CHAPTER 1

RATIONALE IN STUDYING FINANCIAL MARKETS

AND INSTITUTIONS
THE NEED TO STUDY FLNANCÄL MARKETS
In a market system, businesses of all QP•e.s face risks, and many business—
fanEconomists and policy makers are particularly and
peentlal failure that financial institutions (bank and non-sank) face because they
play a vital role in the financial system.

Financial markets and institutions not only influence y•ur life but also involve
huge flovss of funds — trillions of dollars — throuzhout the '*0tid economy
which is turn affect business profits. the production of •oods and services and
the economic well-being of countries around the

The study of financial markets and institutions '*ill re».zrd you '*ith an
understanding of many exciting issues such as how funds are transferred from
people who have an excess of as ailable funds to people have a shortage.

Indeed, well-functioning financial markets are a key factor in producing high

economic grov,th and poorly performing financial markets are one reason that many
countries in the '*orld remain desperately poor. Activities in financial markets also
have direct effects on personal 'O.ealth, the beha',ior of business and consumers and
the cyclical performance of the economy.

On the evening television news, you just heard that the Fond market has been
booming. In the business section of a local you read that the Euro is slightly
higher against the yen. A European airline loses millions of dollars with
derivatives. The Dow Jones Industrial Al,erage is off IS points in active trading.
Another local reported that 'Söith inflation s10',ying again in June, 2019, the
Bangko Sentral ng Pilipinas (BSP) Go.ernor has sounded off on potential rate
cuts in the near term. There a hint that the overnight borrowing rate cut tome
before the last installment of the latest reserve requirement reduction s±heduled
at the snd of July, 2019 was implemented by the BSP in early May; 20 (9,
 Does this mean that interest rates will fall so that it is easier for you to
finance the purchase of a new computer system for your small retail
business? wul the economy improve in future that it is a good time to build a
new factory building or add to be you in? Should you fry to raise funds by
issuing stocks or bonds or go to the bank for a loan? If you import goods
from abroad, shouu you worried that that they will become more expensive?
All these events are examples of Financial Markets at work- That markets exercise
enormous influence over modern life comes is not news. But although people around
the word speak glibly of "Wall Street", the "stock market" and the "currency marks",
the meanings they attach to these time-worn phrases are often unclear and out-of-date.

This book explains the purposes that different financial markets serve and
clarifies the way they work. It cannot tell you whether your investment portfolio is
likely to rise or fall in value. But it may help you understand how its value is
determined and how the different securities or financial instruments in it are
created and traded.

This book provides answers to the businessmen's questions by examining how

financial markets (such as those for stocks, bond and foreign currency exchange) and
financial institutions (such as banks, insurance companies, mutual funds and other
institution) work.

The word "market" usually conjures up an image of the bustling, paper-strewn

floor of the New York Stock Exchange and of Philippine Stock Exchange and of
traders motioning frantically in the "futures" cubicles of Chicago. These images
are out-of-date as almost all the dealings are now handled computer to computer,
often with minimal human intervention.

Financial Markets have been around ever since mankind settled down to
growing crops and tading them with others. The independent decisions of all
of those frmers constituted a basic financial market, and that market fulfilled
may be the sne purpxes as financial markets do today.
Financial Markets are comprehensively discussed in Unit Ill.
 Rationale in Studvin Financial Markets and Institutions S
THE NEED To STUDY FINANCIAL INSTITUTIONS
Direct funds transfers are common among individuals and small businesses and
in economies where financial markets and institutions are less developed. But
large businesses in, developed economies generally find it more efficient to
enlist the services ofa financial institution when the to raise capital.
Financial institutions are what make financial market work. Without them,
financial markets would not be able to move funds from people who save to
people who have productive investment opportunities. Thus, they also have
important effects on the performance of the economy as a whole.

Financial institutions are financial that acquire funds by issuing liabilities and in turn use
those funds to acquire assets by purchasing securities or

They play on important role in the financial system because they reduce transaction
costs, allow sharing and solve problems' created by adverse relation and moral
hazard. As a result, financial institutions allow small savers and borrowers to benefit
from the existence of financial markets thereby increasing the efficiency of the
economy.

The field of financial markets and institutions is indeed an exciting one. Not only
will one learn materials that affect the life of the individual directly but also gain
a clearer understanding of events in financial markets and institutions that we
hear about in the news media. Understanding how financial institutions are
managed is important because there will be many times in one's life, as an
individual, an employee, or the owner of a business, when you will interact with
them. Cases provided in this textbook which provide specific analytic tools are
useful if one makes his/her career at a financial institution and also give him/her a
feel of what a job as a manager of a financial institution is all about.

Another reason for studying financial institutions is that they are among the largest
employers in the country and frequently pay very high salaries. Hence some of you
have a very practical reason for studying financial institutions: It may help you get a
good job in the financial sector. Even if your interests lie elsewhere, you should still
care about how financial institutions are run because there will be many times in your
life, as an individual, an employee, or the owner of a business, when you will interact
with these institutions. Knowing how financial institutions are managed may help
you get a better deal when you need to borrow from them or if you decide to supply
them with funds.
 6 Chapter /
APPROACH IN STUDYING FINANCIAL MARKETS AND
INSTITUTIONS
The fiagncwork underlying all discussions in this text has three levels, namely,

a) Understanding
Students learn to understand economic analysis, that is, students develop the
economic intuition they nccd to organize concepts and facts'

h) Evaluating
Student.s learn to evaluate current developments and the financial news.
Students learn to use financial data and economic analysis to think critically
about how they interpret current events.

c) Predicting
Students learn to use economic analysis to predict likely changes in the
economy and the financial system.

This book stresses a unifying, analytic framework to study financial markets

and institutions. This framework uses a few basic concepts to keep organize
your thinking about the determination of asset prices, the structure of financial
markets, bank management and the role of monetary policy in the economy.
The basic concepts are equilibrium, basic supply and demand analysis to
explain behavior in the financial markets, the search for profits, and an
approach to financial structure based on transaction costs and asymmetric
information.

The framework also provides the tools needed to understand trends in the
financial market place and in variables such as interest rates and exchange rates.
1 his text also emphasizes the interaction of theoretical analysis and empirical
data in order to expose the reader to real-life events and data.

And to function better in the real world outside the classroom, it is recommended
that one must get into the lifelong habit of regularly following the financial news
that appears in leading financial publications or read the financial / business
section of the newspapers.

Lastly, the World Wide Web has become an extremely valuable and convenient
resource for financial research. These sites contain additional information and are
updated frequently. Visit these sites to further explore topics that one finds of
 CHAPTER 2
INTRODUCING MONEY AND INTEREST RATES
ROLE OF MONEY IN THE ECONOMY

Money is any item or commodity that is generally accepted as a means of

payment for goods and services or for repayment of debt, and that serves as an
asset to its holder. On the simplest level, money is composed of the bills and
coins which have been printed or minted by the National Government (these
are called currency). But money also includes the funds stored as electronic
entries in one's checking account and savings account.

Because money in a modern economy is not directly backed by intrinsic value

(e.g., the coin's weight in gold or silver), the financial system works on an
entirely fiduciary basis, relying on the public's confidence in the established
forms of monetary exchange.

Money is the oil that keeps the machinery of our world turning. By giving goods
and services an easily measured value, money facilitates the billions of
transactions that take place every day. Without it, the industry and trade that form
the basis of modern economies would grind to a halt and the flow of wealth
around the world would cease.

Money has fulfilled this vital role for thousands of years. Before its invention, people
bartered, swapping goods they produced themselves for things they needed from
others. Barter is sufficient for simple transactions, but not when the things traded are
of difTering values, or not available at the same time. Money, by contrast, has a
recognized uniform value and is widely accepted. At heart a simple concept, over
many thousands of years, it has become very complex indeed.

At the start of the modern age, individuals and governments began to establish
banks, and other financial institutions were formed. Eventually, ordinary people
could deposit their money in a bank account and earn interest, borrow money and
buy property, invest their wages in business, or start companies themselves.
Banks could also insure against the sorts of calamities that might devastate
families or traders, encouraging risk in the pursuit of profit.
 econorny. The Federal Reserve (known as "The Fed") is the central bank "'i the
US. The Fed issues currency, determines how much of it is in circulation, Ond
decides how much interest it will charge banks to borrow its money.

In the Philippines, the central bank that controls the country's economy
"Bangko Sentral ng Pilipinas". While government still print and guarantee money, in today's
world it no longer needs to exist as physical coins or notes, but can be found solely in digital
form.

CHARACTERISTICS AND KEY FUNCT10NS OF MONF„Y

Money is not money unless it has all of the following defining characteristics:
Money must have value, be durable, portable, uniform, divisible, in limited
supply, and be usable as a means of exchange. Underlying all of these
characteristics is trust — people must be confident that if they accept money,
they can use it to pay for goods.

Store of value
Money acts as a means by which people can store their wealth for future
use. It must not, therefore, be perishable, and it helps if it is of a practical
size that can be stored and transported easily.

Item of worth
Most money originally has an intrinsic value, such as that of the precious
metal that was used to make the coin. This in itself acted as some guarantee
the coin would be accepted.

Means of exchange
It must be possible to exchange money freely and widely for goods, and its value
should be as stable as possible. It helps if that value is easily divisible and if
there are sufficient denominations so change can be given.

Unit of account
Money can be used to record wealth possessed, traded or spentpersonally and
nationally. It helps if only one recognized authority issues money. If anybody
could issue it, then trust in its value would disappear.
 Introducing Money and Interest Rates 11

Standard of Deferred Payment

Money is also useful because of its ability to serve as a standard Of deferred
payment.

Money can facilitate exchange at a given point by providing a medium of

exchange and unit of account.

THE EVOLUTION OF MONEY

People originally traded surplus commodities with each other in a process
known as bartering. The value of each good traded could be debated, however,
and money evolved as a practical solution to the complexities of bartering
hundreds of different things. Over the centuries, money has appeared in many
forms, but, whatever shape it takes, whether as a coin, a note, or 3tored on a
digital server, money always provides a fixed value against which any item
can be compared.

Barter (10,000 — 3000WE)

In early forms of trading, specific items were exchanged for others agreed by the
negotiating parties to be of similar value.

Barter — the direct exchange of goods — formed the basis of trade for thousands
of years. Adam Smith, 1 8 th-century author of The Wealth ofNations, was one of
the first to identify it as a precursor to money.

Barter in practice
Essentially, barter involves the exchange of an
item (such as a cow) for one or more of a perceived
equal "value" (for example a load of wheat). For the
most part of the two parties bring the goods with
them and hand them over at the time of a
transaction. Sometimes, one of the parties will
accept an "I owe you," or IOU, or even a token, that
it is agreed can be exchanged for the same goods or
something else at a later date.
 Introduci M and Interest ROOS 3
ARTIFACTS OF MONEY
Since the early attempts at setting values for bartered goods, "money'* has
come in many forms, from IOUs to tokens. Cows, shells and precious metals
have all been used.

Barter

Early trade involved directly exchanged items — often perishable ones such as a
cow.

Sumerian cuneiform tablets (4,000BCE)

ScriEB recorded transactions on clay tablets, which could also act as receipts.

Cowrie shells (1,000WE)

U!sed as currency across India and the South Pacific, they appeared in many colors and
sizes.

Lydian gold coins (600BCE)

In Lydia, a mixture of gold and silver was formed into disks, or coins, stamped
with inscriptions.

right across the

punched in
Athenian drachma (600WE)

their

throughout the Roman

metals such as
 Chapt
er 2
Anglo-Særon coin (900CE)

This 10th century silver penny has an inscription stating that Offa is King ("rex") of
Mercia.

Arabic dirham (900CE)

Many silver coins from the Islamic empire were carried to Scandinavia by Vikings.

THE ECONOMICS OF MONEY

From the 16th century, understanding of the nature of money became more
sophisticated. Economics as a discipline emerged, in part to help explain the
inflation caused in Europe by the large-scale importation of silver from the
newly discovered Americans. National banks were established in the late
century. with the duty of regulating the countries' money supplies.

By the early 20th century, money became separated from its direct relationship to
precious metal. The Gold Standard collapsed altogether in the 1930s. By the
mid20th century, new ways of trading with money appeared such as credit cards.
digital transactions, and even forms of money such as cryptocurrencies and
financial derivatives. As a result, the amount of money in existence and in
circulation increased enormously.

Potosi inflation (1540-1640)

The Spanish discovered silver in Potosi, Bolivia, and caused a century of inflation by
shipping 350 tons of the metal back to Europe annually.

The great debasement (1542-1551)

England's Henry Vlll debased the silver penny, making it three-quarters copper.

Early joint-stock companies (1553)

Merchants in England began to form companies in which investors bought shares

'wrod»ci't$ Money and Interest Rates S

 Bank or England (1694)
The Bank of England was creaed •s a body that could raise funds at a low interest rate and
manage national debt.

The Royal Mint (1696)

Isaac Newton became Warden and argued that debasing undermined confidence.
All coins were recalled and new silver ones were minted.

US dollar (1775)
The Continental Congress •uth«ized tir issue of United States dollars in 1775, but
the first national currency was not minted by the US Treasury until 1794.

Gold Standard (From 1844)

The British pound was tied to a defined equivalent amount of gold. Other countries
adopted a similar Gold Standard.

Credit Cards (1970s)

The creation of credit cards enabled consumers to access short-term credit to make
smaller purchases. This resulted in the growth of personal debt.

Digital Money (1990s)

The easy transfer of funds and convenience of electronic payments became increasingly
popular as internet use increased.

Euro (1999)
Twelve EU countries joined together and replaced their national currencies with
the Euro. Bank notes and coins were issued three years later.

Bitcoin (2008)
Bitcoin a form of electronic money that exists solely as encrypted data on servers
is announced. The first transaction took place in January 2009.

UIGHL.IGHTS IN THE HISTORY OF MONEY IN THE PHILIPPINES

Pre-Spanish Regime
Prior to the coming of the Spanish in 1521, the Philippine was already trading
 with neighboring countries such as China, Java and Macau. Through the
prevailing medium of exchange was barter, some coins were circulating in the
Philippines as early as the 8th century.

Commodity money such as gold, gold dust, silver wires, coffee, sugar rice,
spices, carabao were used as money. Between the 8th and 14th century the
penniform gold batter rings were predominantly used by foreign merchants.
Piloncitos and other commodities were in circulation.

Spanish Regime
The Spanish introduced coins in the Philippines when they colonized the country
in 1521. Silver coins minted in Mexico were predominantly used in 1861, the first
mint was established in order to standardize coinage.

American Regime
After gaining independence in 1898 when Spain ceded the Philippines to the
United States. The country's first local currency, the Philippine Peso, was
introduced replacing the Spanish-Filipino Peso.

The Philippine National Bank was authorized to issue Philippine Bank

Notes. Later, the Bank of the Philippine Island was authorized to issue its
own bank notes. These notes were redeemable by the issuer but not made
legal tender.

Japanese Regime
When the Philippines was occupied by Japan during World War Il, the
Japanese issued the Japanese War Notes. There bills had no reserves nor
backed up by any government asset and were called "mickey mouse" money.

Post-War Period
In 1944, when the American forces defeated the Japanese Imperial army, the
Philippine Commonwealth was established under President Sergio Osmeia. All
Japanese currencies circulating in the Philippines were declared illegal, all
banks were closed and all Philippine National Bank notes were withdrawn from

The new treasury certificate (called Victory Money) were printed in P500, P200, PI
 00, P50, P20, P 10, P5, P2 and PI denominations with the establishment of the
Central Bank. In 1949, a new currency called "Central Bank Notes" was issued.

Jn 2010 the Central Bank launched the "New Generation Currency", which
is uniform in size where significant events in Philippine history, iconic
buildings and heritage sites were featured.

In 201 8, the New Generation Currency Coin series were put in circulation.

THE SUPPLY AND DEMAND FOR MONEY

Money facilitates the flow of resources in the circular model of

macroeconomy. Not enough money will slow down the economy, and too
much money can cause inflation because of higher price levels. Either way,
monitoring the supply and demand for money is vital for the economy's central
bank's monetary policy, which aims to stabilize price levels and to support
economic growth.

The Money Supply

Although the general description of money is relatively straightforward, the

precise definition of the overall supply of money is complex because of the wide
variety of forms of money in modern economies.

The Key Measures for the Money Supply are:

• Ml. The narrowest measure of the money supply. It includes currency in

circulation held by the nonbank public, demand deposits, other checkable
deposits, and traveler's checks. Ml refers primarily to money used as a

medium of exchange.

M2. In addition to Ml, this measure includes mo.ney held in savings,

deposits, money market deposit accounts, noninstitutional money
market mutual funds and other short-term money market assets (e.g.,
"overnight" Eurodollars). M2 refers primarily to money used as a store
of value.

M3. In addition to M2,. this measure includés the financial institutions,

(e.g., large-denomination time deposits and term Eurodollars). M3 refers
primarily to money used as a unit of account.
 • L. In addition to M3, this measure includes liquid and
near-liquid assets (e.g.. short-term Treasury notes,
high-grade commercial paper and bank acceptance
notes).

The deposits of the public at banks and other depository

institutions are considered money and are therefore included in
the Ml money supply. If the public withdraws money from bank
deposits to hold money as personal currency ("under the
mattress"), this increase in inactive money will affect the banks'
ability to extend loans and will influence the supply of money.

Some common forms of public payment may not count as part of

the supply of money. Check payments from one person to another
are not included in the money supply because check merely
transfers money without being a net addition to the supply of
money. Consumer credit cards are not included in the money
supply; they are considered instant loans to consumers and
therefore are not a net addition to the money supply.

The Bangko Sentral ng Pilipinas (BSP) is responsible for

determining the supply of money. It uses daily open market
operations to influence the creation of money by banks and to
guide the availability of money in the economy. BSP also has an
impact on the creation of money by banks through reserve
requirements and the discount rate that is, the interest rate at
which banks can borrow from the BSP as a lender of last resort.
Changes in the supply of money will affect the interest rate and
therefore the cost of borrowing money. This will have an impact
on consumption and investment levels in the economy.

The Demandfor Money

The Sources of the Demand for Money are:

• Transaction demand. Money demanded for day-to-day

payments through balances held by households and firms
(instead of stocks, bonds or other assets). This kind of demand
varies with GDP; it does not depend on the rate of interest.

• Precautionary demand. Money demanded as a result of

unanticipated payments. This kind of demand varies with
GDP.

• Speculative demand. Money demanded because of

expectations about interest rates in the future. This
means that people will decide to expand their money
balances and hold off on bond purchases if they expect
 Intro
ducing Money and Interest Rates 19
interest rates to rise. This kind of demand has a negative relationship with
toe interest rate.

The rate ofinterest is the price paid in the money market for the use of money
(or loans). The rate is a percentage of the amount borrowed.

If a person holds P 1,000 in currency, the opportunity cost of holding the

money is the interest that could he earned on the PI ,000 in an interest-
bearing account. The opportunity cost of holding money goes up if the
interest rate increases,

which may lead to decreased consumption and increased saving. Conversely,

if the interest rate is low, it is relatively cheap to borrow money and the
quantity of money demanded goes up. Therefore, the demand for currency has
a negative relationship with the interest rate.

Changes in other factors will lead to shifts in the demand curve for money.
Increases in the economy's price level will increase the demand for money
(note that the demand for money is tied to the interest rate, not the price
level). If the real GDP increases, the demand for money increases because
of the higher demand for products. Also, when banks develop new money
products that allow for easier, low-cost withdrawal, the demand for money
will decrease, such as, banks offering savings accounts with shorter (or, less
stringent) time deposit requirements and lower penalties for withdrawal.

THE IMPACT OF MONEY

In the macroeconomic short-run, some prices (e.g., wage rates affected by
labor contracts) will be inflexible. This causes economic fluctuations, with real
GDP either below potential GDP (recessionary gap) or above potential GDP
(inflationary gap).

The BSP's monetary policy has an immediate, short-run impact on the

economy. In particular, higher interest rates will decrease investment because
it becomes more expensive to borrow money, and will also decrease
consumption because consumers will tend to, save more as interest rate returns
increase. In addition, as higher Philippine interest rates increase the demand
for pesos on the foreign exchange markets (because of the higher returns on
Philippines deposits), the higher pesos will decrease exports by making them
increasingly expensive. This means that real GDP growth and the inflation rate
slow when the BSP raises th interest rate. The reverse occurs when the interest
rate is lowered.
 20 Chapter 2
Monetary policy can be applied in the short-run when the economy faces an
inflationary gap (real GDP exceeds potential GDP). The BSP may then pursue a
policy to avoid inflation by decreasing the quantity of money and raising the interest
rate. The higher interest rate decreases investment, consumption and, net export. This
decrease in aggregate demand will decrease, real GDP and lower the price level. In
the macroeconomic long-run, prices are assumed to be fully flexible, and this will
move real GDP toward potential GDP.

If the economy is at its long-run equilibrium and the BSP increases the money
supply, it will increase aggregate demand. Consequently, the price level goes up,
as well as the real GDP. This means that an inflationary gap exists, with the
actual unemployment rate being below the natural rate. The tightness in the labor
market will lead to a rise in the money wage rate. Because of higher labor costs,
the short-run aggregate supply will increase returning real GDP to the level of
potential GDP.

THE QUANTITY THEORY OF MONEY

The quantity theory of money holds that changes in the money supply MS directly
influences the economy's price level, but nothing else. This theory follows from the
equation ofexchange:

where M = quantity of money

V = velocity of money (i.e., the average number of times a unit
of money is used during a year to purchase GDP's goods'
and services)
P price level real
GDP

The equation of exchange essentially states that the economy's nominal GDP or
expenditures (P x Y) equal the money actually used in the economy (M x V).
According to the quantity theory of money, velocity V is not affected by the
quantity of money M and is considered constant: V=VCOI
GDP (i.e., long-run equilibrium) is not affected by M and is considered constant'.
constant. It not follows directly from the equation of exchange (M x V constant) that
changes in M are equal to the changes in P, in the long-run. This view of the
equation of exchange expresses the (neo) classical neutrality of money, that is,
money affects only nominal values but not real values. In other words, the money
supply leaves real output unaffected.
 Introducing Money and Interest Rates 21

Historical evidence suggests that the money growth rate and the inflation rate
are positively related in the long-run. However, the year-to-year relationship is
weaker.

The equation of exchange does not hold in the short-run, as the economy does not
immediately adjust because of price inflexibility. Although, the relationship
between EM and P may not be casual, as suggested by quantity money theorists, it
appears that there is a correlation between M and P in the long-term. Therefore,
growth in AT can be used as a statistical estimate for the rate of inflation, that is,
the Central bank can he effective in stabilizing prices. It is less clear what the
Central bank's impact on short-term real GDP and real interest rates is.

THE TI M E VALUE OF MONEY

In general business terms, interest is defined as the cost of using money over time.
This definition is in close agreement with the definition used by economists,
prefer to say that interest represents the time value of money.

Present Value

The concept of present value (or present discounted value) is based on the
commonsense notion that a peso of cash flow paid to you one year from now is
less ulluable to you than a peso pai4 to you today: This notion is true because you
can deposit a peso in a savings account that earns interest and have more than a
peso in one year. Economists use a more formal definition, as explained in this
section.

Let's look at the simplest kind 01 debt instrument, we will call a simple loan. In this
loan, the lender provides the borrower with an amount of funds
(called the principal) that must be repaid to the lender at the maturity date, along

an additional payment for the interest. For example, if you made your
friend Jane a simple loan of P 100 for one year, you would require her to repay
the principal of P 100 in one year's time along with an additional paymet t for
interest; say, PI 0. In the case of a simple loan like this one, the interest
payment divided by the amount of the loan is a natural and sensible way to
measure the interest rate. This measure of the so-called simple interest rate, i, is:
 22 2

gnake (his P loon, at the end of the year you would have PI 10, which can be
rewritten as:
PIOO x (l + 0.1 0) PI 10
If you then lent out the PI 1 (), at the end of the second year you would have:

PI 10 x (l + 0.10) - P121
or, equivalently,

PI 00 x (l + 0.10) x (l + 0.10) moo x (l + 0.10)2 P121

Continuing with the loan again, you would have at the end of the third year:

P121 x (l + 0.10) = PIOO + 0.10/ = P133

Generalizing, we can see that at the end of n years, your PI 00 would turn into:

PIOO x (l +

The amounts you would have at the end of each year by making the P 100 loan today
can be seen in the following timeline:

Mear
'l 2,

PIOO PIIO P121 P133 P100 +

This concept is extensively discussed in another book of these authors. Financial

Management, 2019 Comprehensive Edition.
 Introducing Money
and Interest Rates 23
INTEREST RATES
The interest rates link the future to the present. It allows individuals to
evaluate the present value (the value today) of future income and costs. In
essence, it is the market price of earlier availability.

From the viewpoint of a potential borrower, the interest rate is the premium that
must be paid in order to acquire goods sooner and pay for them later. From the
lender's viewpoint, it is a reward for waiting — a payment for supplying others
with current purchasing power. The interest rates allows the lender to calculate
the future benefit (future payments earned) of extending a loan or saving funds
today.

In a modern economy, people often borrow funds to finance current investments

and consumption. Because of this, the interest rate is often defined as the price of
loanable funds. This definition is correct. But we should remember that, it is the
earlier availability of goods and services purchased, not the money itself that is
desired by the borrower.

HOW INTEREST RATES ARE DETERMINED

Interest rates are determined by the demand for and supply of loanable funds. Investors
demand funds in order to finance capital assets that they believe will

increase output and generate profit. Simultaneously, consumers demand

loanable funds because they have a positive rate of time preference. They prefer
earlier availability.

The demand of investors for loanable funds stems from the productivity of capital.
Investors are willing to borrow in order to finance the use of capital in production
because they expect that expanding future output will provide them with more than
enough resources to repay the amount borrowed (the principal) and the interest on
the loan.

As Figure 2-1 illustrates, the interest rate brings the choices of investors and
consumers wanting to borrow funds into harmony with the choices of lenders
willing to supply funds. Higher interest rates make it more costly for investors to
undertake capital spending projects and for consumers to buy now rather than
later. Both investors and consumers will therefore, curtail their borrowing as the
interest rate rises. Investors will borrow less because some investment projects
that would be profitable at a low interest rate will be unprofitable at higher rates.
Some consumers will reduce their current consumption rather than pay the high
 interest premiunt when the rote increases. Tljerefore, the amount of funds detnanded by
borrowers is inversely related to the intcrcst rate,

The intetvst rate al«o rewords people (lenders) w)lling to reduce their current
consutnption in order to provide loanablc funds to others. Jf some people are going
to borrow in order to unclcfl'ikc an investment project (or consume more than their
current incotne), others tnust curlail their current consumption by an equal amounts
In essence. the interest rate provides lenders with the incentive to reduce their current
consurnption so that, borrowers can either invest or consume beyond their present
incojne. Jligher interest rates give people willing to save (willing to supply loanable
funds) the ability to purchase more goods in the future in exchange for sacrificing
current consumption. Even though people have a positive rate of time preference,
they will give up current consumption to supply funds to the loanable funds market if
the price is right. Higher interest rates will induce people to save more. Therefore, as
the interest rate rises, the quantity of funds supplied to the loanable funds market will
increase.

Figure 2-1: Determining the Interest Rate

Interest rate

Q Loanable Funds

As Figure 2-1 illustrates, the interest rate will bring the quantity of funds demanded into
balance with the quantity supplied. At the equilibrium interest rate, the quantity offunds
borrowers demandfor investment and consumption now (rather than later) willjust equal
the quantity offunds lenders save. So the interest rate brings the choices of borrowers and
lenders into harmony

The rate of interest functions as the price in the money market. Money has a time value,
and its use is bought and sold in the money market in for' the Payment of interest. The
financial institutions that deal in govemment securities
 and loans, gold and foreign exchange make up the money market, The money
market is not a specific physical location but consists of transactions made
electronically or by phone. Equilibrium in the money market occurs when the MD
and MS curves intersect at the equilibrium interest rate, as shown in Figure 2-2

If the BSP were to decide to increase the quantity of money from MS to MS', the
supply of money curve would shift to the right, resulting in a decrease in the
equilibrium interest rate. The lower cost of borrowing could spur higher
consumption and investment.
The equilibrium interest rate goes down from r to rl as the money supply
curve shifts to the right from MS to MSI (e.g., when the BSP increases the
quantity of money).

Figure 2-2: Money market equilibrium

Note: MS = money suppiy, MD = money demand

MS M.st

Interest rate

MD

According to Keynesian theory, the

rate of interest is determined as
a price in two markets:

l. Investment funds. The rate of interest balances the demand for funds
(required for investment) and the supply of funds (from savings). If
investors can earn a 10 percent return on a capital investment project
(e.g., building a factory), they will be willing to pay a rate of interest of
up to 10 percent. Households delay consumption by saving (and are
rewarded by earning interest) depending on their time preference and the
rate of interest. Savings percentages can differ significantly from one
nation to ancther.
 26 Cha
2. Liquid assets. Households and businesses may have reasons to hold assets in
liquid form (i.e., readily available money). Because borrowers require cash
in the long-term (that doesn't need to be repaid to the lender immediately),
they are willing to compensate lenders for giving up liquidity. Keynes
introduced the influence of the liquidity preference on the interest rate. The
classical economists, who considered investment funds as the critical
market for the interest rate, disregarded the topic of liq•uidity preference.

Although, intermediaries can achieve equality between the rates of interest in two
markets, the potential lack of balance between the investment and money markets
was essential to Keynesians, who claimed that it caused unemployment in the short-
run.

THE NOMINAL OR MONEY RATE VERSUS THE REAL RATE OF INTEREST

We have emphasized that the interest rate is a premium paid by borrowers for earlier
availability and a reward received by lenders for delaying consumption. However, during
a period of inflation (a general increase in prices), the nominal interest rate or money rate
of interest is misleading indicator Of how much borrowers are paying and lenders are
receiving. Inflation reduces the purchasing power of a loan's principal. Rising prices
means that, when the borrower repays the principal in the future, it will not purchase as
much as it would have when the funds were initially loaned.

When inflation is common, lenders will recognize they are being repaid with pesos of less
purchasing power. Unless they are compensated for the anticipated inflation by an upward
adjustment in the interest rate, they will supply fewer funds to the loanable funds market. At
the same time, when borrowers an!icipate inflation, they will want to purchase goods and
services now before they become even more expensive in the future. Thus, they are willing to
pay an inflationary premium, an additional amount of interest that reflects the expected rate of
future price increases. For example, if borrowers and lenders fully anticipate a 5 percent rate
ofinflation, they will bejust as willing to agree on a 9 percent interest rate as they were earlier
to agree on a 4 percent interest rate when both anticipated price

Unlike when the general price level is stable, the supply of loanable funds will decline
(the supply curve will shift to the left) and the demand will (the demand curve will shift
to the right) once decision makers anticipate future
 Introducing Money and Interest Rates 21

inflation. The money interest rate thus, rises overstating the "true" cost of
borrowing and the yield from lending, This true cost is the real rate interest,It
which is equal to the money rate of interest minus the inflationary premium.
reflects the real burden to borrowers and payoff to lenders in terms of their being
able to buy goods and services.

Our analysis indicates that, high rates of inflation will lead to a high money rate of
interest. The real world is consistent with this view.

INTEREST RATES AND RISK

So far, we have assumed there is only a single interest rate present in the loanable
funds market. In the real world, of course, there are many interest rates. There is the
mortgage rate, the prime interest rate (the rate charged to business firms with strong
credit ratings), the consumer loan rate and the credit card rate , to name but a few.

Interest rates in the loanable funds market will differ mainly because of
differences in the risks associated with the loans. It is riskier, for example, to
loan money to an unemployed worker than to a well-established business with
substantial assets. Similarly, credit card loans are riskier than loans secured by
an asset. An example of a secured loan would be a mortgage loan on a house. If
the borrower defaults, the lender can repossess the house. The risk also
increases with the duration of the loan. The longer the time period of the loan,
the more likely it is that the borrower's ability to repay the loan will deteriorate
or market conditions changes in an highly unfavorable manner.

As Figure 2-3 shows, the money rate of interest on a loan has three components.
The pure-interest component is the real price one must pay for earlier availability.
The inflationary premium component reflects the expectation that the loan will be
repaid with pesos of less purchasing power as the result of inflation. The risk-
premium component reflects the probability of default (the risk imposed on the
lender by the possibility that the borrower may be unable to repay the loan).

Figure 2-3: The Three Components of Money Interest

Risk remium
Inflationa remium
Pure interest
 RAVES ARE

more
gtirnulaong

*hat
•pla:n of thc of a country

ef feut tnatn fu!htions of moncs,

aur•nctatc art.} t.'•.c efdctnand foc rnoncyz

ct to u '»c a of exchange.

ate and tnakcrs INtcrcstcd tncasurun n money?

8
A Stu.fcnt rmkcs thc follov• ing asscrtion:
9
 It not the total iulue prekiuctlon to Increase unless the
supply Increases. ,4ftcr all. how can the value of the
goods and wes beang bought und sold jncrease unless there as more
money available
Explain u hether you agree u ith this assertion.