principles of money, banking, and financial markets
TRANSCRIPT
Principles of Money, Banking, and Financial Markets
Tenth edition
Lawrence S. Ritter New York University
William L. Silber New York University
Gregory F. Udell Indiana University
^ ADDISON-WESLEY
An imprint of Addison Wesley Longman, Inc.
Reading, Massachusetts • Meiilo Park, California • New York • Harlow, England Don Mills, Ontario • Sydney • Mexico City • Madrid • Amsterdam
B R I E F T A B L E O F C O N T E N T S
Contents ix
Preface xxiii
Acknowledgments xxvi
About the Authors xxviii
PART I The Basics 1 CHAPTER 1 Introducing Money, Banking, and Financial Markets 3
CHAPTER 2 The Role of Money in the Macroeconomy 13
CHAPTER 3 Financial Instruments, Markets, and Institutions 31
PART II Financial Instruments and Markets 49 CHAPTER 4 Interest Rate Measurement and Behavior 51
CHAPTER 5 The Risk and Term Structure of Interest Rates 75
CHAPTER 6 The Structure and Performance of Securities Markets 93
CHAPTER 7 The Pricing of Risky Financial Assets 109
CHAPTER 8 Money and Capital Markets 121
CHAPTER 9 Demystifying Derivatives 151
CHAPTER 10 Understanding Foreign Exchange 173
PART III Banks and Other Intermediaries 193 CHAPTER 11 The Nature of Financial Intermediation 195
CHAPTER 12 Depository Financial Institutions 217
CHAPTER 13 Nondepository Financial Institutions 245
vii
viii Brief Contents
PART IV Financial System Architecture 261 CHAPTER 14 Understanding Financial Contracts 263
CHAPTER 15 The Regulation of Markets and Institutions 287
CHAPTER 16 Financial System Design 309
CHAPTER 17 Financial Innovation 329
PART V The Art of Central Banking 339 CHAPTER 18 Who's in Charge Here? 341
CHAPTER 19 Bank Reserves and the Money Supply 353
CHAPTER 20 The Instruments of Central Banking 375
CHAPTER 21 Understanding Movements in Bank Reserves 391
CHAPTER 22 Monetary Policy Strategy 413
PART VI Monetary Theory 427
CHAPTER 23 The Classical Foundations 429
CHAPTER 24 The Keynesian Framework 451
CHAPTER 25 The ISLM World 481
CHAPTER 26 Money and Economic Stability in the ISLM World 515
CHAPTER 27 An Aggregate Supply and Demand Perspective on Money and Economic S 531
CHAPTER 28 Rational Expectations: Theory and Policy Implications 551
CHAPTER 29 Empirical Evidence on the Effectiveness of Monetary Policy 561
PART VII Grand Finale 575 CHAPTER 30 Tying It All Together 577
Glossary 591
Index 609
C O N T E N T S
Preface xxiii
Acknowledgments xxvi
About the Authors xxviii
PARTI The Basics 1
CHAPTER 1 Introducing Money, Banking, and Financial Markets 3
An Overview 4
Why Study Money, Banking, and Financial Markets? 5
Careers in Banking and Financial Markets 5 An Overview 6 Specific Opportunities 7
TRADING 7
SALES 8
FINANCIAL ECONOMIST 9
FIXED-INCOME RESEARCH 9
LOAN OFFICER 10
BANK EXAMINER 10
CHAPTER 2 The Role of Money in the Macroeconomy 13
Introducing Money 14
Going Out on a Limb: It's Time to Change Our Small Change 14 Who Determines Our Money Supply? 16 The Importance of Money I: Money Versus Barter 18 The Importance of Money II: Financial Institutions and Markets 19
Money, the Economy, and Inflation 21 Bank Reserves and the Money Supply 21 How Large Should the Money Supply Be? 22 Velocity: The Missing Link 24 Money and Inflation 25
Going Out on a Limb: Can It Happen Here? 27
Ix
X Contents
Summary 28
Questions 29
CHAPTER 3 Financial Instruments, Markets, and Institutions 31
Flow of Funds 31
Financial Instruments and Markets 33 Bonds Represent Borrowing 34 Stocks Represent Ownership 35 Mortgages Involve Real Estate 36 Derivatives: Options and Futures 37 The Money and Capital Markets: A Summary 38
Financial Intermediaries: Purposes and Profile 41 The Role of Financial Intermediaries 41 Financial Intermediaries in Profile 43
Summary 46
Questions 48
PART II Financial Instruments and Markets 49
CHAPTER 4 Interest Rate Measurement and Behavior 51
Calculating Interest Rates 51 Simple Interest 51 Compound Interest 52 Coupon Rate on Bonds 53 Current Yield 54 Yield to Maturity 54
Off the Record: The Million Dollar Lottery: A Case of Misleading Advertising? 56 Zero-Coupon Bonds 57
Reading the Financial News: Government Bond Market Quotations 58 The Inverse Relationship Between Yields and Bond Prices 59 Why Long-Term Bonds Are Riskier than Shorts 60 Nominal Versus Real Interest Rates 61 Return Versus Yield to Maturity 62
What Determines the Level of Interest Rates? 63
Contents xi
Supply and Demand Determine the Interest Rate 63 Why Does the Interest Rate Fluctuate? 66 Behind Supply and Demand 68
In The News: Slower Economic Activity Raises Bond Prices and Lowers Interest Rates 69 The Importance of Inflationary Expectations 70 Cyclical and Long-Term Trends in Interest Rates 70
Summary 72
Questions 73
CHAPTER 5 The Risk and Term Structure of Interest Rates 75
The Term Structure of Rates and the Yield Curve 75 SUPPLY AND DEMAND 76
THE PURE EXPECTATIONS APPROACH 77
THE LIQUIDITY PREMIUM MODIFICATION 78
THE PREFERRED HABITAT APPROACH 79
REAL WORLD OBSERVATIONS 79
Going Out on a Limb: Is the Shape of the Yield Curve a Crystal Ball? 82 An Aside on Marketability 83
Risk and Tax Structure of Rates 83
Summary 86
Questions 87
Appendix: Bond Price Volatility: Duration Versus Maturity 89
CHAPTER 6 The Structure and Performance of Securities Markets 93
Nature and Function of Securities Markets 93 AUCTION MARKET 94
BROKERED MARKET 94
DEALER MARKET 94
Primary Versus Secondary Markets 95
Efficiency of Secondary Market Trading 98
In The News: Dealers Make Money Buying at Their Bid and Selling at Their Offer 102
Going Out on a Limb: The Computer Will Prevail 103
In The News: London Meets Its Match 104
xii Contents
Efficient Capital Markets and Regulation 104
Summary 107
Questions 108
CHAPTER 7 The Pricing of Risky Financial Assets 109
A World of Certainty 110
Consequences of Uncertainty and Risk Aversion 111 An Aside on Measuring Risk 112
Principles of Diversification 114
In The News: Sometimes More Is Less as Far as Risk Is Concerned 116
The Risk Premium on Risky Securities 116
Going Out on a Limb: Buy an Index Fund 117
Summary 119
Questions 119
CHAPTER 8 Money and Capital Markets 121
The Government Bond Market 121 Types of Securities and Investors 122 How the Market Works 124 Treasury Bills: Auctions amd Yields 124 Repurchase Agreements 128
Bank-Related Securities: CDs and Eurodollars 129
Corporate Securities 130 Corporate Bonds 131
Going Out on a Limb: Junk Is Good 132
Reading the Financial News: Corporate Bond Market Quotations 133 Commercial Paper 134
Municipal Securities 134
In The News: General Obligation Bonds Might Yield More than Revenue Bonds 137
Mortgage Securities 138
The Stock Market 139 Structure of the Stock Market 139
Reading the Financial News: Stock Market Quotations 140
Contents xiii
What Determines Whether Stock Prices Rise or Fall? 141
Off the Record: The Dow Jones Versus the S&P 500 143 Money and Stock Prices 144
Going Out on a Limb: The Crash of 1987 and Market Efficiency 145
Summary 147
Questions 149
CHAPTER 9 Demystifying Derivatives 151
An Overview of Financial Futures 151
In The News: Financiers Plan to Put Controls on Derivatives 152 Using Financial Futures Contracts 155
Reading the Financial News: Financial Futures Quotations 156 Pricing Financial Futures Contracts 158
An Overview of Options Contracts 159 Using and Valuing Options 162
Reading the Financial News: Options Quotations 163 What Determines Option Premiums? 165
Going Out on a Limb: Don't Blame Derivatives 166
An Overview of Swaps 167 Why Swap? 169 Valuing a Swap 170
Summary 171
Questions 172
CHAPTER 10 Understanding Foreign Exchange 173
What Determines Foreign Exchange Rates? 173
Reading the Financial News: Foreign Exchange Quotations 174 Why Do Exchange Rates Fluctuate? 177
In The News: Global Investors Chase High Yields 182 How Global Investors Cause Exchange Rate Volatility 183
Fixed Versus Floating Exchange Rates 186
In The News: We Have Liftoff! 187 How Fixed Rates Are Supposed to Work 188 International Financial Crises 190
Summary 191
Questions 192
PART HI Banks and Other Intermediaries 193
CHAPTER 11 The Nature of Financial Intermediation 195
The Economics of Financial Intermediation 195
The Evolution of Financial Intermediaries in the United States 200 The Shifting Sands of Interest Rates 200
THE REGULATION Q SECURITY BLANKET 202
THE BIRTH OF THE MONEY MARKET MUTUAL FUND 203
THE SAVINGS AND LOAN CRISIS 204
THE RISE OF COMMERCIAL PAPER 206
The Institutionalization of Financial Markets 207 The Transformation of Traditional Banking 208
Financial Intermediaries: Assets, Liabilities, and Management 210
In The News: One-Stop Shopping 211
Summary 214
Questions 216
CHAPTER 12 Depository Financial Institutions 217
The Fundamentals of Bank Management 217 Sources of Bank Funds 220 Bank Profitability 223 Bank Risk 225
LEVERAGE RISK 226
CREDIT RISK 226
INTEREST RATE RISK 227
In The News: It's a Risky Business 228 TRADING RISK 229
LIQUIDITY RISK 229
Major Trends in Bank Management 230 The Consolidation of the Banking Industry 230
THE MCFADDEN ACT 230
THE EROSION OF MCFADDEN 230
Contents xv
MEASURING CONSOLIDATION 232
THE ECONOMICS OF CONSOLIDATION 232
Nontraditional Banking 234
In The News: Fed Approves Citicorp-Travelers Merger 235 Globalization 231
AMERICAN BANKS ABROAD 237
FOREIGN BANKS IN THE UNITED STATES 237
THE EUROMARKETS 238
Nonbank Depository Institutions—The Thrifts 241
Summary 242
Questions 243
CHAPTER 13 Nondepository Financial Institutions 245
Life Insurance Companies 245 Pension Funds 247 Property and Casualty Insurance Companies 249
In The News: It's All in the Family 250 Mutual Funds 252 Finance Companies 253 Securities Brokers and Dealers and Investment Banks 254 Venture Capital Funds and Mezzanine Debt Funds 256 Banks Versus Nondepository Institutions 257 Summary 258 Questions 259
PART IV Financial System Architecture 261
CHAPTER 14 Understanding Financial Contracts 263
How Business Obtains Financing 264 Financing Small Businesses 264 Financing Midsize Businesses 269 Financing Large Businesses 212
The Economics of Financial Contracting 275
In The News: Journey Into the Secret Heart of Capitalism 276 Asymmetric Information and Financial Contracting 211 Contracting and the Firm Continuum 280 Consumer Lending, Financial Contracting, and Securitization 283
xvi Contents
Summary 284
Questions 285
CHAPTER 15 The Regulation of Markets and Institutions 287
The Regulation of Financial Markets in the United States 288 The Regulation of the Primary Market 289 The Regulation of the Secondary Markets 289
Off the Record: Insider Trading: Efficiency Versus Equity 290
The Regulation of Commercial Banks in the United States 291 The U.S. Banking Regulatory Structure 291 Regulations to Protect Individual Depositors and Financial System
Stability 293 DEPOSIT INSURANCE 294
MORAL HAZARD AND DEPOSIT INSURANCE 295
RISK-BASED CAPITAL REQUIREMENTS 297
PROMPT CORRECTIVE ACTION 299
RISK-BASED DEPOSIT INSURANCE PREMIUMS 301
Regulation of Nondepository Financial Intermediaries 301
Where Securities Market and Banking Regulation Meet: The Glass-Steagall Act, A Collapsing Barrier 302 The Genesis of Glass-Steagall 303 The Erosion of Glass-Steagall 303 The Risk of Universal Banking 304
Summary 305
Questions 307
CHAPTER 16 Financial System Design 309
Information and Financial System Design 310 Stockholder-Lender Conflict 310 Manager-Stockholder Conflict 310 Conflict Resolution and Financial System Design 312
SMALL FIRMS: STOCKHOLDER-LENDER CONFLICT 312
LARGE FIRMS: STOCKHOLDER-LENDER CONFLICT 313
LARGE FIRMS: MANAGER-STOCKHOLDER CONFLICT 314
Financial System Design: A Descriptive Summary of Germany, Japan, the United Kingdom, and the United States 315 Germany 315
In The News: German Banking's Industrial Revolution 317
Contents xvii
Japan 318 United Kingdom 319 United States 320
Financial System Design and Conflict Resolution: Germany, Japan, the United Kingdom, and the United States 320 Conflict Resolution in the Big Four 322 And the Winner Is . . . 324
Financial System Design for Eastern Europe and Other Emerging Economies 325
Summary 325
Questions 327
CHAPTER 17 Financial Innovation 329
Circumventing Regulation 330
Double-digit Inflation 331
In The News: Financial Innovation in Action—I 332
In The News: Financial Innovation in Action—II 333
Legislative Encouragement 334
The Philosophy of Deregulation 335
Technological Change 336
Necessity Is the Mother of Invention 337
Summary 337
Questions 338
PARTV The Art of Central Banking 339
CHAPTER 18 Who's In Charge Here? 341
Formal Structure of the Federal Reserve System 342
The Realities of Power 345
The Problem of Federal Reserve Independence 347
Going Out on a Limb: Central Bank Independence Abroad 348
Summary 350
Questions 351
CHAPTER 19 Bank Reserves and the Money Supply 353
Check Clearing and Collection 354
xviii Contents
Deposit Expansion: The Single Bank 357
Deposit Expansion: The Banking System 360
Deposit Contraction 363
Summary 365
Questions 365
Appendix The Complete Money Supply Process 367
Shifts Between Currency and Checking Deposits 368
Shifts Between Time Deposits and Checking Accounts 371
The Role of Interest Rates 373
CHAPTER 20 The Instruments of Central Banking 375
Reserve Requirements 375
Discounting and the Discount Rate 377
Going Out on a Limb: The Discount Window Prevented a Financial Meltdown in 1987 379 The Discount Rate and Market Interest Rates 380
Open Market Operations 382
Off the Record: Three Key Interest Rates 384 A Day at the Trading Desk 386
Summary 388
Questions 389
CHAPTER 21 Understanding Movements in Bank Reserves 391
The Fed's Balance Sheet 392
The U.S. Treasury's Monetary Accounts 398
The Bank Reserve Equation 399
Putting It All to Use 401
Off the Record: Why Did Germany Let the Pound Sink in September 1992? 402
In The News: The Holiday Shopping Season Causes Defensive Open-Market Operations 403
Focusing on the Monetary Base 404
Summary 404
Questions 405
Appendix Monetary Effects of Treasury Financing 407
Contents xix
CHAPTER 22 Monetary Policy Strategy 413
The FOMC Directive 414
The Fed's Strategy 416 Reserves Versus the Federal Funds Rate 417 Linking Reserves and the Monetary Aggregates 421 How Useful Are the Monetary Aggregates? 422
Going Out on a Limb: Rip Van Winkle Rips Fed 423
The Fed's Track Record 424
Summary 425
Questions 426
PART VI Monetary Theory 427
CHAPTER 23 The Classical Foundations 429
Say's Law 429
Classical Interest Theory 431
Off the Record: Investment Versus Investment 432
The Quantity Theory of Money 434 The Cambridge Approach 435
Money Demand and the Quantity Theory 436
Aggregate Demand and Supply: A Summary 438
Real Versus Nominal Rates of Interest 441
Modern Modifications: Monetarists and New Classicists 442
Going Out on a Limb: The Money Supply and the Great Depression 443
Summary 444
Questions 445
Appendix GDP Definitions and Relationships 446
The Circular Flow of Spending, Income, and Output 446
Saving and Investment 447
CHAPTER 24 The Keynesian Framework 451
When Saving Doesn't Equal Investment 452
Consumption and Simple GDP Determination 453
XX Contents
Changes in GDP 457
Autonomous Versus Induced Changes in GDP 460 Exports and Imports 461
Government to the Rescue 461
Off the Record: Taking the Pulse of the Economy 464
Money and the Rate of Interest 465
Monetary Policy 469 Monetary Policy and International Trade 472 Transactions Demand and Monetary Policy 473 Expectations and Monetary Policy 475
Aggregate Demand and Supply 476
Summary 479
Questions 480
CHAPTER 25 The ISLM World 481
Money, Interest, and Income 481
All About LM 484 Monetary Policy and the LM Curve 485
The Goods Market 487
All About IS 490
The Simultaneous Determination of Income and Interest: IS and LM Together 493
Monetary and Fiscal Policy 495 Monetary Policy 495 Fiscal Policy 497
Keynes and the Classics 500
When Will Full Employment Prevail? 503
Going Out on a Limb: ISLM Analysis Lives 504
ISLM and Aggregate Demand 507
Summary 509
Questions 510
Appendix The Simple Algebra of Income Determination 511
The Model 511
The IS and LM Functions 512
Equilibrium Income and Interest 512
Contents xxi
Multiplier Effects on Income and the Interest Rate 512
Policy Implications 513
CHAPTER 26 Money and Economic Stability in the ISLM World 515
Monetary Policy, Fiscal Policy, and Crowding Out 515
Is the Private Sector Inherently Stable? 521
Flexible Prices, the Natural Rate of Interest, and Real Crowding Out 523
Summary 525
Questions 526
Appendix Interest Rates Versus the Money Supply Under Uncertainty 527
CHAPTER 27 An Aggregate Supply and Demand Perspective on Money and Economic Stability 531
Is the Private Sector Inherently Stable? 532
Monetary Policy, Fiscal Policy, and Crowding Out 536
Going Out on a Limb: Are Bank Loans Special? 538
Inflation, Money, and the Phillips Curve 539
Inflation and Interest Rates 542
Should a Robot Replace the Federal Reserve? 545
Summary 549
Questions 550
CHAPTER 28 Rational Expectations: Theory and Policy Implications 551
When Are Expectations Rational? 552
Anticipated Versus Unanticipated Monetary Policy 552
Off the Record: Applying Rational Expectations to the Securities Markets 553
Implications for Stabilization Policy 554
Inflation, the Phillips Curve, and Credibility 556
Interest Rates and Anticipated Monetary Policy 558
Summary 559
Questions 560
CHAPTER 29 Empirical Evidence on the Effectiveness of Monetary Policy 561
Living with Velocity 562
xxii Contents
The Demand for Money 564
Going Out on a Limb: Where Is All That Cash Hiding? 565
Computer Simulations and Time Lags 566
The Impact of Monetary Policy on GDP 567
Fiscal Policy and Crowding Out 568
The Impact of Money on Interest Rates 569
Business Investment 571
Residential Construction 572
Consumer Spending 572
Summary 573
Questions 573
PARTVII Grand Finale 575
CHAPTER 30 Tying It All Together 577
The Economic Indicators 577 The Employment Report 580
In The News: Consumer Price Index to Get Changes to Make It a Better Inflation Measure 581 Housing Starts and Building Permits 582 Purchasing Management Index 582 Index of Leading Economic Indicators 583
Valuation, the Fed, and Market Reaction 583 Good News Versus Bad News: The Role of Expectations 584 Stock and Bond Valuation—A Refresher 585
In The News: Interest-Rate Worries Send Stocks, U.S. Bonds Lower 585
Putting It All Together 588
Summary 589
Questions 589
GLOSSARY 591
INDEX 609