Module 4:

Applications of Supply and Demand

In this module, you will be able to

* explain the different market structures;
* analyze the effects of contemporary issues, such as migration, fluctuations in the exchange rate, oil price
increases, unemployment, peace and order, etc., on the purchasing power of the people;
* understand the application of the law of supply and demand in the different sectors
of the economy; and
* learn the role of the central bank and how monetary policy works.
The Philippine Product Market

The product market is characterized by exchange of goods and services.

Businesses provide products that cater to the needs and wants of
consumers. Households, on the other hand, receive an income in return for
the labor they supply. Take a look at figure 4.1. The lower half of the circular
flow model is the focus of this section. It shows how buyers and sellers
interact and influence the prices of goods and services in the market.

Fig. 4.1 The circular flow model for a domestic economy with no govemment
and foreign trade
To understand the domestic product market, it is helpful to first study
how the different local industries function. Businesses are assumed
to be profit-maximizing entities, and how the corresponding industry
is structured largely impacts the profit potential of businesses.
Different structures have varying degrees of competition, which in
turn influence consumer and producer behaviors in different ways.

The Different Market Structures

Market structures are classified based on the following aspects:

degree of competition, number of firms, bargaining power of
consumers, and barrier to entry.
1. The degree of competition is driven by the number of competing firms in the
industry. The higher the number of firms, the greater the degree of competition.

2. The number of firms pertains to the actual number of competitors in the market.

3. The bargaining power of consumers refers to the ability of consumers to

influence market prices. A high bargaining power means that consumers are price
makers. On the contrary,a low or no bargaining power implies that suppliers are
price makers and that consumers are price takers.

4. A barrier to entry refers to the ease with which new firms can penetrate the
industry. A high barrier to entry is characterized by high setup costs that require
entrants to have a huge amount of initial investment. This is observed in large-
scale manufacturing where machineries and infrastructure need to be built.
Another example is in the case of low- cost products that have to be produced and
sold in high volume in order to recover the investment. This concept of producing
in large quantity to spread the cost per unit is formally known as economies of
scale. Another factor that contributes to a high barrier to entry is exclusivity of
resource. For example, a new technology that is protected by copyright laws
discourages competitors from setting up business.
Based on the above criteria, different industries adopt one of the
four main market. structures. More examples of applicable industries
and products are discussed under each type of market structure.

Perfect Competition

A market with perfect competition is characterized by many firms selling

homogenous or identical goods and many buyers who have access to the good. It is
very easy for new sellers to enter the market and put up business in a perfectly
competitive market. This means that there are no or minimal barriers to entry.
Additionally, because of the abundance of sellers and readily available information
on goods, switching costs are low. This signifies that it is very easy for consumers
to compare prices and switch from one seller to another. Low switching costs imply
that consumers have high bargaining power, that is, consumers influence the price.
In a perfectly competitive market, sellers are considered to be price takers.
Examples would be stalls in the public market that sell staple goods like bread,
fruits, and vegetables. Another example would be cell phone and gadget stalls in
Greenhills, which offer the same products. If a person is planning to buy a
secondhand cell phone, he or she would typically go around first and compare rates
before buying a phone.
Monopolistic Competition

While perfect competition is considered as the ideal market structure,

monopolistic competition is closer to what occurs in reality. Monopolistic
competition also features many sellers but the sellers typically have less
capability and are smaller in size. Similar to a perfect competition, there is a
low barrier to entry, which means sellers can come and go. However, the
goods are slightly differentiated in a monopolistic competition. This means
that although competing for the same consumers, monopolistic firms try to
distinguish their products and services through advertising in a niche
market. Due to product differentiation, monopolistic firms can dictate the
price and consumers have only moderate bargaining power. Salons and
spas are examples of firms in a monopolistic competition. A salon may
differentiate its services. by creating a certain ambience in its shop or by
having experts and well-trained stylists to justify its higher rates. The
restaurant industry is another example. You can see a group of restaurants
in malls. Although catering to the same clientele, one restaurant may
choose to serve Filipino favorites, while another would offer Japanese
cuisine. This product differentiation allows firms to set different levels of
Oligopoly

An oligopolistic market structure is characterized by having only a few

players in the industry. Since there are only a handful of players, these
firms dominate the market in terms of market share. Due to their size
and consumers having limited choices, oligopolistic firms are price
makers or they dictate the price of a good. This means that consumers
have no bargaining power. An example of an industry that displays
oligopolistic behavior is the telecommunications industry. In the
Philippines, there are only three companies that provide mobile telecom
services and two of these merged to form a bigger company.

Moreover, there is a high barrier to entry in an oligopolistic industry. This

is driven by expensive infrastructure prevalent in such industries. In the
case of telecom companies, cellular sites have to be constructed in
order to provide cellular signals to an area. The same attributes (e.g.,
high barrier to entry, consumers with no or little bargaining power) are
also found in the cable service industry, making it oligopolistic.
Monopoly

On the other end of the spectrum is monopoly-a market

structure that has a single player that controls the market.
In terms of competitiveness, a monopoly has no
competition, making it the least competitive of the four
structures. Being the sole provider of a good or service in
the market means that the firm is the price maker and
consumers have no bargaining power. Monopolies happen
when there is exclusive ownership of a resource or idea.
Having exclusivity guarantees no entrants to the market,
which means barriers to entry are extremely high. An
example would be an innovation that is protected by a
patent. The owner has exclusive
rights to produce and sell the product until the patent expires. Patent-protected
monopolies are common in the fields of information technology (IT), medicine, and
utilities. In the Philippines, electricity is an example of a monopoly.

Fig. 4.2 Four main market structures

What Have I Learned So Far?

Differentiate the different market structures in the economy by describing and contrasting
the degree of competition, number of firms, bargaining power of consumers, and barrier to
entry.

Economic Growth as a Macroeconomic Goal

What is the relevance of knowing how the product market works? Remember that one
macroeconomic goal of a country is economic growth, which is measured by real GDP. Real GDP
depends on the aggregate output in the economy and this output is driven by consumption.
Thus, consumption of goods and services drives economic growth and specific sectors'
performance; contribution to this growth is regularly measured by the government. To focus on
the country's economic well-being, the government has to decide where to appropriate budgets
and subsidies.
Reflect Upon

Given the ability to make one of the following happen, which one will you choose: (1)
increase the country's production output as measured by higher GDP. (2) eliminate
unemployment, or (3) lower the prices of commodities? Explain your choice.

BEYOND WALLS 4.1

Read and Answer

Read the govemment press release at [Link]

nap_release/press%20release%[Link] and answer the questions that follow.
1. What is the article about?

2. Which sector is the biggest contributor to country's economic growth? Which sector
experienced decline?

3. Explain the relevance of this news to businesses and to consumers.

The Philippine Labor Market

This section covers the domestic labor market, which is another application of the law of supply and demand.
Remember that labor is a factor of production that earns factor income through wages. Going back to figure 4.1,
the factor market is illustrated at the top portion of the diagram. Households provide the labor required to
manufacture goods or provide services. Businesses in turn will compensate the laborers by paying wages. Just like
prices that drive quantity in the product market, wages influence the quantity demanded and supplied in the labor
market.

Labor Supply and Population Growth

To appreciate how the Philippine labor market is performing, it is

useful to define some basic terminologies commonly used in the
discussion of labor and employment.
Big Idea
Labor force refers to the total number of people identified as
employed and unemployed. The term employed represents those Individuals who are unemployed
individuals who have a job in either full-time or part-time capacity. A and at the same time not actively
bank teller who works from 9:00 AM to 6:00 PM and a service crew searching for a job are not part of
member who works part-time at a fast food chain are both the labor force.
considered employed and are part of the labor force. The term
unemployed, on the other hand, refers to people who are presently
searching for a job, workers who are temporarily laid off but are
waiting to be called back for a job, and applicants who are about to
start a new job. Finally, underemployed describes those workers who
are better skilled than what their current jobs require.
Underemployment happens when there is a mismatch in skills and
capabilities or there is overqualification. A civil engineer doing
Reflect Upon

Given the definition and qualifications of being part of the labor force, are
retired individuals included in the labor force? How about people in prison?

Population growth is the increase in the total number of human beings in the country. A
census, or the official collection of population information, is locally conducted once every five
years by the Philippine Statistics Authority (PSA). The latest one was in 2015. Based on this
latest census, the Philippine population reached 100.98 million as of 1 August 2015. In
comparison to the 2010 figure of 92.34 million, the population grew by roughly 9% in five
years. This translates to an additional 8.64 million people.

How does population growth affect the labor force? An increase in population potentially
increases the labor supply. However, the impact of population growth largely depends on the
increase in the number of adult population. To better illustrate the relationship of population
growth and labor supply, consider the formula for labor force participation rate in equation
4.1.
Equation 4.1 Labor Force Participation Rate

Labor force
Labor force participation rate = x 100
Working age population
The labor force participation rate approximates the percentage of the population
that is actually part of the labor pool. A population growth affects the labor force
only in as much as there is growth in the working age population. The working age
in the Philippines is 15 to 64 years old. In essence, the working age population
includes people who are part of the labor force and those who are not.

Unemployment and Wages

Full employment is another macroeconomic goal of a nation. In reality, however,

there are imbalances in the economy (also known as market failures) that make it
impossible to achieve a state of zero unemployment. The unemployment rate
measures the percentage of individuals in the labor force who do not have a job. It
is calculated using equation 4.2.
 Equation 4.2 Unemployment Rate

Unemployment
Unemployment rate = x100
Labor force

There are four types of unemployment that are considered in deriving the value of the numerator in
equation 4.2. The first type is frictional unemployment, which is temporary unemployment that is a
result of people being in between jobs or being in transition. An example would be new graduates who
are looking for jobs or are still deciding which job to choose from several offers. These individuals are
technically in transition and thus are considered under frictional unemployment.

The second type is structural unemployment, which is a type of unemployment that results from
technology changes and upgrades that require specialized skills. This is also driven by location and
proximity. For example, a company that relocates from Manila to Cebu will potentially cause
unemployment because some employees might not be able to move to Cebu.

The third type of unemployment, cyclical unemployment is caused by the upturn and downturn in the
business cycle. During expansion, the economy is generally doing well because firms tend to open
new businesses or widen their operations during this time. The expansion will create more job
opportunities and tend to lower unemployment. In the case of a recession,
businesses and the economy are in a slump. Firms will likely hold off hiring or even lay off workers
during this time. Thus, unemployment goes up in a recession. Full employment is technically having
zero cyclical unemployment.

The last type is seasonal unemployment, which happens in industries with peak and lean seasons.
Examples would be tourism and farming. The peak season for most beach destinations in the country
is in the summer during which time, there is a higher demand for workers in businesses such as
hotels, travel, and restaurants in the tourist areas.
What Have I Learned So Far?

Use the given data to calculate the labor force, unemployment rate, and labor force participation
rate.

Given:

Employed individuals = 35 800 000

Unemployed individuals = 8 500 000
Working age population 50 000 000

1. Labor force

2. Unemployment rate

3. Labor force participation rate

Just as businesses earn profit in exchange for goods and services, factors of
production earn what is called as factor income. The factor income for labor is wage.
Wage is what a worker gets as compensation for hours of labor. More formally, wage
measures the amount of return (money) per hour of input (labor). A construction
worker earning $100.00 per hour is an example. In the Philippines, employees are
typically paid salaries instead of wages. What is the difference between wage and
salary? While wage measures the hourly or daily rate, salary refers to the aggregate
amount received. Salaries in the Philippines are normally paid on a monthly or bi-
monthly (i.e., 15th and 30th) basis. The difference is in the way of payment or
reference for calculation (i.e., hourly vs. monthly). It does not mean that a worker
have worked more or less hours if paid a salary rather than a wage because the total
compensation remains the same. To illustrate, the same construction worker who
earns a wage of P100.00 per hour would receive a monthly salary of at least P19
200.00 considering the worker works for eight hours a day from Monday to Saturday
(P100.00 8 hours 6 days × 4 weeks). By convention, wage is more commonly used in
theoretical discussion in economics such as in the concept of labor productivity, where
minimum wage is set on a per hour or per day basis.

Minimum wage is the least possible amount firms must pay their employees as
mandated by the country's labor laws. Minimum wage in the Philippines varies per
region and across sectors. The Department of Labor and Employment (DOLE) is
responsible for the setup and regular review of minimum wages in the Philippines.
Wage and profit of a firm are negatively correlated. This means that higher wages
translate to higher operating costs and ultimately, to lower profit for a firm. The same
applies when the government decides to increase minimum wage rates. In response,
firms tend to pass on the higher cost to consumers by making their goods and
services more expensive. Another typical response of firms is to cut back on the
number of employees to maintain the same level of operating costs. Some individuals
will take below minimum wage pay rather than be forced into unemployment. This
market failure in the labor market is illustrated in figure 4.3, which shows the labor
supply (S) and demand (D) curves.

The labor market is in equilibrium at the prevailing minimum wage rate of W and
quantity of labor (2). Assume that the government in response to lobbyists increased
the minimum wage rate from W to W. At this new wage rate, quantity supplied of labor
exceeds quantity demanded. On the supply side, the higher wage rate encourages
more people to actually look for a job. Thus, increasing the level of quantity supplied
from 2 to Q,. On the other hand, the fall in the demand for labor from 0 to 2, is due to
firms cutting back on the number of workers to maintain a certain level of operating
costs. In short, a higher wage rate leads to unemployment. The number of
unemployed workers is represented by the difference of Q, and Q, in the diagram.
Fig. 4.3 A minimum wage increase (W to W) potentially leads to unemployment as
quantity supplied exceeds quantity demanded of labor (Q,- Q.).
Labor Migration and Overseas Filipino Workers (OFWs)

Filipinos working abroad are formally referred to as overseas Filipino workers (OFWs).
Choosing to work in a foreign country is the concept of labor migration. Filipino labor
migration is driven by the lack of opportunities locally and encouraged by better pay
abroad.

Globalization is another driver of increased labor migration. It encourages

interdependence of factors of production across the world driven by advances in
technology. Products, innovations, and human capital are increasingly shared across
nations. Specifically, globalization has helped spur labor migration through faster access
to information, standardization of international labor standards, and increased ease of
travel. Additionally, countries with shortage of skilled workers tend to relax migration
policies to attract migrant workers. Examples of such countries are Australia and Canada,
both of which encourage foreigner applications to fill the gap in their different industries.
This opens up opportunities to countries such as the Philippines, which has an abundant
supply of skilled workers.

Labor policies in the Philippines are governed by the labor code implemented by
government agencies such as DOLE for locally employed individuals and the Philippine
Overseas Employment Administration (POEA) for OFWs. Additionally, the Philippines being
a member of the United Nations (UN) is governed by global labor standards set by the
International Labor Organization, a sub-agency of the UN.
The Philippine Financial Market

Along with products and labor markets, the financial market is also governed by the laws
of supply and demand. What is a financial market? A financial market is a marketplace for
the exchange of financial securities such as stocks and bonds. Investors or creditors
represent the buyers while borrowers or debtors represent the sellers in the financial
market. Securities trading is conducted in organized institutions such as the Philippine
Stock Exchange (PSE). An exchange is the equivalent of a physical market for products.
Although innovative online platforms are now widely used in trading, traditional stock
exchanges are still popular. Most commonly traded securities in the domestic financial
market include stocks and bonds.

Stocks represent ownership in a company. Stocks of public companies are traded on a

stock exchange such as the PSE. A stockholder, who is also referred to as a shareholder,
earns income through dividends and is entitled to vote on company issues and policies
during a company's shareholder meetings.

Bonds represent debts and these debts are largely traded over-the-counter or privately
through investment brokers. Bondholders are considered creditors who, by buying bonds,
are lending money to the issuer. The issuer is, in effect, the borrower. A bondholder gets
compensated through regular interest payments plus the principal amount upon the
bond's maturity. Bond issuers include private and public companies as well as the
government. Companies issue bonds mainly to finance capital expenditures.
On the other hand, the government through the central bank issues
bonds primarily to manage the supply of money in the economy. Bonds
issued by the government are called treasury bonds or T-bonds. In
contrast to company-issued bonds, T-bonds are risk free. This means
that the government guarantees the payment of the principal. As a
trade-off, the interest on T-bonds is generally much lower relative to
company-issued bonds, which bear considerably greater risks of
default.

In addition to financial securities, commodities like agricultural

products and precious metals such as gold and silver are also traded in
Big Idea
the financial market. But the succeeding discussion on money supply
Higher risk means
and the price-interest rate relationship will focus on bonds.
higher return. Riskier
assets often pay a
Money Supply and the Central Bank
higher return in the form
of higher interest rates
Money is defined in economics much more broadly than the
to compensate investors
conventional sense in which it is taken to refer to cash. To elaborate,
for the greater
there are three functions of money in economic context. First, it is
uncertainty.
considered as a medium of exchange. This means that it is a legal
tender or a recognized form of payment for purchases and
transactions. The country's legal tender is the Philippine peso (P or
Php) and this is the widely accepted form of payment nationwide.

Second, money is a unit of account. This means that money is used as

a standard to measure the value of goods and services. The existence
in the market drives the need for a single common measure to easily compare the values of
different items. Understanding the value of goods helps in consumer decision-making. For
example, you can compare a piece of land in the city being sold for P20 000.00 per square meter
and a lot of the same size in the province being sold for P2 500.00 per square meter. You may
conclude that land prices in the city are much higher than those in rural areas. Imagine the
difficulty in comparing a piece of land in the city that is priced in terms of number of cars with a
piece of land in the province priced in terms of number of cows. The absence of a standard unit
of account will make it so much harder to compare and evaluate the values of items.

Finally, money is a store of value. This means that you can choose to keep your money now and
save it for the future. It will still be accepted when you decide to spend it five years from now.
Putting your money in a time deposit is an example. Other assets that can be used as a store of
value are financial securities, real estate, and gold. However, in contrast to money on hand or
kept in the bank, these alternative assets have less liquidity.

Liquidity refers to the ease of use of an asset to pay for transactions. For instance, real estate
needs to be sold, and gold and other precious metals need to be converted to cash first before
they can be used as payment. In this sense, the closer the form of an asset is to cash, the more
liquid it is. High liquidity facilitates buying and selling in the economy.

The concept of liquidity forms the basis of money supply measures in the economy. The
classifications may vary per country but would generally have a distinction between money
in the hands of the public, short-term deposits, and long-term securities. In the Philippines,
money supply measures are defined by the Bangko Sentral ng Pilipinas (BSP).
M0 or BM- This is known as base money that includes currency in circulation (e.g.,
paper bills and coins in the hands of the public), bank reserves (e.g., money kept in
banks' vaults), and government reserves.

MI - This is known as narrow money. This includes M0 or BM plus peso demand

deposits (e.g., peso checking accounts).

M2- This is known as broad money. This includes M1 plus savings and time deposits
denominated in peso.

M3-This is known as broad money liabilities. This measure includes M2 plus money
market securities such as promissory notes and commercial papers.

M4 -This measure includes M3 plus deposits denominated in foreign currency (e.g.,

dollar deposits) and transferable assets (e.g., shares).

The country's central bank is the BSP. While the executive branch of the government
oversees the general state of the economy, the central bank is in charge of the
country's money supply. The strategy in which the government manages tax
collection and government spending is known as fiscal policy. In contrast, BSP's
control of the country's money supply and liquidity is known as monetary policy.
In terms of governance, the central bank still reports to the executive branch led by
the president. But deciding on the appropriate monetary policy tools to employ is
entirely the responsibility of the BSP.

In addition to liquidity management through adjustments in the money supply, the

central bank also performs other functions. One of these functions is supervision.
The central bank oversees all commercial banks in the country and ensures that
these banks comply to set banking standards and requirements. The central bank
likewise closely monitors the credit levels of banks and has the power to regulate
the operations of banks.

Additionally, the central bank serves as the lender of last resort to commercial
banks in the country. This means that when banks are running low on funds, they
can ask for a loan from the central bank subject to applicable interest rates (also
referred to as bank rates).

Another function of the central bank is to print money. The BSP has the exclusive
right to print the country's currency of issue. The banknotes and coins presently in
use are referred to as new generation currency (NGC) rolled out by the central bank
in late 2010. The banknotes and coins that the NGC replaced were completely
demonetized on 31 December 2016.
Finally, the central bank is responsible for managing the Philippine peso
exchange rate and for maintaining the strength of the peso against other
currencies. This will be elaborated in later discussion.

Price and Interest Rate

How does the central bank influence the country's money supply? Before
going to the various tools used by the central bank, there is a need to
understand the relationship between price and interest rate.

Remember the features of a bond transaction discussed earlier. A Big Idea

bondholder receives a regular stream of income based on a bond's
coupon rate until the bond's maturity. Investors, however, may decide to It is important to
resell their bonds in the secondary market where bond prices fluctuate regularly change the
daily. In such cases, the yield is used to assess the value of the bond in design of banknotes and
relation to its price. Yield measures the aggregate interest a bondholder coins to update their
will receive if he or she holds the bond to maturity. To illustrate the security features and
inverse relationship of price and interest rate using yield, consider a avoid counterfeiting.
bond paying a 5% coupon rate with a par value of P1 000.00.

A bond that is sold at par means that the bond price is equal to its par
value. In this case, the bond is sold at P1 000.00 and the yield will be the
same as the coupon rate, which is 5% (or 0.05 x 1000 =0.05)
1000
A bond that is sold at a discount means that the bond
price is below par (e.g., P950.00). In this case, the yield
is expected to go up. Given a bond price of P950.00, the
Big idea
yield is 5.26% (or 0.05 x 1000 =0.0526)
Coupon rate is a good indication of
950 the riskiness of a bond transaction.
Risk-averse investors tend to
choose less risky assets that pay
lower returns, while aggressive
investors tend to invest in assets
Finally, a bond that is sold at a premium means that the with the highest return potential
regardless of the higher risk
bond price is above par (e.g., P1 200.00). In this associated with such assets.
scenario, the yield is expected to fall. Given a bond price
of P1 200.00, the yield drops to 4.17% (or 0.05 x 1
000=0.0417).
As observed, the yield (potential interest income)
1200 goes up (i↑) as
the bond price goes down (PI). Conversely, a lower yield (i↓) is
expected when the bond price goes up (P↑).

The negative price and interest relationship is apparent in

monetary policy. Here are the three tools conventionally
employed by the BSP in achieving a desired level of money
supply.
Bank rate - This is the central bank's lending rate to commercial banks. An increase
in the bank rate discourages borrowing by commercial banks. Financial institutions that
are running low on funds will likely decide to reduce their loans to the public instead
of borrowing from the central bank and incurring higher interest rates. The reduction in
loans and credit transactions leads to a decrease in money supply.

Open market operations - This refers to the buying and selling of bonds by the central bank
in order to manage the supply of money in the economy. The BSP issues bond securities
when it wants to reduce the money supply (MSI) and buys bond securities to increase
money supply (MST) and to infuse liquidity to the economy.

Reserve requirement ratio - Philippine commercial banks are required to maintain a

minimum cash reserve with the central bank, which may not be used for lending and
regular bank operations. An increase in the reserve requirement by the BSP means that
banks have to deposit a larger amount in the BSP. This results in less funds being available
for lending to the public. Thus, increasing the reserve requirement lowers money supply.
However, if the BSP decides to reduce the reserve requirement, more of the commercial
banks' funds will be made available for lending, which will lead to an increase in the money
supply. The central bank reserve requirement ratio is presently at 20%.

Graphically, how is the money market equilibrium represented? Refer to figure 4.4. The
demand for money (MD) follows the law of demand and is represented by a downward-
sloping curve. This suggests that a lower interest rate makes borrowing desirable, which
leads to an
increase in the demand for money. The supply of money (MS), on the other hand, is taken
as a constant. It is represented by a vertical line given that the amount of money (Qm) in
the economy for a certain period is set by the central bank. Finally, the intersection of the
demand and supply of money determines the equilibrium interest rate (r*).

Fig. 4.4 The intersection of the demand and supply of money determines the equilibrium
interest rate (r*).
The money market through monetary policies can hugely impact the country's
economy. For instance, a higher money supply ultimately leads to an increase
in real GDP and higher prices. Refer to figure 4.5 for the simplified example on
how monetary policy affects the overall economy as well as to enforce your
understanding of the negative relationship between interest rate and price.

Figure 4.5 (a) depicts the money market, while figure 4.5 (b) shows the
aggregate demand and supply equilibrium. For example, the BSP decides to
reduce the reserve requirement ratio from 20% to 18%. As you have learned,
this will lead to a higher money supply (MS↑). Graphically, this increase is
represented by a shift in the money supply curve to the right leading to a
lower money market equilibrium, which translates to a fall in the interest rate
(r↓). A lower interest rate encourages borrowing and spending. This will shift
the aggregate demand curve to the right (AD to AD) and move the aggregate
equilibrium level up (to point 4), ceteris paribus. The new equilibrium level
translates to more output or higher real GDP (Y to Y') and subsequently to a
higher general price level (P to P).
Fig. 4.5

In figure (a), given the demand curve for money (MD), an increase in money supply (MS to
MS) will lower the money market equilibrium to point 2. This will lead to a lower interest rate
(r to r) and an increase in the quantity of real money (Qm to Qm').

In figure (b), the lower interest rate encourages borrowing and consumption, leading to
higher economic output and is evidenced by a shift in the aggregate demand curve to the
right (AD to AD). The new AD curve leads to a higher aggregate equilibrium, which
determines a new and higher price level (P to P'). This corresponds to the intersection of the
new AD curve and the short-term aggregate supply curve (SAS).
This example shows how monetary policy drives economic growth. However, later you will
realize that this is not always good since a lower interest rate has a negative impact on
investments and purchasing power.

The Philippine Peso and Foreign Exchange

The foreign exchange market is the market for the exchange of foreign currencies. The
market is also quite often referred to as forex or FX. The price in the forex market refers to
the prevailing exchange rate while the goods being exchange are the currencies. More
formally, exchange rate can be defined as the price of a currency in terms of another
currency. For example, when you say that the peso-dollar exchange rate is P45.00, this is the
same as saying "P45.00 for US$1" or "US$1 is equivalent to P45.00."

There are two components of an exchange rate quotation. The first currency quoted is called
the base currency, while the second currency is the counter currency. Counter currency is
also referred to as the quote currency. How the domestic currency is cited in the quotation
determines the type of quotation of the exchange rate.

A direct quote provides the domestic currency as the base currency, while an indirect quote
provides the domestic currency as the counter or quote currency. See figure 4.6.
Alternatively, a direct quote can be defined as the price of the domestic currency per unit of
foreign currency, while an indirect quote is the price of the foreign currency per unit of the
domestic currency.
Fig. 4.6 Exchange rate quotations: A direct quote gives the domestic currency as
the base currency while an indirect quote gives the domestic currency as the
counter or quote currency.

There are two ways to determine the exchange rate value or price in the forex
market. One is through the supply and demand of currencies like in a typical
market. This system of letting market forces determine the exchange rate is
called a floating forex regime. In contrast, a fixed forex regime is when the value
of the local currency is pegged to another, usually more stable, currency such as
the US dollar.
The Philippines follows a floating forex regime, along with the
majority of countries in the world. The strength of the
Philippine peso can be measured through its foreign
exchange rate. Floating forex systems are technically
"managed floating" because a nation's central bank usually
intervenes in critical times to maintain stability of the local
currency. In the Philippines, maintaining a stable currency is Big idea
Most commonly traded
one of the responsibilities of the BSP. currencies are the US dollar
and the euro. Countries with
While there are relatively fewer countries with pegged fixed forex regimes choose
to peg their local currency
currencies, it is worthwhile to know the reasons why some to the US dollar primarily
nations fix their currency value to the value of another because of its stability.
currency. The first reason is to maintain competitiveness. This
is typical of small countries that have one primary source of
income. For example, many Caribbean countries have pegged
their currency to the US dollar because most of their
revenues come from tourists spending US dollars. The second
reason is to maintain oil price stability. This is applicable to
Middle East countries such as United Arab Emirates, Saudi
Arabia, and Qatar, which have fixed their currencies to the US
dollar.
Figure 4.7 illustrates how equilibrium levels are determined in the Philippine forex
market.

Fig. 4.7 The forex market equilibrium is determined by the supply and demand of
currency in the economy. The equilibrium point for the peso exchange rate is at
the intersection of the prevailing exchange rate (P*) and quantity (Q*).
Currency depreciation happens when the currency loses value relative to another currency. This is
evidenced by an increase in the nominal value of a directly quoted exchange rate. For example, a
peso-dollar exchange rate increase from P45.00 to P46.00 means that the peso has depreciated and
that you will need to exchange more pesos for a dollar.

In contrast, currency appreciation occurs when the currency becomes more valuable relative to
another currency. This is evidenced by a decrease in the nominal value of the exchange rate. For
example, a peso-dollar exchange rate drop from P45.00 to P44.00 means that the peso has
appreciated, that is, it has become stronger because you will need to give up less pesos in exchange
for one dollar.

There are three main factors that affect the exchange rate. One is foreign trade. Forex is particularly
important in foreign trade where imported goods are largely paid in foreign currency. Manufacturing
companies that import raw materials, for instance, typically maintain foreign currency reserves to
ensure sufficient funds in the case of exchange rate fluctuations.

In case of a trade surplus where exports exceed imports, there is an expected rise in demand for the
local currency. This demand causes an appreciation of the exchange rate. The opposite happens in a
trade deficit where imports exceed exports. There is a decline in the demand for local currency or
conversely, a higher demand for foreign currency. This causes a depreciation of the exchange rate.

Figure 4.8 illustrates the effect of foreign trade on the exchange rate. Note that an increase in the
dollar-peso quote is equivalent to an appreciation of the peso. This means that the increase from
US$0.22 to US$0.23 is equivalent to a peso appreciation of P46.00 to P44.00 per dollar.
Fig. 4.8 An increase in demand for exports means an increase in demand for the local currency (Q to
Q). This shifts the demand curve to the right (D to D') causing an appreciation to the domestic local
currency. A peso appreciation is equivalent to more dollars in exchange for 1 peso.

In addition to foreign trade, another variable that impacts the exchange rate is the level of interest
rates on treasury bonds. A higher interest rate on domestic T-bonds attracts foreign investors. The
increase in demand for T-bonds issued by the Philippine government causes an appreciation of the
Philippine peso. In contrast, a lower interest rate on the domestic T-bonds relative to foreign T-bonds
causes a decline in demand and a depreciation of the peso. Figure 4.9 illustrates how an increase in
interest rates on T-bonds affects the exchange rate.
Fig. 4.9 A higher interest rate on government T-bonds causes an increase in demand
of the local currency represented by a shift in the demand curve (D to D). The shift
leads to a higher equilibrium level (point 1 to point 2) corresponding to an increase
in the exchange rate and appreciation of the local currency.

Price Stability as a Macroeconomic Goal

In addition to economic growth and full employment, another macroeconomic goal of

a nation is price stability. The country's general price level is impacted by monetary
policies
employed by the central bank. Recall in figure 4.4 how an increase in money supply leads to a
lower interest rate and higher real GDP. Since real GDP is one of the measures of economic
growth, you can conclude that an increase in money supply drives economic growth. But while
there is improvement in terms of real GDP or output, there is a corresponding increase in price
levels. The central bank is cautious in increasing money supply because it might lead to inflation
and price instability.

Inflation is the increase in prices over time. So while a higher GDP is desirable, a high level of
inflation is not. Inflation erodes the consumers' purchasing power. This means that the same
amount of money is worth less after taking into account price adjustments caused by inflation.
For example, your P1 000.00 previously gets you two carts of groceries. After several price
increases, your P1 000.00 gets you only one cart of groceries. Inflation indicators include the
consumer price index (CPI), which measures goods and services for final consumption, and the
producer price index (PPI), which largely includes goods and services as inputs. The PSA regularly
releases the CPI and inflation rate data for the Philippines,

Similar to the effect of a perceived absence of peace and order in the country, a weak currency
discourages foreign direct investments (FDIs). Both imply poor governance and a vulnerable
economy. In contrast to local investments, FDIS pertain to investments in domestic industries by
foreign investors. Local investments and FDIs are essential drivers of economic growth that tend
to be impacted by monetary policies. Indirectly through inflation, which diminishes the value of a
currency, the peso becomes less desirable in the foreign exchange rate market.

Given the wide-ranging effects of its monetary policies, the central bank has to constantly find
the balance between economic growth and price stability.
BEYOND WALLS 4.2 Apply It in Real Life

You are the governor of the BSP. The newly elected president
wants to have a meeting with you together with his economic
advisors to ensure economic goals are aligned. Among the
agenda is to discuss the continued depreciation of the Philippine
peso. Being in charge of the country's monetary policies, use any
of the monetary instruments, including graphs, to explain to the
president how any of the monetary tools can be used to
strengthen the local currency. The graph must be clear with all
variables labeled correctly.

The Philippine Real Estate Market

The law of supply and demand is also apparent in the case of the
real estate market. Prices of housing and property are driven by
the demand and supply equilibrium similar to the product and
Rent and Price Structure

Given a typical demand curve, the quantity demanded of real estate rises as prices fall, ceteris paribus.
Lower real estate prices encourage people to buy a house. Thus, increasing the quantity demanded.
Similarly, when housing becomes more expensive, people are discouraged to own a house or would
postpone buying one. Figure 4.10 shows price as an endogenous variable or one that directly influences
quantity demanded. On the supply side, higher prices encourage real estate developers to build more
houses while lower prices diminish the incentive for developers to supply more.

Fig. 4.10 The demand and supply of real estate determines the equilibrium
quantity and price. The relative inelasticity of the supply of real estate is
represented by a slightly steep supply curve.
Notice in figure 4.10 that, although the supply curve is the typical upward-
sloping curve, it is slightly steeper. This is not a coincidence. Real estate is
relatively inelastic or not very responsive to price changes. This means that a
huge jump in price leads to a small change in quantity supplied.

In contrast to normal goods, the housing market does not easily respond to
market demands compared to other goods. Why is it the case? Basically, this is
due to the dependencies of real estate on a lot of factors such as cost,
availability of land, and government regulations. It involves a much more
complex process than that of manufacturing consumer products. Building real
estate properties entails securing permits and complying with several
regulatory requirements. In addition, the actual construction also takes time.

Variables with outcomes that are dependent on other variables or factors in a

model are sometimes referred to as endogenous variables, while those that are
completely independent from the other factors in the model are called
exogenous variables. While price as a driver of quantity demanded and supplied
is considered to be endogenous, other quantity determinants that have nothing
to do with price are considered exogenous. On the demand side, income and
availability of substitutes affect the quantity demanded of houses. As income
improves, more people will be able to afford a house. In addition, people who
cannot afford to own one will likely rent. Renting, in this case, is considered as a
substitute. Finally, interest rate influences the quantity demanded of housing. A
lower interest rate means lower mortgage payments, which encourage people
to buy a house.

Similarly, supply is subject to other factors such as regulations, availability of

land, and costs of construction. Housing subsidies, for instance, potentially
increase supply of real estate because the government pays a portion of the
cost of owning a house.

Graphically, a change in endogenous factor (e.g., price) is represented by a

movement along the demand or supply curve, but changes in exogenous
factors (e.g., income) are represented by a shift of either the demand or the
supply curve. Figure 4.11 illustrates a change in the equilibrium level as a result
of a lower mortgage interest rate. A lower interest rate encourages people to
purchase real estate. This will shift the demand curve to the right and will result
in a higher equilibrium quantity and price.
Fig. 4.11 A lower interest rate reduces mortgage payments, which increases the
demand for housing. This will shift the demand curve to the right (D to D) and
pushes the equilibrium level up, which eventually leads to higher prices.
What Have I Learned So Far?

Analyze the effect on equilibrium quantity and demand of an increase in real

estate taxes, which are typically shouldered by consumers. Explain and
illustrate the effect using a graph.

BEYOND WALLS 4.3

Apply It in Real Life

You are the manager of a small money changing establishment. You noticed that there was a
decline in your daily transactions recently. Your boss suspects that customers are choosing to
exchange their money at the banks. To better compare and adjust your rates accordingly, you
were asked to conduct a survey of at least four banks nearest to your location. Gather data on
their peso-dollar exchange rates-both buying and selling rates. Analyze your data to find out
which bank provides the most attractive exchange rate and how much is the rate. Present your
data in tabular form for easier comparison. (Note: Exchange rate information is typically
displayed daily inside banks for customers' reference.)
Extend Your Knowledge

Visit the following Web sites to learn more about the given topics. 1.
Labor standards, statistics, and other labor and employment-related
information in the Philippines

• International Labor Organization: [Link]

• Department of Labor and Employment: [Link]

•Philippine Overseas Employment Association: [Link]

2. Functions of the BSP and the latest updates on monetary policies,

interest rate, and exchange rate data

•[Link]
ESSENTIAL LEARNING

In this module, you learned the most common applications of the law of
supply and demand in the different sectors of the economy: product, labor,
financial, and real estate. Additionally, you became aware of the different
market structures and how they influence consumer and supplier behaviors.

You also learned the three primary macroeconomic goals of the country:
economic growth, full employment, and price stability. While the
government leads the efforts in achieving economic growth through fiscal
policies, it is the central bank that is responsible for maintaining price
stability and strong currency through its monetary policies. Moreover, you
learned the basic functions of the central bank and how it utilizes the
monetary instruments to achieve a desired level of liquidity.

Finally, you had more chances to build your skills in analyzing economic
changes through graphs. The ability to illustrate real-world scenarios using
diagrams helps to reinforce your understanding of the concepts. Getting
familiar with the different economic indicators helps you grasp and assess
the country's economic well-being.
THANK YOU