The economics of Money, Banking and Financial Markets Part 1 ppsx

Seventh Edition


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Frederic S. Mishkin
Columbia University


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Credits to copyrighted material appear on p. C-1, which constitutes a continuation of the copyright page.
Library of Congress Cataloguing-in-Publication Data
Mishkin, 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 0-321-12235-6
1. Finance. 2. Money. 3. Banks and banking. I. Title. II. Series.
HG173.M632 2004
332—dc21
2003041912
Copyright © 2004 by Frederic S. Mishkin. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical,
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1 2 3 4 5 6 7 8 9 10—DOW—06050403

To Sally



CONTENTS IN BRIEF

PA RT I

Introduction

1

1 Why Study Money, Banking, and Financial Markets? . . . . . . . . . . . . . . . . . . . .3
2 An Overview of the Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
3 What Is Money? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44

PA RT I I

Financial Markets

59

4 Understanding Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61
5 The Behavior of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85
6 The Risk and Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . .120
7 The Stock Market, the Theory of Rational Expectations,

and the Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .141

PA RT I I I

Financial Institutions

167

8 An Economic Analysis of Financial Structure . . . . . . . . . . . . . . . . . . . . . . . .169
9 Banking and the Management of Financial Institutions . . . . . . . . . . . . . . . . .201
10 Banking Industry: Structure and Competition . . . . . . . . . . . . . . . . . . . . . . . .229
11 Economic Analysis of Banking Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . .260
12 Nonbank Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287
13 Financial Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .309

PA RT I V

Central Banking and the Conduct of
Monetary Policy 333
14 Structure of Central Banks and the Federal Reserve System . . . . . . . . . . . . .335
15 Multiple Deposit Creation and the Money Supply Process . . . . . . . . . . . . . .357
16 Determinants of the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .374
17 Tools of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .393
18 Conduct of Monetary Policy: Goals and Targets . . . . . . . . . . . . . . . . . . . . . .411

PA RT V

International Finance and Monetary Policy

433

19 The Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .435
20 The International Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .462

21 Monetary Policy Strategy: The International Experience . . . . . . . . . . . . . . . .487

vii


viii

Contents in Brief

PA RT V I

Monetary Theory

515

22 The Demand for Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .517
23 The Keynesian Framework and the ISLM Model . . . . . . . . . . . . . . . . . . . . . .536
24 Monetary and Fiscal Policy in the ISLM Model . . . . . . . . . . . . . . . . . . . . . . .561
25 Aggregate Demand and Supply Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . .582
26 Transmission Mechanisms of Monetary Policy: The Evidence . . . . . . . . . . . .603
27 Money and Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .632
28 Rational Expectations: Implications for Policy . . . . . . . . . . . . . . . . . . . . . . . .658


CONTENTS

PA RT I

Introduction

1

CHAPTER 1

WHY STUDY MONEY, BANKING, AND FINANCIAL MARKETS? . . . . . . . . . . . . . . . . .3
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3
Why Study Financial Markets? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3
The Bond Market and Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3
The Stock Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5
The Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

Why Study Banking and Financial Institutions? . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7
Structure of the Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7
Banks and Other Financial Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8
Financial Innovation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8

Why Study Money and Monetary Policy? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8
Money and Business Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9
Money and Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10
Money and Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12
Conduct of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12
Fiscal Policy and Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12

How We Will Study Money, Banking, and Financial Markets . . . . . . . . . . . . . . . . . .13
Exploring the Web . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14

Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . . .17
Appendix to Chapter 1

Defining Aggregate Output, Income, the Price Level,
and the Inflation Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20
Aggregate Output and Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20
Real Versus Nominal Magnitudes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20
Aggregate Price Level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21
Growth Rates and the Inflation Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22

ix


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Contents
CHAPTER 2

AN OVERVIEW OF THE FINANCIAL SYSTEM . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
Function of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
Structure of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25
Debt and Equity Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25
Primary and Secondary Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26
Exchanges and Over-the-Counter Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27
Money and Capital Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27

Internationalization of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28
International Bond Market, Eurobonds, and Eurocurrencies . . . . . . . . . . . . . . . . . . . . . . . .28
World Stock Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29

Function of Financial Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29
Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29

Following the Financial News Foreign Stock Market Indexes . . . . . . . . . . . . . . . .30
Box 1 Global: The Importance of Financial Intermediaries to Securities
Markets: An International Comparison . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31
Risk Sharing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31
Asymmetric Information: Adverse Selection and Moral Hazard . . . . . . . . . . . . . . . . . . . . .32

Financial Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34
Depository Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34
Contractual Savings Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .35
Investment Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37

Regulation of the Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37
Increasing Information Available to Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39
Ensuring the Soundness of Financial Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39
Financial Regulation Abroad . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . . .41
CHAPTER 3

WHAT IS MONEY? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44
Meaning of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44
Functions of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45
Medium of Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45
Unit of Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .46
Store of Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .47

Evolution of the Payments System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48
Commodity Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48

Fiat Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48
Checks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48

Box 1 Global: Birth of the Euro: Will It Benefit Europe? . . . . . . . . . . . . . . . . . . . . .49
Electronic Payment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .50


Contents
Box 2 E-Finance: Why Are Scandinavians So Far Ahead of Americans in
Using Electronic Payments? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .50
E-Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .51

Measuring Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .51
The Federal Reserve’s Monetary Aggregates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .51

Box 3 E-Finance: Are We Headed for a Cashless Society? . . . . . . . . . . . . . . . . . . . .52
Following the Financial News The Monetary Aggregates . . . . . . . . . . . . . . . . . . .54
How Reliable Are the Money Data? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . . .56

PA RT I I

Financial Markets

59

CHAPTER 4

UNDERSTANDING INTEREST RATES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61

Measuring Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61
Present Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61
Four Types of Credit Market Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .63
Yield to Maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .64

Box 1 Global: Negative T-Bill Rates? Japan Shows the Way . . . . . . . . . . . . . . . . . . .69
Other Measures of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .69
Current Yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .70
Yield on a Discount Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .71

Application Reading the Wall Street Journal: The Bond Page . . . . . . . . . . . . . . . . .72
Following the Financial News Bond Prices and Interest Rates . . . . . . . . . . . . . . .73
The Distinction Between Interest Rates and Returns . . . . . . . . . . . . . . . . . . . . . . . . .75
Maturity and the Volatility of Bond Returns: Interest-Rate Risk . . . . . . . . . . . . . . . . . . . . . .78

Box 2 Helping Investors to Select Desired Interest-Rate Risk . . . . . . . . . . . . . . . . .79
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .79

The Distinction Between Real and Nominal Interest Rates . . . . . . . . . . . . . . . . . . . .79
Box 3 With TIPS, Real Interest Rates Have Become Observable in the
United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .82
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . . .82
CHAPTER 5

THE BEHAVIOR OF INTEREST RATES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85
Determinants of Asset Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85
Wealth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .86

xi

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Contents
Expected Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .86
Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .87
Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .87
Theory of Asset Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .87

Supply and Demand in the Bond Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .87
Demand Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .88
Supply Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .90
Market Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .90
Supply and Demand Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .91
Loanable Funds Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .91

Changes in Equilibrium Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .93
Shifts in the Demand for Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .93
Shifts in the Supply of Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .97

Application Changes in the Equilibrium Interest Rate Due to Expected
Inflation or Business Cycle Expansions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .99
Changes in Expected Inflation: The Fisher Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .99
Business Cycle Expansion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .100

Application Explaining Low Japanese Interest Rates . . . . . . . . . . . . . . . . . . . . . .103
Application Reading the Wall Street Journal “Credit Markets” Column . . . . . . . .103
Following the Financial News The “Credit Markets” Column . . . . . . . . . . . . . .104
Supply and Demand in the Market for Money: The Liquidity

Preference Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .105
Changes in Equilibrium Interest Rates in the Liquidity Reference Framework . . . . .107
Shifts in the Demand for Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .107
Shifts in the Supply of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .108

Application Changes in the Equilibrium Interest Rate Due to Changes
in Income, the Price Level, or the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . .108
Changes in Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .108
Changes in the Price Level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .108
Changes in the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .109

Following the Financial News Forecasting Interest Rates . . . . . . . . . . . . . . . . . .111
Application Money and Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .112
Does a Higher Rate of Growth of the Money Supply Lower Interest Rates? . . . . . . . . . . . .114

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .117
CHAPTER 6

THE RISK AND TERM STRUCTURE OF INTEREST RATES . . . . . . . . . . . . . . . . . . .120
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .120
Risk Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .120
Default Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .120

Application The Enron Bankruptcy and the Baa-Aaa Spread . . . . . . . . . . . . . . . .124


Contents
Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .125
Income Tax Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .125
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .127

Application Effects of the Bush Tax Cut on Bond Interest Rates . . . . . . . . . . . . .127
Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .127
Following the Financial News Yield Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . .128
Expectations Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .129
Segmented Markets Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .132
Liquidity Premium and Preferred Habitat Theories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .133
Evidence on the Term Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .136
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .137

Application Interpreting Yield Curves, 1980–2003 . . . . . . . . . . . . . . . . . . . . . . .137
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .138
CHAPTER 7

THE STOCK MARKET, THE THEORY OF RATIONAL EXPECTATIONS,
AND THE EFFICIENT MARKET HYPOTHESIS . . . . . . . . . . . . . . . . . . . . . . . . . . . .141
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .141
Computing the Price of Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .141
The One-Period Valuation Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .142
The Generalized Dividend Valuation Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .143
The Gordon Growth Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .143

How the Market Sets Security Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .144
Application Monetary Policy and Stock Prices . . . . . . . . . . . . . . . . . . . . . . . . . .146
Application The September 11 Terrorist Attacks, the Enron Scandal,
and the Stock Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .146
The Theory of Rational Expectations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .147
Formal Statement of the Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .148
Rationale Behind the Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .149
Implications of the Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .149

The Efficient Markets Hypothesis: Rational Expectations in Financial Markets . . . .150
Rationale Behind the Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .151
Stronger Version of the Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . .152

Evidence on the Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . .153
Evidence in Favor of Market Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .153

Application Should Foreign Exchange Rates Follow a Random Walk? . . . . . . . .155
Evidence Against Market Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .156
Overview of the Evidence on the Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . .158

Application Practical Guide to Investing in the Stock Market . . . . . . . . . . . . . . .158
How Valuable Are Published Reports by Investment Advisers? . . . . . . . . . . . . . . . . . . . . .158

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Contents
Following the Financial News Stock Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . .159
Box 1 Should You Hire an Ape as Your Investment Adviser? . . . . . . . . . . . . . . . .160
Should You Be Skeptical of Hot Tips? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .160
Do Stock Prices Always Rise When There Is Good News? . . . . . . . . . . . . . . . . . . . . . . . . .161
Efficient Market Prescription for the Investor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .161

Evidence on Rational Expectations in Other Markets . . . . . . . . . . . . . . . . . . . . . . .162
Application What Do the Black Monday Crash of 1987 and the Tech
Crash of 2000 Tell Us About Rational Expectations and Efficient Markets? . . . .163

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .164

PA RT I I I

Financial Institutions

167

CHAPTER 8

AN ECONOMIC ANALYSIS OF FINANCIAL STRUCTURE . . . . . . . . . . . . . . . . . . . .169
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .169
Basic Puzzles About Financial Structure Throughout the World . . . . . . . . . . . . . . .169
Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .173
How Transaction Costs Influence Financial Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . .173
How Financial Intermediaries Reduce Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . .173

Asymmetric Information: Adverse Selection and Moral Hazard . . . . . . . . . . . . . . . .174
The Lemons Problem: How Adverse Selection Influences Financial Structure . . . . .175
Lemons in the Stock and Bond Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .175
Tools to Help Solve Adverse Selection Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .176

Box 1 The Enron Implosion and the Arthur Andersen Conviction . . . . . . . . . . .178
How Moral Hazard Affects the Choice Between Debt and Equity Contracts . . . . . .180
Moral Hazard in Equity Contracts: The Principal–Agent Problem . . . . . . . . . . . . . . . . . . .181
Tools to Help Solve the Principal–Agent Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .182

Box 2 E-Finance: Venture Capitalists and the High-Tech Sector . . . . . . . . . . . . . .183
How Moral Hazard Influences Financial Structure in Debt Markets . . . . . . . . . . . .184
Tools to Help Solve Moral Hazard in Debt Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . .184

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .186

Application Financial Development and Economic Growth . . . . . . . . . . . . . . . .187
Financial Crises and Aggregate Economic Activity . . . . . . . . . . . . . . . . . . . . . . . . .189
Factors Causing Financial Crises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .189

Application Financial Crises in the United States . . . . . . . . . . . . . . . . . . . . . . . .191
Box 3 Case Study of a Financial Crisis: The Great Depression . . . . . . . . . . . . . . .194
Application Financial Crises in Emerging-Market Countries:
Mexico, 1994–1995; East Asia, 1997–1998; and Argentina, 2001–2002 . . . . . . .194
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .199


Contents
CHAPTER 9

BANKING AND THE MANAGEMENT OF FINANCIAL INSTITUTIONS . . . . . . . . . . . .201
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .201
The Bank Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .201
Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .201
Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .204

Basic Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .205
General Principles of Bank Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .208
Liquidity Management and the Role of Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .208
Asset Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .211
Liability Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .212
Capital Adequacy Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .213

Application Strategies for Managing Bank Capital . . . . . . . . . . . . . . . . . . . . . . . .215

Application Did the Capital Crunch Cause a Credit Crunch in the
Early 1990s? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .216
Managing Credit Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .217
Screening and Monitoring . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .217
Long-Term Customer Relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .218
Loan Commitments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .219
Collateral and Compensating Balances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .219
Credit Rationing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .220

Managing Interest-Rate Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .220
Gap and Duration Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .221

Application Strategies for Managing Interest-Rate Risk . . . . . . . . . . . . . . . . . . . .222
Off-Balance-Sheet Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .223
Loan Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .223
Generation of Fee Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .223
Trading Activities and Risk Management Techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . .224

Box 1 Global: Barings, Daiwa, Sumitomo, and Allied Irish:
Rogue Traders and the Principal–Agent Problem . . . . . . . . . . . . . . . . . . . . . . . . .225
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .226
CHAPTER 10

BANKING INDUSTRY: STRUCTURE AND COMPETITION . . . . . . . . . . . . . . . . . . . .229
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .229
Historical Development of the Banking System . . . . . . . . . . . . . . . . . . . . . . . . . . . .229
Multiple Regulatory Agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .231

Financial Innovation and the Evolution of the Banking Industry . . . . . . . . . . . . . .232
Responses to Changes in Demand Conditions: Interest Rate Volatility . . . . . . . . . . . . . . .233

Responses to Changes in Supply Conditions: Information Technology . . . . . . . . . . . . . . .234

Box 1 E-Finance: Will “Clicks” Dominate “Bricks” in the Banking Industry? . . . .236
Avoidance of Existing Regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .237
Financial Innovation and the Decline of Traditional Banking . . . . . . . . . . . . . . . . . . . . . .239

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Contents
Structure of the U.S. Commercial Banking Industry . . . . . . . . . . . . . . . . . . . . . . . .243
Restrictions on Branching . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .244
Response to Branching Restrictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .245

Bank Consolidation and Nationwide Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . .245
Box 2 E-Finance: Information Technology and Bank Consolidation . . . . . . . . . . .247
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 . . . . . . . . . . . .248
What Will the Structure of the U.S. Banking Industry Look Like in the Future? . . . . . . . .248

Box 3 Global: Comparison of Banking Structure in the United States
and Abroad . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .249
Are Bank Consolidation and Nationwide Banking Good Things? . . . . . . . . . . . . . . . . . . .249

Separation of the Banking and Other Financial Service Industries . . . . . . . . . . . . . .250
Erosion of Glass-Steagall . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .250
The Gramm-Leach-Bliley Financial Services Modernization Act of 1999:
Repeal of Glass-Steagall . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .251
Implications for Financial Consolidation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .251

Separation of Banking and Other Financial Services Industries Throughout the World . . .251

Thrift Industry: Regulation and Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .252
Savings and Loan Associations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .252
Mutual Savings Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .253
Credit Unions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .253

International Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .253
Eurodollar Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .254

Box 4 Global: Ironic Birth of the Eurodollar Market . . . . . . . . . . . . . . . . . . . . . . .255
Structure of U.S. Banking Overseas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .255
Foreign Banks in the United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .256

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .257
CHAPTER 11

ECONOMIC ANALYSIS OF BANKING REGULATION . . . . . . . . . . . . . . . . . . . . . . .260
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .260
Asymmetric Information and Banking Regulation . . . . . . . . . . . . . . . . . . . . . . . . . .260
Government Safety Net: Deposit Insurance and the FDIC . . . . . . . . . . . . . . . . . . . . . . . .260

Box 1 Global: The Spread of Government Deposit Insurance Throughout
the World: Is This a Good Thing? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .262
Restrictions on Asset Holdings and Bank Capital Requirements . . . . . . . . . . . . . . . . . . . .264
Bank Supervision: Chartering and Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .265

Box 2 Global: Basel 2: Is It Spinning Out of Control? . . . . . . . . . . . . . . . . . . . . . .265
Assessment of Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .267
Disclosure Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .268

Consumer Protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .269
Restrictions on Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .269

Box 3 E-Finance: Electronic Banking: New Challenges for Bank Regulation . . . . .270


Contents
International Banking Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .272
Problems in Regulating International Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .272
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .272

The 1980s U.S. Banking Crisis: Why? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .273
Early Stages of the Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .274
Later Stages of the Crisis: Regulatory Forbearance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .275
Competitive Equality in Banking Act of 1987 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .276

Political Economy of the Savings and Loan Crisis . . . . . . . . . . . . . . . . . . . . . . . . . .276
The Principal–Agent Problem for Regulators and Politicians . . . . . . . . . . . . . . . . . . . . . . .277

Savings and Loan Bailout: The Financial Institutions Reform, Recovery, and
Enforcement Act of 1989 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .278
Federal Deposit Insurance Corporation Improvement Act of 1991 . . . . . . . . . . . . .279
Banking Crises Throughout the World . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .280
Scandinavia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .280
Latin America . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .281
Russia and Eastern Europe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .282
Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .282
East Asia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .284
“Déjà Vu All Over Again” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .284

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .284
CHAPTER 12

NONBANK FINANCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287
Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287
Life Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287
Property and Casualty Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .288
The Competitive Threat from the Banking Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . .290

Application Insurance Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .290
Screening . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .291
Risk-Based Premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .291
Restrictive Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .292
Prevention of Fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .292
Cancellation of Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .292
Deductibles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .292
Coinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .293
Limits on the Amount of Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .293
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .293

Pension Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .294
Private Pension Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .295
Public Pension Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .295

Box 1 Should Social Security Be Privatized? . . . . . . . . . . . . . . . . . . . . . . . . . . . . .296
Finance Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .296
Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .297

xvii

xviii

Contents
Box 2 E-Finance: Mutual Funds and the Internet . . . . . . . . . . . . . . . . . . . . . . . . .298
Money Market Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .299
Hedge Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .299

Box 3 The Long-Term Capital Management Debacle . . . . . . . . . . . . . . . . . . . . . .300
Government Financial Intermediation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .301
Federal Credit Agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .301

Box 4 Are Fannie Mae and Freddie Mac Getting Too Big for Their Britches? . . . .302
Securities Market Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .302
Investment Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .303

Following the Financial News New Securities Issues . . . . . . . . . . . . . . . . . . . . .304
Securities Brokers and Dealers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .304
Organized Exchanges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .305

Box 5 The Return of the Financial Supermarket? . . . . . . . . . . . . . . . . . . . . . . . . .305
Box 6 E-Finance: The Internet Comes to Wall Street . . . . . . . . . . . . . . . . . . . . . . .306
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .306
CHAPTER 13

FINANCIAL DERIVATIVES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .309
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .309
Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .309
Interest-Rate Forward Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .310

Application Hedging with Interest-Rate Forward Contracts . . . . . . . . . . . . . . . .310
Pros and Cons of Forward Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .311

Financial Futures Contracts and Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .311
Following the Financial News Financial Futures . . . . . . . . . . . . . . . . . . . . . . . .312
Application Hedging with Financial Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . .314
Organization of Trading in Financial Futures Markets . . . . . . . . . . . . . . . . . . . . . . . . . . .315
The Globalization of Financial Futures Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .317
Explaining the Success of Futures Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .317

Application Hedging Foreign Exchange Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . .319
Hedging Foreign Exchange Risk with Forward Contracts . . . . . . . . . . . . . . . . . . . . . . . . .319
Hedging Foreign Exchange Risk with Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . . . .320

Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .320
Following the Financial News Futures Options . . . . . . . . . . . . . . . . . . . . . . . . .321
Option Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .322
Profits and Losses on Option and Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . .322

Application Hedging with Futures Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . .325


Contents
Factors Affecting the Prices of Option Premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .326
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .327

Interest-Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .328
Interest-Rate Swap Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .328

Application Hedging with Interest-Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . .329

Advantages of Interest-Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .329
Disadvantages of Interest-Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .330
Financial Intermediaries in Interest-Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .330

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .330

PA RT I V

Central Banking and the Conduct of
Monetary Policy 333
CHAPTER 14

STRUCTURE OF CENTRAL BANKS AND THE FEDERAL RESERVE SYSTEM . . . . . . .335
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .335
Origins of the Federal Reserve System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .335
Box 1 Inside the Fed: The Political Genius of the Founders of the
Federal Reserve System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .336
Formal Structure of the Federal Reserve System . . . . . . . . . . . . . . . . . . . . . . . . . . .336
Federal Reserve Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .337

Box 2 Inside the Fed: The Special Role of the Federal Reserve Bank of
New York . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .339
Member Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .340
Board of Governors of the Federal Reserve System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .340
Federal Open Market Committee (FOMC) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .341

Box 3 Inside the Fed: The Role of the Research Staff . . . . . . . . . . . . . . . . . . . . . . .342
The FOMC Meeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .343

Box 4 Inside the Fed: Green, Blue, and Beige: What Do These Colors Mean

at the Fed? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .344
Informal Structure of the Federal Reserve System . . . . . . . . . . . . . . . . . . . . . . . . . .344
Box 5 Inside the Fed: The Role of Member Banks in the Federal
Reserve System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .346
How Independent Is the Fed? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .346
Structure and Independence of Foreign Central Banks . . . . . . . . . . . . . . . . . . . . . .349
Bank of Canada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .349
Bank of England . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .349
Bank of Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .350
European Central Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .350
The Trend Toward Greater Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .351

Explaining Central Bank Behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .351

xix


xx

Contents
Box 6 Inside the Fed: Federal Reserve Transparency . . . . . . . . . . . . . . . . . . . . . . .352
Should the Fed Be Independent? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .352
The Case for Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .352
The Case Against Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .354
Central Bank Independence and Macroeconomic Performance Throughout the World . . .354

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .355
CHAPTER 15

MULTIPLE DEPOSIT CREATION AND THE MONEY SUPPLY PROCESS . . . . . . . . . .357

Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .357
Four Players in the Money Supply Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .357
The Fed’s Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .358
Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .358
Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .359

Control of the Monetary Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .359
Federal Reserve Open Market Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .359
Shifts from Deposits into Currency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .363

Box 1 Global: Foreign Exchange Rate Intervention and the Monetary Base . . . . .363
Discount Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .364
Other Factors That Affect the Monetary Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .365
Overview of the Fed’s Ability to Control the Monetary Base . . . . . . . . . . . . . . . . . . . . . . .365

Multiple Deposit Creation: A Simple Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .365
Deposit Creation: The Single Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .366
Deposit Creation: The Banking System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .367
Deriving the Formula for Multiple Deposit Creation . . . . . . . . . . . . . . . . . . . . . . . . . . . . .370
Critique of the Simple Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .371

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .372
CHAPTER 16

DETERMINANTS OF THE MONEY SUPPLY . . . . . . . . . . . . . . . . . . . . . . . . . . . . .374
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .374
The Money Supply Model and the Money Multiplier . . . . . . . . . . . . . . . . . . . . . . .375
Deriving the Money Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .375
Intuition Behind the Money Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .377

Factors that Determine the Money Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . .378
Changes in the Required Reserve Ratio r . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .378
Changes in the Currency Ratio c . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .379
Changes in the Excess Reserves Ratio e . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .379

Additional Factors That Determine the Money Supply . . . . . . . . . . . . . . . . . . . . . .381
Changes in the Nonborrowed Monetary Base MBn . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .382
Changes in the Discount Loans DL from the Fed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .382

Overview of the Money Supply Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .383
Application Explaining Movements in the Money Supply, 1980–2002 . . . . . . . .384


Contents
Application The Great Depression Bank Panics, 1930–1933 . . . . . . . . . . . . . . . .387
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .390
CHAPTER 17

TOOLS OF MONETARY POLICY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .393
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .393
The Market for Reserves and the Federal Funds Rate . . . . . . . . . . . . . . . . . . . . . . .393
Supply and Demand in the Market for Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .394
How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate . . . . . . . . . .395

Open Market Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .398
A Day at the Trading Desk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .398
Advantages of Open Market Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .400

Discount Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .400
Operation of the Discount Window . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .401

Lender of Last Resort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .402
Advantages and Disadvantages of Discount Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .403

Reserve Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .403
Box 1 Inside the Fed: Discounting to Prevent a Financial Panic:
The Black Monday Stock Market Crash of 1987 and the Terrorist Destruction
of the World Trade Center in September 2001 . . . . . . . . . . . . . . . . . . . . . . . . . . .404
Advantages and Disadvantages of Reserve Requirement Changes . . . . . . . . . . . . . . . . . . .405

Application Why Have Reserve Requirements Been Declining Worldwide? . . . .406
Application The Channel/Corridor System for Setting Interest Rates in
Other Countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .406
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .408
CHAPTER 18

CONDUCT OF MONETARY POLICY: GOALS AND TARGETS . . . . . . . . . . . . . . . . . .411
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .411
Goals of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .411
High Employment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .411
Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .412
Price Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .412

Box 1 Global: The Growing European Commitment to Price Stability . . . . . . . . .413
Interest-Rate Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .413
Stability of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .413
Stability in Foreign Exchange Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .414
Conflict Among Goals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .414

Central Bank Strategy: Use of Targets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .414
Choosing the Targets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .416

Criteria for Choosing Intermediate Targets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .418
Criteria for Choosing Operating Targets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .419

xxi


xxii

Contents
Fed Policy Procedures: Historical Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . .419
The Early Years: Discount Policy as the Primary Tool . . . . . . . . . . . . . . . . . . . . . . . . . . . .420
Discovery of Open Market Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .420
The Great Depression . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .421

Box 2 Inside the Fed: Bank Panics of 1930–1933: Why Did the Fed Let
Them Happen? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .421
Reserve Requirements as a Policy Tool . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .422
War Finance and the Pegging of Interest Rates: 1942–1951 . . . . . . . . . . . . . . . . . . . . . . .422
Targeting Money Market Conditions: The 1950s and 1960s . . . . . . . . . . . . . . . . . . . . . . .423
Targeting Monetary Aggregates: The 1970s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .424
New Fed Operating Procedures: October 1979–October 1982 . . . . . . . . . . . . . . . . . . . . .425
De-emphasis of Monetary Aggregates: October 1982–Early 1990s . . . . . . . . . . . . . . . . . .426
Federal Funds Targeting Again: Early 1990s and Beyond . . . . . . . . . . . . . . . . . . . . . . . . .427
International Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .427

Box 3 Global: International Policy Coordination: The Plaza Agreement and
the Louvre Accord . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .428
The Taylor Rule, NAIRU, and the Philips Curve . . . . . . . . . . . . . . . . . . . . . . . . . . .428
Box 4 Fed Watching . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .430
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .431

PA RT V

International Finance and Monetary Policy

433

CHAPTER 19

THE FOREIGN EXCHANGE MARKET . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .435
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .435
Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .435
What Are Foreign Exchange Rates? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .436

Following the Financial News Foreign Exchange Rates . . . . . . . . . . . . . . . . . . .437
Why Are Exchange Rates Important? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .438
How Is Foreign Exchange Traded? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .438

Exchange Rates in the Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .439
Law of One Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .439
Theory of Purchasing Power Parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .439
Why the Theory of Purchasing Power Parity Cannot Fully Explain Exchange Rates . . . . .440
Factors That Affect Rates in the Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .441

Exchange Rates in the Short Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .443
Comparing Expected Returns on Domestic and Foreign Deposits . . . . . . . . . . . . . . . . . . .443
Interest Parity Condition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .445
Equilibrium in the Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .446

Explaining Changes in Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .448

Shifts in the Expected-Return Schedule for Foreign Deposits . . . . . . . . . . . . . . . . . . . . . .448
Shifts in the Expected-Return Schedule for Domestic Deposits . . . . . . . . . . . . . . . . . . . . .450


Contents
Application Changes in the Equilibrium Exchange Rate: Two Examples . . . . . .452
Changes in Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .452
Changes in the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .453
Exchange Rate Overshooting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .453

Application Why Are Exchange Rates So Volatile? . . . . . . . . . . . . . . . . . . . . . . .455
Application The Dollar and Interest Rates, 1973–2002 . . . . . . . . . . . . . . . . . . . .455
Application The Euro’s First Four Years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .457
Application Reading the Wall Street Journal: The “Currency Trading” Column .457
Following the Financial News The “Currency Trading” Column . . . . . . . . . . . .458
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .459
CHAPTER 20

THE INTERNATIONAL FINANCIAL SYSTEM . . . . . . . . . . . . . . . . . . . . . . . . . . . . .462
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .462
Intervention in the Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . .462
Foreign Exchange Intervention and the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . .462

Box 1 Inside the Fed: A Day at the Federal Reserve Bank of New York’s
Foreign Exchange Desk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .463
Unsterilized Intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .465
Sterilized Intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .466

Balance of Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .467
Evolution of the International Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . .468

Gold Standard . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .469
Bretton Woods System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .469

Box 2 Global: The Euro’s Challenge to the Dollar . . . . . . . . . . . . . . . . . . . . . . . . .471
Managed Float . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .473
European Monetary System (EMS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .474

Application The Foreign Exchange Crisis of September 1992 . . . . . . . . . . . . . . .475
Application Recent Foreign Exchange Crises in Emerging Market Countries:
Mexico 1994, East Asia 1997, Brazil 1999, and Argentina 2002 . . . . . . . . . . . . . .477
Capital Controls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .478
Controls on Capital Outflows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .478
Controls on Capital Inflows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .479

The Role of the IMF . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .479
Should the IMF Be an International Lender of Last Resort? . . . . . . . . . . . . . . . . . . . . . . . .480

International Considerations and Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . .482
Direct Effects of the Foreign Exchange Market on the Money Supply . . . . . . . . . . . . . . . .482
Balance-of-Payments Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .483
Exchange Rate Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .483

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .484

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Contents

CHAPTER 21

MONETARY POLICY STRATEGY: THE INTERNATIONAL EXPERIENCE . . . . . . . . . . .487
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .487
The Role of a Nominal Anchor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .487
The Time-Consistency Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .488

Exchange-Rate Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .489
Advantages of Exchange-Rate Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .489
Disadvantages of Exchange-Rate Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .490
When Is Exchange-Rate Targeting Desirable for Industrialized Countries? . . . . . . . . . . . .492
When Is Exchange-Rate Targeting Desirable for Emerging Market Countries? . . . . . . . . .492
Currency Boards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .492
Dollarization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .493

Box 1 Global: Argentina’s Currency Board . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .494
Monetary Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .496
Monetary Targeting in Canada, the United Kingdom, Japan, Germany, and Switzerland . . .496

Box 2 Global: The European Central Bank’s Monetary Policy Strategy . . . . . . . . .498
Advantages of Monetary Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .500
Disadvantages of Monetary Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .501

Inflation Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .501
Inflation Targeting in New Zealand, Canada, and the United Kingdom . . . . . . . . . . . . . . .501
Advantages of Inflation Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .504
Disadvantages of Inflation Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .506
Nominal GDP Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .508

Monetary Policy with an Implicit Nominal Anchor . . . . . . . . . . . . . . . . . . . . . . . . .509

Advantages of the Fed’s Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .510
Disadvantages of the Fed’s Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .510

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .512

PA RT V I

Monetary Theory

515

CHAPTER 22

THE DEMAND FOR MONEY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .517
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .517
Quantity Theory of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .517
Velocity of Money and Equation of Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .518
Quantity Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .519
Quantity Theory of Money Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .519

Is Velocity a Constant? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .520
Keynes’s Liquidity Preference Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .521
Transactions Motive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .521
Precautionary Motive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .522
Speculative Motive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .522
Putting the Three Motives Together . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .523

Further Developments in the Keynesian Approach . . . . . . . . . . . . . . . . . . . . . . . . .524
Transactions Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .524

Contents
Precautionary Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .527
Speculative Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .527

Friedman’s Modern Quantity Theory of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . .528
Distinguishing Between the Friedman and Keynesian Theories . . . . . . . . . . . . . . . .530
Empirical Evidence on the Demand for Money . . . . . . . . . . . . . . . . . . . . . . . . . . . .532
Interest Rates and Money Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .533
Stability of Money Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .533

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .533
CHAPTER 23

THE KEYNESIAN FRAMEWORK AND THE ISLM MODEL . . . . . . . . . . . . . . . . . . .536
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .536
Determination of Aggregate Output . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .536
Consumer Expenditure and the Consumption Function . . . . . . . . . . . . . . . . . . . . . . . . . .538
Investment Spending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .539

Box 1 Meaning of the Word Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .540
Equilibrium and the Keynesian Cross Diagram . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .540
Expenditure Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .542

Application The Collapse of Investment Spending and the Great Depression . .545
Government’s Role . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .545
Role of International Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .548
Summary of the Determinants of Aggregate Output . . . . . . . . . . . . . . . . . . . . . . . . . . . . .548

The ISLM Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .551

Equilibrium in the Goods Market: The IS Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .552
Equilibrium in the Market for Money: The LM Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . .555

ISLM Approach to Aggregate Output and Interest Rates . . . . . . . . . . . . . . . . . . . . .557
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .558
CHAPTER 24

MONETARY AND FISCAL POLICY IN THE ISLM MODEL . . . . . . . . . . . . . . . . . . . .561
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .561
Factors That Cause the IS Curve to Shift . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .561
Factors That Cause the LM Curve to Shift . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .564
Changes in Equilibrium Level of the Interest Rate and Aggregate Output . . . . . . . .566
Response to a Change in Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .566
Response to a Change in Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .567

Effectiveness of Monetary Versus Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . .568
Monetary Policy Versus Fiscal Policy: The Case of Complete Crowding Out . . . . . . . . . . .568

Application Targeting Money Supply Versus Interest Rates . . . . . . . . . . . . . . . . .571
ISLM Model in the Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .575
ISLM Model and the Aggregate Demand Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . .577
Deriving the Aggregate Demand Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .577
Factors That Cause the Aggregate Demand Curve to Shift . . . . . . . . . . . . . . . . . . . . . . . .578

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .580

xxv