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2. www.GetPedia.com*More than 150,000 articles in thesearch database*Learn how almost everythingworks 3. Seventh Edition 4. Abel/BernankeMacroeconomicsBade/ParkinFoundations of MicroeconomicsBade/ParkinFoundations of MacroeconomicsBierman/FernandezGame Theory with Economic ApplicationsBinger/HoffmanMicroeconomics with CalculusBoyerPrinciples of Transportation EconomicsBransonMacroeconomic Theory and PolicyBrucePublic Finance and the American EconomyByrns/StoneEconomicsCarlton/PerloffModern Industrial OrganizationCaves/Frankel/JonesWorld Trade and Payments:An IntroductionChapmanEnvironmental Economics:Theory, Application, and PolicyCooter/UlenLaw and EconomicsDownsAn Economic Theory of DemocracyEaton/MishkinOnline Readings to AccompanyThe Economics of Money, Banking, andFinancial MarketsEhrenberg/SmithModern Labor EconomicsEkelund/TollisonEconomics: Private Marketsand Public ChoiceFusfeldThe Age of the EconomistGerberInternational EconomicsGhiaraLearning Economics:A Practical WorkbookGordonMacroeconomicsGregoryEssentials of EconomicsGregory/StuartRussian and Soviet Economic Performanceand StructureHartwick/OlewilerThe Economics of Natural Resource UseHubbardMoney, the Financial System,and the EconomyHughes/CainAmerican Economic HistoryHusted/MelvinInternational EconomicsJehle/RenyAdvanced Microeconomic TheoryKleinMathematical Methodsfor EconomicsKrugman/ObstfeldInternational Economics:Theory and PolicyLaidlerThe Demand for Money:Theories, Evidence, and ProblemsLeeds/von AllmenThe Economics of SportsLipsey/Courant/RaganEconomicsMcCartyDollars and Sense:An Introduction to EconomicsMelvinInternational Moneyand FinanceMillerEconomics TodayMiller/Benjamin/NorthThe Economics of Public IssuesMills/HamiltonUrban EconomicsMishkinThe Economics of Money, Banking, andFinancial MarketsParkinEconomicsParkin/BadeEconomics in Action SoftwarePerloffMicroeconomicsPhelpsHealth EconomicsRiddell/Shackelford/Stamos/SchneiderEconomics: A Tool for CriticallyUnderstanding SocietyRitter/Silber/UdellPrinciples of Money, Banking,and Financial MarketsRohlfIntroduction to Economic ReasoningRuffin/GregoryPrinciples of EconomicsSargentRational Expectationsand InflationSchererIndustry Structure, Strategy,and Public PolicySchotterMicroeconomics:A Modern ApproachStock/WatsonIntroduction to EconometricsStudenmundUsing Econometrics:A Practical GuideTietenbergEnvironmental and NaturalResource EconomicsTietenbergEnvironmental Economics and PolicyTodaro/SmithEconomic DevelopmentWaldman/JensenIndustrial Organization:Theory and PracticeWilliamsonMacroeconomicsThe Addison-Wesley Series in Economics 5. Frederic S. MishkinColumbia University 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 2004332dc212003041912Copyright 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 10DOW06050403 7. To Sally 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. 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. 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. 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. Box 2 E-Finance: Why Are Scandinavians So Far Ahead of Americans inUsing Electronic Payments? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .50E-Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .51Measuring Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .51The Federal Reserves 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. 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. 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, 19802003 . . . . . . . . . . . . . . . . . . . . . . .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. 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 PrincipalAgent Problem . . . . . . . . . . . . . . . . . . .181Tools to Help Solve the PrincipalAgent 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, 19941995; East Asia, 19971998; and Argentina, 20012002 . . . . . . .194Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .199PA RT I I Ixiv Contents 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 PrincipalAgent 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. 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. 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 PrincipalAgent 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .284Dj 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. 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. 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. 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 Feds 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 Feds 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, 19802002 . . . . . . . .384xx Contents 22. Application The Great Depression Bank Panics, 19301933 . . . . . . . . . . . . . . . .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. 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 19301933: Why Did the Fed LetThem Happen? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .421Reserve Requirements as a Policy Tool . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .422War Finance and the Pegging of Interest Rates: 19421951 . . . . . . . . . . . . . . . . . . . . . . .422Targeting Money Market Conditions: The 1950s and 1960s . . . . . . . . . . . . . . . . . . . . . . .423Targeting Monetary Aggregates: The 1970s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .424New Fed Operating Procedures: October 1979October 1982 . . . . . . . . . . . . . . . . . . . . .425De-emphasis of Monetary Aggregates: October 1982Early 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. 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, 19732002 . . . . . . . . . . . . . . . . . . . .455Application The Euros 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 YorksForeign Exchange Desk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .463Unsterilized Intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .465Sterilized Intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .466Balance of Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .467Evolution of the International Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . .468Gold Standard . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .469Bretton Woods System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .469Box 2 Global: The Euros 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. 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: Argentinas Currency Board . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .494Monetary Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .496Monetary Targeting in Canada, the United Kingdom, Japan, Germany, and Switzerland . . .496Box 2 Global: The European Central Banks 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 Feds Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .510Disadvantages of the Feds 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? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .520Keyness 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. Precautionary Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .527Speculative Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .527Friedmans 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 . .545Governments 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. 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, 19641970 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .598Negative Supply Shocks, 19731975 and 19781980 . . . . . . . . . . . . . . . . . . . . . . . . . . .598Favorable Supply Shocks, 19951999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .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. 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, 19211923 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .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, 19601980 . . . . . . . . . . . . . .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 Volckers Victory over Inflation . . . . . .655Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .655Contents xxvii 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