Money, the Central Bank and Monetary Policy
Exam scope and model
Canvas Quiz #2 explicitly lists Monetary Policies. Lecture 07 connects the functions of money to the central bank, interest rates, money demand and supply, and expansionary versus contractionary policy. The study items use its simple money-market diagram with interest rate on the vertical axis and money quantity on the horizontal axis. Any numerical relationship is supplied in the question as a hypothetical model.
Three jobs that money performs
Medium of exchange means money is accepted in purchases, reducing the need to find someone who both has what you want and wants what you have. Unit of account means prices and obligations share a common monetary measure. Store of value means money can carry purchasing power from one period into another.
One example may involve more than one function, so identify the specific action in the question. Paying ₱120 for lunch uses the medium of exchange. Comparing a ₱120 lunch with a ₱90 lunch uses the unit of account. Holding cash to buy lunch next month uses the store of value. Money can store value imperfectly: inflation reduces how much a fixed nominal amount buys. “Store of value” never implies guaranteed constant real purchasing power.
Nominal pesos versus purchasing power
If cash remains ₱1,000 while the price of an identical basket rises from ₱200 to ₱250, the cash buys five baskets initially and four later. The nominal amount is unchanged, while purchasing power in baskets falls 20%. The basket price rose 25%; reciprocal changes use different denominators.
The lecture calls interest both a cost of borrowing and a reward for saving. Higher interest makes a given debt more costly and can make interest-bearing saving more attractive. These tendencies help explain a spending response; they do not mean every household or firm responds identically or that all money disappears when someone deposits it.
For a supplied annual simple-interest exercise, interest = principal × annual rate × years. A ₱60,000 one-year loan costs ₱3,600 at 6%, versus ₱4,800 at 8%. The ₱1,200 increase may discourage a project whose return does not cover the higher financing cost. These are simple one-year hypothetical comparisons, not a claim about actual loan contract terms.
Reading the course money-market diagram
Money demand slopes down with respect to the interest rate. Holding money has an opportunity cost when interest-bearing alternatives exist. At a higher interest rate, the quantity of money demanded is lower, other determinants held constant. An interest-rate change moves along a given money-demand curve.
Higher real GDP can shift money demand to the right because more transactions require more money at each interest rate. That is a shift of the curve, not merely a movement along it. With fixed money supply, the new equilibrium interest rate is higher.
Money supply is vertical in the lecture's model: the supplied quantity is policy-determined rather than varying with the interest rate within that diagram. This is a model assumption, not a full description of every banking response.
Equilibrium occurs where quantity of money demanded equals quantity supplied. At a rate above equilibrium, this model has excess supply of money; at a rate below equilibrium it has excess demand for money. Label the axes and identify which curve changed before predicting a rate movement.
Fully specified numerical diagram
Suppose hypothetical money demand is Md = 900 − 30r, where money is in ₱ billion and r is a numerical annual percentage rate (r = 5 means 5%). Money supply is ₱750 billion.
- At equilibrium, 900 − 30r = 750.
- Thus 30r = 150 and r = 5%.
- If supply rises to ₱810 billion with demand unchanged, 900 − 30r = 810 gives r = 3%.
- Supply has shifted right; demand has not shifted. The quantity demanded rises along the same demand curve as the equilibrium interest rate falls.
Expansionary and contractionary monetary policy
| Direction | Money supply in the course diagram | Interest rate, other things equal | Intended demand effect |
|---|---|---|---|
| Expansionary | Right | Down | Encourage interest-sensitive spending and activity |
| Contractionary | Left | Up | Restrain spending and inflationary pressure |
Use the whole chain: a policy action affects monetary conditions; financing and saving incentives change; spending may respond; output, employment and prices respond subject to the economy's circumstances. The central bank influences inflation through these channels. It does not directly edit the measured CPI into a desired number.
The tools named in the source
The lecture lists issuance of money, interest-rate policy, reserve requirements, open-market operations (OMO) and quantitative easing. For introductory reasoning:
- A central-bank purchase of securities supplies payment to the financial system and is expansionary in the simple model; a sale withdraws it and is contractionary.
- A lower reserve requirement permits a larger share of a given deposit base to support lending under the stated assumptions; a higher requirement constrains that capacity.
- Quantitative easing refers to asset purchases financed by newly created central-bank money in the lecture. Do not equate it with a tax cut or government purchases of roads.
A reserve requirement of 10% on a stated ₱500 million deposit base requires ₱50 million in reserves. At 12%, required reserves are ₱60 million, a ₱10 million increase. This calculation describes required reserves, not a guaranteed change in aggregate lending. If a problem assumes fixed deposits and every unreserved peso lends, state that assumption before computing a maximum.
Inflation and the historical example
The lecture uses wartime currency to illustrate a warning: increasing nominal money while goods and services fail to expand can create strong inflationary pressure. More printed currency is not the same as more real productive resources. The example is a mechanism to analyze, not a numerical rule that a given percentage change in money must always cause the same percentage inflation.
Monetary versus fiscal authority
Monetary policy is undertaken by the central bank through monetary and financial conditions. Fiscal policy uses the government's expenditure and tax choices. A road-building program is fiscal even if it affects employment and prices. A central-bank securities purchase is monetary even if its objective is to support growth. The policy's instrument and authority identify its category more reliably than its desired goal.
The source describes monetary responses as faster and fiscal responses as slower. Treat this as a broad classroom comparison of implementation channels, not an unconditional forecast of when prices or employment must change.
Common traps
- Confusing the function of money with a promise that its real value never changes.
- Shifting money demand merely because the interest rate changes, or moving along demand when GDP changes its position.
- Predicting a lower rate from a supply reduction.
- Calling all government-related financial activity fiscal.
- Treating a reserve calculation as a guaranteed lending outcome.
- Describing inflation control as a direct instruction to every seller's price tag.
Source map
07. Money, The Central Bank, and Monetary Policies.pdf, pp. 3–11: authority, functions, rates, money market, policy tools and inflation mechanism.- The same file, pp. 13–14: true/false practice themes. These materials provide original questions and explicit assumptions rather than a copied answer key.
08. Fiscal Policies, International Market & Foreign Exchange Market.pdf, p. 3: comparison of monetary and fiscal instruments.