ECONOMIC ANALYSIS

MIDTERM EXAM

WHAT IS MONETARY POLICY

a.

b.

c.

d.

2. Monetary policy comprises actions taken by the central bank (BSP) to

influence economic activity and stabilize prices by controlling the money
supply in the economy. The BSP implement this by Inflation Targeting as
the main framework.
Just like Fiscal Policy, Monetary Policy is implemented in two ways with two
opposing effects. First is the Expansionary Monetary Policy which intends to
increase the level of money supply in the economy and which could also
result in a relatively higher inflation path for the economy. Examples are the
lowering of policy interest rates and the reduction in reserve requirements.
Expansionary monetary policy tends to encourage economic activity as more
funds are made available for lending by banks. This, in turn, increases
aggregate demand which could eventually fuel inflation pressures in the
domestic economy. On the other hand, Contractionary Monetary Policy
intends to decrease the level of money supply in the economy and which
could also result in a relatively lower inflation path for the economy. Examples
of this are increases in policy interest rates and reserve requirements.
Contractionary monetary policy tends to limit economic activity as less funds
are made available for lending by banks. This, in turn, lowers aggregate
demand which could eventually temper inflation pressures in the domestic
economy.
One ill side effect of the implementation of the monetary policy is that when
interest rates are so low, people are encouraged to have loans and excess
debts with artificially low interest rates can lead to crash (e.g. real estate
bubble).
The tools used by BSP in implementing the monetary policy are Open
Market Operations
(outright sales/purchases of the BSP's holding of government securities,
repurchase and reverse repurchase (RRP), and foreign exchange swaps);
Accepting Fixed Term Deposits (encouraging/discouraging deposits in the
special deposit account (SDA) facility by banks and trust entities of BSPsupervised financial institutions); Rediscounting (adjusting the rediscount
rate on loans extended to banking institutions on a short-term basis against
eligible collateral of banks' borrowers); and Reserve Requirements
(increasing/decreasing the reserve requirement).
Open Market Operations (OMO) involve Repurchase and Reverse
Repurchase of Government Securities, Direct Purchase or Sale of Government
Securities, and Foreign Exchange Swaps.
- Repurchase and reverse repurchase transactions are carried out through
the reverse repurchase (RRP) facility and the repurchase (RP) facility of
the BSP. In a repurchase or repo transaction, the BSP buys government
securities (GS) from a bank with a commitment to sell it back at a

specified future date at a predetermined rate. When the BSP purchases

government securities, this will increase the banks reserve balances
thereby increasing money supply in the economy stimulating economic
activity. On the other hand, in a reverse repurchase, the BSP acts as the
seller of GS and the banks payment to the BSP has a contractionary effect
on liquidity or decreasing money supply in the economy cooling down
economic activity.
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
transaction thus increases the buyers holdings of central bank reserves
and expands the money supply, thereby encouraging economic activity.
Conversely, when the BSP sells securities, the buyers payment causes the
money supply to contract, slowing down economic activity.
Foreign exchange swaps refer to transactions involving the actual
exchange of two currencies on a specific date at a rate agreed on the deal
date, and a reverse exchange of the same two currencies at a date further
in the future at a rate agreed on deal date. Currency swaps serve two
main purposes. First, they can be used to minimize foreign borrowing
costs. Second, they could be used as tools to minimize exposure to
exchange rate risk. It will smoothen out fluctuations in exchange rates.