MONETARY POLICY & CENTRAL BANKING

CHAPTER 1

INTRODUCTION TO MONETARY POLICY & CENTRAL BANKING

LESSON 1:

MONEY: NATURE AND FUNCTIONS

One of the traditional definitions of Money and Economists define money as

anything used by society as a medium of exchange, and is widely acceptable for the
payment of goods and services without questioning the integrity of the person
offering it. The primary function of money is to facilitate the process of exchange.

Money is a commodity that is widely used as a means of exchange for goods

and services. It is a method of communicating pricing and worth. Money is
transmitted anonymously from person to person and nation to country, allowing
commerce and services to serve as the major indicator of wealth.

Barter system was the first stage monetary development. It is the direct exchange or
swapping of goods for goods, services for services, goods for services or services for
goods.

Society abandoned the barter system for the following reasons:

1. It was difficult to look for that person who has the things you need and who
also wants the things you are offering for exchange.
2. There is no common denominator to measure the value of goods and
services sought for exchange.
3. Most of the goods traded have unequal values.
4. It is time consuming, cumbersome and very inconvenient for individuals to
use the barter system.

Evolution of Money

Money is derived from the Latin word "moneta," which means "coin." It is a
surname derived from the Roman goddess Juno, for whom temple coins were minted.

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Money evolved in response to the demands and necessities of the period. The
primary goal was to eliminate the inadequacies of the Barter System.

There are five (5) stages of evolution of money namely:

1. Commodity money - Goods were exchanged for goods in the early

stages of human civilization. This is referred to as a "Barter Exchange
or Barter System." Goods like furs, skins, salt, rice, wheat, utensils,
weapons etc. Were commonly used as money. Commodity money, on
the other hand, raises a number of issues, including the divisibility of
products, durability, storage, and transportation.

2. Metallic money - with progress of human civilization, commodity

money changed into metallic money. Metals like gold, silver, copper,
etc. Were used as they could be easily handled and their quantity can
be easily ascertained. It was the main form of money throughout the
major portion of recorded history.

The discovery of precious metals such as gold, silver, or copper was

utilized as a form of payment at this time. These metals were divided
into two categories: uncoined and minted or coined. Uncoined metals
were used as bullion rather than coins. This caused a difficulty with
calculating the weight and value. The standard coin had the
same weight and worth as other coins. Metallic money can be
completely bodied, with a face value equal to the value of the
metal contained in it, or token money, with an inherent worth greater
than the value of the metal included in it.

3. Paper money - Carrying gold and silver pieces from place to place
was discovered to be both impractical and unsafe, thus the advent of
paper money represented a significant milestone in the evolution of
money. The Central Bank regulates and controls paper money. It can
be:

a. Representative paper money - money that is completely

backed by comparable metallic reserves. It is a certificate or
token that can be exchanged for the underlying commodity.

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b. Fiat money - recognized as a medium of exchange since it

has been proclaimed legal tender by the issuing authorities. A
money that does not have intrinsic value and does not
represent an asset in a vault somewhere. Its value comes from
being declared "legal tender"-an acceptable form of payment-
by the government of the issuing country. In this case, we
accept the value of the money because the government says it
has value and other people value it enough to accept it as
payment.

4. Credit money - As the volume of transactions escalated, even paper

money became impractical due to the time needed in counting it and
the space necessary for its storage. As a result, credit money was
introduced in the form of checks, drafts, bills of exchange, credit cards,
and so on. Plastic money, such as debit or credit cards, has become
the most significant type of money in contemporary times since it
removes dangers and is long-lasting.

5. Electronic money - Digital money is a form of money or scrip which is

exchanged only electronically. It is also known as e-money, electronic
cash, electronic currency, digital money or cash or currency. Typically,
this involves use of computer networks, the internet and a digital
stored value system.

FUNCTIONS OF MONEY

1. As a medium of exchange: Before the invention of money, we relied on the

barter system that had many disadvantages. Money, however, removes all
these disadvantages. So as a medium of exchange is the primary advantage
of money.

Now we do not have to rely on a double coincidence of wants (barter system).

Money allows us to separate the transaction into sale and purchase, rather
than exchange.

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And since money is a universally accepted medium of exchange, we now

have freedom of choice. It gives us the economic independence to buy any
goods and/or services from a wide market. In fact, it also facilitates more
choices and healthy competition.

2. As a standard to measure the value of goods and services: How do we

measure the value of things? We use the standard of money. Like the
standard of measuring the height of objects is feet or inches, the standard of
measuring the value of goods and services is money. This value of goods and
services is expressed in terms of its price.

3. As a store of value: To be an effective medium of exchange, money must

retain its value over time. If I work today and earn 25 thousand pesos, I can
hold on to the money before I spend it because it will hold its value until

tomorrow, next week, or even next [Link], it must be a store of value. Even

after a long period of time money still remains valuable. This is why it is a
good medium of exchange and eliminates the need for double coincidence.

Now money is not the perfect tool for storing value. Because with time it does
lose some value due to inflation. This is not the case with some other
commodities, like say land or gold. But money remains the most liquid store
of value. It is universally accepted and easily transported.

Money can be kept for future use. Since money is widely acceptable, it enjoys
a generalized purchasing power and can serve as a store of value.

There are two ways of keeping money for future use:

o By saving
o By investing

4. As a means of deferred payment: Money enables people to buy goods on

credit. Goods and services can be obtained at the present time in exchange
for a promise to pay at a future date.

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ATTRIBUTES OF GOOD MONEY

1. General Acceptability – good money should be acceptable to everybody in a

specific territory. It refers to the willingness of people to accept the money in
exchange for goods and services.
2. Stability of Value – This characteristic is a prerequisite to general
acceptability. Before a particular kind of money becomes acceptable, it must
first have a stable value.
3. Portability – This refers to the quality of money being easily carried from
place to place. It is important that the material used as money should conform
to these characteristics.
4. Cognizability – The money circulating within a country can be easily
distinguished from other kinds of money. A fake bill can be recognized from
genuine bill.
5. Divisibility – The material used as money must be capable of being divided
into smaller denominations without impairing or destroying the value as a
whole.
6. Homogeneity – The material used as money should not only be capable of
being divided into equal parts or smaller units, but that such equal parts
should have equal weight and fineness, and must be made of the same
material and possess equal value.
7. Elasticity – This characteristic refers to the volume of money being capable
of manipulation by monetary authorities. Money supply can easily be
increased or decreased depending upon the needs of our economy.
8. Durability – This characteristic enables money to withstand wear and tear.
The paper used by almost all countries of the world is made of a special kind
of paper, which has extra strength to withstand usage.

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LESSON 2

MONETARY STANDARDS AND SYSTEMS

Nature of the Monetary Standard

A country is said to establish a monetary standard or system when it sets down rules
to govern the creation of money and control the quantity in circulation whether the rules are
strictly followed or are to be accepted simply as guidelines for its own money managers. It
will start out by deciding what its monetary unit will be. Standard money is the monetary
unit recognized by the government as the ultimate basic standard of value upon which all
other kinds of money are convertible. In the case of the Philippines, the monetary system is
the managed currency system, and the monetary unit is the Peso.

Monetary Standard refers to the currency system adopted by a country to provide a

stable medium of exchange for domestic transactions and a means of international payment
for foreign obligation. It is a standard that adopts a monetary unit to be the basis of all kinds
of money in circulation. The Monetary Unit is the ultimate standard unit of value, upon which
all kinds of money in the Monetary System are based. Monetary unit also refers to standard
money.

Classification of Monetary Standards

The monetary standards are generally divided into two broad types, namely:

1. Commodity Standard or Metallic Standard

2. Non-Commodity Standard or Fiat Standard

A. Commodity Standard is a monetary system in which the purchasing power or value

of the monetary unit is equal to the value of a designated quantity of a particular
commodity or set of commodities. This is sometimes called the full-bodied money
because it is one hundred percent (100%) backed-up by gold or silver reserves.

Commodity standard may either be monometallic or bimetallic.

 A monometallic standard is a one-metal standard whereby a country uses either

gold or silver as a standard unit of value.

 A bimetallic standard on the other hand, is a two-metal standard whereby gold

and silver are used as a standard unit of value.

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Monometallic Standard is further divided into gold standard and silver standard.
The gold standard is further divided into gold coin standard, gold bullion standard, and
gold exchange standard. The silver standard, in the same manner, is also divided into
silver coin standard, silver bullion standard and silver exchange standard.

 Gold Coin Standard - A country is said to be in the gold coin standard when the
government allows the conversion of gold bullions into coins, which are freely
obtained by the citizens of a country in exchange for other forms of money

The characteristics of gold coin standard are as follows:

1. The monetary unit of the country is stated in a definite weight and fineness of
gold.
2. People are free to convert their bullions into coins.
3. The government allows gold to be used in any manner.
4. Gold can be freely imported and exported. This allows the automatic
stabilization of the domestic value of gold with its foreign value.
5. All other kinds of money and bills circulating in the country should be
exchangeable to gold coins,
6. Money supply is determined by the amount of gold reserves the country has.
7. There is free coinage of gold whereby any citizen can convert gold bullions into
coins. This is important because it equalizes the value of gold as coin with its
value as metal.
8. There is free market of gold in that people are free to import and export gold.

 Gold Bullion Standard- is a system wherein the monetary unit or standard money
of the country is expressed in a definite weight and fineness of gold in bar or bullion
form.

Some of the characteristics of the gold bullion standard are as follows:

1. The monetary unit of the country is also expressed in a definite weight and
fineness of gold, but gold was kept in the form of bars.
2. People were forbidden to coin their gold and all the gold coins were melted into
bars.
3. Redemption of representative money in gold coins was forbidden except for
foreign transactions subject to the approval of the monetary authorities.
4. The government fixed the price of gold.

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5. The government was required by law to buy and sell all gold metals that meet
the requirements of law as to fineness.
6. Gold may be freely imported and exported.
7. All other currencies circulating in the country are freely convertible into gold, if
the holder can afford to buy 400 ounces, which is the weight of one gold bar.

Advantages of the Gold Bullion Standard is that expense of minting gold bullions into
coins is eliminated, and there is economy in the use of gold since gold bullions are no longer
made into coins People have the tendency of not hoarding gold, thereby allowing more gold
reserves to support more money in circulation. Only the legitimate demands for gold are met.
If there is a great demand for gold from the Treasury or the Central Bank, this becomes a
warning to the monetary authorities that they should decrease money supply to lower the
general price level, in order to maintain the usual reserves needed.

 The Disadvantages of the Gold Bullion Standard is that small amounts of gold
less than 400 ounces are not redeemed, just like in the case of Great Britain. The
place where gold bars could be bought is inconveniently located to discourage
conversion of paper money into gold. Gold bullion standard hinders the free
movement of gold because exporters are required to present licenses, which are
quite difficult to obtain. Sometimes the government deliberately imposes annoying
delays in the redemption of the metals.

When the government sells gold, it is usually much higher than when it buys metal,
thereby destroying the parity between gold and other forms of money. Parity means
that the different kinds of money in daily use within a country must be equal to their
purchasing power at a given ration, as between the gold and silver, at a fix weight
and fineness, or in terms of the monetary unit.

The Gold Exchange Standard is one in which the monetary unit of the country is
expressed in terms of gold. The domestic currency of the country adopting this
monetary standard is interchangeable for foreign gold drafts at a fixed rate, which is
convertible into foreign currency that is ultimately redeemable in gold coins or gold
bullions.

Under this system, a country buys and sells from and to its citizens at a fixed rate the
foreign exchange of a country under the gold standard. In this standard, the currency
of the country is redeemable in bills of exchange or drafts payable in gold in a foreign
country.

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The reasons why some counters do these systems is because my countries have
difficulty establishing the gold coin standard. A change from silver to gold standard is
also expensive must be obtained first the necessary reserve for gold.

Classification of the Gold Exchange Standard

 Automatic Gold Exchange Standard- this standard is adopted by country that

cannot practically put up any good reserves and therefore, would entirely depend on
the gold reserves of other countries to which they are related.

A country that depends on the gold reserves of other countries adopts this standard.
India, for example, was entirely dependent on the gold reserves of England

 Managed Gold Exchange Standard or nearly Automatic Gold Exchange

Standard - adopted by a country which can maintain a partial reserve at home and
would still count as part of its reserves, short-term investments and gold deposits
that it can build up in other countries. The Philippines, for example, related its
currency to that of the United States.

Important Characteristics of the Gold Exchange Standard

1. Gold does not have to be coined or used as bullions but the monetary unit of the
country must be defined in terms of a specific quantity of gold. (In the Philippines, the
Peso was equivalent to 12.9 grains of gold, 9 fines, whereas the U.S. Dollar was
equivalent to 25.8 grains of gold, 9 fine)
2. The Central Bank or Treasury builds up a credit balance with banks in foreign
countries that adopt the gold coin or gold bullion standard. This balance can be
established by borrowing from abroad, exporting goods, and investing abroad.
Importing, paying foreign obligations, lending money abroad, and spending abroad
could reduce it.
3. The Treasury or the Central Bank buys and sells any amount of gold drafts drawn
upon banks located in the foreign country to which it has related its currency or to
foreign banks which operates under the gold coin or gold bullion standard.
4. The government allows people to export and import their gold and hoard it and use it
for any other purpose.
5. All other kinds of currency circulating in the country can ultimately be redeemed at
par in gold drafts, which will eventually be equivalent to gold.

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Advantages of the Gold Exchange Standard

1. The country can adopt any circulating medium to be used as the monetary unit.
2. The country does not have to maintain large size of reserves as is needed in a full
gold standard.
3. Since gold coins do not circulate, there is economy in the use of gold and loss of gold
from abroad is prevented.
4. It avoids the expense incurred in handling, packing, as well as shipping of gold
abroad.
5. Reserves deposited in foreign countries earn interest.
6. Borrowed money when deposited abroad may lead to a favorable credit transaction
for the depositing country.
7. The government realizes a profit from the buying and selling of foreign gold drafts.

Disadvantages of the Gold Exchange Standard

1. It does not have the check and balance present in the gold coin and gold bullion
standard. (Check and balance mean that the money supply should always be equal
to the gold reserves so that if gold reserves are reduced money supply is also
reduced and vice-versa.)
2. The country adopting the standard does not control its reserve deposited in the other
country.
3. There is a possibility of an excessive exportation of gold. If this happens, people
begin to lose confidence in their monetary unit, thereby encouraging hoarding of gold.
4. Both countries, the depository country and the depositing country are using the same
reserve. In case an economic crisis arises in the country where the reserves are kept,
two things could possibly happen: First, the depository country might suspend the
convertibility of their currency into gold, causing the depositing country to suffer since
its currency could only be convertible to a weak currency. Thus, other countries might
refuse to deal with them, which will affect their trade, Second, if the depositing
country transfers their reserves to another gold standard country, the depository
country will suffer a drastic reduction in their money supply since their gold reserves
were reduced.

Bimetallic Standard - is a monetary system in which two metals provides the basis for
the money in circulation and the issuer stands ready to buy or sell either of the two metals at
stated prices.

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Bimetallism may also be defined as a monetary system in which coins of two different
metals at a fixed legal ratio of weights and fineness are used as the monetary unit or the
standard unit of value.

Legal ratio, coinage ratio or mint ratio refers to the ratio between the weights of gold
coins and silver coins in the mint. Market ratio refers to the ratio of the value of gold and
silver as being bought and sold in the market.

A mint ratio of 16 to 1 means that a gold dollar is equivalent to 16 times the value of a
silver dollar. Discoveries of the metals may cause market disturbances in their relative
values. When silver discoveries decrease the bullion value of silver, the silver dollar no
longer contains as much bullion value as the gold dollar. On the other hand, if gold
discoveries reduce the value of gold as compared to silver, the bullion value of the dollar
becomes less than that of the silver dollar. Such a situation invites the operation of
Gresham's Law. The dearer metal displaces the cheaper metal from circulation. The same
thing happens when other bimetallic countries have their legal ratio differ from that of the
country concerned, thus foreign mint ratio affects the domestic ratio.

Gresham's Law states that the bad or overvalued money drives out the good or
undervalued money from circulation. Given a sufficient supply of bad or overvalued money,
which has the qualities of general acceptability, the good or undervalued money will be
displaced by the lighter or overvalued money. Gresham's Law operates whenever the
market ratio of silver to gold shifts away from the mint or legal ratio. When the value of gold
and silver are equal, then mint ratio and market ratio are also equal. But when silver
becomes over abundant thus reducing its value and becomes cheaper, silver would tend to
drive the gold coins out of the circulation.

If mint ratio were 16 to 1, both gold and silver circulate but if silver production should
expand and make silver cheaper than gold, making the ratio 17 to 1, it would be profitable to
convert the gold coins into bullions and exchange it in the market for 17 to 1. Out of the 17
parts of silver, 16 parts are made into silver coins and replace the gold coins melted, and
one part of silver would be left as a profit. So long as the market ratio remains sufficiently
different from the mint ratio, the displacement of the dearer metal by the cheaper metal will
continue.

If an increase in the output of gold lowered the value of gold relative to silver so that the
metal ratio becomes 15 to 1, the reverse of what we have just analyzed will happen.

Characteristics of the Bimetallic Standard

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1. Two kinds of coins at a fixed legal ratio of weights are used as standard money.
2. Both metals have unlimited coinage at a fixed legal ratio.
3. Both gold and silver are legal tender.
4. Both metals can be freely imported and exported. In other words, there is free market
for both gold and silver.
5. All kinds of money circulating in the country are ultimately convertible into both gold
and silver coins.

B. Non-commodity or Fiat Standard - This standard refers to a monetary system in which

the face value of the monetary unit is much higher than that of the value of the material used
as money. Essential Characteristics of the Fiat Standard

1. A fiat money is adopted as the standard unit of value or monetary unit.

2. The fiat money is legal tender.
3. All other money issued by the government is redeemable in the standard fiat money.

Types of Fiat Standard

1. Utopian paper Standard or Pure Fiat Standard. This standard proposes the
adoption of standard money that is desired, primarily because of what it can buy for
the individual in goods and services and not for what it is made of, whether gold or
silver. It is important that the said money must have legal tender power. This
standard is more of a theory because it has not yet been put into use. This theory
was the forerunner of the Involuntary Paper Standard and the Managed Currency
System.
2. Involuntary Paper Standard. It is adopted by a country that finds itself in a dilemma
of not being able to redeem its currency in either gold or silver and so is forced by
circumstance to adopt the involuntary paper standard. This often comes about during
wartime. The Philippines adopted this standard during the Japanese time from the
year 1941 to 1945.
3. Managed Currency Standard. This standard espouses the use of an inconvertible
and irredeemable paper money that is issued against no gold or silver reserves,
which is managed by the Central Bank in such a way as to keep the price levels fairly
stable by increasing the amount of paper money at one time and decreasing it at

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another, using the trade and industrial conditions as barometer. People accept this
paper money because the government has given it a legal tender power.

Legal tender power refers to that power given to money to settle all obligations whether
public or private. This power is given by law. The Philippines adopted this monetary standard
in 1949 and still operates under the same standard up to the present time.

General Characteristics of the Managed Currency Standard

1. The paper money is inconvertible and irredeemable.

2. No reserves are maintained to back up the domestic money supply.
3. The Central Bank is authorized to exercise control over the credit system so as to
control money supply.

Objectives of the Managed Currency Standard

In the Philippines, the Managed Currency Standard share the same objective with
the Central Bank of the Philippines. Its first objective is to facilitate production; second, to
make prices stable, third, to make each and every Filipino maximize his income; fourth, to
promote full employment, fifth, to have an equitable distribution of wealth in the country; sixth,
to preserve the international value of the peso; and seventh, to make the country
economically rich, and politically and militarily strong and powerful.

The Central Bank has devised ways by which we could attain such objectives. This
will be discussed later on in the later chapter entitled Central Banking

Advantages of the Manage Currency System

1. Money supply is not dependent on the gold reserves, but is controlled by the
monetary authorities.
2. There will be greater price stability since prices depend on the volume of money in
circulation.

Disadvantages of the Manage Currency System

1. Since money is not tied up to any reserve, there is always the danger of over
issuance of money, which will lead to inflation.

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2. Since foreign exchange rates are not fixed by the metallic content of currencies, this
may result to an erratic fluctuation of prices.
3. Competitive monetary depreciation might easily be used by each nation in a fight for
world trade.

From a political point of view, it is easier to issue paper money or what we term
"Printing Press" money than increase taxes.

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