Equilibrium Income

• Keynesian Approach: AEd determines Y (income/output) produced

• Can there be limitations to this link?YES because interest rates and/or prices

might change that will reduce the effect on Y.

Interest Rates

• Interest rates are determined by the supply and demand of loanable funds.

• Let’s take a closer look at this market.Money

MarketFinancial MarketBond Market

Equities Market

Money Market

• What is money?

Historical Development of Money

• No Money: Barter Economy (goods for goods)• Money as a medium of Exchange:

Goods Money Goods

• How did all start?– Precious metals,– Paper money backed by gold,– Paper money fractionally backed by gold,– Fiat money,

Properties of a Good Medium of Exchange

1. Acceptable2. Standardized quality3. Durable4. Valuable relative to its weight5. Divisible

The Functions of Money

1) Medium of Exchange2) Unit of account3) Store of Value4) Standard of deferred payments

Money Supply Today

• Money supply (M1)Currency (in circulation) + demand deposits (TL and Foreign Currency)

• Money supply (M2)M1 + Time deposits (TL and Foreign Currency)

M1 and M2 in Turkey

2005 2006 2007 2008 2009 2010 2011 20120

100000000

200000000

300000000

400000000

500000000

600000000

700000000

800000000

M1M2

US Money Supply

Nov. Dec. Jan. 2011

Feb. Mar. Apr. May June July Aug. Sep. Oct. Nov. Dec. Jan. 2012

Feb. Mar. Apr. May June July Aug. Sep. Oct.0

2000

4000

6000

8000

10000

12000

M1M2

Can the Central Bank change MS?

• YES!!!

• HOW? – With some tools known as monetary policy tools.

(Tools are instruments that a policy maker can change in order to influence the workings of an economy)

Monetary Policy Tools

1. Discount Rate,2. Reserve Requirement ratio,3. Open Market Operations.

How do they work? Need to look at how banking system work and money changes hands…

Commercial Banks

• Banks are profit seeking institutions.– They accept deposits,– They give loans

• Public Banks (Ziraat, Halk …) and Private banks (IsBank, Akbank, Garanti

…)

Commercial Banks Balance SheetsAssets Liabilities

Reserves Deposits

Loans Short and long term borrowing

Building and Equipment Other Liabilities

Other Assets

Total Liabilities

Stock holders equities

Total Assets Total liabilities + stock holders’ equities

Rules that commercial banks follow:

• Hold the required reserve ratio determined by Central Bank.

If required reserve ratio (rr) is 15%, then in equilibrium

(Reserves/ Deposits)*100 ratio=15 %.

e.g. If Total Deposits are 2000 billion TL, then reserves need to be 300 billion TL.

(Reserves/ Deposits)*100 ratio=(300/2000)*100=15 %

A new deposit comes into Bank One

Change Assets Change LiabilitiesReserves +1000 Deposits +1000

Loans

Total Assets +1000 Total Liabilities +1000

Bank One uses this new deposits in giving out new loans

(Reserves/deposits)*100= 15 %. Result: Creates a new loan equal to 850.

Change Assets Change Liabilities

Reserves + 150 Deposits +1000

Loans + 850

Total Assets +1000 Total Liabilities +1000

The new loan comes back to Bank Two Change Assets Change LiabilitiesReserves +850 Deposits +850

Loans

Total Assets +850 Total Liabilities +850

Change Assets Change LiabilitiesReserves +127.5 (850*0.15) Deposits +850

Loans +722.5 (850*0.85)

Total Assets +850 Total Liabilities +850

New loans of 722.5 TL are created by Bank Two

This will repeat ∞ times

• Total change in the deposits: 1000+ (0.85*1000)+(0.85*1000)2+(0.85*1000)3+…

(0.85*1000)∞=

• Total change =

• Change in total deposits=

Money supply

• Money market • Tools to increase the MS1) Discount rate increase,2) Reserve requirement

ratio decrease,3) Open Market

Operations (Buy bonds)

I

Q of money

Money demand

• Money market • Types of Money demand

1) Transaction demand,2) Speculative demand,3) Precautionary

demand,

• MD= L(Y, i) or• MD= 5*Y – 3*i

I

Q of money

Money demand

• Money market • If Y increases, then MD curve shifts to the right

• MD= L(Y, i) or• MD= 5*Y – 3*i

I

Q of money

Money market equilibrium

• Money market MS=MD

• Money supplyMS= 1000

• Money demandMD= L(Y, i) orMD= 5*Y – 3*I

(For a given Y level you will be able to determine equilibrium interest rate)

I

Q of money