Bangko Sentral ng Pilipinas

How Monetary Policy Works

The BSP

The Bangko Sentral ng Pilipinas (BSP) is the central bank of the Republic of the Philippines. It was established on 3 July 1993 pursuant to the provisions of the 1987 Philippine Constitution and the New Central Bank Act of 1993. The BSP took over from the Central Bank of Philippines, which was established on 3 January 1949, as the country’s central monetary authority. The BSP enjoys fiscal and administrative autonomy from the National Government in the pursuit of its mandated responsibilities.

Functions

The Bangko Sentral ng Pilipinas has three core functions ( three pillars of central banking):

1.) Maintenance of price stability

2.) Supervision and examination of banks and other financial institutions (regulation)

3.) Establishment and maintenance of an efficient payments and settlements system

Maintenance of Price Stability

• Price stability refers to the condition of low and stable inflation. By keeping inflation low, the BSP helps ensure strong and sustainable economic growth and better living standards. With price stability, prices of goods do not rise too quickly and people have a degree of certainty when deciding how to spend, save or invest their money.

• The BSP conducts monetary policy using an approach called inflation targeting. In this approach, the BSP promises to keep average inflation close to pre-announce target. If for example, prices are rising more rapidly than the desired inflation rate. Because of the very strong demand for goods and services relative to supply, then the BSP will take action to bring down inflation to the target level by tightening monetary policy.

On the other hand, if forecasted inflation below the target, and then there's a weak demand for goods and services, then the BSP will ease monetary policy. The BSP has several means or instruments to carry out its monetary policy. To tighten monetary policy, the BSP can raise its policy interest rates pumping market interest rates to follow suit. It can also sell government securities as part of its open market operations to reduce the amount of money in the the financial system. Or it can raise reserve requirements imposed on banks. 

The BSP can also accept fixed-term deposit from banks and non-banks financial institutions. To ease monetary policy, the BSP does the opposite. For example, it can reduce policy rates, buy government securities or bring down the reserve requirements. The BSP also ensures adequate liquidity on the banking system with loans to banks through the rediscounting facility.

• The BSP extends discounts, loans and advances to banking institutions in order to influence the volume of credit consistent with objective of price stability. It also grants loans or advances to banking institutions in precarious financial condition or under serious financial pressures, subject to certain conditions.

• When availing of the loan facilities of the BSP, private banks assign to BSP their receivables including the collaterals. Upon failure of these banks or their borrowers to pay their loans, the BSP forecloses these real properties. Banks also pay their loans with properties under a dacion en pago agreement. As such, the BSP has acquired assets which it administers, preserves and disposes properly.

Supervision of Financial Institutions

• The Bangko Sentral has supervision over the operations of banks and exercises such regulatory powers as provided in the New Central Bank Act and other pertinent laws over the operations of finance companies and non-bank financial institutions performing quasi-banking functions.

Establishment of Efficient Payment Systems

• Efficient payment systems are important because they allow the safe and timely completion of big ticket transactions. These big tickets include the following: Interbank loan transactions, purchase and sale of government securities, foreign currency transactions, and interbank settlement of ATM transactions.Undoubtedly, the payments and settlements system plays a crucial role in the Philippine economy. Director Bella Santos, head of the BSP's Payments and Settlements Office says: “If transactions are the lifeblood of market economy, then the payments and settlements system is the circulatory system for these transactions.”

• For this purpose, the Bangko Sentral ng Pilipinas established in December 2002 the Philippine Payments and Settlements System or PhilPaSS. The PhilPaSS is a real time gross settlement system (RTGS) that enables the high-value payment transactions between participating institutions through the deposit accounts which they maintain with the BSP.

• Under the system, banks and other non-banks with quasi-banking functions (NBQBs) could settle their payments in real time. The banks and NBQBs send electronic messages to the BSP through the PhilPaSS, instructing the central monetary authority to debit their account with the BSP and credit the account of the payee bank.

How does the BSP create money?

• When banks give out loans, they do not give out money that they already have. They simply give the loan which is a promise to pay the actual money which they never really have to do. In the economy, 95% of the money is in the form of bank credit. There is no real currency backing it.

• Whenever we borrow money, the bank creates new money. This process constantly (almost) expands the money supply. This dilutes the value of the existing money. This is because total debt has to keep expanding in order for people to be able to pay back what they owe, otherwise there simply won’t be enough money to earn to pay back what we owe. When that happens, we declare bankruptcy, there are foreclosures, unemployment and so on which causes the vicious cycle of deflation.

What is Monetary Policy?

Monetary policy, collectively, are actions of a central bank, currency board or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates. Monetary policy is maintained through actions such as increasing the interest rate, or changing the amount of money banks need to keep in the vault (bank reserves).

The primary objective of BSP's monetary policy is to promote a low and stable inflation conducive to a balanced and sustainable economic growth. The adoption of inflation targeting framework for monetary policy in January 2002 is aimed at achieving this objective.

Monetary & Fiscal Policies

While fiscal policy deals with government spending in relation to the different economic circumstances in the market, monetary policy deals with the very creation and availability of money. These two policies interplay to regain control over the excess or lack of different economic activities like spending, producing, saving, and loaning.

BSP’s Approach to Monetary Policy

• Inflation targeting is focused mainly on achieving a low and stable inflation, supportive of the economy’s growth objective. This approach entails the announcement of an explicit inflation target that the BSP promises to achieve over a given time period. 

• The inflation rate in Philippines was recorded at 3.80 percent in August of 2012. Historically, from 1958 until 2012, Philippines Inflation Rate averaged 9.08 Percent reaching an all time high of 62.80 Percent in September of 1984 and a record low of -2.10 Percent in January of 1959. Inflation rate refers to a general rise in prices measured against a standard level of purchasing power. The most well known measures of Inflation are the CPI which measures consumer prices, and the GDP deflator, which measures inflation in the whole of the domestic economy. This page includes a chart with historical data for Philippines Inflation Rate. 

• The Inflation Target• The government’s inflation target is defined in

terms of the average year-on-year change in the consumer price index (CPI) over the calendar year. The inflation targets have been set at 4.5 percent with a tolerance interval of + 1.0 percentage point for 2010 and 4.0 percent with a tolerance interval of + 1.0 percentage point for 2011.

• The BSP has a number of monetary policy instruments at its disposal to promote price stability. To increase or reduce liquidity in the financial system, the BSP uses open market operations, accepts fixed-term deposits, offers standing facilities and requires banking institutions to hold reserves on deposits and deposit substitutes.

Open Market Operations

• Open Market Operations (OMO) – the sale or purchase of government securities by the BSP to withdraw liquidity from or inject liquidity into the system.

• Open market operations are a key component of monetary policy implementation. These consist of repurchase and reverse repurchase transactions, outright transactions, and foreign exchange swaps.

Repurchase and reverse repurchase transactions are carried out through the repurchase (RP) facility and the reverse repurchase (RRP) facility of the BSP.

• In a repurchase or repo transaction, the BSP buys government securities from a bank with a commitment to sell it back at a specified future date at a predetermined rate. The BSP’s payment to the bank increases the latter’s reserve balances and has an expansionary effect on liquidity.

• Conversely, in a reverse repo, the BSP acts as the seller of government securities and the bank’s payment has a contractionary effect on liquidity. RP and RRP transactions have maturities ranging from overnight as well as two weeks to one month. The interest rates for the overnight RRP and RP facilities signal the monetary policy stance and serve as the BSP’s primary monetary policy instruments.

• Outright transactions refer to the direct purchase/sale by the BSP of its holdings of government securities from/to banking institutions. In an outright transaction, the parties do not commit to reverse the transaction in the future, creating a more permanent effect on money supply. The transactions are conducted using the BSP’s holdings of government securities.

• When the BSP buys securities, it pays for them by directly crediting its counterparty’s Demand Deposit Account with the BSP. The transaction thus increases the buyer’s holdings of central bank reserves and expands the money supply. Conversely, when the BSP sells securities, the buyer’s payment (made by direct debit against his Demand Deposit Account with the BSP) causes the money supply to contract.

• Foreign exchange swaps refer to transactions involving the actual exchange of two currencies (principal amount only) on a specific date at a rate agreed on the deal date (the first leg), and a reverse exchange of the same two currencies at a date further in the future (the second leg) at a rate (different from the rate applied to the first leg) agreed on deal date.

• The agreement consists of swapping principal and interest payments on a loan made in one currency for principal and interest payments of a loan of equal value in another currency.

• The main worry is that such swap agreements could create inflationary pressure since opening new means to distribute liquidity can increase the total demand for and consequently the supply of money. Moreover, the maximum amount of a swap agreement is agreed upon several months in advance or may even be unlimited. Since the receiving central bank may auction off the maximum amount but can only supply as much funds as are effectively demanded by its banking system, the uncertainty in the growth of the money supply increases.

• The fact that demand for foreign-denominated-currency spikes only when liquidity tensions are high implies that the inflationary effect of these swap agreements is very contained. When liquidity demand spikes, banks tend to hoard any funds they receive and increasing the money supply does not create inflationary pressure. In contrast, in calm times, the swaps are not used since banks finance themselves on the interbank market. Since swap agreements are essentially not used precisely in circumstances were increasing money supply would create inflationary pressure, their effect on inflation is minimal.

Acceptance of Fixed-Term Deposits

• The BSP also accepts deposits from banks. The Special Deposit Accounts (SDA) facility consists of fixed-term deposits by banks and by trust entities of banks and non-bank financial institutions with the BSP. It was introduced in November 1998 to enable the BSP to expand its toolkit in liquidity management. In April 2007, the BSP expanded access to the SDA facility by allowing trust entities to deposit in the SDA facility in order to better manage liquidity in the face of strong foreign exchange inflows.

SDAs

• SDAs are money instruments employed by the BSP as a tool to mop up excess liquidity in the market. Excess funds can lead to inflation and since the BSP’s primary mandate is to control inflation in the country, the agency utilizes several tools to help achieve this goal. Special Deposit Accounts (SDA) are one of these liquidity management tools.

• To motivate retail and institutional investors to invest in SDAs, the BSP offers interest rates relatively higher than the rates offered by regular savings and time deposit accounts. Placements are also backed by the BSP, the agency in charge of printing the country’s currency, so there is very low risk of default.

SDAs

• Deposit terms are usually up to one month, meaning, the investor can already earn interest and pull out the placement after one month. This scenario, however, poses a risk to the Philippine’s foreign exchange market because wild swings in the inflows and outflows of currencies can produce volatility in the Peso-Dollar exchange rate.

• The Philippine Peso has emerged as Southeast Asia’s fastest-rising currency during the first half of 2012. Partly to blame is the foreigners’ increased appetite for the Peso, dumping the US Dollar (and other foreign currencies) in the process.

SDAs

• Worse, some large, foreign institutional fund companies engage in currency carry trade which puts additional pressure to the Peso against the Dollar. Carry trade occurs when fund managers borrow currencies that pay low interest rate (such as the US Dollar or the Japanese Yen) and converts them into currencies paying high interest rates, as in the case of the Philippine Peso and the SDA offering.

• Foreign funds flowing into the country contribute to an appreciating peso which may be good to some sectors but it also creates market instability when these funds turn out to be “hot money,” or funds that flow in and out of the country very quickly. Such erratic movement of funds produce, among others, a fluctuating exchange rate.

Standing Facilities

• The BSP extends discounts, loans and advances to banking institutions in order to influence the volume of credit in the financial system. Rediscounting is a standing credit facility provided by the BSP to help banks meet temporary liquidity needs by refinancing the loans they extend to their clients. The rediscounting facility allows a financial institution to borrow money from the BSP using promissory notes and other loan papers of its borrowers as collateral. There are two types of rediscounting facilities available to qualified banks: the peso rediscounting facility and the Exporters’ Dollar and Yen Rediscount Facility (EDYRF) which was introduced in 1995.

Reserve Requirements

• Reserve requirements refer to the percentage of bank deposits and deposit substitute liabilities that banks must keep on hand or in deposits with the BSP and therefore may not lend. Changes in reserve requirements have a significant effect on money supply in the banking system, making them a powerful means of liquidity management.

Reserve Requirements• We saw that banks created money as a by-product of their

quest for profit. Banks are limited in the process of money creation by the need to hold some assets in the form of reserves. In the early days of banking, banks needed reserves so that they could redeem deposits or notes on demand. Today the amount of reserves and the form that they take are determined by government regulation.

• (1) Required Reserves = (Required Reserve Ratio)x(Deposits).• Banks can hold more reserves than are required. Any reserves

above what are required are excess reserves, or:• (2) Excess Reserves = Legal Reserves - Required Reserves.

• Reserve requirements apply to peso demand, savings, time deposit and deposit substitutes (including long-term non-negotiable tax-exempt certificates of time deposit or LTNCTDs) of universal banks (UBs) and commercial banks (KBs) and may be kept in the form of cash in vault, deposits with the BSP and government securities.

• Required reserves consist of two forms: regular or statutory reserves; and liquidity reserves. Deposits maintained by banks with the BSP up to 40 percent of the regular reserve requirement are paid interest at 4 percent per annum, while liquidity reserves are paid the rate on comparable government securities less half a percentage point. The use of liquidity reserves help to reduce bank intermediation costs since they are paid market-based interest rates. In March 2006, the Monetary Board began to require banks to keep liquidity reserves in the form of term deposits in the reserve deposit account (RDA) with the BSP instead of government securities bought directly from the BSP.

• The expansion of a country's money supply that results from banks being able to lend. The size of the multiplier effect depends on the percentage of deposits that banks are required to hold as reserves. In other words, it is money used to create more money and is calculated by dividing total bank deposits by the reserve requirement. 

If, for example, the reserve requirement is 20%, for every $100 a customer deposits into a bank, $20 must be kept in reserve. However, the remaining $80 can be loaned out to other bank customers. This $80 is then deposited by these customers into another bank, which in turn must also keep 20%, or $16, in reserve but can lend out the remaining $64. This cycle continues - as more people deposit money and more banks continue lending it - until finally the $100 initially deposited creates a total of $500 ($100 / 0.2) in deposits. This creation of deposits is the multiplier effect. 

The higher the reserve requirement, the tighter the money supply, which results in a lower multiplier effect for every dollar deposited. The lower the reserve requirement, the larger the money supply, which means more money is being created for every dollar deposited.

Monetary Policy and Inflation

• Price stability exists when prices overall are stable (ie, money is an effective store of value). This does not mean that prices are frozen, but rather that taken on the whole they are stable. In an environment of price stability, you would expect some prices to be rising but others to be falling.

• The rate of inflation tends to increase when the overall demand for goods and services exceeds the economy's capacity to sustainably supply goods and services. Likewise, when productive capacity is greater than demand, the rate of inflation tends to decrease, and, if the excess capacity persists, deflation can occur.

• By "demand" we mean the desire for goods and services that is supported by the means to purchase those goods and services.

• By "the economy's capacity to sustainably supply those goods and services" we mean the level of production that can be sustained without shortages occurring.

• Thus, throughout the economy, if factories are working flat out to meet demand, inflationary pressure may emerge. Factory staff will work longer hours, which may require overtime payments, thereby forcing firms to put up their prices.

• Conversely, if factories are producing more goods than they can sell, then to get rid of the stock that is building up they may have to reduce their prices. If enough do this the rate of inflation will start to fall.

Monetary Policy and Inflation• Monetary policy can control the growth

of demand through an increase in interest rates and a contraction in the real money supply. For example, in the late 1980s, interest rates went up to 15% because of the excessive growth in the economy and contributed to the recession of the early 1990s.

• The benchmark interest rate in Philippines was last reported at 3.75 percent. Historically, from 1985 until 2012, Philippines Interest Rate averaged 10.16 Percent reaching an all time high of 56.60 Percent in December of 1990 and a record low of 3.75 Percent in July of 2012. 

• The Lending interest rate (%) in Philippines was last reported at 6.66 in 2011, according to a World Bank report published in 2012. Lending interest rate is the rate charged by banks on loans to prime customers.

• The Real interest rate (%) in Philippines was last reported at 2.32 in 2011, according to a World Bank report published in 2012. Real interest rate is the lending interest rate adjusted for inflation as measured by the GDP deflator.

The effects of higher interest rates

• Higher interest rates reduce aggregate demand in three main ways

• • Discouraging borrowing by both households and companies• • Increasing the rate of saving (the opportunity cost of

spending has increased)• • The rise in mortgage interest payments will reduce

homeowners' real 'effective' disposable income and their ability to spend. Increased mortgage costs will also reduce market demand in the housing market

• • Business investment may also fall, as the cost of borrowing funds will increase. Some planned investment projects will now become unprofitable and, as a result, aggregate demand will fall.

• • Higher interest rates could also be used to limit monetary inflation. A rise in real interest rates should reduce the demand for lending and therefore reduce the growth of broad money.

Monetary Policy and Inflation• The balance between the overall demand for goods

and services and the economy's capacity to sustainably supply them determines inflation.

• In the jargon of economists, the difference between demand and the economy's capacity to supply is known as the output gap. Monetary policy can't affect the economy's capacity to supply. However, monetary policy can stimulate or dampen demand. This is done by adjusting short-term interest rates.

• The output gap is the difference between demand and the economy's capacity to supply. This is the difference between the ‘actual' level of output (GDP) and the economy's ‘potential' level of output (potential GDP).

• If the economy is running above capacity (GDP > potential GDP) the output gap is positive. Conversely, if the economy is running below its full capacity (GDP < potential GDP) the output gap will be negative.

Monetary Policy and Inflation• A reiteration of the things that you already know

Inflation is an autonomous occurrence that is impacted by money supply in an economy. Central governments use the interest rate to control money supply and, consequently, the inflation rate. When interest rates are high, it becomes more expensive to borrow money and savings become attractive. When interest rates are low, banks are able to lend more, resulting in an increased supply of money.

Alteration in the rate of interest can be used to control inflation by controlling the supply of money in the following ways:

A high interest rate influences spending patterns and shifts consumers and businesses from borrowing to saving mode. This influences money supply.

A rise in interest rates boosts the return on savings in building societies and banks. Low interest rates encourage investments in shares. Thus, the rate of interest can impact the holding of particular assets.

A rise in the interest rate in a particular country fuels the inflow of funds. Investors with funds in other countries now see investment in this country as a more profitable option than before.

• A central bank affects the level of short term interest rate via changes in the money supply. When the it wants to tighten (loosen) monetary policy, it will perform an open market sale (purchase) of government bonds that will lead to a reduction (increase) in the money supply and an equilibrium increase (fall) in the short term interest rate.

• Consider first how the money supply is increased. In general, the central bank changes the supply of money through open market purchases or sales of government bonds. Consider the following balance sheet of the central bank:

• Central Bank Balance Sheet• Assets Liabilities • -------------- ------------------

• Treasury Bills held by the CB 300 Currency 500

• Foreign Exchange Reserves 200

• The liabilities of the central bank are equal to the total amount of currency in circulation. Money is, in fact, a liability of the government, a zero interest rate loan that the private sector makes to the public sector by being willing to hold cash.

• orrespondingly, the balance sheet of the private sector is:

• Private Sector Balance Sheet

• Assets Liabilities and Net Worth

• Currency 500 Net Worth 2000

• Treasury Bills held by public 1200

• Foreign T-Bills held by public 300 •

• Here, we assume that all private wealth is held only in three assets, money and domestic and foreign Treasury Bills; private agents do not have any liabilities so that their net worth is equal to their assets.

• Now, consider the effects on the supply of money of an open market purchase by the central bank of 100b of domestic T-bills previously held by the public. Since the central bank buy these bonds from the public by printing more money, this open market purchase of T-bills leads to an increase in the money supply by 100b, from 500 to 600b:

• Central Bank Balance Sheet• Assets Liabilities• Treasury Bills 400 Currency 600

• Forex Reserves 200 •

• Private Sector Balance Sheet

• Assets Liabilities and Net Worth

• Currency 600 Net Worth 2000

• Treasury Bills held by public 1100

• Foreign T-Bills held by public 300

• Consider now the effects of this open market operation on the money and bond markets (see Figure 5): the supply of money increases (as the MS curve shifts to the right) while the supply of bonds available to the public decreases (as the BS curve shifts to the left). At the initial interest rate, the open market purchase of bonds leads to an increase in the money supply (from 500 to 600) and a reduction in the supply of T-bills available to the private sector (1200 to 1100).

• The increase in the money supply implies that now the money supply is greater than the money demand: agents were happy with their initial holdings of cash and are now forced to hold more cash than they desire. Conversely, in the bond market, the reduction in the supply of T-bills implies that the demand for bonds is now greater than its supply. Since private agents have now more cash than they desire and less bonds than they desire, they try to get rid of the excess money balances by buying more T-bills. Their attempt to buy bonds in exchange for cash leads to an increase in the price of bonds and a fall in the interest rate. The interest rate fall, in turn, reduces the excess supply of money and the excess supply of bonds.

• Since the supply of money and bonds is exogenously given, the attempt of agents to get rid of excess cash in exchange of more bonds cannot succeed: in equilibrium the greater amount of cash has to be willingly held by agents and the lower supply of bonds has to be willingly held by agents. Then, the interest rate has to fall so that the demand for money is increased and demand for bonds is decreased. This process has to continue up to the point in which the interest rate has fallen enough so that the demand of money is equal to the higher money supply while the bond demand is equal to the lower bond supply. Therefore, an increase in the money supply through an open market purchase of T-bills leads to a reduction in the equilibrium interest rate.

…because we believe that academic freedom and intelligence

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