FInancial MArket

CHAPTER 2 Eventually, ordinary people could deposit

INTRODUCING MONEY AND INTEREST their money in a bank account and earn
RATES interest, borrow money and buy property,
invest their wages in business, or start
ROLE OF MONEY IN THE ECONOMY companies themselves. Banks could also
insure against the sorts of calamities that
Money is any item or commodity that is might devastate families or traders,
generally accepted as a means of payment encouraging risk in the pursuit of profit.
for goods and services or for repayment of
debt, and that serves as an asset to its Today it is the nation’s government and
holder. On the simplest level, money is central bank that control a country’s
composed of the bills and coins which economy. The Federal Reserve (known as
have been printed or minted by the “The Fed”) is the central bank in the US.
National Government (these are called The Fed issues currency, determines how
currency). But money also includes the much of it is in circulation, and decides
funds stored as electronic entries in one's how much interest it will charge banks
checking account and savings account. to borrow its money.

Because money in a modern economy is not In the Philippines, the central bank that
directly backed by intrinsic value (e.g., the controls the country’s economy is the
coin's weight in gold or silver), the financial “Bangko Sentral ng Pilipinas”. While
system works on an entirely *fiduciary government still print and guarantee money,
basis*, relying on the public's confidence in in today’s world it no longer needs to exist
the established forms of monetary exchange. as physical coins or notes, but can be found
solely in digital form.
Money is the oil that keeps the machinery of
our world turning. By giving goods and CHARACTERISTICS AND KEY FUNCTIONS
services an easily measured value, money OF MONEY
facilitates the billions of transactions
that take place every day. Without it, the Money is not money unless it has all of the
industry and trade that form the basis of following defining characteristics: Money
modern economies would grind to a halt and must have value, be durable, portable,
the flow of wealth around the world would uniform, divisible, in limited supply, and
cease. be usable as a means of exchange.
Underlying all of these characteristics is
Money has fulfilled this vital role for trust – people must be confident that if they
thousands of years. Before its invention, accept money, they can use it to pay for
people bartered, swapping goods they goods.
produced themselves for things they needed
from others. Barter is sufficient for simple Store of value
transactions, but not when the things Money acts as a means by which people can
traded are of differing values, or not store their wealth for future use. It must
available at the same time. Money, by not, therefore, be perishable, and it helps if
contrast, has a recognized uniform value it is of a practical size that can be stored
and is widely accepted. At heart a simple and transported easily.
concept, over many thousands of years, it
has become very complex indeed. Item of worth
Most money originally has an intrinsic
At the start of the modern age, individuals value, such as that of the precious metal
and governments began to establish banks, that was used to make the coin. This in
and other financial institutions were formed.
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itself acted as some guarantee the coin
would be accepted. Barter in practice

Means of exchange Essentially, barter involves the exchange

It must be possible to exchange money of an item (such as a cow) for one or more
freely and widely for goods, and its value of a perceived equal “value” (for example
should be as stable as possible. It helps if a load of wheat). For the most part of the
that value is easily divisible and if there two parties bring the goods with them and
are sufficient denominations so change hand them over at the time of a transaction.
can be given. Sometimes, one of the parties will accept an
“I owe you,” or IOU, or even a token, that it
Unit of account is agreed can be exchanged for the same
Money can be used to record wealth goods or something else at a later date.
possessed, traded or spent-personally
and nationally. It helps if only one Advantages and Disadvantages of
recognized authority issues money. If Barter
anybody could issue it, then trust in its value Advantages
would disappear.  Trading relationship - Fosters strong
links between partners.
Standard of Deferred Payment  Physical goods are exchanged -
Money is also useful because of its ability to Barter does not rely on trust that
serve as a standard of deferred payment. money will retain its value.
Money can facilitate exchange at a given Disadvantages
point by providing a medium of exchange  Market needed - Both parties must
and unit of account. want what the other offers.
 Hard to establish a set value on
THE EVOLUTION OF MONEY items - Two goats may have a certain
value to one party one day, but less a
People originally traded surplus week later.
commodities with each other in a process  Goods may not be easily divisible -
known as bartering. The value of each good For example, a living animal cannot be
traded could be debated, however, and divided.
money evolved as a practical solution to  Large-scale transactions can be
the complexities of bartering hundreds of difficult - Transporting one goat is
different things. Over the centuries, money easy, moving 1,000 is not.
has appeared in many forms, but, whatever
shape it takes, whether as a coin, a note, or Evidence of trade records (7000 BCE)
stored on a digital server, money always Pictures of items were used to record
provides a fixed value against which any trade exchanges, becoming more complex
item can be compared. as values were established and documented.

Barter (10,000 – 3000 BCE) Coinage (600 BCE – 1100 CE)

Defined weights of precious metals used
In early forms of trading, specific items were by some merchants were later formalized
exchanged for others agreed by the as coins that were usually issued by states.
negotiating parties to be of similar value.
Barter – the direct exchange of goods – Bank notes (1100-2000)
formed the basis of trade for thousands of States began to use bank notes, issuing
years. Adam Smith, 18th-century author of paper IOUs that were traded as currency,
*The Wealth of Nations*, was one of the and could be exchanged for coins at any
first to identify it as a precursor to money. time.
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This 10TH century silver penny has an
Digital money (2000 onward) inscription stating that Offa is King
Money can now exist "virtually," on ("rex") of Mercia.
computers, and large transactions can take
place without any physical cash changing Arabic dirham (900 CE)
hands. Many silver coins from the Islamic empire
were carried to Scandinavia by Vikings.
ARTIFACTS OF MONEY
Since the early attempts at setting values for THE ECONOMICS OF MONEY
bartered goods, “money” has come in many
forms, from IOUs to tokens. Cows, shells From the 16TH century, understanding of the
and precious metals have all been used. nature of money became more
sophisticated. Economics as a discipline
Barter (5,000 BCE) emerged, in part to help explain the inflation
Early trade involved directly exchanged caused in Europe by the large-scale
items – often perishable ones such as a importation of silver from the newly
cow. discovered Americans. National banks
were established in the late 17TH century,
Sumerian cuneiform tablets (4,000 BCE) with the duty of regulating the countries'
Scribes recorded transactions on clay money supplies.
tablets, which could also act as receipts.
By the early 20TH century, money became
Cowrie shells (1,000 BCE) separated from its direct relationship to
Used as currency across India and the precious metal. The Gold Standard
South Pacific, they appeared in many collapsed altogether in the 1930s. By the
colors and sizes. mid 20TH century, new ways of trading
with money appeared such as credit
Lydian gold coins (600 BCE) cards, digital transactions, and even
In Lydia, a mixture of gold and silver was forms of money such as cryptocurrencies
formed into disks, or coins, stamped with and financial derivatives. As a result, the
inscriptions. amount of money in existence and in
circulation increased enormously.
Athenian drachma (600 BCE)
The Athenians used silver from Laurion to Potosi inflation (1540-1640)
mint a currency used right across the The Spanish discovered silver in Potosi,
Greek world. Bolivia, and caused a century of inflation
by shipping 350 tons of the metal back to
Han dynasty coin (200 BCE) Europe annually.
Often made of bronze or copper, early
Chinese coins had holes punched in their The great debasement (1542-1551)
center. England's Henry VIII debased the silver
penny, making it three-quarters copper.
Roman coin (27 BCE) Inflation increased as trust dropped.
Bearing the head of the emperor, these
coins circulated throughout the Roman Early joint-stock companies (1553)
Empire. Merchants in England began to form
Byzantine coin (700 CE) companies in which investors bought
Early Byzantine coins were pure gold; later shares (stock) and shared its rewards.
ones also contained metals copper.
Bank of England (1694)
Anglo-Saxon coin (900 CE)
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The Bank of England was created as a neighboring countries such as China, Java
body that could raise funds at a low and Macau. Through the prevailing medium
interest rate and manage national debt. of exchange was barter, some coins were
circulating in the Philippines as early as the
The Royal Mint (1696) 8th century.
Isaac Newton became Warden and argued
that debasing undermined confidence. All Commodity money such as gold, gold dust,
coins were recalled and new silver ones silver wires, coffee, sugar rice, spices,
were minted. carabao were used as money. Between the
8th and 14th century the penniform gold
US dollar (1775) barter rings were predominantly used by
The Continental Congress authorized the foreign merchants. Piloncitos and other
issue of United States dollars in 1775, commodities were in circulation.
but the first national currency was not
minted by the US Treasury until 1794. Spanish Regime
The Spanish introduced coins in the
Gold Standard (From 1844) Philippines when they colonized the
The British pound was tied to defined country in 1521. Silver coins minted in
equivalent amount of gold. Other countries Mexico were predominantly used in 1861,
adopted a similar Gold Standard. the first mint was established in order to
standardize coinage.
Credit Cards (1970s)
The creation of credit cards enabled American Regime
consumers to access short-term credit After gaining independence in 1898 when
to make smaller purchases. This resulted Spain ceded the Philippines to the United
in the growth of personal debt. States. The country’s first local currency,
the Philippine Peso, was introduced
Digital Money (1990s) replacing the Spanish-Filipino Peso.
The easy transfer of funds and The Philippine National Bank was
convenience of electronic payments authorized to issue Philippine Bank
became increasingly popular as internet Notes. Later, the Bank of the Philippine
use increased. Island was authorized to issue its own
bank notes. These notes were redeemable
Euro (1999) by the issuer but not made legal tender.
Twelve EU countries joined together and
replaced their national currencies with Japanese Regime
the Euro. Bank notes and coins were issued When the Philippines was occupied by Japan
three years later. during World War II, the Japanese issued
the Japanese War Notes. There bills had
Bitcoin (2008) no reserves nor backed up by any
Bitcoin a form of electronic money that government asset and were called
exists solely as encrypted data on servers “mickey mouse” money.
is announced. The first transaction took
place in January 2009. Post-War Period
In 1944, when the American forces defeated
HIGHLIGHTS IN THE HISTORY OF MONEY the Japanese Imperial army, the Philippine
IN THE PHILIPPINES Commonwealth was established under
President Sergio Osmeña. All Japanese
Pre-Spanish Regime currencies circulating in the Philippines
Prior to the coming of the Spanish in 1521, were declared illegal, all banks were
the Philippine was already trading with
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closed and all Philippine National Bank  M2. In addition to M1, this measure
notes were withdrawn from circulation. includes money held in savings
deposits, money market deposit
The new treasury certificate (called accounts, noninstitutional money
Victory Money) were printed in P500, market mutual funds and other
P200, P100, P50, P20, P10, P5, P2 and short-term money market assets
P1 denominations with the establishment of (e.g., “overnight” Eurodollars). It refers
the Central Bank. In 1949, a new currency primarily to money used as a store
called “Central Bank Notes” was issued. of value.
In 2010 the Central Bank launched the  M3. In addition to M2, this measure
“New Generation Currency”, which is includes the financial institutions,
uniform in size where significant events in (e.g., large-denomination time
Philippine history, iconic buildings and deposits and term Eurodollars). It
heritage sites were featured. refers primarily to money used as a
unit of account.
In 2018, the New Generation Currency  L. In addition to M3, this measure
Coin series were put in circulation. includes liquid and near-liquid
assets (e.g., short-term Treasury
notes, high-grade commercial paper
and bank acceptance notes).

THE SUPPLY AND DEMAND FOR MONEY The deposits of the public at banks and
other depository institutions are
Money facilitates the flow of resources considered money and are therefore
in the circular model of macroeconomy. Not included in the M1 money supply. If the
enough money will slow down the public withdraws money from bank deposits
economy, and too much money can cause to hold money as personal currency
inflation because of higher price levels. ("under the mattress"), this increase in
Either way, monitoring the supply and inactive money will affect the banks' ability
demand for money is vital for the to extend loans and will influence the supply
economy’s central bank’s monetary policy, of money.
which aims to stabilize price levels and to
support economic growth. Some common forms of public payment may
not count as part of the supply of money.
The Money Supply Check payments from one person to
Although the general description of money is another are not included in the money
relatively straightforward, the precise supply because check merely transfers
definition of the overall supply of money is money without being a net addition to
complex because of the wide variety of the supply of money. Consumer credit
forms of money in modern economies. cards are not included in the money
supply; they are considered instant loans
The Key Measures for the Money Supply to consumers and therefore are not a net
are: addition to the money supply.
 M1. The narrowest measure of the
money supply. It includes currency in The Bangko Sentral ng Pilipinas (BSP) is
circulation held by the nonbank responsible for determining the supply
public, demand deposits, other of money. It uses daily open market
checkable deposits, and traveler’s operations to influence the creation of
checks. It refers primarily to money money by banks and to guide the
used as a medium of exchange. availability of money in the economy. BSP
also has an impact on the creation of money
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by banks through reserve requirements demand for currency has a negative
and the discount rate that is, the interest relationship with the interest rate.
rate at which banks can borrow from the BSP
as a lender of last resort. Changes in the Changes in other factors will lead to shifts in
supply of money will affect the interest the demand curve for money. Increases in
rate and therefore the cost of borrowing the economy's price level will increase
money. This will have an impact on the demand for money (note that the
consumption and investment levels in the demand for money is tied to the interest
economy. rate, not the price level). If the real GDP
increases, the demand for money
The Demand for Money increases because of the higher demand
for products. Also, when banks develop
The Sources of the Demand for Money new money products that allow for
are: easier, low-cost withdrawal, the demand
 Transaction demand. Money for money will decrease, such as, banks
demanded for day-to-day payments offering savings accounts with shorter (or,
through balances held by households less stringent) time deposit requirements
and firms (instead of stocks, bonds or and lower penalties for withdrawal.
other assets). This kind of demand
varies with GDP; it does not depend THE IMPACT OF MONEY
on the rate of interest.
 Precautionary demand. Money In the macroeconomic short-run, some prices
demanded as a result of (e.g., wage rates affected by labor contracts)
unanticipated payments. This kind will be inflexible. This causes economic
of demand varies with GDP. fluctuations, with real GDP either below
 Speculative demand. Money potential GDP (recessionary gap) or
demanded because of expectations above potential GDP (inflationary gap).
about interest rates in the future. The BSP's monetary policy has an
This means that people will decide to immediate, short-run impact on the
expand their money balances and hold economy. In particular, higher interest
off on bond purchases if they expect rates will decrease investment because it
interest rates to rise. This kind of becomes more expensive to borrow
demand has a negative relationship money, and will also decrease
with the interest rate. consumption because consumers will tend
to, save more as interest rate returns
The rate of interest is the price paid in increase. In addition, as higher Philippine
the money market for the use of money interest rates increase the demand for
(or loans). The rate is a percentage of the pesos on the foreign exchange markets
amount borrowed. (because of the higher returns on Philippines
deposits), the higher pesos will decrease
If a person holds P1,000 in currency, the exports by making them increasingly
opportunity cost of holding the money expensive. This means that real GDP
is the interest that could he earned on the growth and the inflation rate slow when
P1,000 in an interest-bearing account. The the BSP raises the interest rate. The
opportunity cost of holding money goes up if reverse occurs when the interest rate is
the interest rate increases, which may lowered.
lead to decreased consumption and
increased saving. Conversely, if the Monetary policy can be applied in the
interest rate is low, it is relatively cheap short-run when the economy faces an
to borrow money and the quantity of inflationary gap (real GDP exceeds
money demanded goes up. Therefore, the potential GDP). The BSP may then pursue
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a policy to avoid inflation by decreasing considered constant: (Y = Yconstant. It
the quantity of money and raising the follows directly from the equation of
interest rate. The higher interest rate exchange (M x Vconstant) = (P x Yconstant) that
decreases investment, consumption changes in M are equal to the changes in P,
and, net export. This decrease in in the long-run. This view of the equation of
aggregate demand will decrease, real exchange expresses the (neo) classical
GDP and lower the price level. In the neutrality of money, that is, money
macroeconomic long-run, prices are affects only nominal values but not real
assumed to be fully flexible, and this will values. In other words, the money supply
move real GDP toward potential GDP. leaves real output unaffected.

If the economy is at its long-run Historical evidence suggests that the

equilibrium and the BSP increases the money growth rate and the inflation rate
money supply, it will increase aggregate are positively related in the long-run.
demand. Consequently, the price level However, the year-to-year relationship is
goes up, as well as the real GDP. This weaker.
means that an inflationary gap exists,
with the actual unemployment rate being The equation of exchange does not hold in
below the natural rate. The tightness in the short-run, as the economy does not
the labor market will lead to a rise in the immediately adjust because of price
money wage rate. Because of higher inflexibility. Although, the relationship
labor costs, the short-run aggregate between M and P may not be casual, as
supply will increase returning real GDP suggested by quantity money theorists, it
to the level of potential GDP. appears that there is a correlation
between M and P in the long-term.
THE QUANTITY THEORY OF MONEY Therefore, growth in M can be used as a
statistical estimate for the rate of
The quantity theory of money holds that inflation, that is, the Central bank can be
changes in the money supply MS effective in stabilizing prices. It is less clear
directly influences the economy's price what the Central bank's impact on short-
level, but nothing else. This theory follows term real GDP and real interest rates is.
from the equation of exchange:
THE TIME VALUE OF MONEY
MxV=PxY
where M = quantity of money In general business terms, interest is
V = velocity of money (i.e., the defined as the cost of using money over
average number of times a unit of time. This definition is in close agreement
money is used during a year to with the definition used by economists, who
purchase GDP's goods and services) prefer to say that interest represents the
P = price level time value of money.
Y = real GDP
The equation of exchange essentially states Present Value
that the economy's nominal GDP or
expenditures (P x Y) equal the money The concept of present value (or present
actually used in the economy (M x V). discounted value) is based on the
According to the quantity theory of commonsense notion that a peso of cash
money, velocity (V) is not affected by flow paid to you one year from now is
the quantity of money (M) and is less valuable to you than a peso paid to
considered constant: V = Vconstant. Also, you today: This notion is true because you
potential real GDP (i.e., long-run can deposit a peso in a savings account that
equilibrium) is not affected by (M) and is earns interest and have more than a peso in
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one year. Economists use a more formal
definition, as explained in this section. Interest rates are determined by the
demand for and supply of loanable
Let's look at the simplest kind of debt funds. Investors demand funds in order
instrument, which we will call a simple to finance capital assets that they believe
loan. In this loan, the lender provides the will increase output and generate profit.
borrower with an amount of funds (called the Simultaneously, consumers demand
principal) that must be repaid to the lender loanable funds because they have a
at the maturity date, along with an positive rate of time preference. They
additional payment for the interest. For prefer earlier availability.
example, if you made your friend Jane a
simple loan of P100 for one year, you would The demand of investors for loanable
require her to repay the principal of P100 in funds stems from the productivity of
one year's time along with an additional capital. Investors are willing to borrow
payment for interest; say, P10. In the case of in order to finance the use of capital in
a simple loan like this one, the interest production because they expect that
payment divided by the amount of the loan expanding future output will provide them
is a natural and sensible way to measure the with more than enough resources to repay
interest rate. This measure of the so-called the amount borrowed (the principal) and the
simple interest rate, (i). interest on the loan.

INTEREST RATES As Figure 2-1 illustrates, the interest rate

brings the choices of investors and
The interest rates link the future to the consumers wanting to borrow funds into
present. It allows individuals to evaluate the harmony with the choices of lenders willing
present value (the value today) of future to supply funds. Higher interest rates
income and costs. In essence, it is the make it more costly for investors to
market price of earlier availability. undertake capital spending projects and
for consumers to buy now rather than
From the viewpoint of a potential later. Both investors and consumers will
borrower, the interest rate is the therefore, curtail their borrowing as the
premium that must be paid in order to interest rate rises. Investors will borrow less
acquire goods sooner and pay for them because some investment projects that
later. From the lender's viewpoint, it is a would be profitable at a low interest rate will
reward for waiting — a payment for be unprofitable at higher rates. Some
supplying others with current purchasing consumers will reduce their current
power. The interest rates allows the lender to consumption rather than pay the high
calculate the future benefit (future payments interest premium when the interest rate
earned) of extending a loan or saving funds increases. Therefore, the amount of funds
today. demanded by borrowers is inversely related
to the interest rate.
In a modern economy, people often
borrow funds to finance current The interest rate also rewards people
investments and consumption. Because (lenders) willing to reduce their current
of this, the interest rate is often defined as consumption in order to provide loanable
the price of loanable funds. This definition funds to others. If some people are going to
is correct. But we should remember that, it is borrow in order to undertake an investment
the earlier availability of goods and project (or consume more than their current
services purchased, not the money itself income), others must curtail their current
that is desired by the borrower. consumption by an equal amount. In
HOW INTEREST RATES ARE DETERMINED essence, the interest rate provides
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lenders with the incentive to reduce Note: MS = money supply, MD = money
their current consumption so that, demand
borrowers can either invest or consume According to Keynesian theory, the rate of
beyond their present income. Higher interest is determined as a price in two
interest rates give people willing to save markets:
(willing to supply loanable funds) the ability
to purchase more goods in the future in 1. Investment funds. The rate of interest
exchange for sacrificing current balances the demand for funds
consumption. Even though people have a (required for investment) and the supply
positive rate of time preference, they will of funds (from savings). If investors can
give up current consumption to supply funds earn a 10 percent return on a capital
to the loanable funds market if the price is investment project (e.g., building a factory),
right. Higher interest rates will induce they will be willing to pay a rate of interest of
people to save more. Therefore, as the up to 10 percent. Households delay
interest rate rises, the quantity of consumption by saving (and are rewarded by
funds supplied to the loanable funds earning interest) depending on their time
market will increase. preference and the rate of interest. Savings
percentages can differ significantly from one
As Figure 2-1 illustrates, the interest rate will nation to another.
bring the quantity of funds demanded into
balance with the quantity supplied. At the 2. Liquid assets. Households and
equilibrium interest rate, the quantity of businesses may have reasons to hold assets
funds borrowers demand for in liquid form (i.e., readily available money).
investment and consumption now (rather Because borrowers require cash in the long-
than later) will just equal the quantity of term (that doesn't need to be repaid to the
funds lenders save. So, the interest rate lender immediately), they are willing to
brings the choices of borrowers and lenders compensate lenders for giving up liquidity.
into harmony. Keynes introduced the influence of the
liquidity preference on the interest rate. The
The rate of interest functions as the price classical economists, who considered
in the money market. Money has a time investment funds as the critical market for
value, and its use is bought and sold in the the interest rate, disregarded the topic of
money market in return for the payment of liquidity preference.
interest. The financial institutions that deal
in government securities and loans, gold and Although, intermediaries can achieve
foreign exchange make up the money equality between the rates of interest in two
market. The money market is not a markets, the potential lack of balance
specific physical location but consists of between the investment and money markets
transactions made electronically or by was essential to Keynesians, who claimed
phone. Equilibrium in the money market that it caused unemployment in the short-
occurs when the MD and MS curves run.
intersect at the equilibrium interest
rate, as shown in Figure 2-2. THE NOMINAL OR MONEY RATE VERSUS
THE REAL RATE OF INTEREST
If the BSP were to decide to increase the
quantity of money from MS to MS', the We have emphasized that the interest rate
supply of money curve would shift to the is a premium paid by borrowers for
right, resulting in a decrease in the earlier availability and a reward
equilibrium interest rate. The lower cost of received by lenders for delaying
borrowing could spur higher consumption consumption. However, during a period of
and investment. inflation (a general increase in prices),
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the nominal interest rate or money rate
of interest is misleading indicator of how INTEREST RATES AND RISK
much borrowers are paying and lenders are So far, we have assumed there is only a
receiving. Inflation reduces the single interest rate present in the loanable
purchasing power of a loan's principal. funds market. In the real world, of course,
Rising prices means that, when the borrower there are many interest rates. There is the
repays the principal in the future, it will not mortgage rate, the prime interest rate (the
purchase as much as it would have when the rate charged to business firms with strong
funds were initially loaned. credit ratings), the consumer loan rate and
the credit card rate , to name but a few.
When inflation is common, lenders will
recognize they are being repaid with pesos Interest rates in the loanable funds market
of less purchasing power. Unless they are will differ mainly because of differences in
compensated for the anticipated inflation by the risks associated with the loans. It is
an upward adjustment in the interest rate, riskier, for example, to loan money to an
they will supply fewer funds to the loanable unemployed worker than to a well-
funds market. At the same time, when established business with substantial assets.
borrowers anticipate inflation, they will want Similarly, credit card loans are riskier
to purchase goods and services now before than loans secured by an asset. An example
they become even more expensive in the of a secured loan would be a mortgage loan
future. Thus, they are willing to pay an on a house. If the borrower defaults, the
inflationary premium, an additional lender can repossess the house. The risk
amount of interest that reflects the also increases with the duration of the
expected rate of future price increases. loan. The longer the time period of the
For example, if borrowers and lenders fully loan, the more likely it is that the
anticipate a 5 percent rate of inflation, they borrower's ability to repay the loan will
will be just as willing to agree on a 9 percent deteriorate or market conditions changes
interest rate as they were earlier to agree on in an highly unfavorable manner.
a 4 percent interest rate when both
anticipated price stability. As Figure 2-3 shows, the money rate of
interest on a loan has three
Unlike when the general price level is stable, components. The (1) pure-interest
the supply of loanable funds will decline (the component is the real price one must
supply curve will shift to the left) and the pay for earlier availability. The (2)
demand will increase (the demand curve will inflationary premium component reflects
shift to the right) once decision makers the expectation that the loan will be
anticipate future inflation. The money repaid with pesos of less purchasing
interest rate thus, rises overstating the power as the result of inflation. The (3)
"true" cost of borrowing and the yield risk-premium component reflects the
from lending. This true cost is the real probability of default (the risk imposed on
rate interest, which is equal to the the lender by the possibility that the
money rate of interest minus the borrower may be unable to repay the loan).
inflationary premium. It reflects the real
burden to borrowers and payoff to lenders THE IMPACT OF CHANGING INTEREST
in terms of their being able to buy goods and RATES
services.
Control over short-term interest rates is
Our analysis indicates that, high rates of one of the main tools of the BSP to
inflation will lead to a high money rate achieve its main goals of controlling
of interest. The real world is consistent with inflation, smoothing out the business
this view. cycle and ensuring financial stability.
 FInancial MArket
impact long-term savings plans, such as
Short-term interest rates are relevant pensions.
for loans with a relatively short length for
repayment while long-term interest
rates on the other hand, are relevant for WHEN INTEREST RATES ARE RAISED
loans such as long-term corporate
borrowing and 10-20-30 year fixed rate Higher interest rates make loans less
mortgages. affordable, while high interest on
savings accounts encourages saving
If the BSP pushes short-term interest rates rather than spending. As spending slow,
up or down, the effects of its actions are felt so does the economy, with demand for
most directly by interest-rate sensitive goods and services decreasing. This
sectors of the economy. When it is more eventually effects business and employment
expensive to borrow, people make fewer levels.
purchases that require borrowing. But when
the BSP cuts the short-term interest rate, WHEN INTEREST RATES ARE LOWERED
that encourages borrowing and spending in
the economy and puts upward pressure on Lower interest rates make it cheaper to
prices. take out loans, and hence to spend more
money. Saving becomes less attractive
If interest rates fluctuated all the time, the as interest rates are low. With more
economy would become volatile. This is why money in circulation, demand for products
the government and central bank work and services rise, stimulating businesses and
together to keep inflation and interest at increasing employment.
stable rates. Every time the interest rate is
changed, it sends a signal to society to
either spend or save – and many also
increase or decrease confidence in the state
of the economy. A rise interest rates
encourages saving, since higher interest
will be paid on money in savings
accounts, and investments can grow.
Meanwhile, borrowing becomes less
attractive as interest repayments are
steeper, and banks more selective about
whom they lend to. This impacts the
affordability of obtaining or repaying an
existing loan, such as a mortgage.

By contrast, a drop in interest rates is

intended to cause an increase in
spending, since borrowers are able to take
out loans more cheaply. For those with
mortgages tracking the base rate, interest
repayments will drop. At the same time,
savers will tend to spend or invest
deposits that are attracting little interest.
While discouraging saving through very
low interest rates might stimulate the
economy, this can ultimately negatively