OutlineMacroeconomic Basics

Money Market

Economic Policy

Bilgin Bari

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

1 Macroeconomic BasicsMoney and InflationInflation and Interest Rate

2 Money MarketDetermination of Interest Rate

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

Money and InflationInflation and Interest Rate

Inflation I

Inflation is always and everywhere a monetaryphenomenon.

Milton Friedman

It is valid for the long-run.

but not the short-run

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

Money and InflationInflation and Interest Rate

Inflation II

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

Money and InflationInflation and Interest Rate

Inflation III

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

Money and InflationInflation and Interest Rate

Inflation IV

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

Money and InflationInflation and Interest Rate

Inflation V

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

Money and InflationInflation and Interest Rate

Inflation VI

Central Banks control the quantity of money to preventhigh-inflation episodes.

The growth rate of the quantity of money- explain inflation in the long-run.- not enough for the short-run.

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

Money and InflationInflation and Interest Rate

Money

Economists use word ’money’ differently from conventionalusage.

Economist define money as an asset that is generally acceptedas payments for good and services and in the repayment ofdebts.

According to this definition, checks and deposits are alsoaccepted money.

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

Money and InflationInflation and Interest Rate

Functions of Money

Money has three primary functions in any economy.

Medium of Exchange

The money is used to pay for goods.

The money promotes economic efficiency by minimizingtransaction costs.

Unit of Account

The money measures the value of goods and services in theeconomy.

Store of Value

The money is a repository of purchasing power.

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

Money and InflationInflation and Interest Rate

The Control of Money Supply

The amount of money in the economy is called the moneysupply.

Central bank controls the amount of money (money supply) inthe economy.

The central bank carries out this task primarily through thepurchase and sale of government bonds in ”open marketoperations”.

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

Money and InflationInflation and Interest Rate

Open Market Operations

When the central bank buys a government bond from a bank,it pays for the bond with the currency.

This increase the amount of currency in the bank.

With this additional liquidity, banks can made additional loansto households and businesses.

An open market purchase increases the money supply.

An open market selling reduces money supply.

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

Money and InflationInflation and Interest Rate

Measuring Money

The method by which central banks define money differs from oneeconomy to another.Monetary Aggregates (TCMB)

M1 = Currency in circulation + Demand deposits (TL, FX)

M2 = M1 + Time Deposits (TL, FX)

M3 = M2 + Repurchase Aggreements + Money MarketFunds + Issued Securities

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

Money and InflationInflation and Interest Rate

Measuring Money

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

Money and InflationInflation and Interest Rate

Quantity Theory of Money I

The Quantity Theory of Money explains the inflation phenomenonusing money growth:

MxV = PxY

Velocity of Money (VoC)

VoC provides the link betwwen M and PxY

V =PxY

M

V : The average number of times per year that a currency is spent

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

Money and InflationInflation and Interest Rate

Quantity Theory of Money II

The Equation of Exchange

Equilibrium condition for money market : Ms = Ms

Demand for Money : M = 1V xPY

Real Money Demand : Md

P = kxY

Real money balances : The quantity of money that people want tohold in terms of the goods and services that it can pruchase

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

Money and InflationInflation and Interest Rate

Quantity Theory of Money III

The velocity is fairly constant over long periods of timeso that V = V

We can rewrite as MxV = PxY

This equation means that nominal income-spending (PY) isdetermined by money supply (M)

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

Money and InflationInflation and Interest Rate

Quantity Theory of Money IV

The Classical Dichotomy

Wages and prices are flexible ⇒ Prices of good and services andfactor prices would fully adjust to the levels that equate supply anddemand for each good and service in the long-run.

Result

The amount of goods and services produced in an economy inthe long-run is not affected by price level.

This is also true for real factor prices, such as real wages andreal rental cost of capital.

In the long-run, there is complete separation between real sideof the economy and the nominal side.

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

Money and InflationInflation and Interest Rate

Quantity Theory of Money V

The classical dichotomy says that we can take the aggregateoutput as given :

MxV = PxY

Changes in the quantity of money lead to proportionalchanges in the price level.

Central bank determines the general price level in the long-runbecause it controls the money supply

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

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Money and InflationInflation and Interest Rate

Quantity Theory of Money VI

Quantity Theory of Inflation:

%∆M + %∆V = %∆P + %∆Y

π = %∆P = %∆M + %∆V −%∆Y

π = %∆P = %∆M −%∆Y

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

Money and InflationInflation and Interest Rate

Quantity Theory of Money VII

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

Money and InflationInflation and Interest Rate

Quantity Theory of Money VIII

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

Money and InflationInflation and Interest Rate

Real vs Nominal Interest Rate I

The Fisher Equation: i = r + πe

The Fisher Effect: When expected inflation rises, nominalinterest rate will rise.

Rearranging terms, we define real interest rate : r = i − πe

exante real interest rate : r = i − πe

expost real interest rate : r = i − π

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money Market

Money and InflationInflation and Interest Rate

Real vs Nominal Interest Rate II

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money MarketDetermination of Interest Rate

The Liquidity Preference Framework I

Liquidity preference ⇒ Economic units keep two kinds of assets :money and bond

Money has a zero rate of return.

Bonds have an expected return equal to interest rate.

Opportunity cost of keeping money is the interest rate.

There is negative relation between money demand andinterest rate.

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money MarketDetermination of Interest Rate

The Liquidity Preference Framework II

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money MarketDetermination of Interest Rate

The Liquidity Preference Framework III

Demand for Money

Income Effect

As an economy expands and income rises, wealth increases.People want to hold more money as a store of value.As an economy expands and income rises, people want to carryout more transactions using money as a medium of exchange.

Price-Level Effect

When the price level rises, the same nominal quantity ofmoney is no longer avaliable.To keep on holding money in real terms, demand for moneywill rise.

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money MarketDetermination of Interest Rate

The Liquidity Preference Framework IV

Supply of Money

Central Bank use open market operations as a policy tool.

An open market purchase increases the money supply.

An open market selling reduces money supply.

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money MarketDetermination of Interest Rate

The Liquidity Preference Framework V

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money MarketDetermination of Interest Rate

The Liquidity Preference Framework VI

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money MarketDetermination of Interest Rate

The Liquidity Preference Framework VII

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money MarketDetermination of Interest Rate

The Liquidity Preference Framework VIII

The question :Increase in money supply always lower interest rate?

Income effect: increase in money supply will rise interest ratein response to higher level of income.

Price-Level Effect: increase in money supply will rise interestrate in response to the rise in price level.

Expected-Inflation Effect: increase in money supply will riseinterest rate in response to the rise in expected inflation level.

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money MarketDetermination of Interest Rate

The Liquidity Preference Framework IX

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money MarketDetermination of Interest Rate

The Liquidity Preference Framework X

Bilgin Bari Economic Policy

OutlineMacroeconomic Basics

Money MarketDetermination of Interest Rate

References

F.Mishkin, The Economics of Money,Banking and FinancialMarketsChapter 4 and 5

F. Mishkin, Macroeconomics: Policy and PracticeChapter 5

Bilgin Bari Economic Policy