rate decreases the money supply.
The Monetary Board sets the RRP rate, influencing other interest rates in the economy (e.g., 91-day T-bill rates, average bank lending rates).

The BSP cannot perfectly control the money supply.
Household confidence in the banking system affects deposits and thus the amount banks can loan.
Banks' confidence in the economy affects their willingness to lend; a credit crunch can occur if banks become risk-averse and reduce lending.