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Asset Markets • Let’s take a closer look at this market. Money Market Financial MarketBond Market Equities Market Money Market • What is money? Without it, modern economies could not function Historical Development of Money • No Money: Barter Economy (goods for goods) • Money as a medium of Exchange: Goods Money Goods Lydian Coin (Western Turkey), 700-637 B.C. • How did all start? (shells, barley, peppercorns, gold, and silver) – Precious metals, (Metals objects were introduced as money around 5000 B.C. By 700 BC, the Lydians became the first in the Western world to make coins.) – History of money – Precious metals, (Metals objects were introduced as money around 5000 B.C. By 700 BC, the Lydians became the first in the Western world to make coins.) – Paper money (fully) backed by gold, – Paper money fractionally backed by gold, – Fiat money, Chinese note 1368-1399 (size of a sheet of notebook paper) Properties of a Good Medium of Exchange 1. Acceptable 2. Standardized quality (diamonds, clear or not) 3. Durable (fish, strawberry, do they last) 1. Valuable relative to its weight (cement) 2. Divisible (diamonds, pay for bread) The Functions of Money 1) Medium of Exchange 2) Unit of account 3) Store of Value New York Note, 1776 4) Standard of deferred payments Precious metals are easily divisible into standardized coins and do not lose value when made into smaller units : COINS Initial stages of development of money • Coins, • “Bank Notes” start of Paper money, – Fully backed by gold. – Fractionally backed by gold, • Fiat Money What is the supply? (more efficient) Why is money important? • Using standardized coins or paper bills made it easier to determine prices of goods and services, • the amount of money in the system also plays an important role in setting prices. Inflation or deflation Money Supply Delegated to Central Banks Money Supply Today • Money supply (M1) Currency (in circulation) + demand deposits (TL and Foreign Currency) 229,091,917,800 TL • Money supply (M2) M1 + Time deposits (TL and Foreign Currency) 930,652,330,000 TL M1 and M2 in Turkey 800000000 700000000 600000000 500000000 M1 400000000 M2 300000000 200000000 100000000 0 2005 2006 2007 2008 2009 2010 2011 2012 US Money Supply 12000 10000 8000 6000 M1 M2 4000 2000 0 Nov. Dec. Jan. Feb. Mar. Apr. May June July Aug. Sep. Oct. Nov. Dec. Jan. Feb. Mar. Apr. May June July Aug. Sep. Oct. 2011 2012 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 Sheets Assets 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 Reserves Change Liabilities +1000 Deposits +1000 +1000 Total Liabilities +1000 Loans Total Assets Bank One uses this new deposits in giving out new loans Change Assets Change Liabilities Reserves + 150 Loans + 850 Total Assets +1000 Deposits +1000 Total Liabilities +1000 (Reserves/deposits)*100= 15 %. Result: Creates a new loan equal to 850. The new loan comes back to Bank Two Change Assets Reserves Change Liabilities +850 Deposits +850 +850 Total Liabilities +850 Loans Total Assets Change Assets Change Liabilities Reserves +127.5 (850*0.15) Loans +722.5 (850*0.85) Total Assets +850 Deposits +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)∞ 1 1 = = 6.67 • Total change = 1! 0.85 0.15 • Change in total deposits= 1 *inital change in deposits RR Money supply • Money market • Tools to increase the MS 1) 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, I Q of money • MD= L(Y, i) or • MD= 5*Y – 3*i Money demand • Money market • If Y increases, then MD curve shifts to the right I • MD= L(Y, i) or • MD= 5*Y – 3*i Q of money Money market equilibrium • Money market MS=MD I • Money supply MS= 1000 Q of money • Money demand MD= L(Y, i) or MD= 5*Y – 3*I (For a given Y level you will be able to determine equilibrium interest rate) Money market equilibrium • Money market MS=MD I • Money supply MS= 1000 Q of money • Money demand MD= L(Y, i) or MD= 5*Y – 3*I (For a given Y level you will be able to determine equilibrium interest rate) Central Bank Balance sheet Assets Liabilities FX and Gold Reserves Currency in Circulation Government Required Reserves Open Market Operations Free Reserves Other Capital Central Bank (TCMB) Balance Sheet Central Bank Central Bank Determination of output • Equilibrium in 1. GOODS and SERVICES Market and 2. MONEY Market (Demand side of the economy) Goods and Money Markets What is in the model? GOODS MARKET • The AEd= Y equality MONEY MARKET • MD=MS equality • Other variables: Cd, Id, Gd, NXd, T, YD, -----------------------------IS Curve • Other variables: Y, i -------------------------------LM Curve IS – LM model i • Goods market • Money Market i IS LM Y Y IS curve IS-LM equilibrium • Equilibrium in both markets IS i LM Y IS-LM equilibrium • Expansionary Monetary Policy IS i LM Y IS-LM equilibrium • Expansionary Fiscal Policy: IS i LM Y Mathematical model of the IS-LM • See class notes and homework assignment