MONEY AND

BANKING
DR. Süleyman Yaşar
 The program : The focus of the program
is on the design of strategies for money
and banking management. There will be
an emphasis on learning practical
concepts and techniques of policy
analysis and management.
 SCHEDULE OF PROGRAM
 1. Why study Money and Banking
 An Owerview of the Financial System
 The Defination and Role of Monetary Authorities
 What is the new principles of the global economy?
 2. What is Money
 Functions of Money
 Medium of Exchange
 Unit of Account
 Store of Value
 Evoluation of the payment system
 Electronic Money
 3. Measuring Money
 Theorical and Empirical Definations of Money
 Federal Reserves Monetary Agregates
 Money supply M1, M2, M2Y, M3

 4. Monetary Analysis
 Analytical Balance Sheet of the Banking System
 Balance Sheet of Central Bank
 Balance Sheet of Deposit Money Bank
 5. The Quantity Theory and the Demand
for Money
 The concept of the Money Multiplier
 Financial innovation and deregulation
 Currency substitution
 6.Exchange rate regimes and monetary
analysis
 Monetary equiblirium
 The evaluations of exchange rate regimes
 Exchange rate regimes monetary autonomy

 7. Interest Rate and Rates of Return

 Financial Assets and Rates of return
 Nominal and reel interest rate
 8. The Mundel – Fleming Model
 IS/LM in the closed economy
 IS/LM in the open economy

 9.The instruments of monetary policy

 Seignorage
 Real interest rate and tight money paradox
 Inflation target and fiscal consistency
 Inflation and disinflation
 The cost of disinflation
 Central bank independence
 Lessons from Inflation Targeting Experiences
 10. Banking Industry
 Historical Development of the Banking System
 Basic Operation of a Bank
 General Principles of Bank Management
 Liquidity Management and the Role of Bank
Management
 Assets Management
 Liability Management
 Capital Adequacy Management

 11. Managing Credit Risk
 Screening and Monitoring
 Long term Customer Relationship
 Loan Commitments
 Management Interest rate risk

 12.Asymmetric Information and Bank Regulation

 Deposit Insurance
 Bank supervision
 Consumer protection
 13. International banking
 Eurodollar Market
 Currency crises
 Speculative attack under fixed exchange
rates
 The role of expectations
 Banking sector vulnerability and
currency crises
 14. Financial liberalisation and capital
flows
 Financial reforms and capital accounts
liberalisations
 Lending booms and banking crises
 Using the simple monetary model
 IMF Financial Progranmming and
Monetary Model
What is the new principles of the global economy? John Willliamson
defined the new principles of global economy in the 10 topics.

 The “ Washinton Consensus “

1.FISCAL DISIPLINE
 Consolidated public sector deficit should be financeable without
recourse to the inflation tax.

2.PUBLIC EXPENDITURE PRIORITIES

 Redirect public spending towards areas with high economic
returns and potential to improve income distrubution.

3.TAX REFORM
 Broaden tax base and cut marginal tax rates to improve
incentives and horizontal equity without lowering realized
progressivity.
4.FINANCIAL LIBERALIZATION
 Abolish preferential interest rates for priviliged
borrowers and achive moderately positive real
interest rate with eventual goals of market-
determined interest rate.

5.EXCHANGE RATES
 It should be competitive.
The “ Washinton Consensus “
6.TRADE LIBERALIZATION
 Reduce tariffs progresivelly to 10 percent
range.

7.FOREIGN DIRECT INVESTMENT

 Abolish barriers to entry of foreign firms.
8.PRIVATIZATION
 Privatize SEE.

9.DEREGULATION
 Abolish regulations that impede entry of new firm or
restric competition.

10.PROPERTY RIGHTS
 The legal system should provide secure property
rights without excessive cost.
Augmented Washington Consensus
 11. Corporate governance
 12.Anti-corruption
 13.WTO agreements
 14.Financial codes and standarts
 15.Prudent capital account opening
 16.Non-intermediate exchange rate regimes
 17.Independent central bank/inflation targeting
 18.Social safety nets
 19.Flexible labor market
 20. Targeted poverty reduction
 1. Why study Money and Banking

 Money, banking and financial markets is an important field

that directly affects our life.

 Monetary policy may affect your job prospects and the prices
of goods in the future.

Interest rates influance earnings on your savings and the

payments on loans you may seek on a car or a house.

On the other hand, activities in finacial markets have directly

effects on individuals wealth, the behavior of businesses and
the efficiency of our economy.
 Three financial markets deserve particular attention,
 -the bond market,
 -the stock market
 -the foreign exchange market.

 On the other hand,financial markets can be

classified as
 -debt and equity markets,
 -primary and secondary market,
 -exchange and over the counter market.
 An Owerview of the Financial System

 A market economy based on money, the financial system
provides intermediation for the resources flowing among the
economic sectors.

 The monetary sector serves as a clearing house for all finacial

flows, the monetary accounts provide unique insigth into the
behavior of these flows,which mirror the flows of real
resources among sectors.

 Monetary accounts focus on variables ( such as Money, credit,

and foreign assets and liabilities) that play a central role in the
macroeconomic analysis of an open economy.
The Defination and Role of
Monetary Authorities

 The term monetary authorities is a fuctional

rather than an institutional concept.

 In most countries, the monetary authorities

are represented by the central bank, but the
concept can include agencies of the
government, such as the treasury,that
perform some of the functions of a central
bank.
The monetary authorities,

 -issue currency,
 -hold the country’s foreigns Exchange
reserves,
 -borrow for balance of payments purposes,
 -act as banker to the government,
 -oversee the monetary system, and
 -serve as the lender of last resort to the
banking system.
 -In many countries, the treasury,
issues coins and holds the official
reserves.

 -In some countries, a treasury

controlled Exchange stabilisation fund
instead holds the country’s official
reserves.
THE SYSTEM OF NATIONAL ACCOUNTS (SNA)

 The System of National Accounts was developed as an

accounting framework within which macroeconomic data can
be compiled and presented for economic analysis.

 The Key Macro economic Aggregates

 Gross Output (Q) is the value of all goods and services
produced in the economy.

 Value Added (VA) is the value of gross output less the value of
intermediate consumption.

 Gross Domestic Product (GDP) is defined as the sum of value

added across all sectors in the economy.
 Investment, in macroeconomic terms, refer to
additions to the physical stock of capital in an
economy.

 Depreciation is used to differentiative net from

gross investment and is sometimes call the
consumption of fixed capital.

 Net investment = Gross investment – Depreciation

 Net exports, which are equal to the value of export
of
 goods and services less the value of imports of
goods and services, are used to measure the impact
of foreign trade on aggregate demand.

 Absorbtion (A), also called aggregate domestic

demand, is defined as the sum of total final
consumption (C) and gross investment (I)
 A= C + I
MACROECONOMIC
CONSISTENCY FRAMEWORK

 Y - A = CAB = ( A – Y)*
 + + +

 Bs - Bd = KA = ( Bd –Bs)*
 + + +
 Ms - Md = R = ( Md – Ms)*
 0 0 0
 MACROECONOMIC CONSISTENCY FRAMEWORK
 CAB= TB + NFP + NFT
 A= C+ I
 KA = FDI + NFB

 TB= Trade balance

 NFP= NET FACTOR PAYMENT ( Remittence)
 NFT= NET FOREIGN TRANSFER (Grand)
 FDI= FOREIGN DIRECT INVESTMENT
 NFB= NET FOREING BORROW
 * = REST OF THE WORLD
 CAB= CURRENT ACCOUNT BALANCE
 A = ABSORPTION
 KA= CAPITAL ACCOUNT BALANCE
 R = CHANGE IN RESERVES
 B= BOND
 M= MONEY

AGGREGATE INCOME AND ABSORBTION AND THE EXTERNAL
CURRENT ACCOUNT BALANCE

 GNI= GDP +Yf

 GNDI= GNI + TRf
 S= GNDI – C
 GNDI – A= CAB

 CURRENT ACCOUNT DEFICITS MIRROR AN EXCESS OF

ABSORPTION OVER INCOME.

 S - I = CAB
 CAB= X – M + Yf+ TRf
 ECONOMY WIDE SAVING – INVESTMENT = CAB= USE OF FOREIGN
SAVING.
 Yf= Net factor income from abroad
 TRf= Net transfer from abroad
 OVERVIEW
 Economics : The study of how scarce resources are
allocated among competing uses.
 What is the factors of productions ?
 Labor ….. wage
 Land ….. rent
 Capital….. interest
 Businessman…. profit
 Key Economic Questions Include :
 What is produced ?
 How is it produced ?
 Who gets what is produced ?
 Production Possibility Frontier :
 The alternative combinations of final goods
and services that could be produced in a
given time period with all available and
limited resources and tecnology.
 OVERVIEW
 Production Possibility Frontier :

 Productivity or GDP per Hour Worked : how much an avarage

worker produces per hour, calculated by dividing real GDP
by hours worked in the economy.
 How Choice Are Made :
 Market Mechanism …. Market determinant prices signal
surpluses and shortages, and owners allocated resources to
take advantage of highest monetary rewards.
 Command Economy…. Central authority allocates resources
to achive goals.
 Mixed Economy…. An economy that uses both market and
non-market signals to allocate goods and resources.
 MACROECONOMICS : The study of
economic aggregates such as national
productions, unemployment, exchange rate
and the price level etc.
 MICROECONOMICS : The study of the
behavior of individual consumers and
producers operating in the individual market
of the economy.
 OVERVIEW
 LAW OF DEMAND : Increase in price ( P )
causes decrease in quantity ( Q ) demanded.
 LAW OF SUPPLY : Increase in price ( P )
causes increase in quantity ( Q ) supplied.
 Inflation : A sustained rise in the general price level.
 Cost - Push inflation : inflation whose initial cause is a rise in
production cost.
 Demad – Pull inflation : inflation whose initial cause is
aggregate demand execeding aggregate supply at the current
price level.
 Very High Inflation : we define as an annual inflation rate of
100 percent or more .
 Hyperinflation : an inflation of more than 50 percent per
month.
 Disinflation : the process of eliminating or reducing inflation.
 Deflation : a sustained fall in the general price level.
 OVERVIEW
 Stagflation : a situation in which high inflation is
combined with low growth and high unemployment.
 Aggregate demand curve : a curve relating the total
demand for the economy’s good and services at
each price level, given the level of wages.
 Aggregates expenditures schedule : a curve that
traces out the relation ship between expenditures –
the sum of consumption, investment, government
expenditures, and net exports - and national
income, at a fixed price level.
 Consumption expenditure : aggregate
expenditures on goods and services to
satisfy current wants.
 Savings : all income not spent on goods and
services which are used for current
consumption.
OVERVIEW

Devaluation : a reduction in the rate of exchange between one

currency and other currencies under a fixed exchange rate
system.

 Deregulation : the lifting of government regulations to allow the

market to function more freely.

 Externality : a phenomenon that arises when an individual or firm

takes an action but does not bear all the cost ( negative
externality ) or receive all the benefits ( positive externality )

 Public Goods : a commodity or service which if supplied to one

person is available to others at no extra cost.
 Taxatation : compulsory levies on private induviduals and
organizations made by government to raise revenue to finance
expenditure on public goods and services, and to control the
volume of private expenditure in the economy. Taxes are
classified in various way. Some are called direct taxes. Others are
called indirect taxes.

 Tariff : a tax imposed on a good imported into a country .

 Privatization : reduce the government economic activites in the

whole economy.

 Horizontal Equity: the principle that says that those who are in
identical or similer circumcitances should pay identical or similar
amount in taxes.
ALTERNATIF APPROACH TO
DETERMINING GDP
 The GDP can be determined using three basic approaches :
 1. The production approach
 2. The income approach
 3. The expenditure approach

 These alternative approaches yield equivalent results.

 The production approach

 GDP = VA
 VA = sum of value added across all sectors in the economy.
 NDP = GDP – D
 D= depreciatiıon or cosumption of fixed capital
 The Income Approach
 GDP can also be considered as equel to the sum of
incomes generated by resident producers.
 GDP = W + OS + TSP

 W = wages, salaries, other labor cost ( employers

social security contributions and plus employees’
social security contributions)
 OS = gross operating surplus of enterprises
( including profits, rents, interests, and
depreciations)
 TSP = taxes less subsidies on products
 The Expenditure Approach
 GDP is equal to the sum of its final uses.
 GDP = C + I + (X – M )

 C = final consumption of the government and non

govermental sectord
 I = gross investment ( fixed capital formation and
changes in inventories)
 X = exports of goods and non factor services
 M = imports of goods and non factor services
 Other standard Aggregates
 Gross National Income
 GNI = GDP + Yf
 Yf = net factor incomes from abroad
 Gross National Disposable Income
 GNDI = GNI + TRf
 TRf = net current transfers
 Gross National Saving
 S = GNDI – C
 Nominal and Real GDP
 Nominal GDP = Real GDP x GDP Deflator / 100
 Real GDP = Nominal GDP / GDP Deflator x 100
 GDP Deflator = Nominal GDP / Real GDP x 100
 GDP Deflator = GDP measured current prices / GDP
 measured in base year prices =  p q /  p q x 100

 This known as a Paashe , or current -weighed, price index
 CPI or WPI =  p q /  p q x 100
 This price index is a Laspeyres or base- weighted index.

2. What is money ?

 Money is the stock of assets that can be readily used to

make transactions.

 The Functions of Money

 Money has three functions.
 A medium of exchange. This function corresponds to the
transactions motive for holding money.
 A store of value. Money is an asset that can be used to
transfer purchasing power from the present to the future.
This function corresponds to the portfolio (speculative)
motive for holding money.
 A unit of account. Prices of goods, services and assets
are typically expressed in term of money.
 What is the Money Supply
 The quantity of money avaliable is called the money supply.

 The control over the money supply is called monetary policy.

 Monetary Policy is delegated to a partially independent institution

called the central bank.

 The central bank controls the supply of money is through open-

market operations – the purchase and sale of government bonds.
Analytical Balance Sheet of the Monetary Authority
(the Central Bank)

 Assets Liabilities
 Net foreign assets Reserve money
 Net Claims on the Government - Reserves of deposit Money Banks
 Net claims on the Private Sectors - Currency held by the public
 Other items net
 Total Assets Total Liabilities
 Analytical balance sheet of Deposit Money Bank

 Assets Liabilities
 Net foreign assets Deposits
 Reserves - Demand
 - Required reserves - Time
 - Excess reserves - Foreign currency
 Domestic Credit - Liabilities to monetary authority
 - Claims of government Other less liquid liabilities
 - Claims on other domestic sector
 Other items
 Total assets Total liabilities
 Consolidated Banking System
 Analytical Balance Sheets of the Banking System : Monetary Survey

 Assets Liabilities
 Net Foreign assets (NFA) Broad Money (M2)
 Net Domestic Assets(NDA) Narrow Money (M1)
 Net Domestic Credit (NDC) -Currency in Circulation
 -Net Claims of Government (NDCg) -Demand deposits( DD)
 -Claim on the private sector (NDCp) Quasi money
 Other items (net) Time deposits (TD)
 Foreign currency deposits

 Total assets Total Liabilities

 Reserve Money (RM) = CY + R

 Narrow Money (M1) = Currency in circulation (CY)+

Demand Deposits (DD)

 Broad Money (M2) = Narrow Money (M1) + Quasi

Money (QM)
 Or
 M2 = CY + DD+ TD
 M2 = NFA + NDA
 NFA= M2 - NDA
The Quantity Theory and the Demand
for Money

 The earliest monetary theory is based on the link between the

stock of money (M) and the market value of output that it
finances (PY). The so- called quantity equation equates the
stock of money in real terms with real output, with
aproportionality factor, ( k ). Thus,
 M /P = k.Y

 If (k ) is assumed to be constant, this expression provides the

quantity theory of money.
 This theory postulates a direct link between the stock of money (M)
and the price level (P) whenever the economy is assumed to be at full
employment. Thus, so long as ( k ) remains constant, there is a
proportional relation between ( M ) and ( P ).
 M x V = P x Y where V = 1 / k is the income velocity of money, which
is the ratio of the money income (nominal GDP) to the money stock.

 The nominal demand for Money is the demand for a given number
specific currency units, such as Lira or Dollar.

 The real demand for money, or the demand for real money balances,
is the demand for money expressed in terms of the number of units
of goods that the Money can buy.

 Therefore, the demand for real money balances is the quantity of

money (M) expressed in real terms (M/P), that is , deflated by the
index for the general level of prices. The demand for money is
fundementally a demand for real money balances, because people
hold money for what it can buy.
 Money Multiplier
 Under the fractional reserve system ,
banks use their deposits to make loans,
keeping only a fraction of their deposits
as reserves.
 mm = M2 / RM
 mm = money multiplier
 Money and Inflation
 Milton Friedman : “ Inflation is always
and everywhere a monetary
phenomenon.”

 V = PY / M
 Inflation (  ) =  M / M - g +  V / V
 6.Exchange rate regimes and monetary analysis

 Exchange rate regimes

 -Fixed or managed exchange rate →
 commitment to intervene in forex
market to limit movement of Exchange
rate (E)
 -Floating Exchange rate →
 no commitment to forex intervention
 Exchange rate Exogenous Endogenous
 regimes variable variable
 Fixed or
 Managed path to E NFA

 Band path of upper E within bands,

 and lower band NFA at bounds

 Floating path of NFA E

Continuum of exchange rate regimes:
From flexible to rigid
FLEXIBLE CORNER

1) Free float 2) Managed float

INTERMEDIATE REGIMES

3) Target zone/band 4) Basket peg

5) Crawling peg 6) Adjustable peg

FIXED CORNER

7) Currency board 8) Dollarization

9) Monetary union
 Reference:Jeffrey A. Frankel
 Of 185 economies, the IMF at end-1999 (the last de jure list) classified:
 51 independent floaters
 45 have given up currencies -- of which:
 11 member of EMU
 2009 (The eurozone (officially the euro area is a currency union of 16 European Union (EU)
states which have adopted the euro as their sole legal tender. It currently consists of Austria,
Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the
Netherlands, Portugal, Slovakia, Slovenia and Spain.)
 14 members of the CFA Franc Zone
 The CFA franc (in French: franc CFA, "cé éfa", or just franc colloquially) is a currency used in
twelve formerly French-ruled African countries, as well as in Guinea-Bissau (a former
Portuguese colony) and in Equatorial Guinea (a former Spanish colony).
 89 intermediate regimes -- of which:
 30 pegs to a single currency (China)
 13 pegs to a composite
 5 crawling pegs
 7 horizontal bands (minor Slovakia)
 7 crawling bands
 26 managed floats

 Fischer (2001): Intermediate pegs, at 34%, down from 62% in 1991

 But: there are as many currencies as in 1991

Advantages of fixed rates

1) Encourage trade <= lower exchange risk

 Theory Costs of hedging.
 Missing markets, transactions costs, and risk premia.

 Empirical: Exchange rate volatility & trade.

 Time-series evidence showed little; but more evidence in:
 - Cross-section evidence,
 esp. small & less developed
countries.
 - Borders, e.g., Canada-US:
 McCallum-Helliwell; Engel-Rogers
 - Common Currencies: Rose (2000)
 .
2) Encourage investment
<= cut currency premium out of interest rates
3) Provide nominal anchor for monetary policy
 Barro-Gordon model of time-consistent inflation-fighting
 But which anchor? Exchange rate target vs. Alternatives
4) Avoid competitive depreciation
5) Avoid speculative bubbles that afflict floating rates
(particularly in so far as variability is not fundamental real exchange rate
risk, which would just pop up in prices instead of nominal exchange rates).
New popularity of
institutionally-fixed corner in 1990s
 currency boards
(e.g., Hong Kong, 1983- ; Lithuania, 1994- ; Argentina,
1991-2001; Bulgaria, 1997- ; Estonia 1992- ; Bosnia,
1998- ; …)

 dollarization
(e.g, Panama, El Salvador, Ecuador)

 monetary union
(e.g., EMU, 1999)
Advantages of floating rates

 1 )Monetary independence
 2) Automatic adjustment to trade shocks
 3) Retain seignorage
 4)Retain landing of last resort ability
 5) Avoiding crashes that hit pegged rates,
 particularly if origin of speculative attacks is multiple equilibria,
not fundamentals.
 Which dominate: advantages of fixing or
advantages of floating?
 Answer depends on circumstances, of course:

 No one exchange rate regime is right for all

countries or all times.
On what criteria should a country
base its choice of regime?
 Traditional criteria for choosing - Optimum
Currency Area.
 Focus: trade and stabilization of business cycle.
 1990s criteria for choosing –
 Focus: financial markets & stabilization of speculation.
 The return of two neglected criteria --
 Terms of trade volatility
 Financial development
Optimum Currency Area criteria
for fixing the exchange rate:
 Definition: An optimum currency area is a region
that should have its own currency and own
monetary policy
 This definition can be given more content by
observing that smaller units tend to be more open
and integrated.
 Then an OCA can be defined as: a region that
is neither so small and open that it would be
better off pegging its currency to a neighbor,
nor so large that it would be better off splitting
into subregions with different currencies
 On the other hand we can explain an
optimum currency area or bloc refers to a
group of nations whose national currencies
are linked through permanently fixed
exchange rates and the conditions that
would make such area optimum.
 The currencies of member nations could than
fload jointly with respect to the currencies of
nonmember nations.

 The formation of an optimum currency area also

encourages producers to view the entire area as
a single market and to benefit from greater
economies of scale in production.
 The formation of an optimum currency area
is more likely to be beneficial on balance
under the following conditions: (1) the
greater is the mobility of resources among
the various member nations, (2) the greater
their structural similarities, (3) the more
willing they are to closely coordinate their
fiscal, monetary, and other policies.
 An optimum currency area should aim at
maximizing the benefits from permanently fixed
exchange rates and minimizing the costs.

 According to Economist Paul R.Krugman,Europe

is not an optimum currency area. Therefore,
asymmetric economic development within
different countries of the euro zone will be hard to
handle through monetary policy.
 Optimal currency areas
 Economists typically cite four criteria, often called the
optimum currency area (OCA) criteria, to evaluate the
value of switching to a single currency. There are three
economic criteria (labour and capital mobility, product
diversification, and openness) and one political criterion
(fiscal transfers). Robert A. Mundell formulated the idea
that perfect capital and labour mobility would mitigate
the adverse consequences of asymmetric shocks in a
currency area. While capital is quite mobile in the
Eurozone, labour mobility is relatively low, especially
when compared to the U.S. and Japan.
 Ronald McKinnon formulated the idea that areas which are very
open to trade and trade heavily with each other form an optimum
currency area. This is because the high trade intensity will lower the
significance of the distinction between domestic and foreign goods
as competition will equalize the prices of most goods,
independently of exchange rates.

 The Eurozone members trade heavily with each other (intra-

European trade is greater than international trade), and all evidence
so far seems to indicate that the monetary union has at least
doubled trade between members.
 So while Europe scores well on some of the measures
characterizing an OCA, it has lower labour mobility than the United
States and similarly cannot rely on Fiscal federalism to smooth out
regional economic disturbances.
Optimum Currency Area criteria
for fixing the exchange rate:
 Small size and openness
 Symmetry of shocks
 Labor mobility
 Fiscal cushions
New proposal: Peg the Export Price (PEP)

 Combines the best of both worlds:

 The advantage of automatic accommodation to terms of trade

shocks (as floating rates promise, but fail to deliver in the case of
extraneous volatility), together with the advantages of a nominal
anchor and integration (which exchange rate pegs promise, but fail
to deliver in the case of currency crashes).

 How would it work operationally, say, for oil-exporter Iraq?

 Each day, after noon spot price of oil in London S($/barrel), the
central bank announces the day’s exchange rate, according to the
formula:
 E (dinar/$) = fixed price P (dinar/barrel) / S($/barrel).
6 proposed nominal target and
Achilles heel of each:
Targeted
Vulnerability Example
variable
US 1982
Monetarist rule M1 Velocity shocks
CPI Import price Oil shocks of
Inflation targeting
shocks 1973, 1980, 2000
Less
Nominal income Measurement
Nominal GDP developed
targeting problems
countries
Vagaries of
Price world gold 1849 boom;
Gold standard
of gold market 1873-96 bust

Shocks in
Price of agr. &
Commodity imported Oil shocks of
mineral
standard commodity 1973, 1980, 2000
basket
Fixed $ Appreciation of
1995-2001
exchange rate (or euro) $ (or other)
The imposiple trinity
 The hypothesis in international economics that it is impossible to have all three of the
following at the same time:
 A fixed exchange rate
 Free capital movement
 An independent monetary policy.

Fix exchange rate

Why is Peg the export price better
than CPI-targeting?
Better response to adverse terms of trade shocks:

 If the $ price of imported commodity (say, oil) goes up, CPI target
says to tighten monetary policy enough to appreciate currency.
Wrong.
 If the $ price of the export commodity goes down, PEP says to
ease monetary policy enough to depreciate currency. Right.
More moderate versions of PEP
 Target a broader Export Price Index (PEPI).
 1st step for any central bank dipping its toe in these waters:
compute monthly export price index.
 2nd step: announce that it is monitoring the index.
 Target a basket of major currencies ($, €, ¥) and minerals.
 A still more moderate, still less exotic-sounding, version of
PEPI proposal: target a producer price index (PPI).
 Key point: exclude import prices from the index,
& include export prices.
 Flaw of CPI target: it does it the other way around.
7. Interest Rate and Rates of Return
 Reel interest rate
 r= i-π
 r=reel interest rate
 i= nominal interest rate
 π = inflation rate

 The after tax reel interest rate

 r = i ( 1- tax rate) - π

 Sensitive reel interest rate

 1+ r = 1+i / 1 + π
 Measuring interest rate

 A) Current yield of the bond= Yearly

coupon payment / Price of the coupon bond
 I c= TL 10/ TL 100 = 0.10 %
 B) Discount bond (also call a zero- coupon bond)
 One year Treasury bill, which pays off a face value of TL
1000 in one year’s time. If the current purchhase price of this
bill is TL900, then equating this price to the present value of
TL 1000 received in one year using equation TL 900=
TL1000/ 1 + i
 i= TL 1000- TL 900/ TL 900 = 0.11
 i= F – Pd/ Pd
 F= face value of the discount bond
 Pd= current value of the discount bond
 C) Yield on the discount basis
 On our one year bill, which is selling for TL 900 and has
a face value of TL 1000, the yield on a discount basis
would be as follows:
 İdb= 1000 – 900/ 1000 . 360/365 = 0.099= 9.9 %

 D) Present value of bond

PV= R/ (1+i)n
Par value = TL 1000
i= 10 % for one year
 PV= 1000/1.10=TL 909
 E) Future value

FV= P . (1+i)n
par value TL 100
i= 10%
FV= TL 100 . ( 1+ 0.10)= 100. 1.10= TL110
 F) Interest rate calculation for days
 i= 10 %
 Time = 30 days
Yield= TL 1000. 10. 30 / 36500 = TL 8.21
Interest rate changes is so important that is
has been given a special name, interest
rate risk
8. The Mundel – Fleming Model

 Explaining Fluctuations With the IS-LM Model

 The IS (Investment- saving) curve represents the
equilibrium in the market for goods and services.

 The LM ( liquidity- money ) curve represents the

equiblirium in the market for real money balances.
 The intersection of IS curve and LM curve determines the
level of national income. When one of these curves
shifts, the short - run equilibrium of the economy
changes, and national income fluctuates.
 Mundel- Fleming Model is an open-economy version of the IS-
LM model.

 The Mundel –Fleming Model makes one important and extreme

assumption ; it assumes that the economy being studied is a
small open economy with perfect capital mobility.
 That is, the economy can borrow or lend as
much as it wants in world financial markets
and, as a result, the economy’s interest rate
is determined by the world interest rate .
 One virtue of this assumption is that it
simplifies the analysis: ones the interest rate
is determined , we can concentrate our
attention on the role of the exchange rate.
 In addition, for some economies, such as
Belgium and the Netherlands, the
assumption of a small open economy with
perfect capital mobility is a good one. One
lesson from the Mundell – Fleming model is
that the behavior of an economy depends on
the exchange rate system it has adopted.
 Good market equiblirium
 Q= Desired absurbtion + Trade balance
 So the good market equilibrium condition is:
 Q= Cpr +Ipr+ Cpub+ Ipub+TB
 Trade balance (TB) = X-EP/ PxIM
 Short run macro policy: Closed economy
 A monetary expansion raises aggregate demand ( and
therefore employment and output) indirectly, by stimuluing
interest-sensitive spending.
 M up → i down, Q up
 A fiscal expansion raises aggregatedemand directly, via a tax
cut stimules private spending.
 C pub up, I pub up, or tax down → Q up, i up.
9.The instruments of monetary policy

 The control over the money supply is called monetary policy.

 The objective of monetary policy are high employment, stable price

level (no inflation), steady growth in the nation’s productive capacity,
and a stable foreign exchange value for national money.

 The chain of reactions in the economy that transmits cahange in

money growth to the levels of unemployment and inflation is referred
to by economists as the transmission mechanism.


 Monetary Policy is delegated to a partially independent institution
called the central bank.
 Tools of monetary policy

 A) The central bank controls the supply of money is through open-market

operations – the purchase and sale of government bonds.

 B) Reserve of deposit money banks

 Balance sheet of Central bank

 Assets Liabilities
 Net foreign assets Reserve money
 Net Claims on the Government - Reserves of deposit Money Banks
 Net claims on the Private Sectors - Currency held by the public
 Other items net
 Total Assets Total Liabilities
 C) Central bank discount rate

 Liquidity Trap

 Liquidity trap refers to a state in which the nominal interest rate is

close or equal to zero and the monetary authority is unable to
stimulate the economy with monetary policy.

 In such a situation, because the opportunity cost of holding money

is zero, even if the monetary authority increases money supply to
stimulate the economy, people hoard money.Consequently, excess
funds may not be converted into new investment.
11. Managing Credit Risk

 To be profitable, financial institutions must overcome the

adverse selection and moral hazard problems that make
loan defaults more likely.

 The attempts of financial institutions to solve these

problems help explain a number of principles for
managing credit risk: screening and monitoring,
establishmnet of long-term customer relationships, loan
commitments, colleteral, compensating balance
requirements, and credit rationing.

 Screening and Monitoring
 Screening, adverse selection in loan market
requires that lenders screen out the bad
credit risks from the good ones so that loans
are profitable to them.

 To accomplish effective screening, lenders

must collect reliable information from
prospective borrovers.

 Long term Customer Relationship

 Long term relationships benefit the customers

as well as the bank. A firm with a previous
relationship will find it easier to obtain a loan
at a low interest rate because the bank has an
easier time determining if the prospective
borrower is a good credit risk and incurs
fewer costs in monitoring the borrower.
 Loan Commitments
 A loan commitment is a bank’s commitment to
provide a firm with loans up to a given amount
at an interest rate that is tied to some market
interest rate.
 Management Interest rate risk
 If a bank has more rate-sensitive liabilities than
assets, a rise in interest rates will reduce bank
profits and a decline in interest rates will raise
bank profits.
12.Asymmetric Information and Bank Regulation

 Asymmetric information analysis explains what types of

banking regulations are needed to reduce moral hazard and
adverse selection problems in the banking system.

 Regulators are continually playing cat and Mouse with

financial institutions- financial institutions think up clever
ways to avoid regulations which then causes regulators to
modify their regulation activities.
 Because of financial innovation, deregulation and a set of
historical accidents adverse selection and moral hazard
problems increased in the 1980’s and resulted in huge losses
for the US savings and loan industry and for taxpayers.
 Moral hazard: the risk that one party to a transaction will engage in behavior
that is undesirable from the other party’s point of view.

 Asymmetric information: The unequal knowledge that each party to a

transaction has about the other party.

 Deposit Insurance, depositors lack information about the quality of private
loan and about the quality of bank assets. So
 insurance companies can give guarantee to the depositors.

 Bank supervision, regulators are continually playing cat and mouse with
financial instutions think up clevar ways to avoid regulations.

 Consumer protection,the existance of asymmetric information also suggests

that consumer may not have enough information to protect themselves.
Consumer regulation has taken severel forms.
13. International banking

 Why international banking

 A) The rapid growth in international trade and

multinational corporations

 B) The desire to escape burden some regulation

 Euro dollar market

 Euro dollars are created when deposits in accounts in
the USA are transferred to a bank outside the country.
The main center of the eurodollar market is London,
 Currency crises
 Contemporary macroeconomic management focuses increasingly on
management of volatile capital flows.
 We look at the basies on of balance of payment crises. A BOP crises
can emerge if a country ignores the restraint on monetary policy that
is imposed by commitment to a managed Exchange rate.
 Few if any crises, however, are predictable with exactitude- in their
timing or severity- on the basis of fundamentals. The problem is not
only the constant arrival of “news”.
 Of equal or greater importance is that market psychology can be self
conforming.
 Acting on expectations of devaluation, market participants withdraw
foreignexchange from the centralbank, thereby increasing the
probability of a devaluation.
 BOP crises can emerge, therefore, even when the
fundamentals are sound.
 -Fist generation models:
 Mocro policy fundamentals are incosistent with
maintanence of the peg. Forward-looking speculators
bring about an earlier and more spectucular demise than
would be implied by the central bank’s steady loss
reserves.
 -Second generation models:
 Collapse is not inevitabşle based on the fudamentals, but
there are multiple self confirming sets of market
expectations, at least one of which involves a crises and
collapse of peg. Reserve limits not necessarily key.
 First generation models (Krugman 1979):
 -The structure of the economy is given by our simple monetary
model, with Y fixed at Fixed Exchange Rate (FE).
 -A transition to floating occurs when the NFA of the central
bank reach a lower bound.
 -Speculators have perfect foresight.
 -There is an underlyng fiscal deficit that is financed trought
steady increases in DC from the central bank.
 Krugman showed that reserves would fall steady until a
speculative attack occured that would wipe out the remaining
reserves “overnight”.
 Second Generation Sepeculative Attack Models: Self fulfilling
panics.
 Second Generation Sepeculative Attack Models: Self fulfilling panics.
 Consider 2 sets of expectations regarding the nominal Exchange rate:
 GOOD EXPECTATIONS : The peg will continue to hold.
 BAD EXPECTATIONS: The authorities will devalue by some known
percentange ε>0
 PROBLEM : Both expectations may be correct, self conforming.
 In the good case:
 - (∆E / E )e =0, so i=i* and the economy stays at FE with no
speculative activity in the forex market: so no pressure on the peg.
 In the BAD case:
 (∆E / E )e = ε so the domestic interest rate rises to i* +ε.
 If inflation expectations rise by less, the real interest rate, r, has
risen. This exerts a contra dictionary effect on aggregate demand
and a slump in the Non tradable goods market. Putting pressure on
the public authorities to devalue the nominal Exchange rate and
create demand and supply switching. If they do devalue,
expectations are confirmed.
 While E is still pegged, inflation is zero (P=EP* and π = 0) and we
have assumed Y is fixed and since ∆E / E = 0, velocity is fixed at
v(i*). There fore M is constant, so the steady rise in DC is ofset 1
for 1 by a steady loss of reserves.
 -Once is floating, Rising DC will cause a steady rise in H and
trefore steady depreciation of E . Since this deprecitaion is
expected, the domestic interest rate rises from i* to i*+ (∆E / E).
Therefore velocity is higher, the demand for real Money balance is
lower, once the float is underway.
14. Financial liberalisation and
capital flows
 Financial repression and liberalization
 FINANCIAL REPRESSION: The government decides on the allocation
and price of credit.
 FINANCIAL LIBERALIZATION entails:
 → Elimanating credit controls
 → Deregulating interest rate
 Banking sector reforms→Allowing free entry into banking and
financial
 services

 → Allowing bank authonomy in management
 → Privatizating bank ownership
 → Liberalizing the capital account
 OBJECTIVE OF FINANCIAL LIBERALIZATION
 - increasing quantity and quality of domestic
investment
 - financial market development
 Note: The evidance suggests that growth benefits
come mainly from increased investment quality,
financial deepening occurs ( M2 / GDP rises), but
the effect of financial liberalization on national
saving is general weak.
 Managing the transition
 Secquencing of reforms : Ideally
 Fiscal stabilization
 Trade liberalization
 Banking reform
 Capital account liberalization
 Banking sector weakness and capital flows
 -Inadequate bank supervision complicates the
management of inflows…
 *Especially under fixed Exchange rates with a
convertibility guarantee, financial liberalization can
produce a lending boom with declining assets quality
and increasing foreign Exchange exposure of banks and/
or firms. The implicit the insurance to foreign currency
lenders (moral hazard) is greater for shorter term inflows.
 and may increase vulnerability to currency crises.
 *Foreign lending subject to rapid
reversal on fears of devaluation or
Exchange control.
 *High interest rate strategies become
less credible in supporting the
Exchange rate commitment because
maturity mismatch and poor assets
quality means they can produce bank
failures.
 Reducing vulnarability
 _Stronger prudential regulation of riskness of
bank portfolios to reduce moral hazard,
 -Increased capital requirements
 -Depeosit rate ceiling at Treasury-bill rate
 -Control on capital inflows, paticularly short
term higher marginal reserve requirements
 -Greater Exchange rate flexibility.
 Indicator of vulnerability,
 KEY INDICATORS
 -Real Exchange rate appreciation ( overvalued
exchange rate)
 -Banking sector weaknes, measured by size of
lending boom.( a large stock of short term
foreigng currency liabilities)
 -Exposure of central bank, measured by
M’/(E.NFA) ( a fragile financial system)
 Managing capital inflows
 Objective:
 Maintaning internal and external balance at low inflation
while supporting structural reforms (tarde, financial or
capital account liberalization)
 Problem
 Large gross capital inflows
 Resolution
 “It depends”
 …on the motivations, characteristics, and likely
persistance of the inflow.
 Source of inflow: domestic pull factors
 -Tightening of domestic credit policy or
increase in administered interest rates,
without fiscal adjustment (in anti inflation
program. Effects E-Led disinflation programs.)
 -An improvement in domestic policies.
Structural changes that improve investment
productivity or reduce public sector deficit.
 - Domestic financial liberalization
 Sources of inflow: push external factors.
 A fall in world interset rates. Without fiscal adjustment
 -Bandwagon effects.
 So the dangers are those associated with “overheating”
 -Lending boom with declining assets quality.
 -Aggregate demand and output up, impliying inflationary
pressure, CAB deterioration.
 -Domestic inflation means real Exchange rate
appreaciation, compettivenes, further CAB deterioration.
 Overwiev of possible responses
 Reserve accumulation=ΔNFA= Gross Capital Inflow-
Gross Capital outfow”+ Cab surplus
 -Sterilize the inflow. Do not allow the domestic interest
rate to fall: instead, as M rises use contradictionary
monetary policy to lover H ( open market sales of
government securities) or to lover mm ( increase reserve
requirements, perhaps particularly on foreign currency
deposits if any, which combines sterilization with a tax
on this financing source)
 -Discourage gross inflows or promote
gross outflow.
 -İmpose tax or direct control on inflows
 -Liberalize outflows
 -Increase exchamge rate risk facing
speculators by widening currency
bands.
A small macro model : monetary policy and exchange rate
regime

 A small macro model : monetary policy and exchange

rate regime
 1. M/P=Y/V Money demand = Money supply
 2. P=EP* PPP ( all goods traded)
 3. i = i* +  E / E Uncovered interest parity
( perfect
 capital mobility)
 4.  M = mm .  RM = mm ( E x NFA* +  DC)
Determines
 next period’s money supply.
The IMF Financial Programming Model

 There are two targets and two Projections.

 Two targets : low inflation (  t ) and a sustainable BOP ( NFA
t)
 Two projections : real growth ( g) pr and the change in
velocity ( v / v)pr.
 - We have  =  M/ M - g +  v / v, so the growth and
velocity projections tie down the money growth rate that is
consistent with the  target:
 M /Mpr = t + (g) pr -  v / v
 But the central bank’s balance sheet says
  M = mm ( E.  NFA +  DC )
 So we are stuck. To achive the BOP target, we must place a
ceiling on  DC.