EC 102.01

1. EC 102.01 Midterm 2 – July 21, Thursday 13:00 – 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) + if time permits Ch 12 (Section 1)

2. Outline Macroeconomic Theory and Policy Chapter 10 – Fiscal Policy Wrap-up + Section 3 – The International Sector Chapter 11 – Money and Monetary Policy Section 1 - Why Money? Section 2 – What is Money? Section 3 – The Banking System Private Banks Central Bank Money Creation

3. Budgets, Deficits and Policy Issues Keynesian idea: Government spending is an important part of the economic policies to prevent recession. Recently – controversies over use of fiscal policies especially in relation to the impacts on inflation and deficits Evidence shows that government budget moderates fluctuations in AD without any other intervention Automatic stabilizers – tax and spending institutions tend to increase government revenues and lower expenditures during expansions and vice versa during recessionary periods.

4. Budgets, Deficits and Policy Issues Automatic stabilization but HOW? Suppose there is recession => AD falls, government deficit increases as tax revenues are decreasing due to declining incomes and expenditures increase as there is more receipt of welfare payments (unemployment benefit etc.), decline in C is prevented, therefore recession is moderated. Suppose there is expansion => tax revenues increase as incomes increase, expenditures fall as fewer people receive welfare benefits, disposable income does not rise as fast as national income, C slows down, limiting inflationary overheating

5. The International Sector Remember: Started with the simplistic model with household and business sectors, then added government sector AD = C + II + G Now introducing the foreign (international) sector International sector engaging through trade – exports and imports Trade balance: exports – imports Surplus : exports > imports Deficit: exports > imports – domestic residents spending more on foreign goods

6. The International Sector Trade balance = net exports (NX) = X - M AD = C + II + G + NX Exports as a positive contribution to AD – injection Imports as a leakage from national AD Multiplier effects Increase in Exports – same as in G or II change in Y = multiplier * change in exports Increase in Imports – a bit complicated, changes in income induces import demand as well (through marginal propensity to import - mpm)

7. The International Sector Increase in Imports – a bit complicated, changes in income induces import demand as well (through marginal propensity to import - mpm) similar to the logic of proportional tax – will flatten the AD curve change in Y = multiplier*mpm* change in imports Any portion of AD increase goes to simulate another economy via imports. Trade deficits may not be sustainable for longer term horizon, how to finance???

8. Production generates income to households Output (Y) Income (Y) leakages taxes (T) savings (S) consumption (C) Spending (AD) imports (IM) injections intended investment (II) government spending (G) exports (X)

9. Monetary Policy We covered basic macroeconomic model - circular flow of leakages (savings, taxes and imports) and injections (intended investment, government spending and exports). Balancing three types of leakage with three types of injections, any change will alter equilibrium Classical vs. Keynesian – debates on economic policy Need to consider money supply and monetary policy – effecting interest rates and inflation

10. Why Money? So far very little discussion on financial markets: money, interest rates, inflation etc. Q: How does money and finance relate to macroeconomic behaviour? Illustrate with cases: Case 1: low inflation, sophisticated banking system. Businessman aiming to expand business or households intending to purchase a new property – go to a bank and ask for a loan Volume and terms of the loans affect the level of spending in the economy

11. Why Money? Case 2: simple government and banking system, all payments done by cash, no ability to collect taxes, so print money when needed for expenditures Large and growing – fresh bills will be absorbed Stagnant/staggering – too much money chasing few goods => may lead to hyperinflation! Tend to resort to barter – exchange of goods, services or assets for other goods, services or assets without using any money; BUT normal patterns of saving and lending are distrupted Hyperinflation => low prod’n and high UN, valueless currency; uncertainty, menu costs, “redistribution”

12. Why Money? Case 3: opposite of Case 2; too little money in circulation => prices must bid down (deflation) Deflation – disruptive, redistribution form debtors to creditors, savings are more valuable, borrow cheap but need to repay dear, uncertainty. Generally accompanied by a financial crisis – e.g. Great Depression : bank runs where people rushed to withdraw deposits all at once, causing many banks to fail. Need to stabilize the economy – price stability and maintaining decent standards of living

13. What is Money? Money = banknotes and coins in our wallets; such cash money could not be regarded as the only form! Three main uses of money • as a medium of exchange: when sell sth, accept money in return; without this, barter system! • as a store of value: even hold for a while, it is still useful for transactions when needed; a way of holding wealth; different from other assets because “liquid” – could easily be used in exchange - as a unit of account: monetary value is assigned to things which are not actually sold or bought

14. What is Money? Money is a stock variable – kind of an asset (whereas income is a flow variable over a period of time) but different from wealth (could constitute different forms of assets including real estate, corporate shares etc.) Types of Money • Commodity money: a good that is used as money because it is also valuable itself. E.g. coins made up of silver and gold. (value depends on the context!) Must be generally acceptable, standardized, durable, portable, scarce, easily divisible!

15. What is Money? Types of Money Gold and silver coins fairly portable but inconvenient to carry around in large quantities – certificates used, during gold standard era international transactions based on gold reserves • Fiat money: “let it be done”. Legal authority declares that the bill is money. Some kind of a social construct – accepted in society because of how people think &act but not because it intrinsically is! The basis of value is the expectation that the banknote will be acceptable in exchange.

16. Monetary Policy Remember: use of money (as a medium of exchange, store of value and unit of account) Types of money (commodity vs. fiat money) Measures of Money Varying degrees of liquidity across assets - need to measure the amount of money in circulation Checking accounts also liquid – use of checks or debit cards and electronic transfers. M1 – currency + demand/checkable deposits + traveller’s checks M2 – M1 + saving deposits + some other funds

17. Monetary Policy Use of credit cards? Taking out temporary loan from the bank, payment of the credit card from your account is the monetary transaction itself. Banking System Q: How does the currency finds its way into people’s wallets? Central Bank – sole authority to issue currency; decides on the amount and prints Private Banks – actions with CB create the economy’s volume of checkable/demand deposits.

18. 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.

19. Banking System Tale of Goldsmith – history of banking system Long time ago anything was used as money. Gold and silver were attractive – goldsmiths casting coins, need vaults, people rent space at GS to safeguard coins and valuables. Depositors rarely came in to remove their physical gold and never all came in at once – claim checks being traded in the market as if they were the gold itself GS becoming a lender charging interest upon depositors’ gold + his own. GS grew richer, depositors threatened withdrawal but convinced when saw that gold was all safe there!

20. 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

21. 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

22. 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

23. 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

24. 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.

25. 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

26. 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

27. 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

28. 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↓