During the 1980s, Philippine monetary policy has faced a number of difficult challenges. First, inflation accelerated rapidly in the aftermath of the external financial crisis of late 1983, when the authorities were forced to request a standstill on most debt service payments and imposed a centralized foreign exchange allocation system that severely restricted most imports. The 12-month inflation rate reached a peak of over 60 percent in late 1984, in the wake of a rapid monetary expansion that quickly eroded the benefits of a series of devaluations (Chart 1). Second, the financial position of many banks weakened considerably as a result of the financial crisis and the subsequent recession in 1984-85. During this period, several commercial banks and a large number of thrift institutions and rural banks failed; in 1984-85 alone, financial institutions accounting for about 3 1/2 percent of the total liabilities of the financial system failed. Consequently, there have been periodic crises of confidence affecting much of the financial system that led to recurrent shifts from bank deposits to cash; similar shifts took place during periods of political instability. Third, the adoption of a floating exchange rate system in October 1984 resulted in a much closer linkage between exchange rate and domestic credit policies and led to a number of changes in the intermediate targets of monetary policy.
This paper examines some of the key issues in the conduct of Philippine monetary policy since 1984 in the light of these developments. Section I discusses the factors underlying the monetary authorities’ choice of intermediate policy targets and the instruments used to achieve those targets. Section II reports on the estimation of demand functions for various categories of monetary aggregates and section III discusses various tests for the stability of these demand functions in light of the various shocks to the economy and the financial system. Section IV discusses the interaction between monetary and exchange rate policy, and reports on estimates of a model of exchange market pressure that analyzes the effect of excess money balances on both the exchange rate and net international reserves. Section V provides some concluding observations.