There are three critical functions of money in an economy: (i) unit of account, (ii) medium of
exchange, and (iii) store of value.

The central banks decide on the money supply.

Liquidity of an asset refers to the ease of converting into cash quickly and with little or no loss in value.

The central banks decide on the money supply

M2= M1 + Time deposit (TL)+ Time deposit (dolar)
=120+130+105
=355

M3=M2 + Repo+ Money Market Mutual Funds + Securities
=290+ 80 +20+ 35=425

The conventional monetary policy tools of the central banks are: (i) required reserves, (ii) open market operations, and (iii) discount window facility credits.

500*0.12=60 increase

Open Market Operations is the liabilities side.

The money base is also called “high powered money”, because one unit change in the money base causes more than one unit change in money supply.

Central banks are responsible institutions for conducting monetary policy.

The Sveriges Riksbank in Sweden, established in 1668, is often considered the world’s oldest central.

In 1913, the Federal Reserve System was created as the central banking system of the United States.

Financial stability is defined as the resilience of an economy to unexpected developments that may disturb the balances in the financial system.

The production function: Y = A*(K, L), where A represents technology and labor skill, K denotes capital stock (such as machines, computers, etc.), and L represents the labor force. An increase in A signifies an improvement in productivity.

Central banks use short-term interest rates to achieve the objective of price stability. The short term interest rate that is controlled by the central bank is commonly referred to as the monetary policy rate.

The Interest Rate Channel is widely recognized as one of the most prominent and well-understood transmission mechanisms of monetary policy.

The yield curve represents the relationship between interest rates and the maturity of bonds with equal credit quality.

Monetary policy actions have the potential to impact the prices of various financial assets, including stocks, bonds, and real estate. When central banks lower interest rates, it tends to increase the demand for these assets, leading to an increase in their prices.

However, the Banking Regulation and Supervision Agency has two options to limit the ability of banks to expand their loan portfolios:

1. Increasing the capital adequacy ratio (CAR), and
2. Increasing the risk weights of loans.

Direct policy instruments consist of interest rate ceilings and credit ceilings. Direct policy tools directly intervene in the decisions of the financial system. Direct monetary policy tools encompass various measures aimed at regulating deposits and credits, such as interest rate and credit growth restrictions through the implementation of interest rate and quantity ceilings. Central banks utilize these tools to directly influence and intervene in deposit and credit markets. In the case of an interest rate ceiling, the central bank establishes maximum interest rates for deposit and/or loan rates, thereby exerting control over the prevailing interest rates in the market. Financial institutions are required to adhere to these specified rates.

The indirect monetary policy tools include: (1) required reserves,(2) discount window facility and (3) open market operations [(to provide liquidity; repo, lending deposits, outright purchases) and (to withdraw liquidity; reverse repo, borrowing sales, outright sales, Central Bank liquidity bills)].

Repo: This term refers to repurchase agreement, commonly known as repo. Repos are short-term borrowing instruments involving two parties: one party holds securities but requires liquidity, while the other party possesses surplus liquidity available for lending.

The commonly used open market operations in practice are as follows: (1) Repo; (2) Reverse Repo, (3) Outright Purchase; (4) Outright Sale; (5) Deposits Lending; (6) Deposits Borrowing; (7) Central bank liquidity bills.

The primary function of the discount window facility is to provide short-term liquidity to banks, helping them meet their immediate liquidity needs. Under this facility, the central bank specifies (i) the borrowing rules, (ii) eligible securities, and (iii) the discount rate.

Let us begin by analyzing the actual balance sheet of the Central Bank of the Republic of Türkiye (CBRT). The CBRT publishes two balance sheets regularly. The first one is a detailed weekly balance sheet, which provides comprehensive information about the assets and liabilities of the CBRT. This detailed balance sheet is useful for experts who require an in-depth view of the CBRT’s financial position. The second one is the CBRT analytical balance sheet, which is published daily and provides aggregated information based on the detailed balance sheet. This analytical balance sheet simplifies the analysis process.

The Central Bank of the Republic of Türkiye analytical balance sheet, which is published daily and provides aggregated information based on the detailed balance sheet. This analytical balance sheet simplifies the analysis process.

The demand for TL increases due to several reasons:

1. If households and firms want to hold more cash, or if banks need to hold more banknotes in their branches, this results in an increase in currency issued.
2. If deposits increase, it leads to an increase in required reserves.
3. If The Central Bank of the Republic of Türkiye (CBRT) increases the required reserve ratio.

Foreign currency swaps are indeed an alternative instrument to repos, and they are used by central banks for managing liquidity. In a foreign currency swap, the central bank buys foreign currency from banks and provides the equivalent amount in the local currency (TL) at the agreement date.

Open market operations, such as repo and deposit lending, are common tools used by central banks to manage short-term liquidity in the banking system.

If your answer is wrong, please review the “OBJECTIVES OF MONETARY POLICY” section.
The literature on the determinants of inflation demonstrates a close and positive relationship between monetary policy and inflation. Consequently, it is possible to define that the most critical goal of monetary policy is to ensure price stability. Before the global financial crisis, it was assumed that price stability would ensure financial stability provided that the institutions responsible for regulating and supervising the financial system prevented the distortions in a financial institution’s balance sheet -such issues are discussed in Box 2. With the global financial crisis, central banks’ focus on price stability became increasingly questionable since the global crisis burst despite price stability. The average inflation rate in all countries during 1990-1994 was 28.4 percent, sharply dropping to 3.9 percent in 2000-2007. In this period, inflation in developed countries is even less. The world faced a severe financial crisis in this low-inflation environment as of the end of 2007.
There must be more than just ensuring price stability to prevent financial crises. Thus, should monetary policy also aim to achieve financial stability? Monetary policy can play two critical roles in financial stability. First is the central bank’s ‘lender of last resort facility’ function. What will a bank with a liquidity shortage do if it cannot borrow from banks with excess liquidity? If these conditions prevail, central banks need to step in and provide liquidity to banks that are not bankrupt but are short of cash, which fulfills central banks’ duty of ‘being the lender of last resort.’ The second role of a central bank is to minimize the risk of such liquidity shortages arising. Before the global crisis, the emphasis was on microprudential policies. Institutions responsible for microprudential policies depend on the financial structure of a country. It may be the responsibility of a central bank or another institution.

If your answer is wrong, please review the “Financial Stability” section.
Micro-prudential policies aim to catch the risks in a bank’s balance sheet and take the necessary steps to minimize these risks. For instance, such regulations include minimum capital adequacy ratios, minimum leverage ratios, and the maximum difference between foreign currency-denominated liabilities and assets (currency mismatch)-. Nonetheless, the global financial crisis revealed how significant systemic risk is. To prevent such risks, implementing macro-prudential policies came to the fore. Complex relationships between financial institutions pose the risk that issues in one institution will eventually affect other institutions. Some of the macro-prudential policies aim to prevent these risks. Macro-prudential policies also address risks stemming from procyclical credit growth. Banks tend to boost credit during high growth periods, whereas they cut credit lines during recessions. For example, the financial sector can operate with low (high) leverage ratios during economic booms (contractions). In advantageous times, banks may extend more loans to increase their profitability, whereas, during disadvantageous times, they tighten their credit conditions to lessen their risks stemming from possible non-performing loans. Such behavior can weaken banks’ balance sheets, on the one hand, and escalate the cyclical fluctuation of GDP, on the other hand. An example of the regulations that fall into this group is changing the housing loan-to-house value. A second example is altering the ceiling to the periodic payments consumers must make due to the loan they receive. Eventually, the financial structure is vital. Imagine that each of the three tasks -microprudential policies, macro-prudential policies, and price stability- is the responsibility of separate institutions, which may lead to a critical coordination issue among them. Let us consider another extreme case: it is the responsibility of a single institution to implement macro-prudential, micro-prudential, and price stability policies. This time, a potent institution will emerge. The concentration of so much power in a single institution may jeopardize the independence of this institution.

If your answer is wrong, please review the “Monetary Dominance and Fiscal Dominance” section.
The unpleasant monetarist arithmetic argument proposed by Christopher Sims and Thomas Sargent ( Sargent, T.J., Wallace, N., (1981). Some Unpleasant Monetarist Arithmetic. Federal Reserve Bank of Minneapolis Quarterly Review, 5(3), Winter, 1-17) indicates that even if the central bank initially abstains from monetizing the deficit, it has to give up this policy to prevent a debt default, eventually leading to higher inflation. Moreover, rational agents observing this outcome will form their inflation expectations accordingly, leading to higher inflation today. Fiscal dominance is an immense obstacle to properly working monetary policy. If there is fiscal dominance, budget deficits persist, and monetary policy has to obey fiscal policy. Even if it does not comply for the time being, it eventually has to, as in the example of the unpleasant monetarist arithmetic.
In an economy with fiscal dominance, fiscal policy does not generate enough primary surplus not to resort to seigniorage revenues. Fiscal dominance makes the work of central banks extremely challenging. The fiscal policy goes ‘on its own’ if fiscal dominance exists. Budget deficits persist, and monetary policy has to obey fiscal policy. Even if it does not comply for the time being, it eventually has to, as we have seen in the example of the unpleasant monetarist arithmetic.
In monetary dominance, the monetary policy takes the lead and is disciplined, and fiscal policy is the follower. There is a primary budget surplus as needed to prevent public debt from reaching an unsustainable level: the conditions imposed by equation (6) are met without the need for seigniorage revenues.

If your answer is wrong, please review the “Exchange Rate Regimes” section.
Official dollarization happens when one country voluntarily gives up its currency and uses another country’s currency. The primary purpose here is to take advantage of the credibility of another country’s currency. For instance, to reduce the domestic interest rate to the interest rate level of that country. Ecuador and Panama are the two best-known examples of official dollarization, leaving aside the insignificant ones. Official dollarization is an expression of desperation somehow. When the economic policies implemented lead to an unstable economy -high inflation, risk premium, and interest rates, the extreme volatility of GDP, lack of credibility of economic policies, and alikewhich is persistent, this is sometimes the ‘last resort’ that comes to mind. Official dollarization has three disadvantages: First, the country that opted for using another country’s currency gives up seigniorage incomes because it halts printing its currency. Second, this country puts its financial system at risk. When things go wrong in the financial markets, financial institutions refrain from lending to each other, causing borrowing rates to jump and leading to even more demand for and shortage of liquidity. Central banks must calm this tension. As discussed above, this is a central bank’s lender of last resort facility function. However, if official dollarization exists, how can that country’s central bank print dollars (or euros) and lend to banks desperately needing liquidity? The final downside to official dollarization is the abandonment of monetary policy. The country whose money is used makes the monetary policy decisions appropriate for its economic conditions. However, those decisions may not be suitable for the domestic country. For example, assume that the growth rate has exceeded the potential growth rate in the country where its currency is used. A growth rate above the potential growth rate threatens price stability, and eventually, that country’s central bank will hike the policy interest rate. However, domestic demand may be low in the country then, and what is needed for the economy is just the opposite -lowering interest rates.

If your answer is wrong, please review the “Inflation Targeting” section.
A central bank’s main objective in inflation targeting is to ensure price stability. The central bank is prohibited from extending loans to the public sector and is free to use any policy tool stated in its law in line with its foremost purpose. Short and medium-term inflation targets are determined by the government and/or the central bank and announced to the public. In the classical application of inflation targeting, there are two variables in the objective function of a central bank. The first one is the difference between inflation (π) and the inflation target (πT), called the inflation gap. If inflation is above (below) the target, the inflation gap becomes positive (negative). The second variable is the difference between the output level (Y) and the potential output (YP), called the output gap. If the output gap is positive (negative), the production level is above (below) its potential. Such regimes are called ‘flexible inflation targeting’ regimes. In flexible inflation targeting, the central bank aims to minimize the weighted sum of the two gaps. There are also inflation-targeting regimes that focus only on the inflation gap, despite not being very common in practice, called ‘strict inflation targeting.’ In this case, the weight of the output gap in the objective function is equal to zero.
The central bank is prohibited from extending loans to the public sector and is free to use any policy tool stated in its law in line with its main purpose. Short and medium-term inflation targets are determined by the government and/or the central bank and announced to the public. There are two types of inflation targeting: A central bank implementing strict inflation targeting does not include an output gap in its objective function; there is only the inflation gap. In flexible inflation targeting, the objective function consists of the output gap and the deviation of inflation from the target. Central banks respond to both output and inflation gaps in both regimes. However, strict inflation targeting makes the interest response to inflation and output gaps sharper. Some prerequisites must be met so that inflation targeting can be implemented. First, the central bank must be independent. Second, there should be no financial dominance. Third, the financial system should be sound.

If your answer is wrong, please review the “Inflation Targeting” section.
It is not recommended for a central bank to implement inflation targeting out of the blue. Some prerequisites must be met so that inflation targeting can be implemented. First, the central bank must be independent. In this context, it should be free to set its policy rate (instrument independence), and the law of a central bank that implements inflation targeting should not allow it to extend loans to the public sector. Second, there should be no financial dominance. High public debt and high budget deficit restrict monetary policy, making it challenging to surge the policy rate without corrective fiscal policy. Third, the financial system should be sound. For example, if the financial system has severe liquidity issues, the primary goal for the central bank should be to eliminate this issue. In this case, the aim of ensuring price stability can fall into the secondary plan. A typical example was experienced in developed countries between the end of 2008 and the beginning of 2009 when the global financial crisis intensified. To save their financial systems from the brink of collapse, central banks of developed countries offered generous liquidity support to their banks.

If your answer is wrong, please review the “Inflation Targeting” section.
The policy rate equation and the ‘Taylor rule’ are closely related. The Taylor rule is an equation that displays the interest rate response of the central bank to developments in inflation and output gaps. John Taylor, a well-known economist from the USA, in a study published in 1993, developed a kind of interest rule. According to this rule, the central bank should increase the policy rate if the output gap is positive, that is, if production is above the potential level, as inflationary pressures will escalate. Similarly, as inflation rises, the central bank must respond by raising the short-term interest rate again. There are two differences between the Taylor rule and the equations mentioned above. First, the Taylor rule is based on the historical development of inflation, the output gap, and the US Federal Reserve’s (Fed) policy rates. The above equations are obtained from the solution of a model. Second, the Taylor rule has no real exchange rate since it is formulated in a closed economy framework.

If your answer is wrong, please review the “Currency Boards” section.
There are three essential conditions that a currency board must meet. First, the exchange rate is pegged to a foreign currency. Second, economic units should not be restricted from exchanging domestic currency with the currency chosen as the anchor. Third, there must be enough foreign exchange reserves to meet the currency board’s liabilities at the pegged exchange rate. Unlike official dollarization, another country’s currency does not become that country’s official currency on
a currency board.

If your answer is wrong, please review the “Floating Exchange Rate Regimes” section.
A central bank implementing a pure floating exchange rate regime does not sell or buy foreign exchange to alter the exchange rate level. The currency’s value is determined by the market forces of demand and supply for foreign exchange. If the demand for foreign exchange is greater than the
supply, the exchange rate rises; if it is less than the supply, it falls. In a pure floating exchange rate regime, the central bank’s foreign exchange reserve does not change due to foreign exchange interventions. However, central banks also carry out the foreign exchange transactions of their countries’ treasuries. For example, suppose a country’s treasury that implements a purely floating exchange rate regime has foreign debt, and it is time to repay it. In that case, it either pays it from its foreign exchange account at the central bank or asks the central bank to convert its domestic currency account at the central bank to foreign currency and pay it accordingly. Therefore, in a pure exchange rate regime, the foreign exchange reserves of the central banks will not change except for their transactions with the treasury.
The most significant advantage of the floating exchange rate regime is that there is no need to defend a level of exchange rate, which takes the pressure off the monetary policy. Especially in countries where no restrictions are imposed on capital flows, the floating exchange rate regime is a regime that can be applied in a considerably less challenging way than the fixed exchange rate regime. For example, suppose there are some issues in specific sectors of the economy, such as the financial sector. In that case, the sustainability of the fixed exchange rate regime is endangered. Under these conditions, the floating exchange rate regime at least gives a breath of fresh air to monetary policy. Restoring the system should be a priority before the exchange rate regime is applied in a country where the financial system is struggling with issues.

If your answer is wrong, please review the “Inflation Targeting” section.
In the classical application of inflation targeting, there are two variables in the objective function of a central bank. The first one is the difference between inflation (π) and the inflation target (πT), called the inflation gap. If inflation is above (below) the target, the inflation gap becomes positive (negative). The second variable is the difference between the output level (Y) and the potential output (YP), called the output gap. If the output gap is positive (negative), the production level is above (below) its potential. Such regimes are called ‘flexible inflation targeting’ regimes. In flexible inflation targeting, the central bank aims to minimize the weighted sum of the two gaps. There are also inflation-targeting regimes that focus only on the inflation gap, despite not being very common in practice, called ‘strict inflation targeting.’ In this case, the weight of the output gap in the objective function is equal to zero.

If your answer is wrong, please review the “BASIC CONCEPTS” section.
Balance of Payments (BOP) is a statistical report that displays economic transactions between residents of one country and residents of another country over a certain period. BOP tables are rather detailed and can be summarized by five fundamental variables: Current account, capital account, financial account, net errors and omissions, and change in reserve assets. The current account is the difference between revenues and expenditures stemming from the trade of goods (exports and imports), trade of services (such as tourism and transportation), and primary and secondary income (such as labor income or interest payments). A positive current account indicates that, in that period, there is a current account surplus -revenues exceed expenditures. Conversely, a negative current account means that the current account is in deficit. The remaining variables demonstrate how a current account deficit is financed or a current account surplus yields asset accumulation. The capital account is a small item covering mainly gross acquisition or disposal of non-produced nonfinancial assets and capital transfers like copyrights, trademarks, and debt forgiveness. A negative value for the financial account indicates a net capital inflow to a country -a rise in its foreign indebtedness. For example, let us say that the corporate sector of a country receives a loan of 15 billion dollars from abroad. In the same period, if 10 billion dollars of the loans previously taken are overdue and repaid, there is a net capital inflow of 5 billion dollars from that country through the corporate sector. In contrast, a positive value denotes a net capital outflow from a country to the rest of the world. Simply, it indicates that the country in that specific period increased its holding of foreign assets. In other words, the country is a net lender to the rest of the world. Not every item -such as tourism revenues- in the balance of payments can be measured with 100 percent accuracy. In addition, payments of some goods and services trade can be deferred; consequently, a time difference may occur between payments and physical flows, illustrated by the net errors and omissions item. A positive net errors and omissions entry means that there is a foreign currency entry whose source cannot be determined accurately, which turns into an item that finances foreign exchange expenses. When it gets a negative sign, the opposite is true. Reserve assets item consists of the foreign exchange reserves of a central bank. In addition, any credit taken from the IMF or loan extended to the IMF is displayed in this item. A positive (negative) value
indicates that reserve assets increased (decreased) in that period.

If your answer is wrong, please review the “Nominal and Real Exchange Rate” section.
The nominal exchange rate (E) is defined as the domestic currency value of one unit of foreign currency. Name the foreign and local currencies as the dollar and the lira, respectively. When a dollar is 20 liras, we imply that the nominal exchange rate is 20. The increase in the nominal exchange rate indicates that more liras to buy one dollar is needed. An increase in E is called a devaluation in fixed exchange rate regimes, and a decrease in E is called a revaluation. In floating exchange rate regimes, an increase in E signals that the domestic currency depreciates in nominal terms, while its decrease specifies that the domestic currency appreciates in nominal terms.
Tu sum up, An increase in the nominal exchange rate (E) is called a devaluation in fixed exchange rate regimes, and a decrease in E is called a revaluation. In floating exchange rate regimes, an increase in E indicates that the domestic currency depreciates in nominal terms, while its decrease indicates that the domestic currency appreciates in nominal terms.

If your answer is wrong, please review the “Nominal and Real Exchange Rate” section.
The real exchange rate is the relative prices of goods in two countries when expressed in the same currency, and it is one of the main factors determining the exports and imports of a country. The real exchange rate (Q) denotes the relative prices of goods in two countries when expressed in the same currency.
Q = EP*/P (1)
where P is the domestic price index and P* is the foreign price index. An increase in Q indicates that the lira depreciates in real terms against the dollar, while a decrease in Q shows that the lira appreciates in real terms against the dollar. The real exchange rate can also be calculated for a basket of currencies. The real exchange rate index, calculated using more than one exchange rate, is alternatively called the ‘effective real exchange rate index’ or ‘multilateral real exchange rate index.

If your answer is wrong, please review the “Uncovered Interest Rate Parity” section.
The uncovered interest rate parity (UIP) states that the current foreign interest rate, the expected level of the nominal exchange rate, and the current domestic interest rate determine the current value of the nominal exchange rate. Thus, uncovered interest rate parity implies that the differences between domestic and foreign interest rates can be equal to the relative change in currency foreign exchange rates over the same period. The higher the first two, the higher the nominal exchange rate is. As the domestic interest rate increases, the nominal exchange rate decreases. Note that in deriving this relationship, the financial assets are assumed to be riskless, and financial investors are risk neutral.

If your answer is wrong, please review the “Short Run” section.
For a given domestic interest rate, if the foreign or the expected exchange rate increases (decreases), the nominal exchange rate increases (decreases) in the short-run open economy IS-LM model. Figure 6.6 in page 182 depicts the negative relationship between the domestic interest rate and the nominal exchange rate, given the foreign interest rate and expected exchange rate. This time on the horizontal axis, there is E. At the interest rate level set by the central bank (ī), the exchange rate level is E₀. As the foreign interest rate( i*) or and expected exchange rate (Ee) increases, the Uncovered Interest Rate Parity (UIRP) curve shifts to the right (UIRP1), and the nominal exchange rate increases to E1. Conversely, a decline in i* or Ee, when the domestic interest rate is unchanged, shifts the UIRP curve to the left (UIRP2) and reduces the nominal exchange rate (E2).

If your answer is wrong, please review the “Short Run” section.
The equation (21) indicates that -other variables remain the same- an expansionary fiscal policy (a rise in G and a decline in t) increases output. A rise in government expenditures directly increases domestic demand. A decline in the tax rate, by increasing disposable income (Y - t * Y) increases consumption and thus domestic demand. Similarly, investment expenditures and, thus, domestic demand rise when the central bank sets the interest rate (ī) at a lower level than the prevailing one. To the extent that the rise in domestic demand is met by domestic output (lower the m2), output increases.
A change in the level of the domestic interest rate affects not only investment but also the nominal exchange rate through the uncovered interest rate parity condition (20). For instance, when the central bank reduces the domestic interest rate (remember that so far, we have assumed that there is no risk), the domestic currency depreciates (a rise in E), which triggers a rise in foreign demand for domestically produced goods -since the domestic goods become cheaper for foreigners, and exports increase. At the same time, a rise in E increases the cost of imports and leads to a decline in imports. A similar mechanism works when the foreign interest or expected exchange rate increases by depreciating domestic currency.
Of course, the opposite is also true. An increase in the domestic interest rate and a decline in the foreign interest rate or the expected exchange rate by appreciating the domestic currency (a lower E) will decrease demand for domestically produced goods and increase imports, which amounts to a decline in output. Finally, a rise in foreign income (Y*) increases demand for domestically produced goods (a rise in exports) and causes an increase in output. For ‘graphic lovers’, these relationships can be shown in Figure 6.7. The IS and MP curves are drawn on the left panel, whereas, on the right panel, we have the UIPC curve.
The interest rate set by the central bank is ī. From the uncovered interest rate parity condition, given the foreign interest rate and the expected exchange rate, the nominal exchange is E0. Equilibrium in the goods market is at D0, and the corresponding output is Y0. A lower foreign interest rate or a lower expected exchange rate by increasing the demand for domestic currency-denominated assets shifts the UIRP curve to the left (UIRP1) and lowers the exchange rate (E1), which triggers a decrease in exports and an increase in imports, and the IS curve shifts to the left. The economy settles at the new equilibrium (D1). The result is a decline in output to Y1.
Let us briefly examine this model under the fixed exchange rate. Economic agents expect the parity to be maintained if this regime is credible. Thus, the expected exchange rate will be equal to the fixed rate. In this case, the uncovered interest rate parity dictates that the domestic interest rate should equal the foreign interest rate. Thus, the central bank must set the interest rate at this level.
In other words, monetary policy cannot act independently if a fixed exchange rate regime is applied while capital mobility is unlimited. Despite the ineffectiveness of monetary policy, fiscal policy is quite effective. Consider, for example, increased public spending in an economy that is initially in equilibrium. Demand for domestically produced goods will increase, leading to a rise in output.

If your answer is wrong, please review the “Medium Run” section.
The goods market equilibrium condition and the nominal interest rate set by the central bank give the aggregate demand equation. This equation exhibits a negative relationship between output (Y) and the inflation rate (π). Why? Other factors being the same, a rise in the inflation rate leads the central bank to increase the interest rate. The real interest rate rises if the expected inflation rate does not rise by the same amount, which has two effects. First, an increase in the real interest rate causes a reduction in investment. Second, the higher the real interest rate, the lower the real exchange rate, which leads to a rise in imports and a reduction in exports. All these factors mean less aggregate demand.
Figure 6.8 demonstrates the aggregate demand curve. The inflation rate is on the vertical axis, and the output is on the horizontal axis. Higher government spending, lower tax rate, higher foreign interest rate, and higher foreign income increase aggregate demand at the same inflation rate (π0). That means the aggregate demand curve shifts to the right (AD1). Conversely, lower government spending, higher tax rate, lower foreign interest rate, and lower foreign income decrease aggregate demand at the same inflation rate (π0). The aggregate demand curve shifts to the left (AD2).

If your answer is wrong, please review the “Third-Generation Crisis Models” section.
The basis of the first-generation crisis models is a monetary policy incompatible with the prevailing exchange rate regime. The foremost basis for why monetary policy is mismatched is expansionary fiscal policy and the ensuing monetization of budget deficits. The collapse of the exchange rate regime is inevitable. However, the regime collapses before due to speculative attacks. In the second-generation models, without speculative attacks, the current exchange rate regime could continue without difficulties. However, in the case of a speculative attack, if there are various weaknesses -high unemployment or say weak banking sector- in the economy leading the central bank to refrain from a rise in its policy rate, speculators can attack the domestic currency.
The third-generation crisis models are inspired from the Asian crisis of the late 1990s. They are based on the weak balance sheet structure of the corporate sector and/or the financial sector.The crisis broke out in Thailand, spread to Korea, Indonesia, Malaysia, and the Philippines in mid-1997, and continued in 1998. In some of these countries, the public budget had been in surplus; for example, in 1996, Korea and Thailand had been in this situation, while Indonesia’s budget had been balanced. The budget deficit in the other two is shallow. In short, it is unlikely to discuss an undisciplined fiscal policy for these countries, which is at the core of the firstgeneration models.
On the other hand, before the crisis, these countries above did not have high levels of unemployment. Therefore, the governments did not have to choose between unemployment and maintaining a fixed exchange rate. Moreover, their economies contracted significantly. However, if it were as in the second-generation models, the government would have removed the tremendous pressure on economic activity by choosing to devalue. Consequently, it is neither possible to explain the 1997-1998 Asian crisis with the second-generation crisis models.
Economists again took the task out of the situation and worked. Thus, fundamental models have emerged, which are called third-generation crisis models, which are based on the weak balance sheet structure of the corporate sector and/or the financial sector. For example, banks’ capital-toasset ratio can be relatively low. Alternatively, their foreign currency-denominated liabilities can far exceed their foreign currency-denominated assets. They may have a high non performing loan ratio. The average maturity of their assets may be much higher than the average maturity of their liabilities.

If your answer is wrong, please review the “Purchasing Power Parity” section.
There are various reasons why purchasing power parity may not hold even in the long run. First, the price indices published by the countries do not consist of the same goods and services. However, applied studies use these indices. Moreover, indices must not only contain the same goods but also have the same weight. A second reason is that some of the goods and services included in these indices are not tradable goods and services. For the law of one price to hold, the two countries’ goods must be freely sold. Nonetheless, how will the law of one price hold for the price of haircut service, which is included in the consumer price index? Another reason for purchasing power parity does not hold in the long run is that foreign trade is not carried out freely, contrary to the assumption: there are some regulations restricting foreign trade, such as customs duties, quotas, and the presence of transportation costs.

If your answer is wrong, please review the “Balance of Payments” section.
Balance of Payments (BOP) is a statistical report that displays economic transactions between residents of one country and residents of another country over a certain period. BOP tables are rather detailed and can be summarized by five fundamental variables: Current account, capital account, financial account, net errors and omissions, and change in reserve assets. The current account is the difference between revenues and expenditures from the trade of goods and services and primary and secondary income. The remaining four variables express how a current account deficit is financed or a current account surplus yields asset accumulation. The current account is the difference between revenues and expenditures stemming from the trade of goods (exports and imports), trade of services (such as tourism and transportation), and primary and secondary income (such as labor income or interest payments). A positive current account indicates that, in that period, there is a current account surplus -revenues exceed expenditures. Conversely, a negative current account means that the current account is in deficit. The remaining variables demonstrate how a current account deficit is financed or a current account surplus yields asset accumulation. The
capital account is a small item covering mainly gross acquisition or disposal of non-produced nonfinancial assets and capital transfers like copyrights, trademarks, and debt forgiveness.