Lesson 2: Introducing Money and Interest Rates

Lesson Objectives:
At the end of this lesson, you should be able to:
1. Explain the role of money in a nation’s economy.
2. Enumerate and describe the characteristics and key functions of money.
3. Describe commodity money and fiat money.
4. Define what legal tender is.
5. Know the relationship between supply and demand for money.
6. Describe the time value of money.
7. Explain the impact of money on the growth of the economy.
8. Explain the nature and determination of interest rates.
9. Differentiate nominal interest rate and real interest rate
10. Explain the effect of change in interest rates on the economy.

Discussion:
The Evolution of Money
In the early days, families used to be self-sufficient. Food, for example, may be sourced through hunting,
fishing, or farming. As time goes by, the development of societies and division of labor gave rise to the
need for exchange. To better illustrate this, a family that has no access to fishing equipment or tools but
still would like to eat seafood will now need to provide goods to obtain the seafood that they like. The
need for this exchange paved the way for the barter system – this is trading with the use of goods alone.
Going back to our example, several kilos of seafood may be obtained by exchanging it with a sack of
corn. At first, this worked out well when the wants of men were few and simple. Again, as time passed
by, the barter system had some difficulties:
1. Absence of double coincidence of wants
Barter requires that one must have what the other man wants. This is not possible all the time. For
example, I want a horse. You must have it. If you want a dog in return, I must have it. So, I
should go to someone who has a horse, and I must have what he wants. An exchange is not
possible unless these two conditions are fulfilled.
2. No standard of measurement
Barter provides no measure of value. It does not provide a method for estimating the relative
value of two goods. For example, an ounce of gold may possibly be exchanged with three cows
(if both parties to the barter agree to it). As of this writing, an ounce of gold is worth USD1900.
 3. Absence of subdivision
It is difficult sometimes to split or divide a commodity. You cannot just split a cow into half. It
will lose its value.
4. Difficulty of storage and transportation
There are some commodities that cannot be stored because they are perishable (as in the case of
rice, corn, flour, etc.). For large transactions, it will also be difficult to transport 1,000 horses as
these can be very bulky and heavy.
All these disadvantages of barter system were overcome with the introduction of money.

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 for 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 differing values or not available at the same time.
Money, by contrast, has a recognized uniform value and is widely accepted.

Characteristics of Money
Money is not money unless it has all the following defining characteristics:

 Must have value

 Durable – will not break or fall apart

 Portable – easy to move

 Uniform – should be consistently used

 Divisible – can be easily divided into denominations

 Scarce – limited supply; large amounts are uncommon

Key Functions of Money
Store of Value
Money needs to maintain its value in order for people to 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 some guarantee the coin would be accepted.
Medium of Exchange
It should be widely accepted as a means of exchange for goods and services, and its value should be as
stable as possible.

Unit of Account
Money allows us to compare the value of different goods. It can be used to record wealth possessed,
traded or spent personally and nationally. It helps if only one recognized authority issues money. If
anybody could issue it, then trust in its value would disappear.
Standard of Deferred Payment
This function indicates a widely accepted way to value a debt such that a person can acquire goods at
present and pay for them in the future. Money is used as a standard benchmark or a contract for
specifying future payments for current purchases.

Commodity Money, Fiat Money and Legal Tender

Commodity money refers to a good used as money that has value independent of its use as money.
Historic examples include alcohol, cocoa beans, copper, gold, silver, salt, seashells, tea, and tobacco.
Fiat money refers to money, such as paper currency that has no value apart from its use as money. Its
value is derived from it being issued by the government (that is, the government declares that it has
value).
People accept paper currency in exchange for goods and services partly because the government passed
the same thing to be legal tender, which means that the government accepts paper currency in payment of
taxes and requires that individuals and firms accept it in payment of debts.
Legal tender is anything recognized by law as a means to settle a public or private debt or meet a
financial obligation.

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

The money supply is all the currency and other liquid instruments in a country's economy on the date
measured. The money supply roughly includes both cash and deposits that can be used almost as easily as
cash.
The key measures for the money supply in the Philippines are classified as Ms, such as M0, M1, M2 and
M3. Each classification reflects the type of liquidity and spendability each type of money has in the
economy.
Liquidity – this refers to ease with which an asset or security, can be converted into cash or other
assets without affecting its market price. For example, the cash in your wallet is the most liquid
asset of all because it can be easily converted into other assets. On the other hand, other assets
such as fine art or a rare sneaker model are all relatively illiquid. You will need to sell them first
to obtain cash, which you can spend.

 M0. This includes currency in circulation. This is the money supply that is readily available for
spending (the most liquid).

 M1. In addition to M0, it includes currency in demand deposits, other checkable deposits, and
traveler’s checks. In terms of liquidity, you will need to go to the bank first to have these
converted into cash.

 M2. In addition to M1, this measure includes money held in savings deposits, money market
deposit accounts, non-institutional money market mutual funds and other short-term money
market assets (e.g., “overnight” Eurodollars). This is less liquid than the money supply in M1.

 M3. In addition to M2, this includes money held in large time deposits, institutional money
market funds, short-term repurchase agreements and larger liquid assets. To be able to convert
these funds to cash, withdrawal /penalty fees will be charged.
To better understand the money supply, refer to the diagram below. Notice how M0 is within M1, M1
within M2, and M2 within M3.
The Demand for Money
This refers to the desire to hold cash deposits and liquid assets or wealth in the form of money. The
decision to hold money instead of assets depend on liquidity.

 Transaction Demand – The desire to hold money to purchase goods and services. This is money
demanded for day-to-day payments through balances held by households and firms.
o When you carry money in your purse to buy food or maintain a checking account balance
so you can purchase groceries later in the month, you are holding the money as part of
your transactions demand for money.

 Precautionary Demand – The desire to hold money in order to pay for emergency expenses.
o Money held for precautionary purposes may include checking account balances kept for
possible home repairs or health-care needs. You do not know when such expenditures
will occur, but you can prepare for them by holding money so you’ll have it available
when the need arises.

 Speculative Demand – The demand to purchase financial assets (securities, foreign currency) at
the appropriate time. Such demand arises from the need for cash to take advantage of investment
opportunities.
o Speculative demand is a term from Keynesian economics which describes the desire to
have money for the purpose of investing in assets. This is driven by future expectations of
inflation, interest rates and market returns.
Application:
If a person holds P1,000 in currency, the opportunity cost of holding the money is the interest that could
be earned on the P1,000 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 and other factors will lead to shifts in the demand curve for money. Increase 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 to the Economy

The economy is basically the sum of the transactions that make it up. These happens all the time. For
example, whenever you buy something, you are creating a transaction. Each transaction consists of a
buyer exchanging money or credit to a seller for goods and services. All these spending is what drives the
economy. People, businesses, banks and governments all engage in transactions.
(How the Money Supply Impacts Gross Domestic Product)
An increase in the supply of money should lower interest rates in the economy. An increase in the money
supply means that more money is available for borrowing in the economy. This increase in supply–in
accordance with the law of demand–tends to lower the price for borrowing money. When it is easier to
borrow money, rates of consumption and lending (and borrowing) both tend to go up. In the short run,
higher rates of consumption and lending and borrowing can be correlated with an increase in the total
output of an economy and spending and, presumably, a country's GDP. Although this outcome is
expected (and predicted by economists), it is not always the actual result.
The long-term impact of an increase in the money supply is more difficult to predict. Throughout history,
there has been a strong tendency for the prices of assets–such as housing and stocks–to artificially rise
following an increase in the money supply, or anything that results in a high level of liquidity entering the
economy. This misallocation of capital can lead to waste and speculative investments, which can result in
the rapid escalation of asset prices followed by a contraction (an economic cycle known as a bubble) or an
economic recession, a significant decline in economic activity.
On the other hand, if prices are not misallocated, and the prices of assets do not artificially inflate, it's
possible that in the long-term, the only impact of an increase in the money supply is higher prices than
consumers normally would have faced.

The Time 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, who preferred to say that interest represents time
value of money.
Present Value
The concept of present value (or present discounted value) is based on the common sense notion that a
peso of cash flow paid to you one year from now is less valuable to you than a peso paid to you today.
This notion is true because you can deposit a peso in a savings account have that earns interest and have
more than a peso in one year.
Let us look at the simplest kind of that instrument, which 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 with an additional payment for the interest. For example, if you made
your friend Jane a simple loan of P100 for one year, you would require her to repay the principal of P100
in one years’ time along with an additional payment for interest; say, P10. 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:
Application:
If you make this P100 loan, at the end of the year you would have P110, which can be rewritten as:
P100 x (1 + 0.10) = P110
If you then lent out the P110, at the end of the second year you would have:
P110 x (1 + 0.10) = P121
Or, equivalently,
P100 x (1 + 0.10) x (1 + 0.10) = P100 x (1 + 0.10)2¬ = P121
Continuing with the loan again, you would have at the end of the third year:
P121 x (1 + 0.10) = P100 x (1 + 0.10)3 = P133
Generalizing, we can see that at the end of n years, your P100 would turn into:
P100 x (1+ i)n¬

Interest Rates
An interest rate is the percentage of principal charged by the lender for the use of its money. The principal
is the amount of money loaned. Since banks borrow money from you (in the form of deposits), they also
pay you an interest rate on your money.
Banks use the deposits from savings or checking accounts to fund loans. They pay interest rates to
encourage people to make deposits.
Banks charge borrowers a slightly higher interest rate than they pay depositors so they can profit. At the
same time, banks compete for both depositors and borrowers. The resulting competition keeps interest
rates from all banks within a narrow range of each other.
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 lenders viewpoint, it is a reward for waiting – a
payment for supplying others with the current purchasing power. The interest rates allows the lender to
calculate the future benefit of extending a loan were saving funds today.
In the 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.
How Interest Rates Are Determined
Supply and Demand
Interest rates are determined by the demand for 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.
Inflation – the rate at which the general level of prices for goods and services increase over time.
Economic State
The government of a country can have a say in the interest rates.
Monetary Policy - measures or actions taken by the central bank to influence the general price level and
the level of liquidity in the economy. Monetary policy actions of the BSP are aimed at influencing the
timing, cost and availability of money and credit, as well as other financial factors, for the main objective
of stabilizing the price level. (BSP)
Please refer to the diagram below on the relationship between interest rates and money supply. To better
understand this, please access the following video:
https://www.youtube.com/watch?v=yOQ89RptP2g&list=PLNI2Up0JUWkFCISVn47ZJzL7qx291zlS7&i
ndex=4
Nominal Interest Rate Vs. Real Interest Rate
Nominal Interest Rate – simply the stated interest rate on a loan or bond, this does not take into account
the inflation
Real Interest Rate – this interest rate takes inflation into account
Inflation Rate – the rate at which the general level of prices for goods and services increase over time
Formula: Real Interest Rate = Nominal Interest Rate – Inflation Rate
The nominal interest rate does not take into account the real cost of borrowing money. In effect, the
purchasing power of the money borrowed decreases over time.
Application:
Suppose you took out a bank loan worth P100,000 with an interest of 5% for a period of one year. The
5% here is the nominal interest rate. After a certain period, you will pay back the amount of P105,000.
However, the value of the P100,000 decreased over time due to inflation. If the inflation rate is 2%, that
means prices are higher by 2% which in effect, decreases purchasing goods and services after a year. The
real rate of interest (which reflects the true cost of borrowing money) is 3%.
Real Interest Rate = 5% - 2%

The Effects of Changing Interest Rates to the Economy

When Interest Rates Are Raised
Higher interest rates make loans less affordable, while high interest on savings accounts encourages
saving rather than spending. As spending slow, so does the economy, with demand for goods and services
decreasing. This eventually affects business and employment levels.
When Interest Rates Are Lowered
Lower interest rates make it cheaper to take out loans, and hence to spend more money. Saving becomes
less attractive as interest rates are low. With more money in circulation, demand for products and services
rise, stimulating businesses and increasing employment.

Interest Rates and Risk

Interest rates in the loanable funds market will differ mainly because of differences in the risk associated
with the loans. It is riskier, for example, the loan money to an unemployed worker then 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 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 a highly unfavorable manner.
Application:
  For example, a loan with a house title declared as collateral will be of lesser risk to the lender
because the loan is already secured in case the borrower will not be able to pay.

 A loan with a longer time period to pay possesses more risk because economic conditions may
change will may affect the borrower’s ability to pay. (A more specific example: flight attendants
who have car or housing loans are at risk of defaulting because the recent COVID19 pandemic
slashed out jobs in the aviation sector).

Summary of the Lesson:

 Money is an item or commodity that can be used as a medium of exchange to obtain goods or
services.

 Money should have value, must be durable, portable, uniform, divisible and scarce.

 Money facilitates the flow of resources in the economy. The spending that happens in every
transaction is what drives the economy.

 Interest is the cost of borrowing money.

 Interest rates are determined by the demand and supply for loanable funds.
o The higher the demand for credit will raise interest rates. A decrease in the demand for
credit will lower the interest rates.
o The more that banks can lend means that there is more supply of loanable funds to the
economy. The prices of borrowing then decreases.
Effects of higher interest rates:
To an Individual

 Increased cost of borrowing, may in turn refrain from taking out a loan

 Improved return for savers

 Higher mortgage payments

To Business Owners

 Less likely to borrow funds to establish or sustain business operations

To the Economy

 Decrease inflation due to lower demand of goods and services

 Reduced consumer spending and investment

 Higher unemployment because demand for goods and services are reduced
The opposite happens when interest rates are lowered.