Money banking and financial markets 2nd by ball 2013

www.downloadslide.com


www.downloadslide.com

This page was intentionally left blank


www.downloadslide.com

Money, Banking, and Financial Markets


www.downloadslide.com

The building on this book’s cover is the Second Bank of the United States, located in
Philadelphia. It operated from 1816 to 1836, serving some of the functions of the modern
Federal Reserve. President Andrew Jackson vetoed legislation to extend the Bank’s charter
because he believed it served “moneyed interests” at the expense of common people (see
Chapter 8).
To the right of the Second Bank, the central photo shows a specialist (in a blue coat) and
traders at work on the floor of the New York Stock Exchange (see Chapter 5). They are
flanked by two currencies. At the top is a gold certificate, a type of money used in the United
States in the late nineteenth and early twentieth centuries (see Chapter 2); at the bottom are
Japanese yen.


www.downloadslide.com

SECOND EDITION

Money, Banking, and Financial Markets

Laurence M. Ball
Johns Hopkins University

WORTH PUBLISHERS


www.downloadslide.com

Senior Publisher: Catherine Woods
Executive Editor: Charles Linsmeier
Senior Acquisitions Editor: Sarah Dorger
Executive Marketing Manager: Scott Guile
Senior Development Editor: Marie McHale
Development Editor: Barbara Brooks
Associate Media Editor: Jaclyn Castaldo
Editorial Assistant: Mary Walsh
Associate Managing Editor: Tracey Kuehn
Project Editor: Kerry O’Shaughnessy
Photo Editor: Cecilia Varas
Photo Researcher: Julie Tesser
Art Director: Babs Reingold
Senior Designer, Cover Designer: Kevin Kall
Production Manager: Barbara Anne Seixas
Composition: MPS Limited, a Macmillan Company
Printing and Binding: Quad Graphics, Versailles
Cover Photos: Second Bank of the United States PHILADELPHIA USA: © Aflo Co. Ltd./
Alamy; Stock brokers: AP Photo/Richard Drew; Gold certificate and gold coins:
© Corbis Premium RF/Alamy

Library of Congress Control Number: 2011920626
ISBN-13: 978-1-4292-4409-1
ISBN-10: 1-4292-4409-7
© 2009, 2012 by Worth Publishers
All rights reserved
Printed in the United States of America
First printing 2011
Worth Publishers
41 Madison Avenue
New York, NY 10010
www.worthpublishers.com
www.wortheconomics.com


www.downloadslide.com

Laurence Ball

is Professor of Economics at Johns Hopkins

University. He holds a Ph.D. in economics from the Massachusetts
Institute of Technology and a B.A. in economics from Amherst
College. Professor Ball is a Research Associate of the National
Bureau of Economic Research and has been a visiting scholar at the
Federal Reserve, the Bank of Japan, the Central Bank of Norway,
the Reserve Bank of Australia, and the Hong Kong Monetary
Authority. His academic honors include the Houblon-Norman
Fellowship (Bank of England), a Professorial Fellowship in Monetary
Economics (Victoria University of Wellington and Reserve Bank of
New Zealand), the NBER Olin Fellowship, and the Alfred P. Sloan

Research Fellowship. He is the coauthor with N. Gregory Mankiw of

Macroeconomics and the Financial System (Worth Publishers).
Professor Ball lives in Baltimore with his wife, Patricia, and their son,
Leverett.


www.downloadslide.com

To Patricia


www.downloadslide.com
CONTENTS

| vii

brief contents

Preface xxv
Supplements and Media xxxiii
PART I FOUNDATIONS
1 The Financial System 1
2 Money and Central Banks 25
PART II FINANCIAL MARKETS
3 Asset Prices and Interest Rates 53
4 What Determines Interest Rates? 85
5 Securities Markets 121
6 Foreign Exchange Markets 157
PART III BANKING

7 Asymmetric Information in the Financial
System 189
8 The Banking Industry 221
9 The Business of Banking 253
10 Bank Regulation 285
PART IV MONEY AND THE ECONOMY
11 The Money Supply and Interest Rates 315
12 Short-Run Economic Fluctuations 347
13 Economic Fluctuations, Monetary Policy,
and the Financial System 389
14 Inflation and Deflation 419
PART V MONETARY POLICY
15 Policies for Economic Stability 451
16 Monetary Institutions and Strategies 483
17 Monetary Policy and Exchange Rates 519
18 Financial Crises 551
Glossary G-1
Index I-1

| vii


www.downloadslide.com

This page intentionally left blank


www.downloadslide.com
CONTENTS

| ix

contents
Preface xxv
Supplements and Media xxxiii

indicates coverage of financial crises.

PART I FOUNDATIONS
Chapter 1 The Financial System 1
1.1 Financial Markets 2
Bonds 2
Stocks 3

1.2 Economic Functions of Financial Markets 4
Matching Savers and Investors 4
Risk Sharing 5
CASE STUDY: The Perils of Employee Stock Ownership 6

1.3 Asymmetric Information 7
Adverse Selection 8
Moral Hazard 9

1.4 Banks 10
What Is a Bank? 10
Banks Versus Financial Markets 11
Why Banks Exist 12

1.5 The Financial System and Economic Growth 13
Saving and Economic Growth 13

The Allocation of Saving 14
Evidence on the Financial System and Growth 14
CASE STUDY: Unit Banking and Economic Growth 16
CASE STUDY: Microfinance 17

Markets Versus Central Planning 19

Online Case Study
An Update on Microfinance

CASE STUDY: Investment in the Soviet Union 19

1.6 Financial Crises 21
Summary 21
Key Terms 22
Questions and Problems 23
Appendix: Measuring Output and the Price Level 24

| ix


www.downloadslide.com

x | CONTENTS

Chapter 2 Money and Central Banks 25
2.1 What Is Money? 26
The Medium of Exchange 26
Money Versus Barter 27
CASE STUDY: Nineteenth-Century Visitors to Barter Economies 28

The Unit of Account 28
A Store of Value 29

2.2 Types of Money 29
Commodity Money 30
Fiat Money 31
From Commodity Money to Fiat Money 32
CASE STUDY: The History of the U.S. Dollar 32
Online Case Study
Alternative Currencies
in the United States

Alternatives to a National Currency 34
CASE STUDY: Clean and Dirty Money 36

2.3 Money Today 37
Measuring the Money Supply: M1 37
How We Spend Money 37
What About Credit Cards? 39
The Payments System 39
New Kinds of Money 41

2.4 Liquidity and Broad Money 42
The Need for Liquidity 42
Degrees of Liquidity 43
Measuring Broad Money: M2 44
CASE STUDY: Sweep Programs 45

2.5 Functions of Central Banks 47

Clearing Payments 47
Monetary Policy 47
Emergency Lending 47
Financial Regulation 47
CASE STUDY: The Fed and September 11 48
2.6 The Rest of This Book 49

Financial Markets 49
Banking 49
Money and the Economy 50
Monetary Policy 50

Summary 50
Key Terms 51
Questions and Problems 52


www.downloadslide.com
CONTENTS

PART II FINANCIAL MARKETS
Chapter 3 Asset Prices and Interest Rates 53
3.1 Valuing Income Streams 54
Future Value 54
Present Value 54

3.2 The Classical Theory of Asset Prices 57
The Present Value of Income 57
What Determines Expectations? 59
What Is the Relevant Interest Rate? 59

The Gordon Growth Model of Stock Prices 60

3.3 Fluctuations in Asset Prices 61
Why Do Asset Prices Change? 61
CASE STUDY: The Fed and the Stock Market 62

Which Asset Prices Are Most Volatile? 63

3.4 Asset-Price Bubbles 64
How Bubbles Work 65
CASE STUDY: Tulipmania 66

Looking for Bubbles 66
CASE STUDY: The U.S. Stock Market, 1990–2010 68

3.5 Asset-Price Crashes 70
How Crashes Work 71
CASE STUDY: The Two Big Crashes 71

Crash Prevention 73

3.6 Measuring Interest Rates and Asset Returns 73
Yield to Maturity 74
The Rate of Return 75
Returns on Stocks and Bonds 76
Rate of Return Versus Yield to Maturity 76

3.7 Real and Nominal Interest Rates 77
Real Interest Rates: Ex Ante Versus Ex Post 78
CASE STUDY: Inflation and the Savings and Loan Crisis 79

Inflation-Indexed Bonds 80

Summary 81
Key Terms 82
Questions and Problems 82

Online Case Study
An Update on the
Stock Market

| xi


www.downloadslide.com

xii | C O N T E N T S

Chapter 4 What Determines Interest Rates? 85
4.1 The Loanable Funds Theory 86
Saving, Investment, and Capital Flows 87
Effects of the Real Interest Rate 88
The Equilibrium Real Interest Rate 89

4.2 Determinants of Interest Rates in the Loanable Funds Theory 91
Shifts in Investment 91
Shifts in Saving 93
CASE STUDY: Budget Deficits and Interest Rates 95

Shifts in Capital Flows 96

Nominal Interest Rates 97

4.3 The Liquidity Preference Theory 99
The Market for Money 100
The Equilibrium Interest Rate 100
Changes in Interest Rates 101
Relating the Two Theories of Interest Rates 104

4.4 The Term Structure of Interest Rates 104
The Term Structure Under Certainty 104
The Expectations Theory of the Term Structure 106
Accounting for Risk 107
The Yield Curve 108
CASE STUDY: Some Historical Examples of Yield Curves 110

4.5 Default Risk and Interest Rates 111
Default Risk on Sovereign Debt 112
Online Case Study
An Update on
European Debt

CASE STUDY: Greece’s Debt Crisis 113

Default Risk on Corporate Debt 114
CASE STUDY: The High-Yield Spread 115
4.6 Two Other Factors 117

Liquidity 117
Taxes 117

Summary 118
Key Terms 119
Questions and Problems 119

Chapter 5 Securities Markets 121
5.1 Participants in Securities Markets 122
Individual Owners 122
Securities Firms 123
Other Financial Institutions 124
Financial Industry Consolidation 125


www.downloadslide.com
CONTENTS

CASE STUDY: The Upheaval in Investment Banking 125

5.2 Stock and Bond Markets 127
Primary Markets 127
CASE STUDY: Treasury Bill Auctions 129

Secondary Markets 130
Finding Information on Security Prices 132

5.3 Capital Structure: What Securities Should Firms Issue? 133
Is Capital Structure Irrelevant? 134
Why Capital Structure Does Matter 134
Debt Maturity 135

5.4 Asset Allocation: What Assets Should Savers Hold? 136

The Risk–Return Trade-Off 136
Choosing the Mix 138
CASE STUDY: Age and Asset Allocation 140

5.5 Which Stocks? 140
The Efficient Markets Hypothesis 140
Choosing Between Two Kinds of Mutual Funds 142
Can Anyone Beat the Market? 143
CASE STUDY: The Oracle of Omaha 145

5.6 Derivatives 146
Futures 147
Options 148
Credit Default Swaps 148
Hedging with Derivatives 149
Speculating with Derivatives 150
CASE STUDY: Credit Default Swaps and the AIG Fiasco 152
Summary 153
Key Terms 154
Questions and Problems 154

Chapter 6 Foreign Exchange Markets 157
6.1 Currency Markets and Exchange Rates 158
The Trading Process 158
Measuring Exchange Rates 160

6.2 Why Exchange Rates Matter 161
Effects of Appreciation 161
CASE STUDY: The Politics of the Dollar 163

Hedging Exchange Rate Risk 164
Real Versus Nominal Exchange Rates 165
The Trade-Weighted Real Exchange Rate 167
CASE STUDY: Exchange Rates and Steel 168

Online Case Study
An Update on
Investment Banks

| xiii


www.downloadslide.com

xiv | C O N T E N T S

6.3 The Long-Run Behavior of Exchange Rates 169
Purchasing Power Parity 170
How Reasonable Is PPP? 171
Evidence for PPP 171

6.4 Real Exchange Rates in the Short Run 173
Net Exports and Capital Flows 173
Effects of the Real Exchange Rate 174
The Equilibrium Exchange Rate 174

6.5 Fluctuations in Exchange Rates 175
Shifts in Net Capital Outflows 175
Online Case Study
An Update on

Exchange Rates

CASE STUDY: The Euro Versus the Dollar 177

Shifts in Net Exports 179
Nominal Rates Again 180

6.6 Currency Speculation 182
Forecasting Methods 182
CASE STUDY: More on Technical Analysis 184

Summary 185
Key Terms 186
Questions and Problems 186

PART III BANKING
Chapter 7 Asymmetric Information in the
Financial System 189
7.1 Adverse Selection 190
The Lemons Problem 190
Lemons in Securities Markets 191
Adverse Selection: A Numerical Example 193

7.2 Moral Hazard 195
Moral Hazard in Stock Markets 196
Moral Hazard in Bond Markets 197
The Numerical Example Again for Moral Hazard 197
CASE STUDY: Ponzi Schemes 198

7.3 Reducing Information Asymmetries 200

Information Gathering 200
The Free-Rider Problem 200
Information-Gathering Firms 201
CASE STUDY: Rating Agencies and Subprime Mortgages 201
Online Case Study
An Update on
Shareholder Rights

Boards of Directors 202
CASE STUDY: International Differences in Shareholder Rights 204

Private Equity Firms 206


www.downloadslide.com
CONTENTS

7.4 Regulation of Financial Markets 207
Information Disclosure 208
Insider Trading 209
CASE STUDY: Some Inside Traders 209

7.5 Banks and Asymmetric Information 210
Information Gathering: Screening Borrowers 211
Reducing Default Risk: Collateral and Net Worth 211
Covenants and Monitoring 212
Interest Rates and Credit Rationing 213
CASE STUDY: The Five Cs of Business Lending 213
CASE STUDY: Traditional Home Mortgages 214

7.6 Banks and Transaction Costs 215
Reducing Costs to Savers 215
Reducing Costs to Investors 216

Summary 216
Key Terms 217
Questions and Problems 218

Chapter 8 The Banking Industry 221
8.1 Types of Banks 222
Commercial Banks 222
Thrift Institutions 224
Finance Companies 225

8.2 Dispersion and Consolidation 225
Why So Many Banks? 225
CASE STUDY: The Politics of Banking in U.S. History 226

Consolidation in Commercial Banking 228
International Banking 231
Consolidation Across Businesses 231
CASE STUDY: The History of Citigroup 232

8.3 Securitization 234
The Securitization Process 235
Fannie Mae and Freddie Mac 235
Why Securitization Occurs 236
The Spread of Securitization 237

8.4 Subprime Lenders 238

Subprime Finance Companies 238
CASE STUDY: The Subprime Mortgage Fiasco 239

Payday Lenders 241

Online Case Study
An Update on the
Mortgage Crisis

| xv


www.downloadslide.com

xvi | C O N T E N T S

CASE STUDY: Is Payday Lending Predatory? 242

Pawnshops 244
Illegal Loan Sharks 244

8.5 Government’s Role in Lending 244
Support for Housing 245
Small-Business Loans 246
Student Loans 246
The Community Reinvestment Act 247
Government-Owned Banks 248

Summary 248
Key Terms 249

Questions and Problems 250

Chapter 9 The Business of Banking 253
9.1 Banks’ Balance Sheets 254
Liabilities and Net Worth 255
Assets 256

9.2 Off-Balance-Sheet Activities 257
Lines of Credit 257
Letters of Credit 258
Asset Management 258
Derivatives 258
Investment Banking 259

9.3 How Banks Make Profits 259
Melvin Opens a Bank 259
The Income Statement 260
Profit Rates 261

9.4 The Evolving Pursuit of Profits 262
Sources of Funds 262
Seeking Income 265
CASE STUDY: Fees 267

9.5 Managing Risk 269
Liquidity Risk 269
Credit Risk 272
Interest Rate Risk 273
CASE STUDY: The Rise and Decline of Adjustable-Rate Mortgages 275

Market and Economic Risk 276
Interactions Among Risks 276

9.6 Insolvency 277
An Example 277
The Equity Ratio 278
CASE STUDY: The Banking Crisis of the 1980s 279


www.downloadslide.com
CONTENTS

CASE STUDY: Banks’ Profitability in the Financial Crisis
of 2007–2009 281
Summary 282
Key Terms 283
Questions and Problems 283

Online Case Study
An Update on Bank Profits
and Bank Failures

Chapter 10 Bank Regulation 285
10.1 Bank Runs 286
How Bank Runs Happen 286
A Run on Melvin’s Bank 287
Suspension of Payments 288
CASE STUDY: Bank Runs in Fiction and in Fact 288

Bank Panics 290

CASE STUDY: Bank Panics in the 1930s 290

10.2 Deposit Insurance 292
How Deposit Insurance Works 292
Deposit Insurance in the United States 292

10.3 Moral Hazard Again 293
Misuses of Deposits 293
CASE STUDY: The Keystone Scandal 294

The Problem with Deposit Insurance 296
Limits on Insurance 296
CASE STUDY: Deposit Insurance and Banking Crises 297

10.4 Who Can Open a Bank? 297
Chartering Agencies 298
Obtaining a Charter 298
The Separation of Banking and Commerce 298
CASE STUDY: Walmart Bank? 299

10.5 Restrictions on Bank Balance Sheets 301
Who Sets Banking Regulations? 301
Restrictions on Banks’ Assets 302
Capital Requirements 303
CASE STUDY: Skirting Capital Requirements with SIVs 305
10.6 Bank Supervision 306

Information Gathering 306
CAMELS Ratings 307
Enforcement Actions 308

10.7 Closing Insolvent Banks 308
The Need for Government Action 308
Forbearance 309

| xvii

Online Case Study
An Update on Capital
Requirements


www.downloadslide.com

xviii | C O N T E N T S

Deciding on Closure 310
The Closure Process 310

Summary 311
Key Terms 312
Questions and Problems 313

PART IV MONEY AND THE ECONOMY
Chapter 11 The Money Supply and Interest Rates 315
11.1 The Federal Reserve System 316
11.2 The Fed and the Monetary Base 317
The Monetary Base 317
Creating the Base 317
The Fed’s Balance Sheet 319

11.3 Commercial Banks and the Money Supply 319
An Economy Without Banks 320
A Bank Creates Money . . . 320
. . . and More Money 321
Limits to Money Creation 323

11.4 A Formula for the Money Supply 324
Deriving the Formula 324
Changes in the Money Supply 325
CASE STUDY: The Money Multiplier and the Great Depression 327
Online Case Study
Unwinding the
Expansion of the
Monetary Base

CASE STUDY: The Monetary Base and Money Multiplier, 2007–2010 327

11.5 The Fed’s Monetary Tools 330
Open-Market Operations 330
The Discount Rate 330
Reserve Requirements 331
CASE STUDY: How Reserve Requirements Prolonged
the Great Depression 332

Interest on Reserves 333

11.6 Money Targets Versus Interest Rate Targets 333
Two Approaches to Monetary Policy 333
Does the Choice Matter? 334

The Fed’s Choice 335
CASE STUDY: The Monetarist Experiment 336

11.7 Interest Rate Policy 338
The Federal Funds Rate 338
The Federal Open Market Committee 338
Implementing the Targets 340


www.downloadslide.com
CONTENTS

Summary 342
Key Terms 343
Questions and Problems 344

Chapter 12 Short-Run Economic Fluctuations 347
12.1 The Business Cycle 349
Long-Run Output and Unemployment 349
CASE STUDY: The Natural Rate in the United States 350

Booms and Recessions 351
CASE STUDY: What Is a Recession? 354

Aggregate Expenditure 355

12.2 What Determines Aggregate Expenditure? 356
The Components of Expenditure 356
The Role of the Interest Rate 357
Monetary Policy and Equilibrium Output 358

Expenditure Shocks 359
Countercyclical Monetary Policy 361

12.3 Fluctuations in the Inflation Rate 362
Expected Inflation 362
What Determines Expected Inflation? 363
The Effect of Output 365
Supply Shocks 369
CASE STUDY: Oil Prices and Inflation 370

12.4 The Complete Economy 371
Combining the Two Curves 372
The Economy Over Time 375
JUMBO CASE STUDY: The U.S. Economy, 1960–2010 378
12.5 Long-Run Monetary Neutrality 381

Long-Run Output and Unemployment 381
A Permanent Boom? 382
The Neutral Real Interest Rate 382
An Exception to the Rule? 383

Summary 384
Key Terms 385
Questions and Problems 385
Appendix: The Loanable Funds Theory and the Neutral
Real Interest Rate 387

Online Appendix
Comparing the AE/PC
and AD/AS Models

Online Case Study
An Update on the
U.S. Economy

| xix


www.downloadslide.com

xx | C O N T E N T S

Chapter 13 Economic Fluctuations, Monetary Policy,
and the Financial System 389
13.1 Monetary Policy and the Term Structure 390
The Term Structure Again 390
A Policy Surprise 391
Expected Policy Changes 393
CASE STUDY: Measuring the Effects of Monetary Policy
on the Term Structure 395
13.2 The Financial System and Aggregate Expenditure 397
Online Case Study
An Update on Asset
Prices and Consumption

Changes in Asset Prices 397
Changes in Bank Lending Policies 398
Recent Recessions 399
CASE STUDY: Asset Prices, Banking, and Japan’s Lost Decade 399

The Investment Multiplier 402

13.3 The Monetary Transmission Mechanism 403
Effects in Financial Markets 403
Effects on Bank Lending 404
Effects on Expenditure 404
Multiplier Effects 404
Some Lessons 404
CASE STUDY: Monetary Policy, Inventories, and Small Firms 405

13.4 Time Lags 406
Lags in the AE Curve 406
Lags in the Phillips Curve 407
Evidence for Time Lags 408

13.5 Time Lags and the Effects of Monetary Policy 409
A Disinflation 410
Countercyclical Policy 411
CASE STUDY: Fiscal Versus Monetary Policy 413

Summary 415
Key Terms 416
Questions and Problems 416

Chapter 14 Inflation and Deflation 419
14.1 Money and Inflation in the Long Run 420
Velocity and the Quantity Equation 420
Deriving the Inflation Rate 421
The Data 422
Online Appendix
The Behavior of

Money Growth Under
Interest Rate Targeting

The Phillips Curve Again 423

14.2 What Determines Money Growth? 425
Commodity Money 425


www.downloadslide.com
CONTENTS

CASE STUDY: The Free Silver Movement 426

Fiat Money and Inflation 427
The Output–Inflation Trade-Off 427
Seigniorage and Very High Inflation 428
CASE STUDY: The German Hyperinflation 430
CASE STUDY: The Worldwide Decline in Inflation 431

14.3 The Costs of Inflation 433
The Inflation Fallacy 434
Very High Inflation 434
CASE STUDY: Life in Inflationary Brazil 436

Moderate Inflation 437
CASE STUDY: The After-Tax Real Interest Rate 438
14.4 Deflation and the Liquidity Trap 439

Money Growth Again 439

The Liquidity Trap 439
CASE STUDY: Liquidity Traps in Japan and the United States 442

Any Escaping a Liquidity Trap? 445

Summary 446
Key Terms 447
Questions and Problems 448

Online Case Study
An Update on Liquidity
Traps in Japan and the
United States

PART V MONETARY POLICY
Chapter 15 Policies for Economic Stability 451
15.1 Choosing the Long-Run Inflation Rate 452
The Case for Zero Inflation 453
The Case for Positive Inflation 453
Current Practice 454

15.2 Inflation and Output Stability 455
Inflation Stability 455
Output Stability 456
Balancing the Goals 456
CASE STUDY: How Costly Is the Business Cycle? 457

15.3 The Taylor Rule 458
Martin’s Metaphor 458
Taylor’s Formula 458

Applying the Rule 459
The Rule in Action 460

15.4 The Taylor Rule in the AE/PC Model 461
An Example 461
Choosing the Coefficients 462

Online Appendix
The Taylor Rule in the
AE/PC Model with
Time Lags

| xxi


www.downloadslide.com

xxii | C O N T E N T S

15.5 Uncertainty and Policy Mistakes 463
A Mistake About the AE Curve 464
Mismeasurement of the Output Gap 466
CASE STUDY: The Fed and the Great Inflation 468

Coping with Uncertainty 470

15.6 Making Interest Rate Policy 472
Monitoring the Economy 472
Forecasting the Economy 473
Evaluating Policy Options 474

Online Case Study
An FOMC Meeting

The FOMC Meeting 474

15.7 Deviations from the Taylor Rule 475
Responses to Financial Crises 475
CASE STUDY: Deviating from the Taylor Rule, 2007–2010 476

Responses to Bubbles 477

Summary 479
Key Terms 480
Questions and Problems 480

Chapter 16 Monetary Institutions and Strategies 483
16.1 Time Consistency and Inflation 484
Rational Expectations and the Phillips Curve 484
The Time-Consistency Problem 485
How the Time-Consistency Problem Increases Inflation 485
Solving the Time-Consistency Problem 488

16.2 Central Bank Independence 490
The Independent Federal Reserve 490
Independence Around the World 491
Opposition to Independence 492
The Traditional Case for Independence 493
Independence and Time Consistency 494
Evidence on Independence and Inflation 495

16.3 Monetary-Policy Rules 496
Two Approaches to Policy 497
Traditional Arguments for Rules 497
CASE STUDY: Nixon and Burns 498

Time Consistency Again 500
Money Targets 500

16.4 Inflation Targets 501
How Inflation Targeting Works 501
The Spread of Inflation Targeting 503
The Case for Inflation Targeting 504


www.downloadslide.com
CONTENTS

Opposition to Inflation Targeting 506
CASE STUDY: Targeters and Nontargeters 507

Online Case Study
Inflation Targeting and the
Financial Crisis

CASE STUDY: The ECB’s Two Pillars 508

16.5 Communication by Central Banks 509
Reputation 509
CASE STUDY: Alan Blinder 510

Transparency 512

Summary 515
Key Terms 516
Questions and Problems 516

Chapter 17 Monetary Policy and Exchange Rates 519
17.1 Exchange Rates and Stabilization Policy 520
Exchange Rates and Aggregate Expenditure 520
Offsetting Exchange Rate Shocks 521
CASE STUDY: Canadian Monetary Policy 523

17.2 Costs of Exchange Rate Volatility 524
Exchange Rates and Risk 524
Risk and Global Economic Integration 525

17.3 Exchange Rate Policies 525
Interest Rate Adjustments 526
Foreign Exchange Interventions 527
CASE STUDY: Do Interventions Work? 530

Capital Controls 531
Policy Coordination 533
CASE STUDY: The Yuan 534

17.4 Fixed Exchange Rates 535
Mechanics of Fixed Exchange Rates 536
Devaluation and Revaluation 536
Loss of Independent Monetary Policy 537
Controlling Inflation 538

The Instability of Fixed Exchange Rates 539
CASE STUDY: George Soros Versus the British Pound 540

A Brief History of Fixed Exchange Rates 541

17.5 Currency Unions 543
The Euro Area 543
The Economics of Currency Unions 545
The Politics of Currency Unions 546
More Currency Unions? 547

| xxiii

Online Case Study
An Update on China’s
Currency Policy