Economics of money banking and financial markets

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Economics of money banking and financial markets

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  5. 5. Frederic S. MishkinColumbia University
  6. 6. Editor in Chief: Denise ClintonAcquisitions Editor: Victoria WarneckExecutive Development Manager: Sylvia MalloryDevelopment Editor: Jane TuftsProduction Supervisor: Meredith GertzText Design: Studio MontageCover Design: Regina Hagen Kolenda and Studio MontageComposition: Argosy PublishingSenior Manufacturing Supervisor: Hugh CrawfordSenior Marketing Manager: Barbara LeBuhnCover images: © PhotoDiscMedia Producer: Melissa HonigSupplements Editor: Diana TheriaultCredits to copyrighted material appear on p. C-1, which constitutes a continuation of the copyright page.Library of Congress Cataloguing-in-Publication DataMishkin, Frederic S.The economics of money, banking, and financial markets / Frederic S. Mishkin.—7th ed.p. cm. — (The Addison-Wesley series in economics)Supplemented by a subscription to a companion web site.Includes bibliographical references and index.ISBN 0-321-12235-61. Finance. 2. Money. 3. Banks and banking. I. Title. II. Series.HG173.M632 2004332—dc212003041912Copyright © 2004 by Frederic S. Mishkin. All rights reserved. No part of this publication may be repro-duced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical,photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed inthe United States of America.1 2 3 4 5 6 7 8 9 10—DOW—06050403
  7. 7. To Sally
  8. 8. Introduction 11 Why Study Money, Banking, and Financial Markets? . . . . . . . . . . . . . . . . . . . .32 An Overview of the Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .233 What Is Money? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44Financial Markets 594 Understanding Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .615 The Behavior of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .856 The Risk and Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . .1207 The Stock Market, the Theory of Rational Expectations,and the Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .141Financial Institutions 1678 An Economic Analysis of Financial Structure . . . . . . . . . . . . . . . . . . . . . . . .1699 Banking and the Management of Financial Institutions . . . . . . . . . . . . . . . . .20110 Banking Industry: Structure and Competition . . . . . . . . . . . . . . . . . . . . . . . .22911 Economic Analysis of Banking Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . .26012 Nonbank Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28713 Financial Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .309Central Banking and the Conduct ofMonetary Policy 33314 Structure of Central Banks and the Federal Reserve System . . . . . . . . . . . . .33515 Multiple Deposit Creation and the Money Supply Process . . . . . . . . . . . . . .35716 Determinants of the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37417 Tools of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39318 Conduct of Monetary Policy: Goals and Targets . . . . . . . . . . . . . . . . . . . . . .411International Finance and Monetary Policy 43319 The Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .43520 The International Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .46221 Monetary Policy Strategy: The International Experience . . . . . . . . . . . . . . . .487PA RT VPA RT I VPA RT I I IPA RT I IPA RT IviiCONTENTS IN BRIEF
  9. 9. Monetary Theory 51522 The Demand for Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .51723 The Keynesian Framework and the ISLM Model . . . . . . . . . . . . . . . . . . . . . .53624 Monetary and Fiscal Policy in the ISLM Model . . . . . . . . . . . . . . . . . . . . . . .56125 Aggregate Demand and Supply Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . .58226 Transmission Mechanisms of Monetary Policy: The Evidence . . . . . . . . . . . .60327 Money and Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .63228 Rational Expectations: Implications for Policy . . . . . . . . . . . . . . . . . . . . . . . .658PA RT V Iviii Contents in Brief
  10. 10. Introduction 1CHAPTER 1WHY STUDY MONEY, BANKING, AND FINANCIAL MARKETS? . . . . . . . . . . . . . . . . .3Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3Why Study Financial Markets? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3The Bond Market and Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3The Stock Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5The Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5Why Study Banking and Financial Institutions? . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7Structure of the Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7Banks and Other Financial Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8Financial Innovation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8Why Study Money and Monetary Policy? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8Money and Business Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9Money and Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10Money and Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12Conduct of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12Fiscal Policy and Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12How We Will Study Money, Banking, and Financial Markets . . . . . . . . . . . . . . . . . .13Exploring the Web . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . . .17Appendix to Chapter 1Defining Aggregate Output, Income, the Price Level,and the Inflation Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20Aggregate Output and Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20Real Versus Nominal Magnitudes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20Aggregate Price Level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21Growth Rates and the Inflation Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22PA RT IixCONTENTS
  11. 11. CHAPTER 2AN OVERVIEW OF THE FINANCIAL SYSTEM . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23Function of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23Structure of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25Debt and Equity Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25Primary and Secondary Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26Exchanges and Over-the-Counter Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27Money and Capital Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27Internationalization of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28International Bond Market, Eurobonds, and Eurocurrencies . . . . . . . . . . . . . . . . . . . . . . . .28World Stock Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29Function of Financial Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29Following the Financial News Foreign Stock Market Indexes . . . . . . . . . . . . . . . .30Box 1 Global: The Importance of Financial Intermediaries to SecuritiesMarkets: An International Comparison . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31Risk Sharing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31Asymmetric Information: Adverse Selection and Moral Hazard . . . . . . . . . . . . . . . . . . . . .32Financial Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34Depository Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34Contractual Savings Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .35Investment Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37Regulation of the Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37Increasing Information Available to Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39Ensuring the Soundness of Financial Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39Financial Regulation Abroad . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . . .41CHAPTER 3WHAT IS MONEY? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44Meaning of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44Functions of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45Medium of Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45Unit of Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .46Store of Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .47Evolution of the Payments System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48Commodity Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48Fiat Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48Checks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48Box 1 Global: Birth of the Euro: Will It Benefit Europe? . . . . . . . . . . . . . . . . . . . . .49Electronic Payment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .50x Contents
  12. 12. Box 2 E-Finance: Why Are Scandinavians So Far Ahead of Americans inUsing Electronic Payments? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .50E-Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .51Measuring Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .51The Federal Reserve’s Monetary Aggregates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .51Box 3 E-Finance: Are We Headed for a Cashless Society? . . . . . . . . . . . . . . . . . . . .52Following the Financial News The Monetary Aggregates . . . . . . . . . . . . . . . . . . .54How Reliable Are the Money Data? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . . .56Financial Markets 59CHAPTER 4UNDERSTANDING INTEREST RATES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61Measuring Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61Present Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61Four Types of Credit Market Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .63Yield to Maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .64Box 1 Global: Negative T-Bill Rates? Japan Shows the Way . . . . . . . . . . . . . . . . . . .69Other Measures of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .69Current Yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .70Yield on a Discount Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .71Application Reading the Wall Street Journal: The Bond Page . . . . . . . . . . . . . . . . .72Following the Financial News Bond Prices and Interest Rates . . . . . . . . . . . . . . .73The Distinction Between Interest Rates and Returns . . . . . . . . . . . . . . . . . . . . . . . . .75Maturity and the Volatility of Bond Returns: Interest-Rate Risk . . . . . . . . . . . . . . . . . . . . . .78Box 2 Helping Investors to Select Desired Interest-Rate Risk . . . . . . . . . . . . . . . . .79Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .79The Distinction Between Real and Nominal Interest Rates . . . . . . . . . . . . . . . . . . . .79Box 3 With TIPS, Real Interest Rates Have Become Observable in theUnited States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .82Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . . .82CHAPTER 5THE BEHAVIOR OF INTEREST RATES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85Determinants of Asset Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85Wealth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .86PA RT I IContents xi
  13. 13. Expected Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .86Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .87Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .87Theory of Asset Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .87Supply and Demand in the Bond Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .87Demand Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .88Supply Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .90Market Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .90Supply and Demand Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .91Loanable Funds Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .91Changes in Equilibrium Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .93Shifts in the Demand for Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .93Shifts in the Supply of Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .97Application Changes in the Equilibrium Interest Rate Due to ExpectedInflation or Business Cycle Expansions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .99Changes in Expected Inflation: The Fisher Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .99Business Cycle Expansion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .100Application Explaining Low Japanese Interest Rates . . . . . . . . . . . . . . . . . . . . . .103Application Reading the Wall Street Journal “Credit Markets” Column . . . . . . . .103Following the Financial News The “Credit Markets” Column . . . . . . . . . . . . . .104Supply and Demand in the Market for Money: The LiquidityPreference Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .105Changes in Equilibrium Interest Rates in the Liquidity Reference Framework . . . . .107Shifts in the Demand for Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .107Shifts in the Supply of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .108Application Changes in the Equilibrium Interest Rate Due to Changesin Income, the Price Level, or the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . .108Changes in Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .108Changes in the Price Level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .108Changes in the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .109Following the Financial News Forecasting Interest Rates . . . . . . . . . . . . . . . . . .111Application Money and Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .112Does a Higher Rate of Growth of the Money Supply Lower Interest Rates? . . . . . . . . . . . .114Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .117CHAPTER 6THE RISK AND TERM STRUCTURE OF INTEREST RATES . . . . . . . . . . . . . . . . . . .120Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .120Risk Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .120Default Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .120Application The Enron Bankruptcy and the Baa-Aaa Spread . . . . . . . . . . . . . . . .124xii Contents
  14. 14. Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .125Income Tax Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .125Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .127Application Effects of the Bush Tax Cut on Bond Interest Rates . . . . . . . . . . . . .127Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .127Following the Financial News Yield Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . .128Expectations Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .129Segmented Markets Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .132Liquidity Premium and Preferred Habitat Theories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .133Evidence on the Term Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .136Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .137Application Interpreting Yield Curves, 1980–2003 . . . . . . . . . . . . . . . . . . . . . . .137Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .138CHAPTER 7THE STOCK MARKET, THE THEORY OF RATIONAL EXPECTATIONS,AND THE EFFICIENT MARKET HYPOTHESIS . . . . . . . . . . . . . . . . . . . . . . . . . . . .141Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .141Computing the Price of Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .141The One-Period Valuation Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .142The Generalized Dividend Valuation Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .143The Gordon Growth Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .143How the Market Sets Security Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .144Application Monetary Policy and Stock Prices . . . . . . . . . . . . . . . . . . . . . . . . . .146Application The September 11 Terrorist Attacks, the Enron Scandal,and the Stock Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .146The Theory of Rational Expectations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .147Formal Statement of the Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .148Rationale Behind the Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .149Implications of the Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .149The Efficient Markets Hypothesis: Rational Expectations in Financial Markets . . . .150Rationale Behind the Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .151Stronger Version of the Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . .152Evidence on the Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . .153Evidence in Favor of Market Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .153Application Should Foreign Exchange Rates Follow a Random Walk? . . . . . . . .155Evidence Against Market Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .156Overview of the Evidence on the Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . .158Application Practical Guide to Investing in the Stock Market . . . . . . . . . . . . . . .158How Valuable Are Published Reports by Investment Advisers? . . . . . . . . . . . . . . . . . . . . .158Contents xiii
  15. 15. Following the Financial News Stock Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . .159Box 1 Should You Hire an Ape as Your Investment Adviser? . . . . . . . . . . . . . . . .160Should You Be Skeptical of Hot Tips? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .160Do Stock Prices Always Rise When There Is Good News? . . . . . . . . . . . . . . . . . . . . . . . . .161Efficient Market Prescription for the Investor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .161Evidence on Rational Expectations in Other Markets . . . . . . . . . . . . . . . . . . . . . . .162Application What Do the Black Monday Crash of 1987 and the TechCrash of 2000 Tell Us About Rational Expectations and Efficient Markets? . . . .163Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .164Financial Institutions 167CHAPTER 8AN ECONOMIC ANALYSIS OF FINANCIAL STRUCTURE . . . . . . . . . . . . . . . . . . . .169Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .169Basic Puzzles About Financial Structure Throughout the World . . . . . . . . . . . . . . .169Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .173How Transaction Costs Influence Financial Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . .173How Financial Intermediaries Reduce Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . .173Asymmetric Information: Adverse Selection and Moral Hazard . . . . . . . . . . . . . . . .174The Lemons Problem: How Adverse Selection Influences Financial Structure . . . . .175Lemons in the Stock and Bond Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .175Tools to Help Solve Adverse Selection Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .176Box 1 The Enron Implosion and the Arthur Andersen Conviction . . . . . . . . . . .178How Moral Hazard Affects the Choice Between Debt and Equity Contracts . . . . . .180Moral Hazard in Equity Contracts: The Principal–Agent Problem . . . . . . . . . . . . . . . . . . .181Tools to Help Solve the Principal–Agent Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .182Box 2 E-Finance: Venture Capitalists and the High-Tech Sector . . . . . . . . . . . . . .183How Moral Hazard Influences Financial Structure in Debt Markets . . . . . . . . . . . .184Tools to Help Solve Moral Hazard in Debt Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . .184Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .186Application Financial Development and Economic Growth . . . . . . . . . . . . . . . .187Financial Crises and Aggregate Economic Activity . . . . . . . . . . . . . . . . . . . . . . . . .189Factors Causing Financial Crises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .189Application Financial Crises in the United States . . . . . . . . . . . . . . . . . . . . . . . .191Box 3 Case Study of a Financial Crisis: The Great Depression . . . . . . . . . . . . . . .194Application Financial Crises in Emerging-Market Countries:Mexico, 1994–1995; East Asia, 1997–1998; and Argentina, 2001–2002 . . . . . . .194Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .199PA RT I I Ixiv Contents
  16. 16. CHAPTER 9BANKING AND THE MANAGEMENT OF FINANCIAL INSTITUTIONS . . . . . . . . . . . .201Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .201The Bank Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .201Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .201Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .204Basic Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .205General Principles of Bank Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .208Liquidity Management and the Role of Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .208Asset Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .211Liability Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .212Capital Adequacy Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .213Application Strategies for Managing Bank Capital . . . . . . . . . . . . . . . . . . . . . . . .215Application Did the Capital Crunch Cause a Credit Crunch in theEarly 1990s? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .216Managing Credit Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .217Screening and Monitoring . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .217Long-Term Customer Relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .218Loan Commitments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .219Collateral and Compensating Balances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .219Credit Rationing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .220Managing Interest-Rate Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .220Gap and Duration Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .221Application Strategies for Managing Interest-Rate Risk . . . . . . . . . . . . . . . . . . . .222Off-Balance-Sheet Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .223Loan Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .223Generation of Fee Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .223Trading Activities and Risk Management Techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . .224Box 1 Global: Barings, Daiwa, Sumitomo, and Allied Irish:Rogue Traders and the Principal–Agent Problem . . . . . . . . . . . . . . . . . . . . . . . . .225Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .226CHAPTER 10BANKING INDUSTRY: STRUCTURE AND COMPETITION . . . . . . . . . . . . . . . . . . . .229Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .229Historical Development of the Banking System . . . . . . . . . . . . . . . . . . . . . . . . . . . .229Multiple Regulatory Agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .231Financial Innovation and the Evolution of the Banking Industry . . . . . . . . . . . . . .232Responses to Changes in Demand Conditions: Interest Rate Volatility . . . . . . . . . . . . . . .233Responses to Changes in Supply Conditions: Information Technology . . . . . . . . . . . . . . .234Box 1 E-Finance: Will “Clicks” Dominate “Bricks” in the Banking Industry? . . . .236Avoidance of Existing Regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .237Financial Innovation and the Decline of Traditional Banking . . . . . . . . . . . . . . . . . . . . . .239Contents xv
  17. 17. Structure of the U.S. Commercial Banking Industry . . . . . . . . . . . . . . . . . . . . . . . .243Restrictions on Branching . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .244Response to Branching Restrictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .245Bank Consolidation and Nationwide Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . .245Box 2 E-Finance: Information Technology and Bank Consolidation . . . . . . . . . . .247The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 . . . . . . . . . . . .248What Will the Structure of the U.S. Banking Industry Look Like in the Future? . . . . . . . .248Box 3 Global: Comparison of Banking Structure in the United Statesand Abroad . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .249Are Bank Consolidation and Nationwide Banking Good Things? . . . . . . . . . . . . . . . . . . .249Separation of the Banking and Other Financial Service Industries . . . . . . . . . . . . . .250Erosion of Glass-Steagall . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .250The Gramm-Leach-Bliley Financial Services Modernization Act of 1999:Repeal of Glass-Steagall . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .251Implications for Financial Consolidation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .251Separation of Banking and Other Financial Services Industries Throughout the World . . .251Thrift Industry: Regulation and Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .252Savings and Loan Associations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .252Mutual Savings Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .253Credit Unions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .253International Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .253Eurodollar Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .254Box 4 Global: Ironic Birth of the Eurodollar Market . . . . . . . . . . . . . . . . . . . . . . .255Structure of U.S. Banking Overseas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .255Foreign Banks in the United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .256Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .257CHAPTER 11ECONOMIC ANALYSIS OF BANKING REGULATION . . . . . . . . . . . . . . . . . . . . . . .260Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .260Asymmetric Information and Banking Regulation . . . . . . . . . . . . . . . . . . . . . . . . . .260Government Safety Net: Deposit Insurance and the FDIC . . . . . . . . . . . . . . . . . . . . . . . .260Box 1 Global: The Spread of Government Deposit Insurance Throughoutthe World: Is This a Good Thing? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .262Restrictions on Asset Holdings and Bank Capital Requirements . . . . . . . . . . . . . . . . . . . .264Bank Supervision: Chartering and Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .265Box 2 Global: Basel 2: Is It Spinning Out of Control? . . . . . . . . . . . . . . . . . . . . . .265Assessment of Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .267Disclosure Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .268Consumer Protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .269Restrictions on Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .269Box 3 E-Finance: Electronic Banking: New Challenges for Bank Regulation . . . . .270xvi Contents
  18. 18. International Banking Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .272Problems in Regulating International Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .272Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .272The 1980s U.S. Banking Crisis: Why? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .273Early Stages of the Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .274Later Stages of the Crisis: Regulatory Forbearance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .275Competitive Equality in Banking Act of 1987 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .276Political Economy of the Savings and Loan Crisis . . . . . . . . . . . . . . . . . . . . . . . . . .276The Principal–Agent Problem for Regulators and Politicians . . . . . . . . . . . . . . . . . . . . . . .277Savings and Loan Bailout: The Financial Institutions Reform, Recovery, andEnforcement Act of 1989 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .278Federal Deposit Insurance Corporation Improvement Act of 1991 . . . . . . . . . . . . .279Banking Crises Throughout the World . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .280Scandinavia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .280Latin America . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .281Russia and Eastern Europe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .282Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .282East Asia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .284“Déjà Vu All Over Again” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .284Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .284CHAPTER 12NONBANK FINANCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287Life Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287Property and Casualty Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .288The Competitive Threat from the Banking Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . .290Application Insurance Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .290Screening . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .291Risk-Based Premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .291Restrictive Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .292Prevention of Fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .292Cancellation of Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .292Deductibles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .292Coinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .293Limits on the Amount of Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .293Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .293Pension Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .294Private Pension Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .295Public Pension Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .295Box 1 Should Social Security Be Privatized? . . . . . . . . . . . . . . . . . . . . . . . . . . . . .296Finance Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .296Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .297Contents xvii
  19. 19. Box 2 E-Finance: Mutual Funds and the Internet . . . . . . . . . . . . . . . . . . . . . . . . .298Money Market Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .299Hedge Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .299Box 3 The Long-Term Capital Management Debacle . . . . . . . . . . . . . . . . . . . . . .300Government Financial Intermediation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .301Federal Credit Agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .301Box 4 Are Fannie Mae and Freddie Mac Getting Too Big for Their Britches? . . . .302Securities Market Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .302Investment Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .303Following the Financial News New Securities Issues . . . . . . . . . . . . . . . . . . . . .304Securities Brokers and Dealers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .304Organized Exchanges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .305Box 5 The Return of the Financial Supermarket? . . . . . . . . . . . . . . . . . . . . . . . . .305Box 6 E-Finance: The Internet Comes to Wall Street . . . . . . . . . . . . . . . . . . . . . . .306Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .306CHAPTER 13FINANCIAL DERIVATIVES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .309Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .309Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .309Interest-Rate Forward Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .310Application Hedging with Interest-Rate Forward Contracts . . . . . . . . . . . . . . . .310Pros and Cons of Forward Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .311Financial Futures Contracts and Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .311Following the Financial News Financial Futures . . . . . . . . . . . . . . . . . . . . . . . .312Application Hedging with Financial Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . .314Organization of Trading in Financial Futures Markets . . . . . . . . . . . . . . . . . . . . . . . . . . .315The Globalization of Financial Futures Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .317Explaining the Success of Futures Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .317Application Hedging Foreign Exchange Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . .319Hedging Foreign Exchange Risk with Forward Contracts . . . . . . . . . . . . . . . . . . . . . . . . .319Hedging Foreign Exchange Risk with Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . . . .320Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .320Following the Financial News Futures Options . . . . . . . . . . . . . . . . . . . . . . . . .321Option Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .322Profits and Losses on Option and Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . .322Application Hedging with Futures Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . .325xviii Contents
  20. 20. Factors Affecting the Prices of Option Premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .326Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .327Interest-Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .328Interest-Rate Swap Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .328Application Hedging with Interest-Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . .329Advantages of Interest-Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .329Disadvantages of Interest-Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .330Financial Intermediaries in Interest-Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .330Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .330Central Banking and the Conduct ofMonetary Policy 333CHAPTER 14STRUCTURE OF CENTRAL BANKS AND THE FEDERAL RESERVE SYSTEM . . . . . . .335Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .335Origins of the Federal Reserve System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .335Box 1 Inside the Fed: The Political Genius of the Founders of theFederal Reserve System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .336Formal Structure of the Federal Reserve System . . . . . . . . . . . . . . . . . . . . . . . . . . .336Federal Reserve Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .337Box 2 Inside the Fed: The Special Role of the Federal Reserve Bank ofNew York . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .339Member Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .340Board of Governors of the Federal Reserve System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .340Federal Open Market Committee (FOMC) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .341Box 3 Inside the Fed: The Role of the Research Staff . . . . . . . . . . . . . . . . . . . . . . .342The FOMC Meeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .343Box 4 Inside the Fed: Green, Blue, and Beige: What Do These Colors Meanat the Fed? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .344Informal Structure of the Federal Reserve System . . . . . . . . . . . . . . . . . . . . . . . . . .344Box 5 Inside the Fed: The Role of Member Banks in the FederalReserve System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .346How Independent Is the Fed? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .346Structure and Independence of Foreign Central Banks . . . . . . . . . . . . . . . . . . . . . .349Bank of Canada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .349Bank of England . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .349Bank of Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .350European Central Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .350The Trend Toward Greater Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .351Explaining Central Bank Behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .351PA RT I VContents xix
  21. 21. Box 6 Inside the Fed: Federal Reserve Transparency . . . . . . . . . . . . . . . . . . . . . . .352Should the Fed Be Independent? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .352The Case for Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .352The Case Against Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .354Central Bank Independence and Macroeconomic Performance Throughout the World . . .354Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .355CHAPTER 15MULTIPLE DEPOSIT CREATION AND THE MONEY SUPPLY PROCESS . . . . . . . . . .357Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .357Four Players in the Money Supply Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .357The Fed’s Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .358Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .358Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .359Control of the Monetary Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .359Federal Reserve Open Market Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .359Shifts from Deposits into Currency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .363Box 1 Global: Foreign Exchange Rate Intervention and the Monetary Base . . . . .363Discount Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .364Other Factors That Affect the Monetary Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .365Overview of the Fed’s Ability to Control the Monetary Base . . . . . . . . . . . . . . . . . . . . . . .365Multiple Deposit Creation: A Simple Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .365Deposit Creation: The Single Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .366Deposit Creation: The Banking System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .367Deriving the Formula for Multiple Deposit Creation . . . . . . . . . . . . . . . . . . . . . . . . . . . . .370Critique of the Simple Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .371Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .372CHAPTER 16DETERMINANTS OF THE MONEY SUPPLY . . . . . . . . . . . . . . . . . . . . . . . . . . . . .374Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .374The Money Supply Model and the Money Multiplier . . . . . . . . . . . . . . . . . . . . . . .375Deriving the Money Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .375Intuition Behind the Money Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .377Factors that Determine the Money Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . .378Changes in the Required Reserve Ratio r . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .378Changes in the Currency Ratio c . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .379Changes in the Excess Reserves Ratio e . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .379Additional Factors That Determine the Money Supply . . . . . . . . . . . . . . . . . . . . . .381Changes in the Nonborrowed Monetary Base MBn . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .382Changes in the Discount Loans DL from the Fed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .382Overview of the Money Supply Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .383Application Explaining Movements in the Money Supply, 1980–2002 . . . . . . . .384xx Contents
  22. 22. Application The Great Depression Bank Panics, 1930–1933 . . . . . . . . . . . . . . . .387Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .390CHAPTER 17TOOLS OF MONETARY POLICY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .393Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .393The Market for Reserves and the Federal Funds Rate . . . . . . . . . . . . . . . . . . . . . . .393Supply and Demand in the Market for Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .394How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate . . . . . . . . . .395Open Market Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .398A Day at the Trading Desk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .398Advantages of Open Market Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .400Discount Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .400Operation of the Discount Window . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .401Lender of Last Resort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .402Advantages and Disadvantages of Discount Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .403Reserve Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .403Box 1 Inside the Fed: Discounting to Prevent a Financial Panic:The Black Monday Stock Market Crash of 1987 and the Terrorist Destructionof the World Trade Center in September 2001 . . . . . . . . . . . . . . . . . . . . . . . . . . .404Advantages and Disadvantages of Reserve Requirement Changes . . . . . . . . . . . . . . . . . . .405Application Why Have Reserve Requirements Been Declining Worldwide? . . . .406Application The Channel/Corridor System for Setting Interest Rates inOther Countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .406Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .408CHAPTER 18CONDUCT OF MONETARY POLICY: GOALS AND TARGETS . . . . . . . . . . . . . . . . . .411Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .411Goals of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .411High Employment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .411Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .412Price Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .412Box 1 Global: The Growing European Commitment to Price Stability . . . . . . . . .413Interest-Rate Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .413Stability of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .413Stability in Foreign Exchange Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .414Conflict Among Goals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .414Central Bank Strategy: Use of Targets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .414Choosing the Targets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .416Criteria for Choosing Intermediate Targets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .418Criteria for Choosing Operating Targets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .419Contents xxi
  23. 23. Fed Policy Procedures: Historical Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . .419The Early Years: Discount Policy as the Primary Tool . . . . . . . . . . . . . . . . . . . . . . . . . . . .420Discovery of Open Market Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .420The Great Depression . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .421Box 2 Inside the Fed: Bank Panics of 1930–1933: Why Did the Fed LetThem Happen? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .421Reserve Requirements as a Policy Tool . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .422War Finance and the Pegging of Interest Rates: 1942–1951 . . . . . . . . . . . . . . . . . . . . . . .422Targeting Money Market Conditions: The 1950s and 1960s . . . . . . . . . . . . . . . . . . . . . . .423Targeting Monetary Aggregates: The 1970s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .424New Fed Operating Procedures: October 1979–October 1982 . . . . . . . . . . . . . . . . . . . . .425De-emphasis of Monetary Aggregates: October 1982–Early 1990s . . . . . . . . . . . . . . . . . .426Federal Funds Targeting Again: Early 1990s and Beyond . . . . . . . . . . . . . . . . . . . . . . . . .427International Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .427Box 3 Global: International Policy Coordination: The Plaza Agreement andthe Louvre Accord . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .428The Taylor Rule, NAIRU, and the Philips Curve . . . . . . . . . . . . . . . . . . . . . . . . . . .428Box 4 Fed Watching . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .430Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .431International Finance and Monetary Policy 433CHAPTER 19THE FOREIGN EXCHANGE MARKET . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .435Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .435Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .435What Are Foreign Exchange Rates? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .436Following the Financial News Foreign Exchange Rates . . . . . . . . . . . . . . . . . . .437Why Are Exchange Rates Important? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .438How Is Foreign Exchange Traded? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .438Exchange Rates in the Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .439Law of One Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .439Theory of Purchasing Power Parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .439Why the Theory of Purchasing Power Parity Cannot Fully Explain Exchange Rates . . . . .440Factors That Affect Rates in the Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .441Exchange Rates in the Short Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .443Comparing Expected Returns on Domestic and Foreign Deposits . . . . . . . . . . . . . . . . . . .443Interest Parity Condition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .445Equilibrium in the Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .446Explaining Changes in Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .448Shifts in the Expected-Return Schedule for Foreign Deposits . . . . . . . . . . . . . . . . . . . . . .448Shifts in the Expected-Return Schedule for Domestic Deposits . . . . . . . . . . . . . . . . . . . . .450PA RT Vxxii Contents
  24. 24. Application Changes in the Equilibrium Exchange Rate: Two Examples . . . . . .452Changes in Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .452Changes in the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .453Exchange Rate Overshooting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .453Application Why Are Exchange Rates So Volatile? . . . . . . . . . . . . . . . . . . . . . . .455Application The Dollar and Interest Rates, 1973–2002 . . . . . . . . . . . . . . . . . . . .455Application The Euro’s First Four Years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .457Application Reading the Wall Street Journal: The “Currency Trading” Column .457Following the Financial News The “Currency Trading” Column . . . . . . . . . . . .458Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .459CHAPTER 20THE INTERNATIONAL FINANCIAL SYSTEM . . . . . . . . . . . . . . . . . . . . . . . . . . . . .462Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .462Intervention in the Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . .462Foreign Exchange Intervention and the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . .462Box 1 Inside the Fed: A Day at the Federal Reserve Bank of New York’sForeign Exchange Desk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .463Unsterilized Intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .465Sterilized Intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .466Balance of Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .467Evolution of the International Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . .468Gold Standard . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .469Bretton Woods System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .469Box 2 Global: The Euro’s Challenge to the Dollar . . . . . . . . . . . . . . . . . . . . . . . . .471Managed Float . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .473European Monetary System (EMS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .474Application The Foreign Exchange Crisis of September 1992 . . . . . . . . . . . . . . .475Application Recent Foreign Exchange Crises in Emerging Market Countries:Mexico 1994, East Asia 1997, Brazil 1999, and Argentina 2002 . . . . . . . . . . . . . .477Capital Controls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .478Controls on Capital Outflows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .478Controls on Capital Inflows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .479The Role of the IMF . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .479Should the IMF Be an International Lender of Last Resort? . . . . . . . . . . . . . . . . . . . . . . . .480International Considerations and Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . .482Direct Effects of the Foreign Exchange Market on the Money Supply . . . . . . . . . . . . . . . .482Balance-of-Payments Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .483Exchange Rate Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .483Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .484Contents xxiii
  25. 25. CHAPTER 21MONETARY POLICY STRATEGY: THE INTERNATIONAL EXPERIENCE . . . . . . . . . . .487Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .487The Role of a Nominal Anchor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .487The Time-Consistency Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .488Exchange-Rate Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .489Advantages of Exchange-Rate Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .489Disadvantages of Exchange-Rate Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .490When Is Exchange-Rate Targeting Desirable for Industrialized Countries? . . . . . . . . . . . .492When Is Exchange-Rate Targeting Desirable for Emerging Market Countries? . . . . . . . . .492Currency Boards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .492Dollarization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .493Box 1 Global: Argentina’s Currency Board . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .494Monetary Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .496Monetary Targeting in Canada, the United Kingdom, Japan, Germany, and Switzerland . . .496Box 2 Global: The European Central Bank’s Monetary Policy Strategy . . . . . . . . .498Advantages of Monetary Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .500Disadvantages of Monetary Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .501Inflation Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .501Inflation Targeting in New Zealand, Canada, and the United Kingdom . . . . . . . . . . . . . . .501Advantages of Inflation Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .504Disadvantages of Inflation Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .506Nominal GDP Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .508Monetary Policy with an Implicit Nominal Anchor . . . . . . . . . . . . . . . . . . . . . . . . .509Advantages of the Fed’s Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .510Disadvantages of the Fed’s Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .510Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .512Monetary Theory 515CHAPTER 22THE DEMAND FOR MONEY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .517Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .517Quantity Theory of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .517Velocity of Money and Equation of Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .518Quantity Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .519Quantity Theory of Money Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .519Is Velocity a Constant? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .520Keynes’s Liquidity Preference Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .521Transactions Motive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .521Precautionary Motive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .522Speculative Motive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .522Putting the Three Motives Together . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .523Further Developments in the Keynesian Approach . . . . . . . . . . . . . . . . . . . . . . . . .524Transactions Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .524PA RT V Ixxiv Contents
  26. 26. Precautionary Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .527Speculative Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .527Friedman’s Modern Quantity Theory of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . .528Distinguishing Between the Friedman and Keynesian Theories . . . . . . . . . . . . . . . .530Empirical Evidence on the Demand for Money . . . . . . . . . . . . . . . . . . . . . . . . . . . .532Interest Rates and Money Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .533Stability of Money Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .533Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .533CHAPTER 23THE KEYNESIAN FRAMEWORK AND THE ISLM MODEL . . . . . . . . . . . . . . . . . . .536Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .536Determination of Aggregate Output . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .536Consumer Expenditure and the Consumption Function . . . . . . . . . . . . . . . . . . . . . . . . . .538Investment Spending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .539Box 1 Meaning of the Word Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .540Equilibrium and the Keynesian Cross Diagram . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .540Expenditure Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .542Application The Collapse of Investment Spending and the Great Depression . .545Government’s Role . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .545Role of International Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .548Summary of the Determinants of Aggregate Output . . . . . . . . . . . . . . . . . . . . . . . . . . . . .548The ISLM Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .551Equilibrium in the Goods Market: The IS Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .552Equilibrium in the Market for Money: The LM Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . .555ISLM Approach to Aggregate Output and Interest Rates . . . . . . . . . . . . . . . . . . . . .557Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .558CHAPTER 24MONETARY AND FISCAL POLICY IN THE ISLM MODEL . . . . . . . . . . . . . . . . . . . .561Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .561Factors That Cause the IS Curve to Shift . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .561Factors That Cause the LM Curve to Shift . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .564Changes in Equilibrium Level of the Interest Rate and Aggregate Output . . . . . . . .566Response to a Change in Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .566Response to a Change in Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .567Effectiveness of Monetary Versus Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . .568Monetary Policy Versus Fiscal Policy: The Case of Complete Crowding Out . . . . . . . . . . .568Application Targeting Money Supply Versus Interest Rates . . . . . . . . . . . . . . . . .571ISLM Model in the Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .575ISLM Model and the Aggregate Demand Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . .577Deriving the Aggregate Demand Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .577Factors That Cause the Aggregate Demand Curve to Shift . . . . . . . . . . . . . . . . . . . . . . . .578Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .580Contents xxv
  27. 27. CHAPTER 25AGGREGATE DEMAND AND SUPPLY ANALYSIS . . . . . . . . . . . . . . . . . . . . . . . . .582Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .582Aggregate Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .582Monetarist View of Aggregate Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .582Following the Financial News Aggregate Output, Unemployment, and thePrice Level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .583Keynesian View of Aggregate Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .585The Crowding-Out Debate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .586Aggregate Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .587Shifts in the Aggregate Supply Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .588Equilibrium in Aggregate Supply and Demand Analysis . . . . . . . . . . . . . . . . . . . . .588Equilibrium in the Short Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .589Equilibrium in the Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .589Shifts in Aggregate Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .592Shifts in Aggregate Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .594Shifts in the Long-Run Aggregate Supply Curve: Real Business Cycle Theoryand Hysteresis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .596Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .597Application Explaining Past Business Cycle Episodes . . . . . . . . . . . . . . . . . . . . .598Vietnam War Buildup, 1964–1970 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .598Negative Supply Shocks, 1973–1975 and 1978–1980 . . . . . . . . . . . . . . . . . . . . . . . . . . .598Favorable Supply Shocks, 1995–1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .599Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .600CHAPTER 26TRANSMISSION MECHANISMS OF MONETARY POLICY: THE EVIDENCE . . . . . . .603Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .603Framework for Evaluating Empirical Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . .603Structural Model Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .604Reduced-Form Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .604Advantages and Disadvantages of Structural Model Evidence . . . . . . . . . . . . . . . . . . . . . .605Advantages and Disadvantages of Reduced-Form Evidence . . . . . . . . . . . . . . . . . . . . . . .606Box 1 Perils of Reverse Causation: A Russian Folk Tale . . . . . . . . . . . . . . . . . . . .606Box 2 Perils of Ignoring an Outside Driving Factor: How to Lose aPresidential Election . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .607Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .607Early Keynesian Evidence on the Importance of Money . . . . . . . . . . . . . . . . . . . . .607Objections to Early Keynesian Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .608Early Monetarist Evidence on the Importance of Money . . . . . . . . . . . . . . . . . . . . .611Timing Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .611Statistical Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .613xxvi Contents
  28. 28. Historical Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .615Overview of the Monetarist Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .615Box 3 Real Business Cycle Theory and the Debate on Money andEconomic Activity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .616Transmission Mechanisms of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . .616Traditional Interest-Rate Channels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .617Other Asset Price Channels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .618Credit View . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .621Box 4 Consumers’ Balance Sheets and the Great Depression . . . . . . . . . . . . . . . .624Why Are Credit Channels Likely to Be Important? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .625Application Corporate Scandals and the Slow Recovery from theMarch 2001 Recession . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .625Lessons for Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .626Application Applying the Monetary Policy Lessons to Japan . . . . . . . . . . . . . . .628Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .629CHAPTER 27MONEY AND INFLATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .632Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .632Money and Inflation: Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .632German Hyperinflation, 1921–1923 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .633Recent Episodes of Rapid Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .633Meaning of Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .634Views of Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .635Monetarist View . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .635Keynesian View . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .636Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .638Origins of Inflationary Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .638High Employment Targets and Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .639Budget Deficits and Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .643Application Explaining the Rise in U.S. Inflation, 1960–1980 . . . . . . . . . . . . . .646Activist/Nonactivist Policy Debate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .650Responses to High Unemployment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .650Activist and Nonactivist Positions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .651Expectations and the Activist/Nonactivist Debate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .652Box 1 Perils of Accommodating Policy: The Terrorism Dilemma . . . . . . . . . . . . .654Rules Versus Discretion: Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .654Application Importance of Credibility to Volcker’s Victory over Inflation . . . . . .655Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .655Contents xxvii
  29. 29. CHAPTER 28RATIONAL EXPECTATIONS: IMPLICATIONS FOR POLICY . . . . . . . . . . . . . . . . . . .658Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .658The Lucas Critique of Policy Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .659Econometric Policy Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .659Example: The Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .659New Classical Macroeconomic Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .660Effects of Unanticipated and Anticipated Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .661Box 1 Proof of the Policy Ineffectiveness Proposition . . . . . . . . . . . . . . . . . . . . . .663Can an Expansionary Policy Lead to a Decline in Aggregate Output? . . . . . . . . . . . . . . . .663Implications for Policymakers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .664New Keynesian Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .665Effects of Unanticipated and Anticipated Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .666Implications for Policymakers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .666Comparison of the Two New Models with the Traditional Model . . . . . . . . . . . . . .666Short-Run Output and Price Responses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .668Stabilization Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .670Anti-inflation Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .671Credibility in Fighting Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .673Box 2 Global: Ending the Bolivian Hyperinflation: Case Study of aSuccessful Anti-inflation Program . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .674Application Credibility and the Reagan Budget Deficits . . . . . . . . . . . . . . . . . . .675Impact of the Rational Expectations Revolution . . . . . . . . . . . . . . . . . . . . . . . . . . .676Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .677GLOSSARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . G-1ANSWERS TO SELECTED QUESTIONS AND PROBLEMS . . . . . . . . . . . . . . . . . . . A-1CREDITS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . C-1INDEX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . I-1xxviii Contents
  30. 30. I have continually strived to improve this textbook with each new edition, and theSeventh Edition of The Economics of Money, Banking, and Financial Markets is noexception. The text has undergone a major revision, but it retains the basic hall-marks that have made it the best-selling textbook on money and banking in the pastsix editions:• A unifying, analytic framework that uses a few basic economic principles toorganize students’ thinking about the structure of financial markets, the foreignexchange markets, financial institution management, and the role of monetarypolicy in the economy• A careful, step-by-step development of models (an approach found in the bestprinciples of economics textbooks), which makes it easier for students to learn• The complete integration of an international perspective throughout the text• A thoroughly up-to-date treatment of the latest developments in monetary theory• Special features called “Following the Financial News” and “Reading the WallStreet Journal” to encourage reading of a financial newspaper• An applications-oriented perspective with numerous applications and special-topic boxes that increase students’ interest by showing them how to apply the-ory to real-world examplesWhat’s New in the Seventh EditionIn addition to the expected updating of all data through the end of 2002 wheneverpossible, there is major new material in every part of the text. Indeed, this revisionis one of the most substantial that I have ever done.With the wide swings in the stock prices in recent years, students of money andbanking have become increasingly interested in what drives the stock market. As aresult, I have expanded the discussion of this market by describing simple valua-tion methods for stocks and examining recent developments in the stock marketand the link between monetary policy and stock prices. I have combined this mate-rial with the discussion of the theory of rational expectations and efficient capitalmarkets to create a new Chapter 7, “The Stock Market, the Theory of RationalExpectations, and the Efficient Market Hypothesis.”ExpandedCoverage of theStock MarketxxixPREFACE
  31. 31. In light of continuing changes in financial markets and institutions, I have addedthe following new material to keep the text current:• Extensive discussion of recent corporate scandals and the collapse of Enron,including their impact on the economy (Chapters 6, 7, 11, and 26)• Discussion of the role of venture capitalists in the high-tech sector (Chapter 8)• Examination of how information technology is influencing bank consolidation,and analysis of whether clicks will dominate bricks in the banking industry(Chapter 10)• New material on the Basel Committee on Bank Supervision and where the BaselAccord is heading (Chapter 11)• Discussion of the spread of deposit insurance throughout the world (Chapter 11)• Perspective on the growing concerns about Fannie Mae and Freddie Mac(Chapter 12)• A new type of special-interest box, the E-Finance box, which relates howchanges in technology have affected the conduct of business in banking andfinancial markets. The placement of these boxes throughout the text helps todemonstrate the impact of technology across a broad range of areas in finance.The growing importance of the global economy has encouraged me to add morenew material with an international perspective:• Extensive discussion of recent developments in Argentina (Chapters 1, 8, 11,20, and 21)• Analysis of how central banks set overnight interest rates in other countries(Chapter 17)• Discussion of how the euro has fared in its first four years (Chapter 19)• Additional treatment of recent events in the Japanese economy (Chapters 11and 26)Drawing on my continuing involvement with central banks around the world, Ihave added new material to keep the discussion of monetary theory and policycurrent:• New boxes on Fed watching and Federal Reserve transparency (Chapters 14and 18)• Discussion of the changes (implemented in 2003) in the way the Fed adminis-ters the discount window (Chapter 17)• An updated discussion of the market for reserves and how the channel/corri-dor system for setting interest rates works (Chapter 17)• Discussion of how the recent corporate scandals have hindered the recovery ofthe economy from the 2001–2002 recession (Chapter 25)The incredible advances in electronic (computer and telecommunications) tech-nology in recent years have had a major impact on the financial system. This SeventhEdition reflects these developments by adding many new features with an electronicfocus.Web Enhancement. The Seventh Edition embraces the exploding world of informa-tion now available over the World Wide Web. There are few areas where the InternetE-FocusNew Material onMonetary Theoryand PolicyIncreasedInternationalPerspectiveNew Material onFinancialInstitutionsxxx Preface

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