Finance banking and money v1 1

Finance, Banking, and
Money
v. 1.1


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ii


Table of Contents
About the Authors................................................................................................................. 1
Acknowledgments................................................................................................................. 3
Preface..................................................................................................................................... 4
Chapter 1: Money, Banking, and Your World ................................................................. 5
Dreams Dashed ............................................................................................................................................... 6
Hope Springs .................................................................................................................................................. 9
Suggested Browsing..................................................................................................................................... 11
Suggested Reading ....................................................................................................................................... 12

Chapter 2: The Financial System ..................................................................................... 13

Evil and Brilliant Financiers?...................................................................................................................... 14
Financial Systems......................................................................................................................................... 16
Asymmetric Information: The Real Evil .................................................................................................... 19
Financial Markets......................................................................................................................................... 22
Financial Intermediaries ............................................................................................................................. 26
Competition Between Markets and Intermediaries ................................................................................. 30
Regulation..................................................................................................................................................... 32
Suggested Reading ....................................................................................................................................... 34

Chapter 3: Money ................................................................................................................ 35
Of Love, Money, and Transactional Efficiency .......................................................................................... 36
Better to Have Had Money and Lost It Than to Have Never Had Money at All ..................................... 41
A Short History of Moolah .......................................................................................................................... 44
Commodity and Credit Monies ................................................................................................................... 47
Measuring Money ........................................................................................................................................ 53
Suggested Reading ....................................................................................................................................... 55

Chapter 4: Interest Rates................................................................................................... 56
The Interest of Interest ............................................................................................................................... 57
Present and Future Value............................................................................................................................ 58
Compounding Periods ................................................................................................................................. 64
Pricing Debt Instruments ............................................................................................................................ 66
What’s the Yield on That? ........................................................................................................................... 71
Calculating Returns ..................................................................................................................................... 75
Inflation and Interest Rates ........................................................................................................................ 78
Suggested Reading ....................................................................................................................................... 81

iii

Chapter 5: The Economics of Interest-Rate Fluctuations ........................................... 82
Interest Rate Fluctuations........................................................................................................................... 83
Shifts in Supply and Demand for Bonds .................................................................................................... 87
Liquidity Preference .................................................................................................................................... 95
Predictions and Effects .............................................................................................................................. 100
Suggested Reading ..................................................................................................................................... 103

Chapter 6: The Economics of Interest-Rate Spreads and Yield Curves ................. 104
A Short History of Interest Rates ............................................................................................................. 105
Interest-Rate Determinants I: The Risk Structure.................................................................................. 108
The Determinants of Interest Rates II: The Term Structure ................................................................. 114
Suggested Reading ..................................................................................................................................... 120

Chapter 7: Rational Expectations, Efficient Markets, and the Valuation of
Corporate Equities ............................................................................................................ 121
The Theory of Rational Expectations....................................................................................................... 122
Valuing Corporate Equities ....................................................................................................................... 126
Financial Market Efficiency ...................................................................................................................... 132
Evidence of Market Efficiency .................................................................................................................. 138
Suggested Reading ..................................................................................................................................... 145

Chapter 8: Financial Structure, Transaction Costs, and Asymmetric
Information ........................................................................................................................ 146
The Sources of External Finance .............................................................................................................. 147
Transaction Costs, Asymmetric Information, and the Free-Rider Problem ........................................ 150
Adverse Selection....................................................................................................................................... 154
Moral Hazard .............................................................................................................................................. 160
Agency Problems........................................................................................................................................ 164
Suggested Reading ..................................................................................................................................... 170

Chapter 9: Bank Management ........................................................................................ 171
The Balance Sheet ...................................................................................................................................... 172
Assets, Liabilities, and T-Accounts ........................................................................................................... 175
Bank Management Principles ................................................................................................................... 180
Credit Risk................................................................................................................................................... 190
Interest-Rate Risk ...................................................................................................................................... 194
Off the Balance Sheet................................................................................................................................. 199
Suggested Reading ..................................................................................................................................... 201

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Chapter 10: Innovation and Structure in Banking and Finance ............................. 202
Early Financial Innovations ...................................................................................................................... 203
Innovations Galore..................................................................................................................................... 206
Loophole Mining and Lobbying ................................................................................................................ 209
Banking on Technology............................................................................................................................. 212
Banking Industry Profitability and Structure......................................................................................... 216
Suggested Reading ..................................................................................................................................... 224

Chapter 11: The Economics of Financial Regulation ................................................. 225
Public Interest versus Private Interest .................................................................................................... 226
The Great Depression as Regulatory Failure ........................................................................................... 230
The Savings and Loan Regulatory Debacle.............................................................................................. 235
Better but Still Not Good: U.S. Regulatory Reforms ............................................................................... 240
Basel II’s Third Pillar.................................................................................................................................. 243
Suggested Reading ..................................................................................................................................... 248

Chapter 12: The Financial Crisis of 2007–2009 ........................................................... 249
Financial Crises .......................................................................................................................................... 250

Asset Bubbles.............................................................................................................................................. 253
Financial Panics.......................................................................................................................................... 257
Lender of Last Resort ................................................................................................................................. 260
Bailouts........................................................................................................................................................ 263
The Crisis of 2007–2008 ............................................................................................................................. 265
Suggested Reading ..................................................................................................................................... 271

Chapter 13: Central Bank Form and Function ............................................................ 272
America’s Central Banks ........................................................................................................................... 273
The Federal Reserve System’s Structure ................................................................................................. 277
Other Important Central Banks................................................................................................................ 280
Central Bank Independence...................................................................................................................... 282
Suggested Reading ..................................................................................................................................... 286

Chapter 14: The Money Supply Process ....................................................................... 287
The Central Bank’s Balance Sheet ............................................................................................................ 288
Open Market Operations ........................................................................................................................... 290
A Simple Model of Multiple Deposit Creation......................................................................................... 295
Suggested Reading ..................................................................................................................................... 300

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Chapter 15: The Money Supply and the Money Multiplier ...................................... 301
A More Sophisticated Money Multiplier for M1 ..................................................................................... 302
The M2 Money Multiplier ......................................................................................................................... 310
Summary and Explanation........................................................................................................................ 313
Suggested Reading ..................................................................................................................................... 316

Chapter 16: Monetary Policy Tools ............................................................................... 317

The Federal Funds Market and Reserves................................................................................................. 318
Open Market Operations and the Discount Window.............................................................................. 323
The Monetary Policy Tools of Other Central Banks ............................................................................... 327
Suggested Reading ..................................................................................................................................... 329

Chapter 17: Monetary Policy Targets and Goals ........................................................ 330
A Short History of Fed Blunders............................................................................................................... 331
Central Bank Goal Trade-offs.................................................................................................................... 336
Central Bank Targets ................................................................................................................................. 338
The Taylor Rule .......................................................................................................................................... 342
Suggested Reading ..................................................................................................................................... 347

Chapter 18: Foreign Exchange........................................................................................ 348
The Economic Importance of Currency Markets.................................................................................... 349
Determining the Exchange Rate............................................................................................................... 352
Long-Run Determinants of Exchange Rates ............................................................................................ 356
Short-Run Determinants of Exchange Rates........................................................................................... 360
Modeling the Market for Foreign Exchange ........................................................................................... 368
Suggested Reading ..................................................................................................................................... 372

Chapter 19: International Monetary Regimes ............................................................ 373
The Trilemma, or Impossible Trinity....................................................................................................... 374
Two Systems of Fixed Exchange Rates..................................................................................................... 378
The Managed or Dirty Float ...................................................................................................................... 382
The Choice of International Policy Regime ............................................................................................. 387
Suggested Reading ..................................................................................................................................... 393

Chapter 20: Money Demand............................................................................................ 394
The Quantity Theory.................................................................................................................................. 395
Liquidity Preference Theory..................................................................................................................... 399

Head to Head: Friedman versus Keynes .................................................................................................. 403
Suggested Reading ..................................................................................................................................... 409

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Chapter 21: IS-LM.............................................................................................................. 410
Aggregate Output and Keynesian Cross Diagrams ................................................................................. 411
The IS-LM Model ........................................................................................................................................ 420
Suggested Reading ..................................................................................................................................... 426

Chapter 22: IS-LM in Action............................................................................................ 427
Shifting Curves: Causes and Effects.......................................................................................................... 428
Implications for Monetary Policy............................................................................................................. 432
Aggregate Demand Curve.......................................................................................................................... 435
Suggested Reading ..................................................................................................................................... 437

Chapter 23: Aggregate Supply and Demand, the Growth Diamond, and Financial
Shocks.................................................................................................................................. 438
Aggregate Demand..................................................................................................................................... 439
Aggregate Supply ....................................................................................................................................... 442
Equilibrium Analysis.................................................................................................................................. 445
The Growth Diamond................................................................................................................................. 449
Financial Shocks......................................................................................................................................... 454
Suggested Reading ..................................................................................................................................... 459

Chapter 24: Monetary Policy Transmission Mechanisms ........................................ 460
Modeling Reality ........................................................................................................................................ 461
How Important Is Monetary Policy? ........................................................................................................ 465
Transmission Mechanisms........................................................................................................................ 468

Suggested Reading ..................................................................................................................................... 473

Chapter 25: Inflation and Money................................................................................... 474
Empirical Evidence of a Money-Inflation Link ....................................................................................... 475
Why Have Central Bankers So Often Gotten It Wrong? ......................................................................... 481
Suggested Reading ..................................................................................................................................... 485

Chapter 26: Rational Expectations Redux: Monetary Policy Implications ........... 486
Rational Expectations ................................................................................................................................ 487
New Keynesians.......................................................................................................................................... 490
Inflation Busting ........................................................................................................................................ 493
Suggested Reading ..................................................................................................................................... 496

vii


About the Authors
About Robert E. Wright
I attribute my enduring interest in money and banking, political economy, and
economic history to the troubled economic conditions of my youth. Born in 1969 in
Rochester, New York, to two self-proclaimed factory rats, I recall little of my
earliest days except the Great Inflation and oil embargo, which stretched the family
budget past the breaking point. My only other noneconomic memories are of the
Planet of the Apes films (all five of them!) and the 1972 Olympics massacre in Munich;
my very young mind conflated the two because of the aural similarity of the words
gorilla and guerilla. The recession in the early 1980s also injured my family’s material
welfare and was seared into my brain.
After taking degrees in history from Buffalo State College (B.A., 1990) and the
University of Buffalo (M.A., 1994; Ph.D., 1997), I began teaching a variety of courses
in business, economics, evolutionary psychology, finance, history, and sociology at

a variety of schools until 2009, when I became the Nef Family Chair of Political
Economy at Augustana College in Sioux Falls, South Dakota. I’ve also been an active
researcher, editing, authoring, and co-authoring books about the development of
the U.S. financial system (Origins of Commercial Banking, Hamilton Unbound, Wealth of
Nations Rediscovered, The First Wall Street, Financial Founding Fathers, One Nation Under
Debt), construction economics (Broken Buildings, Busted Budgets), life insurance
(Mutually Beneficial), and publishing (Knowledge for Generations). Due to my unique
historical perspective on public policies and the financial system, I’ve also become
something of a media maven, showing up on NPR and other radio shows, as well as
various television programs, and getting quoted in major newspapers like the Wall
Street Journal, New York Times, Chicago Tribune, and the Los Angeles Times. I publish opeds and make regular public speaking appearances nationally and, increasingly,
internationally, and I serve as director of the Thomas Willing Institute for the Study
of Financial Markets, Institutions and Regulations
I wrote this textbook because I strongly believe in the merits of financial literacy for
all. Our financial system struggles sometimes in part because so many people
remain feckless financially. My hope is that people who read this book carefully,
dutifully complete the exercises, and attend class regularly will be able to follow the
financial news and even critique it when necessary. I also hope they will make
informed choices in their own financial lives.

1


About the Authors

About Dr. Vincenzo Quadrini
I was born and raised in a small town in the Marche region in Italy. In 1990 I
received a B.A. in Economics and Business from Ancona University and in 1991 a
one-year Master in Economics from Coripe-Piemonte in Turin. After fulfilling a oneyear mandatory military service between 1991 and 1992, I moved to the United
States to start my Ph.D. in Economics at the University of Pennsylvania, where I

graduated in 1996. Since my Ph.D. graduation I have been teaching at several
institutions: Pompeu Fabra University in Barcelona, Duke University, New York
University, and University of Southern California. I have been teaching courses on
monetary economics, macroeconomics, international trade, and international
finance. My research interests are in similar topics, and since my graduation in 1996
I have published several articles in scholarly journals including American Economic
Review, Journal of Monetary Economics, Journal of Political Economy, and Review of
Economic Studies.
My current research projects focus on the macroeconomic impact of credit and
financial shocks similar to the ones that are currently affecting the U.S. economy. I
am also interested in understanding how these shocks are propagated
internationally to other economies. Another research interest focuses on the
understanding of how differences in financial markets across countries can lead to
large financial imbalances, that is, a situation in which some countries, like the
United States, borrow heavily from other countries like China and Japan.

2


Acknowledgments
Many people have helped to make this project a reality. At Unnamed Publisher,
Shannon Gattens and Jeff Shelstad helped to shepherd the concept and the
manuscript through the standard trials and tribulations. Along the way, a score of
anonymous academic readers helped to keep our economic analyses and prose on
the straight and narrow. Paul Wachtel and Richard Sylla, two colleagues at New
York University’s Stern School of Business, also aided us along the way with
measured doses of praise and criticism. We thank them all. Thanks too to the
University of Virginia’s Department of Economics, especially the duo of economic
historians and “money guys” there, Ron Michener and John James, for putting up
with Wright one very hot summer in Charlottesville. Very special thanks go to the

members of Wright’s Summer I 2007 Money and Banking class at the University of
Virginia, who suffered through a free but error-prone first draft, mostly with good
humor and always with helpful comments: Kevin Albrecht, Adil Arora, Eric Bagden,
Michelle Coffey, Timothy Dalbey, Karina Delgadillo, Christopher Gorham, Joshua
Hefner, Joseph Henderson, Jamie Jackson, Anthony Jones, Robert Jones, Risto
Keravuori, Heather Koo, Sonia Kwak, Yiding Li, Patrick Lundquist, Maria McLemore,
Brett Murphy, Daniel Park, Bensille Parker, Rose Phan, Patrick Reams, Arjun
Sharma, Cole Smith, Sandy Su, Paul Sullivan, Nedim Umur, Will van der Linde, Neal
Wood, and June Yang. The students and professors who provided feedback on
version 1.0 of this book also have our hearty gratitude.
It’s customary at this point for authors to assume full responsibility for the facts
and judgments in their books. We will not buck that tradition: the buck stops here!
Unlike a journal article or academic monograph, textbooks afford ample room for
revision in subsequent editions, of which we hope there will be many. So if you spot
a problem, contact the publisher and we’ll fix it at the earliest (economically
justifiable) opportunity.
Robert E. Wright, January 2011, Sioux Falls, South Dakota.
Vincenzo Quadrini, February 2009, Los Angeles, California

3


Preface
“Dad,” my kids regularly ask me, “why do you write such boring books?” They then
giggle and run away before I have a chance to tickle them to tears. They are still too
young to realize that boring, like beauty, is in the eye of the beholder. The financial
crisis of 2007–2008 has made the study of money and banking almost as exciting as
sex, drugs, and rock ’n’ roll because it has made clear to all observers just how
important the financial system is to our well-being. This is the first textbook to
examine that crisis and its aftermath, including the regulatory reform passed in July

2010 commonly called the Dodd-Frank Wall Street Reform and Consumer Protection
Act. This book is also exciting, or at least not boring, because of the writing style we
have employed. Numerous humorous links are provided and slang terms are
peppered throughout. Seemingly complex subjects like money, interest rates,
banking, financial regulation, and the money supply are treated in short, snappy
sections, not longwinded treatises. Yet we have sacrificed little in the way of
analytical rigor.
This book is designed to help you internalize the basics of money and banking. There
is a little math, some graphs, and some sophisticated vocabulary, but nothing
terribly difficult, if you put your brain to it. The text’s most important goal is to get
you to think for yourselves. To fulfill that goal, each section begins with one or
more questions, called Learning Objectives, and ends with Key Takeaways that
provide short answers to the questions and smartly summarize the section in a few
bullet points. Most sections also contain a sidebar called Stop and Think. Rather
than ask you to simply repeat information given in the chapter discussion, the Stop
and Think sidebars require that you apply what you (should have) learned in the
chapter to a novel situation. You won’t get them all correct, but that isn’t the point.
The point is to stretch your brain. Where appropriate, the book also drills you on
specific skills, like calculating bond prices. Key terms and chapter-level objectives
also help you to navigate and master the subject matter. The book is deliberately
short and right to the point. If you hunger for more, read one or more of the books
listed in the Suggested Reading section at the end of each chapter. Keep in mind,
however, that the goal is to internalize, not to memorize. Allow this book to inform
your view of the world and you will be the better for it, and so will your loved ones.

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Chapter 1
Money, Banking, and Your World

CHAPTER OBJECTIVES
By the end of this chapter, students should be able to:
1. Describe how ignorance of the principles of money and banking has
injured the lives of everyday people.
2. Describe how understanding the principles of money and banking has
enhanced the lives of everyday people.
3. Explain how bankers can simultaneously be entrepreneurs and lend to
entrepreneurs.

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Chapter 1 Money, Banking, and Your World

1.1 Dreams Dashed
LEARNING OBJECTIVE
1. How can ignorance of the principles of money and banking destroy your
dreams?

At 28, Ben is in his prime. Although tall, dark, and handsome enough to be a movie
star, Ben’s real passion is culinary, not thespian. Nothing pleases him more than
applying what he learned earning his degrees in hospitality and nutrition to
prepare delicious yet healthy appetizers, entrees, and desserts for restaurant-goers.
He chafes, therefore, when the owner of the restaurant for which he works forces
him to use cheaper, but less nutritional, ingredients in his recipes. Ben wants to be
his own boss and thinks he sees a demand for his style of tasty, healthy cuisine.
Trouble is, Ben, like most people, came from humble roots. He doesn’t have enough
money to start his own restaurant, and he’s having difficulty borrowing what he
needs because of some youthful indiscretions concerning money. If Ben is right, and
he can obtain financing, his restaurant could become a chain that might

revolutionize America’s eating habits, rendering Eric Schlosser’s exposé of the U.S.
retail food industry, Fast Food Nation (2001),www.amazon.com/Fast-Food-NationEric-Schlosser/dp/0060838582/sr=8-1/qid=1168386508/ref=pd_bbs_sr_1/
104-9795105-9365527?ie=UTF8&s=books as obsolete as The Jungle
(1901), />Literature/Sinclair/TheJungle/ Upton Sinclair’s infamous description of the
disgusting side of the early meatpacking industry. If Ben can get some financial help
but is wrong about Americans preferring natural ingredients to hydrogenized this
and polysaturated that, he will have wasted his time and his financial backers may
lose some money. If he cannot obtain financing, however, the world will never know
whether his idea was a good one or not. Ben’s a good guy, so he probably won’t turn to
drugs and crime but his life will be less fulfilling, and Americans less healthy, if he
never has a chance to pursue his dream.
1. A mortgage with periodic
payments lower than what
would be required to pay the
interest on the loan. Instead of
declining over time, the
principal owed increases as
unpaid interest is added to it.
2. A principal payment due in a
large lump sum, usually at the
end of the loan period.

Married for a decade, Rose and Joe also had a dream, the American Dream, a huge
house with a big, beautiful yard in a great neighborhood. The couple could not
really afford such a home, but they found a lender that offered them low monthly
payments. It seemed too good to be true because it was. Rose and Joe unwittingly agreed
to a negative amortization mortgage1 with a balloon payment2. Their monthly
payments were so low because they paid just part of the interest due each year and
none of the (growing) principal. When housing prices in their area began to slide
downward, the lender foreclosed, although they had never missed a payment. They

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Chapter 1 Money, Banking, and Your World

lost their home and, worse, their credit. The couple now rents a small apartment
and harbors a deep mistrust of the financial system.
Rob and Barb had a more modest dream of a nice house in a good location with
many conveniences, a low crime rate, and a decent public school system. They
found a suitable home, had their offer accepted, and obtained a conventional thirtyyear mortgage. But they too discovered that their ignorance of the financial system
came with a price when they had difficulty selling their old house. They put it up
for sale just as the Federal Reserve, America’s
central bank (monetary authority), decided to raise the interest rate3 because the
economy, including the housing market, was too hot (growing too quickly),
portending a higher price level across the economy (inflation). Higher interest
meant it was more expensive to borrow money to buy a house (or anything else for
that matter). To compensate, buyers decreased the amount they were willing to
offer and in some cases stopped looking for a new home entirely. Unable to pay the
mortgage on both houses, Rob and Barb eventually sold their old house for much
less than they had hoped. The plasma TV, new carpeting, playground set in the
yard, sit-down mower, and other goods they planned to buy evaporated. That may
have been good for the economy by keeping inflation in check, but Rob and Barb, like Rose,
Joe, and Ben, wished they knew more about the economics of money, banking, and interest
rates.
Samantha too wished that she knew more about the financial system, particularly
foreign exchange4. Sam, as her friends called her, had grown up in Indiana, where
she developed a vague sense that people in other countries use money that is
somehow different from the U.S. dollar. But she never gave the matter much
thought, until she spent a year in France as an exchange student. With only $15,000

in her budget, she knew that things would be tight. As the dollar depreciated (lost
value) vis-à-vis France’s currency, the euro, she found that she had to pay more and
more dollars to buy each euro. Poor Sam ran through her budget in six months.
Unable to obtain employment in France, she returned home embittered, her
conversational French still vibrating with her Indiana twang.

3. The price of borrowed money.
4. Buying and selling of foreign
currencies, for example, the
British pound, the Japanese
yen, and the European Union’s
euro.

1.1 Dreams Dashed

Jorge would have been a rich man today if his father had not invested his inheritance in U.S.
government bonds in the late 1960s. The Treasury promptly paid the interest
contractually due on those bonds, but high rates of inflation and interest in the
1970s and early 1980s reduced their prices and wiped out most of their purchasing
power. Instead of inheriting a fortune, Jorge received barely enough to buy a
midsized automobile. That his father had worked so long and so hard for so little
saddened Jorge. If only his father had understood a few simple facts: when the
supply of money increases faster than the demand for it, prices rise and inflation
ensues. When inflation increases, so too do nominal interest rates. And when
interest rates rise, the prices of bonds (and many other types of assets that pay

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Chapter 1 Money, Banking, and Your World

fixed sums) fall. Jorge’s father didn’t lack intelligence, and he wasn’t even atypical.
Many people, even some otherwise well-educated ones, do not understand the
basics of money, banking, and finance. And they and their loved ones pay for it,
sometimes dearly.
Madison knows that all too well. Her grandparents didn’t understand the
importance of portfolio diversification (the tried-and-true rule that you shouldn’t
put all of your eggs in one basket), so they invested their entire life savings in a
single company, Enron.www.riskglossary.com/link/enron.htm They lost everything
(except their Social Security checks)www.ssa.gov/ after that bloated behemoth
went bankrupt in December 2001. Instead of lavishing her with gifts, Madison’s
grandparents drained resources away from their granddaughter by constantly
seeking handouts from Madison’s parents. When the grandparents died—without
life insurance5, yet another misstep—Madison’s parents had to pay big bucks for
their “final expenses.”www.fincalc.com/ins_03.asp?id=6

Stop and Think Box
History textbooks often portray the American Revolution as a rebellion against
unjust taxation, but the colonists of British North America had other, more
important grievances. For example, British imperial policies set in London
made it difficult for the colonists to control the supply of money or interest
rates. When money became scarce, as it often did, interest rates increased
dramatically, which in turn caused the value of colonists’ homes, farms, and
other real estate to decrease quickly and steeply. As a consequence, many lost
their property in court proceedings and some even ended up in special debtors’
prisons. Why do history books fail to discuss this important monetary cause of
the American Revolution?
Most historians, like many people, generally do not fully understand the
principles of money and banking.

KEY TAKEAWAY

5. A contract that promises to pay
a sum of money to
beneficiaries upon the death of
an insured person.

1.1 Dreams Dashed

• People who understand the principles of money and banking are more
likely to lead happy, successful, fulfilling lives than those who remain
ignorant about them.

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Chapter 1 Money, Banking, and Your World

1.2 Hope Springs
LEARNING OBJECTIVE
1. How can knowledge of the principles of money and banking help you to
achieve your dreams?

Of course, sometimes things go right, especially when one knows what one is doing.
Henry Kaufman,www.theglobalist.com/AuthorBiography.aspx?AuthorId=126 who
as a young Jewish boy fled Nazi persecution in the 1930s, is now a billionaire
because he understood what made interest rates (and as we’ll see, by extension, the
prices of all sorts of financial instruments) rise and fall. A little later, another
immigrant from Central Europe, George Soros, made a large fortune correctly
predicting changes in exchange rates6.www.georgesoros.com/ Millions of other

individuals have improved their lot in life (though most not as much as Kaufman and Soros!)
by making astute life decisions informed by knowledge of the economics of money and
banking. Your instructor and I cannot guarantee you riches and fame, but we can
assure you that, if you read this book carefully, attend class dutifully, and study
hard, your life will be the better for it.
The study of money and banking can be a daunting one for students. Seemingly
familiar terms here take on new meanings. Derivatives refer not to calculus (though
calculus helps to calculate their value) but to financial instruments for trading
risks. Interest is not necessarily interesting; stocks are not alive nor are they
holding places for criminals; zeroes can be quite valuable; CDs don’t contain music;
yield curves are sometimes straight lines; and the principal is a sum of money or an
owner, not the administrative head of a high school. In finance, unlike in retail or
publishing, returns are a good thing. Military-style acronyms and jargon also abound:
4X, A/I, Basel II, B.I.G., CAMELS, CRA, DIDMCA, FIRREA, GDP, IMF, LIBOR, m,
NASDAQ, NCD, NOW, OTS, r, SOX, TIPS, TRAPS, and on and on.www.acronymguide.com/financial-acronyms.html; />
6. The price of one currency in
terms of another.

People who learn this strange new language and who learn to think like a banker
(or other type of financier) will be rewarded many times over in their personal
lives, business careers, and civic life. They will make better personal decisions, run their
businesses or departments more efficiently, and be better-informed citizens. Whether they
seek to climb the corporate ladder or start their own companies, they will discover
that interest, inflation, and foreign exchange rates are as important to success as
are cell phones, computers, and soft people skills. And a few will find a career in

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Chapter 1 Money, Banking, and Your World

banking to be lucrative and fulfilling. Some, eager for a challenging and rewarding
career, will try to start their own banks from scratch. And they will be able to do so,
provided they are good enough to pass muster with investors and with government
regulators charged with keeping the financial system, one of the most important
sectors of the economy, safe and sound.
One last thing. This book is about Western financial systems, not Islamic ones.
Islamic finance performs the same functions as Western finance but tries to do so in
a way that is sharia-compliant, or, in other words, a way that accords with the
teachings of the Quran and its modern interpreters, who frown upon interest. To
learn more about Islamic finance, which is currently growing and developing very
rapidly, you can refer to one of the books listed in Suggested Readings.

Stop and Think Box
Gaining regulatory approval for a new bank has become so treacherous that
consulting firms specializing in helping potential incorporators to navigate
regulator-infested waters have arisen and some, like
Nubank,www.nubank.com/ have thrived. Why are regulations so stringent,
especially for new banks? Why do people bother to form new banks if it is so
difficult?
Banking is such a complex and important part of the economy that the
government cannot allow anyone to do it. For similar reasons, it cannot allow
just anyone to perform surgery or fly a commercial airliner. People run the
regulatory gauntlet because establishing a new bank can be extremely
profitable and exciting.

KEY TAKEAWAY
• Not everyone will, or can, grow as wealthy as Henry Kaufman, George
Soros, and other storied financiers, but everyone can improve their lives
by understanding the financial system and their roles in it.

1.2 Hope Springs

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Chapter 1 Money, Banking, and Your World

1.3 Suggested Browsing
Financial Literacy Foundation: />The FLF “is a nonprofit organization created to address the growing problem of
financial illiteracy among young consumers.” Similar organizations include the
Community Foundation for Financial Literacy
() and the Institute for Financial
Literacy ( />
Museum of American Finance: />In addition to its Web site and its stunning new physical space at the corner of
William and Wall in Manhattan’s financial district, the Museum of American
Finance publishes a financial history magazine. One of this book’s authors (Wright)
sits on the editorial board.

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Chapter 1 Money, Banking, and Your World

1.4 Suggested Reading

Ayub, Muhammed. Understanding Islamic Finance. Hoboken, NJ: John Wiley and Sons,
2008.
El-Gamal, Mahmoud. Islamic Finance: Law, Economics, and Practice. New York:
Cambridge University Press, 2008.

Kaufman, Henry. On Money and Markets: A Wall Street Memoir. New York: McGraw Hill,
2001.
Soros, George. Soros on Soros: Staying Ahead of the Curve. Hoboken, NJ: John Wiley and
Sons, 1995.

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Chapter 2
The Financial System
CHAPTER OBJECTIVES
By the end of this chapter, students should be able to:
1.
2.
3.
4.
5.
6.
7.
8.
9.

Critique cultural stereotypes of financiers.
Describe the financial system and the work that it performs.
Define asymmetric information and sketch the problems that it causes.
List the major types of financial markets and describe what
distinguishes them.
List the major types of financial instruments or securities and describe
what distinguishes them.
List the major types of intermediaries and describe what distinguishes

them.
Describe and explain the most important trade-offs facing investors.
Describe and explain borrowers’ major concerns.
Explain the functions of financial regulators.

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