EC 102.01Midterm 2 – July 21, Thursday 13:15 – 15:00 Exactly at class time, venue: Hisar Campus

HKD 201 : ACAR – ISIKHKD 101 : INAM – YILDIZ

Ch 9, Ch 10, Ch 11 (Sections 1,2,3,4 (except 4.4), 5) + Additional Material uploaded on course website

OutlineMacroeconomic Theory and PolicyChapter 11 – Money and Monetary Policy

Section 3 – The Banking SystemPrivate BanksCentral BankMoney CreationOther Tools of Monetary Policy

Section 4 – Theory of Money, Interest Rates and Aggregate DemandSection 5 – Theory of Money, Prices and Inflation

Banking SystemRemember: Classical model - market for loanable

funds with suppliers and demandersNeed for financial intermediaries to bring lenders

and borrowers together.Individuals deposit funds at intermediaries for safe

keeping, to be able to write checks or earn interest -> intermediaries use these deposited funds to lend to those willing to borrow.

Private bank – for profit: seeking to make earnings on its activities simply via interest charged on the loans made.

Banking SystemCredit-worthiness of the borrower is important as

loaning is risky: use collateral to alleviate some part of the risk; may deny the loan request entirely or charge different interest rates depending on the riskiness of the loan.

Balance Sheet of A Private Bank

Assets Liabilities Loans $ 70 million Deposits $ 100 million Government bonds $ 20 million Reserves $ 10 million

Banking SystemBalance sheet must be in balance: assets = liabilitiesAssets: what it owns, Liabilities: what it owes Liabilities: deposits – need to repay these to the account

holders. Except in case of banking panics, depositors do not show up at the same time to ask for their funds => keep some amount to meet withdrawal needs and use the rest to obtain earnings

Assets: Loans – major asset / main way to make earnings; owed to the bank by individuals, businesses etc.; include consumer loans, mortgages, business loans repaid over a long period

Banking SystemAssets: Bank reserves – funds not loaned out but kept as

vault cash or deposits at the CB; do not earn interestGovernment bonds – securities in the form of Treasury

bills (T-bills), bonds, notesRemember: when the budget shows deficit, government

borrows from the public to finance the deficit or refinance part of its debt.

Issuing government bonds – relatively liquid, earns interest.

Eg. Depositors demand more cash than a bank currently has as vault, may quickly sell its bonds on the open bond market and get the necessary cash to pay back

Banking SystemCentral Bank – usually assumed to be independent

from political authority to insulate the activities from political pressures – in TR: literally not a part of the government but CB governors and board members are appointed by the government and approved by the president.

“banker’s bank” – holds deposits made by the private banks; required reserves – amount held at CB

Assets Liabilities

Government bonds

$ 750 billion Currency in circulation

$ 700 billion

Bank reserves $ 50 billion

Banking SystemNeed to maintain stable functioning of the banking

system as a whole; especially when there is the risk of liquidity crunch, provides emergency loans to the banks.

BDDK – regulatory board for banking in TR; provides guarantee for the value of many accounts.

CB keeps track of the economy and tries to sense whether some adjustment in MS would be needed to support AD or counteract inflationary pressures.

Monetary PolicyCB has various ways of changing the volume of

money and credit in the economyMost commonly used: OMO (open market operations)Buying or selling of government bonds – assets of CBRemember: liabilities on CB balance sheet: currency

in circulation and bank reserves (vault cash and deposits of banks at CB)

Suppose open market purchase of bonds (usually from other banks) – bonds at CB ↑, payment by crediting the bank reserves

Monetary PolicyOpen market purchase – increase in monetary base

(currency + bank reserves)(a) Change in the CB Balance Sheet

Assets Liabilities Government bonds +$ 10 mio Bank reserves +$ 10 mio (b) Change in Commercial Bank’s Balance Sheet

Assets Liabilities Government bonds $ 10 mio Reserves +$ 10 mio So far the open market purchase of bonds did not change the volume of money in circulation (M1)

Remember: banks are for-profit organizations

Monetary PolicyCommercial bank would seek for profit by increasing

the volume of loans available, gives out loans to a private company which deposits it in another bank

A Loan by Commercial Bank1 Becomes a Deposit in Commercial Bank2 (a) Next Change in the Commercial Bank1’s Balance Sheet

Assets Liabilities Loans +$ 10 mio Reserves $ 10 mio (b) Change in Commercial Bank2’s Balance Sheet

Assets Liabilities Reserves +$ 10 mio Deposits +$ 10 mio

Monetary PolicyMoney supply is now increased

1. amount of demand deposits increased by 10 mio.2. Commercial Bank2 now has excess reserves to be given out as fresh loans (after reserve requirement is deposited at CB)

Multiplier effect operates!Money multiplier = Money Supply / Monetary BaseShowing the change in money supply as a response to

change in monetary base or high-powered money – related to the reserve requirement ratio

OM purchase => MS↑; OM sale => MS↓

Monetary PolicyRemember: use of money (as a medium of

exchange, store of value and unit of account)Banking system – CB, private banks,

individuals+businesses => money creationTools of monetary policy: open market operations

(sale or purchase of government bonds) Multiplier effect operating through balance sheets

of CB and private/commercial banksSale = MS↓, purchase = MS↑Now focusing on other tools of monetary policy

Tools of Monetary Policy- Reserve requirement ratio: CB may lower the rr

ratio so that more funds are available for commercial banks to give out as fresh loans, thus MS↑

- Discount rate: rate of interest charged on the loans that commercial banks are borrowing from CB from “discount window”. CB may lower discount rate (lowering the cost of borrowing) and commercial banks become more aggresive about making fresh loans, thus MS↑.

Monetary PolicySo far: HOW money and credit is created in an

economy?“Loose” and “tight” monetary policies, policy toolsNow: WHY?Case 1: fairly stable inflation rate + healthy banking

system and primal concern is the level of output (today)

Case 2: primal concern is the level of inflation (tomorrow)

Monetary PolicyCase 1: fairly stable inflation rate + healthy banking

system and primal concern is the level of outputConcern about MS is related with interest rates,

availability of credit and the level of output/AD.Interest rates: what you see on the financial pages

of the newspaper is the interest rate determined in the private market of bank-to-bank loans for overnight reserves

CB – announce a target/benchmark levels and act on bank reserves to achieve this

Monetary Policy

Suppliers and demanders = comercial banksUpward sloping S, downward sloping D

Quantity of Federal Funds Borrowed and Lent

Fede

ral F

unds

Rat

e

6 %

Supply of Federal Funds

Demand for Federal Funds

E

Monetary Policy

A drop in one large market will tend to carry over to other markets

MS↑ => expands credit and lowers interest rateMS↓ => shrinks credit and raises interest rates

Fede

ral F

unds

Rat

e

6 %

New Supply of Federal Funds

Demand for Federal Funds

E1

E0

5 %

Original Supply of Federal Funds

Quantity of Federal Funds Borrowed and Lent

Interest Rates and InvestmentAgents make investments using borrowed funds,

the cost of borrowing = interest rate, higher rates of interest reduces the intended investment

Business fixed investment responds to changes in sales much more than changes in interest rates => acceleration principle: high GDP growth induces high II growth

Changes in investors confidenceShifts II curve

Monetary Policy and Aggregate DemandRemember the basic macroeconomic model

AD = C + II + G + NXLow inflation, stable banking systemAssume: expansionary monetary policy => lower

interest rates, raise intended investment, AD ↑

Monetary Policy and Aggregate DemandExpansionary monetary policy => the use of MP

tools to increase money supply, lower interest rates and stimulate higher level of economic activity

Accomodating monetary policy => especially in cases of recession, loose or expansionary MP is intended to counterbalance the recesionary tendencies in the economy

Contractionary monetary policy => the use of MP tools to limit money supply, raise interest rates and encourage a levelling-off in economic activity

Monetary PolicyRemember: WHY MP is used to change the level of

money and credit available in the economy?Case 1: fairly stable inflation rate + healthy banking

system and primal concern is the level of outputConcern about MS is related with interest rates,

availability of credit and the level of output/AD.Expansionary MP => MS↑, lower interest rates,

raise intended investment, AD ↑, output↑Contractionary MP => MS↓, higher interest rates,

lower intended investment, AD ↓, output ↓

Theory of Money, Prices and Inflation

Now Case 2: main concern is to control inflationQuantity Theory of Money

M x V = P x Ymoney balances = nominal output

V: velocity of money => number of times a coin has to change hands in a year to support the level of output and exchange

V = (P x Y)/ MClassical and monetarist perspectives assume thay

V is constant => MS and nominal GDP are related

Theory of Money, Prices and Inflation

Classical Monetary Theory M x V = P x Y

Two assumptions: V is constant, Y is at FE level.Thus change in MS does not effect the level of

output, but only prices = monetary neutralityNo need for a discretionary MP:

if economy is non-growing, stable MS to keep price levels stableif economy is growing, MS should grow at the same rate with GDP to avoid inflation -> MS rule

Theory of Money, Prices and Inflation

MonetarismFriedman and Schwarz: “Great Depression is

caused by drastic contraction in MS” – macroeconomic objectives are best met when MS grows at a steady rate

“bad monetary policy could have bad effects on the economy”

GD: both MS and the level of nominal GDP fell sharply – contraction in MS causing reductions in real GDP => CBs should follow a simple monetary rule

Theory of Money, Prices and Inflation

Hyperinflation?Suppose: output stagnant or staggering + CB

causing MS grow quickly.Money becomes “hot potato” – people hold it for a

short time as it loses its value! => V ↑M x V = P x Y

M ↑, V ↑, Y constant => inflation!!Monetization of deficit: case when CB buys

government debt as soon as it is issued, thus injects new money into the economy.

Theory of Money, Prices and Inflation

Importing inflation?Inflation could be triggered by international

economic developmentsSuppose: devaluation or depreciation of domestic

currency – more domestic currency is required to purchase foreign currency.

Price of imports ↑, relative prices change, distruptions in production.

Strictly anti-inflationary position: prices of other goods should ↓ => deeper recession

Loose MP: accomodating, prices may ↑ but output ↓