Monetary Theory and Polıcy (ENG) — Ünite 1 Soru-Cevap

Money has three prices. These are the purchasing power of money (price indices), the intertemporal price of
money (interest rates) and the international price of money (exchange rates).

One of the prices of money is its price in terms of the goods and services it can buy. This is known as the purchasing power of money. For example, if the price of a service doubles, the purchasing power of our money falls to half its previous purchasing power in terms of the number of services we can buy with a given amount of money.

CPI is the Consumer Price Index. It measures the price of a basket of goods and services bought by a representative consumer over a month.

GDP Deflator called Gross Domestic Product Deflator (GDP Deflator). The GDP deflator measures the price of a basket of
final goods and services produced in an economy within a three month period (a quarter of a year), or within a given year. GDP Inflation is the percentage rate of increase in the GDP Deflator.

Inflation is the persistent rise in the price level of a wide range of goods and services.

The price of money over time is the interest rate. In other words, it is the intertemporal price of money.

The real rate of return on a financial asset is the monetary gain from that asset in excess of the loss of purchasing power of money.
The real interest rate on a “fixed income” security is the nominal interest rate on that security in excess of the loss of purchasing power of money.

The international price of money is the exchange rate. The exchange rate between the two currencies is the amount of domestic currency per unit of a foreign currency.

This hypothesis states that the price of the same basket of goods in two countries, measured in the same units will not differ too much from each other if there are no barriers to international units will not differ too much if there are no barriers to international trade and if transport costs are low. There is a long-run relationship between the exchange rate and the and the general price level in two countries. This relationship is called purchasing power parity and is based on the so-called "law of one price".

The simplest theory of inflation is the "quantity theory of money". According to this theory, too much money growth leads to too much (nominal) expenditure growth, and too much expenditure growth leads to too much growth in prices. In short, excessive money growth leads to inflation.

Equation of exchange is M*v=Y=p*y
Where M is the quantity of broad money, v is the velocity of money, p is the price index for final goods and services, Y is nominal expenditure (nominal GDP) and y is the real value of goods and services produced (real GDP) in a given period.
The velocity of money shows how often the money stock is spent on the purchase of goods and services in a year. within a year. In its simplest form, the quantity theory of money assumes that velocity is constant over time.

In central bank practice, short-term interest rates have been used as the main monetary policy instrument, especially since the instrument, especially since the 1990s. A monetary policy aimed at reducing inflation is called "tight". A monetary policy aimed at increasing nominal demand is called "loose".

First of all the short term interest rates are usually closely related to the deposit interest rates. Thereby, a fall in short term interest rates lead to a fall in deposit rates as well. This may lead to a fall in the demand for bank money and hence may cause a rise in expenditures on goods and services, thereby causing a price inflation in case the supply of goods and services cannot catch up with the increased demand.
Secondly, a fall in the short term interest rates may lead to a more limited fall in the longer term nominal and real interest rates, and thereby impact the expenditure patterns of consumers, investors and even the government. The resulting rise in expenditures on goods and services may cause price inflation, in case their supply cannot match the increased demand.
Thirdly, a fall in the short term interest rates may lead to a depreciation of the domestic currency, i.e. a rise in the exchange rate. In such a case the prices of goods and services sold in the country would rise first due to the rise of the costs of imported goods prices, and second, possibly due to second round effects on
wages, rents etc. in an attempt to compensate for the loss of purchasing power of workers, landlords, etc.

The costs of high inflation fall into three categories.
The first is related to the reduction in the attractiveness of money as a medium of exchange and the increased transaction costs associated with the lower real demand for money.
The second is related to the reduction in the propensity to invest due to the reduced predictability of future prices. Higher inflation is also associated with higher volatility of inflation rates and hence higher uncertainty. Such uncertainty is bad for investment projects that might otherwise have been undertaken.
The third is related to the potential growth rates of economies. This is a serious and very high cost of inflation in terms of its general distortions and the inefficient allocation of inefficient allocation of resources.

The experience with many different monetary policy regimes based on various different nominal anchors ended up with the idea of using the targeted inflation rate itself as a nominal anchor.

For this regime to be successful, five main
conditions are required:

1. A low (but positive) inflation target
2. Central Bank independence
3. Sound monetary, fiscal and financial sector
policies
4. A healthy financial system
5. Convincing communication policies.

Money has three main functions. These are as follows;

• Medium of exchange function,
• Unit of account function,
• Store of value function.

Companies hold money mainly for transactional purposes. However, they may also hold money for and speculative purposes, depending on the nature of their business and their operating conditions. Nevertheless, firms are not expected to hold money for savings purposes, as they are typically users of funds rather than sources of funds. They mostly borrow from banks or directly from households to meet their working capital needs. households to meet their working capital needs.

Consumers, firms and governments may hold money for at least one of the below motivations:

1. Transactions motive,

2. Precautionary motive,

3. Savings motive,

4. Speculative motive.

The most commonly used money demand
function has the form: M/p = k*y

Where M is the nominal money stock, p is the general price level of goods and services, y is the quantity of goods and services sold and the real income earned thereby (i.e. real GDP), k is a parameter that tells us the desired real money as a fraction of real income.

The financial development hypothesis states that when the financial system grows faster than the real GDP as part of a financial development stage, there will be an associated additional growth in the demand for real money balances.