EC 102.01

1. EC 102.01 Midterm 2 – July 21, Thursday 13:15 – 15:00 Exactly at class time, venue: Hisar Campus HKD 201 : ACAR – ISIK HKD 101 : INAM – YILDIZ Ch 9, Ch 10, Ch 11 (Sections 1,2,3,4 (except 4.4), 5) + Additional Material uploaded on course website

2. Outline Macroeconomic Theory and Policy Chapter 11 – Money and Monetary Policy Section 3 – The Banking System Private Banks Central Bank Money Creation Other Tools of Monetary Policy Section 4 – Theory of Money, Interest Rates and Aggregate Demand Section 5 – Theory of Money, Prices and Inflation

3. Banking System Remember: Classical model - market for loanable funds with suppliers and demanders Need 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.

4. Banking System Credit-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

5. Banking System Balance sheet must be in balance: assets = liabilities Assets: 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

6. Banking System Assets: Bank reserves – funds not loaned out but kept as vault cash or deposits at the CB; do not earn interest Government bonds – securities in the form of Treasury bills (T-bills), bonds, notes Remember: 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

7. Banking System Central 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

8. Banking System Need 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.

9. Monetary Policy CB has various ways of changing the volume of money and credit in the economy Most commonly used: OMO (open market operations) Buying or selling of government bonds – assets of CB Remember: 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

10. Monetary Policy Open market purchase – increase in monetary base (currency + bank reserves) So far the open market purchase of bonds did not change the volume of money in circulation (M1) Remember: banks are for-profit organizations

11. Monetary Policy Commercial 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

12. Monetary Policy Money 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 Base Showing 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↓

13. Monetary Policy Remember: use of money (as a medium of exchange, store of value and unit of account) Banking system – CB, private banks, individuals+businesses => money creation Tools of monetary policy: open market operations (sale or purchase of government bonds) Multiplier effect operating through balance sheets of CB and private/commercial banks Sale = MS↓, purchase = MS↑ Now focusing on other tools of monetary policy

14. 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↑.

15. Monetary Policy So far: HOW money and credit is created in an economy? “Loose” and “tight” monetary policies, policy tools Now: 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)

16. Monetary Policy Case 1: fairly stable inflation rate + healthy banking system and primal concern is the level of output Concern 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

17. Monetary Policy Supply of Federal Funds Suppliers and demanders = comercial banks Upward sloping S, downward sloping D E 6 % Federal Funds Rate Demand for Federal Funds Quantity of Federal Funds Borrowed and Lent

18. Monetary Policy Original Supply of Federal Funds A drop in one large market will tend to carry over to other markets MS↑ => expands credit and lowers interest rate MS↓ => shrinks credit and raises interest rates New Supply of Federal Funds E0 6 % Federal Funds Rate E1 5 % Demand for Federal Funds Quantity of Federal Funds Borrowed and Lent

19. Interest Rates and Investment Agents 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 confidence Shifts II curve

20. Monetary Policy and Aggregate Demand Remember the basic macroeconomic model AD = C + II + G + NX Low inflation, stable banking system Assume: expansionary monetary policy => lower interest rates, raise intended investment, AD ↑

21. Monetary Policy and Aggregate Demand Expansionary 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

22. Monetary Policy Remember: 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 output Concern 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 ↓

23. Theory of Money, Prices and Inflation Now Case 2: main concern is to control inflation Quantity Theory of Money M x V = P x Y money 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)/ M Classical and monetarist perspectives assume thay V is constant => MS and nominal GDP are related

24. 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 neutrality No need for a discretionary MP: if economy is non-growing, stable MS to keep price levels stable if economy is growing, MS should grow at the same rate with GDP to avoid inflation -> MS rule

25. Theory of Money, Prices and Inflation Monetarism Friedman 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

26. 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.

27. Theory of Money, Prices and Inflation Importing inflation? Inflation could be triggered by international economic developments Suppose: 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 ↓