Economics of money banking and financial markets 9e by mishkin PEARSON 2011

THE ECONOMICS OF

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Money,
Banl{ing
& Financial
Markets

THE ECONOMICS OF

NINTH EDITION

Frederic S. Mishkin
Col umbia University

Boston

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Munich

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Mishkin,Frederic S.
The economics of money, banking,and financial markets I Frederic
Mishkin. -- 9th ed. (and the 2nd ed. of the business ed.)
p. em. -- (The Addison-Wesley Series in economics)
Includes bibliographical references and index.
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ISBN-1 3: 978-0-321 -59988-9 (business edition. alk. paper)
ISBN-1 0 : 0 -321 -59988-8 (business edition : alk. paper)
l. Finance. 2. Money. 3. Banks and banking. I. Title.
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To Sally



BRIEF CONTENTS

PART 1

Introduction

1

Why Study Money,Banking, and Financial Marketsl

.. 3

An Overview of the Financial System .
What Is Money ?

PART 2

Financial Markets

. 25
........ 53

67

4 U nderstanding Interest Rates

. 69

The Behavior of Interest Rates

... 91

6 The Risk and Term Structure of Interest Rates ........................ 1 23
The Stock Market, the Theory of Rational Expectations,

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

PART 3

Financial Institutions

.... 1 47

167

An Economic Analysis of Financial Structure

... 1 6 9

financial Crises and the Subprime Meltdown

... 1 99

10 Banking and the Management of Financial Institutions .
11 Economic Analysis of Financial Regulation .

225
. ...... 255
281

12 Banking Industry : Structure and Competition .

PART 4

Central Banking and the Conduct
of Monetary Policy 313
13 Central Banks and the Federal Reserve System

31 5

14 The Money Supply Process.....................

.... 345

16 The Conduct of Monetary Policy: Strategy and Tactics

395

15 The Tools of Monetary Policy .

PART 5

International Finance and Monetary Policy

... 373

431

17 The Foreign Exchange Market .................................... 433
18 The International Financial System

PART 6

Monetary Theory

19 The Demand for Money

46 3

497

20 The ISLM Model

21 Monetary and Fiscal Policy in the ISLM Model

22 Aggregate Demand and Supply Analysis

23 Transmission Mechanisms of Monetary Policy: The Evidence .

.... 499
51 9
543
... 56 5
... 587

24 Money and ln!lation

617

25 Rational Expectations: Implications for Policy .

6 43

vii


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I

:

CONTENTS

PART l

l

Introd uction
CHAPTER I

Why Study Money, Banking, and Financial Markets?

3

W hy Study Financial Marketsl ... . ...................................... 3
The Bond 1-larket and !merest Rates .
The Srock Marker
W hy Study Financial Institutions and Banking'

....... 5

St.rucmrc of rhe Financial System
Financial Crises
Banks and Other Financial Institutions
Financial lnnovar.ion
W hy Study :v!oney and Monetary Policyl
t-,,toncy and Business Cycles
Money and Inflation
10

1,toncy and Imeresr Rates
Conduct of Monetary Policy

. 10

Fiscal Policy and Monetary Policy

.... 12

W hy Study International Finance'

13

The Foreign Exchange Marker

13

The International Financial System

14
14

How We Will Study :v!oney, Banking, and Financial Markets

15

Exploring the Wr·b
CollecLing and Graphing Data

15

Web Exercises

... 16

Concluding Remarks
Summary 18

•

........... 17

Key Terms

Web Exercises 20

•

19

•

Questions and Problems 19

•

Web References 20

APPENDIX TO CHAPTER I

Defining Aggregate Output, Income, the Price Level,
and the Inflation Rate 21

Aggregate Output and Income

........ 21

Real Versus Nominal Magnitudes

....... 21

Aggregate Price Level

... 22

Growth Rates and the Inllation Rate

23

CHAPTER 2

An Overview of the Financial System

25

Function of Financial Nlarkets

....... 25

Structure of Financial Nlarkets

....... 27

ix


CO NTE NTS
Debt and Equity Markets

27

Primary and Secondary ivlarkers .

28

Exchanges and Over-the-Counter Markets

29
29

Money and Capital Markers

....... 30

Financial Market Instruments

.... 30

t-.·toncy Marker. Instruments

Following the Financial News

Money Market Rates

Following the Financial News

Capital Market Interest Rates

31

Capital t-.-tarkc:.·t Instruments

33
34

Internationalization of Financial Markets

Global

...... 36

Are U.S Capital Markets Losing Their Edgel

36

lntcrnar.ional Bond Market, Eurobonds, and Eurocurrencies

..... 37
37

World Srock Markers

Following the Financial News

Foreign Stock Market Indexes

38

Function of Financial Intermediaries: Indirect Finance

....... 39

Transaction Costs

Global

39

The Importance of Financial Intermediaries Relative to Securities Markets:
An International Comparison

40

Risk Sharing

40

Asymmclric Information: Adverse Sc1ection and T\.foral Hazard

41

Types of Financial Intermediaries ........................
Depository InsLilulions

43

Contracwal Savings Institutions

44

lnvcstmcnt. lnrcrmcdiaries

.. 45

Regulation of the Financial System

..... 46

Increasing InformationAvailable w lnvcsr.ors

..... 46

Ensuring the Soundness of Financial lmermcdlaries

47

Financial Regulation Abroad
Summary 49

•

Key Terms 50

\Veb Exercises 51

....... 42

•

49
•

Questions and Problems 51

•

\Veb References 52

CHAPTER 3

What Is Money?

53

Meaning of Money
Functions of Money

53
... 54

h,tcdium of Exchange

54

Unit of Accoum

55

Store of Value
Evolution of the Papnents System
Commodity Money .

56
57

. 57

Fiat Money

57

Checks

57


C 0 NTE NTS
Elcclronic Paymc:nl

SH

E-Moncy

58

FYI

Are We Headed for a Cashless Society'

59

Measuring Money

....... 6 0
. .

The Federal Reserve's !vionctary Aggrcgar.cs

Following the Financial News
FYI

The Monetary Aggregates

Where Are All the U.S. Dollars?
.

How Reliable Are the Money Data?
Summary 6 4

•

Web Exercises

PART2

xi

Key Terms 65
66

•

•

60

61

62
..................................... 6 3
Questions and Problems 65

•

Web References 6 6

Fi nanci al Markets

67

CHAPTER 4

Understanding Interest Rates

69
69

Measuring Interest Rates
. . . . . . . .

Pre.senL Value

Application Simple Present Value

69

.................... 7l

Application How Much is That j ackpot Worthl .

.

71

Four Types of Credit 1.farket Instruments

72

Yield to MaLUrity

72

Application Yield to Maturity on a Simple Loan

..... 73

Application Yield to Maturity and the Yearly Payment
on a fixed-Pay ment Loan .

....... 74

Application Yield to Maturity and the Bond Price for a Coupon Bond .
Application Perpetuity
Global

Negative T- Bill Rates l It Can Happen

. . . . . . . . .

79

The Distinction Between Interest Rates and Returns

HO
. . . . . .

MaLUrity and the Volatility of Bond ReLUrns: Interest-Rate Risk

FYI

Helping Investors to Select Desired Interest-Rate Risk

Summary

84

Application Calculating Real Interest Rates

With T I P S, Real Interest Rates Have Become Observable

in the United States

Summary 87

82

83

The Distinction Between Real and Nominal Interest Rates .

FYI

76

. 78

•

87

Key Terms

Web Exercises 8 8

•

87

•

Questions and Problems 8 8

Web References 8 9

....... 8 4

. 85


xii

C 0 NTE NTS
CHAPTER 5

The Behavior of Interest Rates

91

Determinants of Asset Demand

....... 9 1

Wealth

92

Expccr.cd Returns

.. 92

Risk

...... 92

Liquidity

..... 93

Theory of Asset Demand

93

Supply and Demand in the Bond Market

...... 9 4

Demand Curve

94

Supply Curve

95

MarkeL Equilibrium

96

Supply and Demand Analysis

97

Changes in Equilibrium Interest Rates

...... 97

Shifts in the Demand for Bonds

97
10 1

Shifts in the Supply of Bonds

Application Changes in the Interest Rate Due to Expected Inflation:
The fisher Effect

10 3

Application Changes in the Interest Rate Due to a Business Cycle Expansion ... 10 4
Application Explaining Low Japanese Interest Rates

...................... 10 6

Application Reading the Wall Street}ottntal "Credit Markets" Column
Following the Financial News

The ''Credit Markets" Column

10 7

10 8

Supply and Demand in the Market for Money: The Liquidity Preference framework .10 9
Changes i n Equilibrium Interest Rates i n the Liquidity Preference framework

111
111

Shifts in the Demand for Money
Shifts i n the Supply o f Money

. Ill

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

112

Changes in Income:

1 13

Changes in rhc Price Level

1 13

Changes in tht· Money Supply

1 13

Application Money and Interest Rates

................................. 114

Docs a Higher Rate of Growth of the Money Supply Lower Inr.erest Rates?

Summary

119

•

Web Exercises

Key Terms
12 0

•

119

•

Questions and Problems

Web References

119

. 1 15
•

12 1

CHAPTER 6

The Risk and Term Structure of Interest Rates

123

Risk Structure of Interest Rates
Default Risk

Application The Subprime Collapse and the Baa-Treasury Spread
Liquidity

12 3
123
. 127
127

Income Tax C:onsiclerar.ions

128

Summary

129


CO NTE NTS
Application Effects of the Bush Tax Cut and Its Possible Repeal

xiii
13 0

on Bond Interest Rates

Term Structure of Interest Rates

..... 130

Following the Financial News

Yield Curves

131

Expectations Theory .

. 132

Segmented Markets Theory

...... 135

LiquidiLy Premium and Preferred HabiLat Theories

136

Evidence on Lhc: Term StrucLurc:

140

Summary

FYI

140

The Yield Curve as a Forecasting Tool for Infiation and the Business Cycle

Application Interpreting Yield Curves,1980 -20 0 9
Summary

142

•

Web Exercises

Key Terms
144

•

14 3

•

141

Questions and Problems

Web References

I 41

14 3

•

144

CHAPTER 7

The Stock Market, the Theory of Rational Expectations,
and the Efficient Market Hypothesis 147
Computing the Price of Common Stock

.. 147

The One-Period Valuation Model

....... 14H
149

The Generalized Dividend Valuation Model

149

The Gordon Growth Model
How the Market Sets Stock Prices

150

Application Monetary Policy and Stock Prices ........................... 151

Application The Subprime Financial Crisis and the Stock Market .

152

.. 152

The Theory of Rational Expectations
Formal Statement of the Theory

..... 154

Rationale Behind the Theory

154
155

Implications of rhe Theory
The Efficient Market Hypothesis: Rational Expectations in Financial Markets

155

Rationale Behind the Hypothesis

157

Stronger Version of the Efficient "t-.,farkct Hypothesis

158

Application Practical Guide to Investing in the Stock Market

158

How ValuableAre Published Reports by lnvestmemAdvisers?

... ISH

Should You Be Skeptical of Hot. Tips>

FYI

. 159

Should You Hire an Ape as Your Investment Ad,iser7

16 0

Do Stock Prices Always Rise VVhen There Is Good News?

160

EITicienl Markel Prescription for lhc Investor

160

Application What Do the Black Monday Crash of 1987 and the Tech Crash

of 20 0 0 Tell U s About Rational Expectations and Efficient Markets' ...... 16 1

Behavioral Finance
Summary

16 3

•

Web Exercises

....... 162
Key Terms
165

•

16 4

•

Questions and Problems

Web References

165

16 4

•

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xiv

C 0 NTE NTS

PART 3

Fi nanci al Ins ti tutions

167

CHAPTER 8

An Economic Analysis of Financial Structure 169
Basic Facts about Financial Structure Throughout the World

... 16 9
.... 172

Transaction Costs

172

How Transaction Casu:; Inl1uc:nce Financial StrucLure

173

How Financial lmermediaries Reduce Transacrion Costs

Asymmetric Information: Adverse Selection and :Vloral Hazard

............... 17 4

The Lemons Problem: How Adverse Selection Influences Financial Structure

.... 17 4

Lemons in the SLOck and Bond Markets
Tools to Help Solve Adverse Selection Problems

FYI

The Enron Implosion

177

How Moral Hazard Affects the Choice Between Debt and Equity Contracts
Moral Hazard in Equity Contracts: The Principal-Agem Problem

180

Tools w Help Solve the Princlpal-Agcm Problem

18 1
1H3

How Moral Hazard Influences Financial Structure in Debt Markets
Tools to Help Solve Moral Hazard in Debt Contracts

183

Summary

. 185

Application Financial Development and Economic Growth
FYI

1HO

Should We Kill

All the

Lawyers>

..... 186

18 8

Application Is China a Counter-Example to the Importance

188

of Financial Development> .

Conflicts of Interest

..... 18 9

\VhaL Are Contlicrs of Interest and \Vhy Do \Ve Care?

. 190

Why Do Canllicts of Interest Arise>

. 190
192

What Has Been Dane to Remedy Canllicts of lnterestl

FYI

The Demise of Arthur Andersen

FYI

Credit-Rating Agencies and the Subprime Financial Crisis

FYI

Has Sarbanes-Oxley Led to a Decline in U.S. Capital :Vlarkets>

Summary

195

•

Web Exercises

Key Terms
197

•

19 6

192

•

Questions and Problems

Web References

19 3
195

19 6

•

19 7

CHAPTER 9

Financial Crises and the Subprime Meltdown 199
Factors Causing Financial Crises

...................................... 19 9

Asset Market Effects on Balance Sheets

200

Dcr.erioration in Financial Institutions' Balance Sheets

201

Banking Crisis

201

Increases i n UnccnainLy

201

Increases in Inr.crcsr. Rates

201

Government Fiscal Imbalances

202


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XV

CO NTE NTS
Dynamics of Past U.S. Financial Crises

...... 20 2

Stage One: Initiation of Financial Crisis

202

Stage Two: Banking Crisis

205

Stage Three: Debt Deflation

206

Application The Mother of all Financial Crises: The Great Depression

The Subprime Financial Crisis of 20 0 7-20 0 8

... 20 6
....... 20 7
... 207

Financial Innovar.ions Emerge in r.hc "t-.·tortgagc tvtarkers
Housing Price Bubble Forms

20H

20H

Agency Problc:ms Arise
Information Problems Surface

209

Housing Price Bubble Bursts

209

Crisis Spreads Globally

209

Banks Balance Shws Deteriorate

2 10

High-Profile Firms Fail

...... 2 10
.... 2ll

Bailout Package Debar.ed
Recovery in Sight?

Global

211

The Treasury Asset Relief Plan and Government Bailouts

21 2
21 2

Dynamics of Financial Crises in Emerging Market Economies
Stage One: Initiation of Financial Crisis

2 12

Stage Two: Currency Crisis

...... 2 15

Sragc Three: Full-Fledged Financial Crisis

...... 2 16

Application Financial Crises in Mexico,1 994-1995; EastAsia,l997-1998;

21 7

and Argentina,20 0 1 -20 0 2

Global

The Perversion of the Financial Liberalization/Globalization Process

Summary

222

•

Web Exercise

Key Terms 222

223

•

•

Questions and Problems 223

21 9

•

Web References 224

CHAPTER 10

Banking and the Management of Financial Institutions 225
The Bank Balance Sheet ............................................. 225
LiabiliLics

225

Assets

228

Basic Banking

...... 229

General Principles of Bank Management

............

...... 23 2

Liyuidicy Management and the Role of Reserves

232

.'\.sseL Managc:menl

235

Liabilicy Management

236

Capital Adequacy 1.fanagemenr

237

Application Strategies for Managing Bank Capital

Application How a Capital Crunch Caused a Credit Crunch
in 20 0 8 ................. .

Managing Credit Risk

· · · · · · · ·

· · · · · · · · · · · · · · · · · ·

... 239

... 240
....... 241

Screening and 1.fonitoring

241

Long-Term Customer Relationships

242


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xvi

CO NTE NTS

Loan Commitments

243

Collateral and Compensating Balances

243

Credit Rationing

244

Managing Interest- Rate Risk

2 45

Gap and Duration Analysis

Application

. 245

Strategies for Managing Interest-Rate Risk .

....... 2 47
2 47

Off- Balance- Sheet Activities
Loan Sales

247

Generation of Fcc Income

248

Trading Activities and Risk i'vlanagcmcm Techniques

248

Global Barings, Daiwa, Sumitomo, and Societe Generate: Rogue Traders
and the Principal-Agent Problem
Summary 250

•

Key Terms 2 5 1

Web Exercises 252

•

•

249

Questions and Problems 2 5 1

•

Web References 253

CHAPTER I I

Economic Analysis of Financial Regulation 255
Asymmetric Information and Financial Regulation

2 55

Government Safety Net

255

Global The Spread of Government Deposit Insurance Throughout the World:
Is This a Good Thingl

257

Restrictions on Asset Holdings

260

Capital Requirements

260
261

Prompt Corrcclivc Action
Global Basel 2 How Well Will It Work?

2 62

Financial Supervision: Charlcring anJ Examination

263

Assessment of Risk Management

.... 264

Disclosure Requirements

...... 265

Consumer Protection

FYI

266

Mark-to-:v!arket Accounting and the Subprime Financial Crisis

266

Restrictions o n Competition

267

Summary

267

FYI

The Subprime Mortgage Crisis and Consumer Protection Regulation

Global International Financial Regulation

268

269

The 19 8 0s Sa\ings and Loan and Banking Crisis
Banking Crises Throughout the World
"Deja vu All Over Again"
Whither Financial Regulation After the Subprime Financial Crisis?

..... 2 7 1
...... 2 7 3
273
..... 2 7 5

Increased Regulation of 1viongage Brokers

. -.... 276

Fewer Subprime tv1ortgage Products

...... 276

Regulation Compensation

276

Higher Capital Requirements

276


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CO NTE NTS

xvii

Additional RcgulaLion of Privately Owned Govc:rnmem-Sponsored Enterprises

277

Heightened Regulation to Limit Financial Institutions' Risk Taking

2 77

Increased Regulation of Credit-Rating Agencies

277

Additional Regulation of Derivatives

277

The Danger of Overregulation
Summary 2 78

•

Key Terms 2 78
•

Web Exercises 2 79

278
Questions and Problems 2 78

•

Web References 2 7 9

CHAPTER 12

Banking Industry: Structure and Competition 281
Historical Development of the Banking System

2 Hl

-r..,tultiplc Regulatory Agencies

283

Financial Innovation and the Growth of The "Shadow Banking System"

2 H4

Responses ro Changes in Demand Conditions: lnr.crcsr.-Rar.c Volatility

..... 285

ResponS('S w Changes in Supply Conclir.ions: Information Technology

. 286

FYI

Will "Clicks" Dominate "Bricks" in the Banking Industry)

FYI

Bruce Bent and the :Vloney :vlarket :vlutual Fund Panic of 2 0 0 8

2 HH

Avoidance: of ExisLing Regulations

289
291

Financial Innovation and the Decline of Traditional Banking

Structure of the U.S. Commercial Banking Industry

296

Restrictions on Branching

297

Response lo Branching Restrictions
Bank Consolidation and ;\!ationwide Banking

292
.... 2 9 5

............................ 2 9 8

The Ricglc-Neal lnterstate Banking and Branching Efficiency Act of 1994

300

\Vhat \Vill rhe Structure of the U.S. Banking Industry Look Like
. 300

in rhc Fmure?
Global Comparison of Banking Structure in the United States
and Abroad

30 1

Arc Bank Consolidation and Nationwide Banking Good Things?
Separation of the Banking and Other Financial Ser\ice Industries .
Erosion of Glass-Sreaga11

30 1
...... 302
302

The Gramm-Leach-Bliley Financial Services ModernizationAct of 1999:
Repeal of Glass-Steagall
Implications for Financial Consolidation

303
303

Separation of Banking and Or.her Financial Services Industries Throughout
che World

FYI

...... 303

The Subprime Financial Crisis and the Demise of Large, Free- Standing
Investment Banks

30 4

Thrift Industry: Regulation and Strucwre
Savings and Loan Associations
tvtutual Savings Banks
Credit Unions
Imernational Banking
Eurodollar Market

30 4
304
.... 305
...... 305
...... 30 6
306


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Global Ironic Birth of the Eurodollar Market

307

Structure of U.S. Banking Overseas

307

Foreign Banks in the United States .
•

Summary 30 9

Web Exercises 311

PART 4

30H

Key Tenns 310
•

Questions and Problems 310

Web References 311

Central Banking and the
Cond uct of Monetary Policy

3 13

CHAPTER 13

Central Banks and the Federal Reserve System 315
The Price Stability Goal and the :-.lominal Anchor

........... 315

The Role of a Naminal Anchor

3 16

The Time- lnconsisu::ncy Problem

3 16

Other Goals of Monetary Policy

317

High Employment

3 17

Economic Growth

3 18

Stability of Financial t.farkets

3 18

Interest-Rate Stability

3 1H

Stability in Foreign Exchange Markets

....... 3 19

Should Price Stability Be the Primary Goal of :Vlonetary Policy?

...... 319
3 19

Hierarchical Versus Dual11andatcs
Price Stability as the Primary, long-Run Goal of MonNary Policy
Origins of the Federal Reserve System

Inside the Fed

320

.................................. 32 0

The Political Genius of the Founders of the Federal Reserve System

Structure of the Federal Reserve System

322

Federal Reserve Banks

Inside the Fed

...... 323

The Special Role of the Federal Reserve Bank of New York

Member Banks

The Role of the Research Staff

326
32 7
32H

Federal Open Markel Commiuee (FOMC)

The FOMC Meeting

Inside the Fed

..... 32H

Green, Blue, and Beige: W hat Do These Colors
Mean at the Fed?

32 9

Why the Chairman of the Board of Governors Really Runs the Show

330

How Independent is the Fedl

Inside the Fed

32 4
325

Board of Governors of the Federal Reserve System

Inside the Fed

32 1

How Bernanke's Style Differs from Greenspan's

Structure and Independence of the European Central Bank

330
331
....... 333

Differences Between the European System of Cemral Banks and
the Federal Reserve System

333


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Governing Council

334

How Indcpenclent Is the ECB'

335

Structure and Independence of Other Foreign Central Banks

335

Bank of Canada

335

. 336

Bank of England

.... 336

Bank of japan

337

The Trend Toward Greater Independence
Explaining Central Bank Behavior

Inside the Fed

xix

..................................... 337

The Evolution of the Fed's Communication Strategy

338
339

Should the Fed Be Independent/
The Case for Independence

339

The Case Against Independence

340

Central Bank Independence and Macroeconomic Performance Throughout the World .. 34 1
Summary 34 1

•

Key Terms 342

Web Exercises 34 3

•

•

Questions and Problems 342

Web References 34 3

CHAPTER 14

The Money Supply Process

345

Three Players in the Money Supply Process
The Fed:S Balance Sheet
Liabilities
i\ssCls

Control of the :vlonetary Base
Federal Reserve Open Market Operations

..... 345
....... 345
...... 346
347
347
348

Shifts from Deposits into Currency

35 1

Discount Loans

352

Other Factors That Affect the Monetary Base
Overview of the Feel's Ability to Comrol the Monetary Base
Multiple Deposit Creation: A Simple Model ...............

.... 353
....... 353
..... 354

Deposit. Crcarion: The Single Bank

354

Deposit Creation: The Banking System

355

Deriving the Formula for T\.fultiplc Deposit Creation

35H

Critique of the Simple Model
Factors that Determine the Money Supply
Changes in t.he Nonborrowed Monetary Base, MB�

Changes in Borrowed Resenrcs, BR, from the Feel

359
36 0
...... 360
...... 360

Changes in Lhe Required Reserve Ralio, r

360

Changes in Currency Holdings

36 1

Changes in Excess Reserves

36 1

Overview of the Money Supply Process

36 1

The Money :v!ultiplier

362

Deriving the Money Multiplier
Inlllition Behind the Money Multiplier
Money Supply Response ro Changes in the Factors

Application The Great Depression Bank Panics,193 0 -193 3

362
...... 364
. 365
. 366


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Summary 36 9

•

Key Terms 370

Web Exercises 371

•

•

Questions and Problems 370

•

Web References 372

CHAPTER 15

Tools of Monetary Policy

373

The Market for Reserves and the Federal Funds Rate

....... 37 3

Demand and Supply in the Market for Reserves

Inside the Fed

...... 373

W hy Does the Fed Need to Pay Interest on Reserves/

375

How Changes in the Tools of Monetary Policy Allect the Federal Funds Rate

Application How the Federal Reserve's Operating Procednres

Limit Flnctuations in the Federal Funds Rate ..............

Open Market Operations

376

...... 3 80
....... 38 1

A Day at the Trading Desk

...... 38 1

Advantages of Open Market Operations
Discount Policy

383

............................

..... 38 4

Operation of the Discount \Vindow

384

Lender of Last Resort

384

Inside the Fed
Inside the Fed

Using Discount Policy to Prevent a Financial Panic

38 6

Federal Reserve Lender-of- Last- Resort Facilities During
the Subprime Financial Crisis

3H7

Advantages and Disadvantages of Discount Policy

388

Reserve Requirements

3H9

Disadvantages of Reserve Requiremcnt:s as a Policy Tool

389

Monetary Policy Tools of the European Central Bank

..... 39 0

Open Market Operations

...... 390

Lending to Banks

....... 390

Reserve Rcq uiremcnts
Summary 39 I

•

39 1

Key Terms 39 1

Web Exercises 392

•

Questions and Problems 392

Web References 39 3

CHAPTER 16

The Conduct of Monetary Policy: Strategy and Tactics
Monetary Targeting

..... 395

Monetary Targering in rhe Unired Stares, japan, and Germany
Global The European Central Bank's Monetary Policy Strategy

... 395
39 8

Advantages of 1-lonetary Targeting
Disadvantages of "tvlonetary Targeting
Inflation Targeting
Inflation Targcr.ing in New Zealand, Canada, and the United Kingdom
Advantages of Innar.ion Targeting
Disadvamagcs of Inflation Targeting
Monetary Policy With an Implicit :-Jominal Anchor

395

399
399
39 9
... 400
...... 402
403
..... 4 0 5

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Advantages of the ':Just Do It" Approach

406

Disadvantages of the 'just Do It" Approach

Inside the Fed

406

Chairman Bernanke and Inflation Targeting

407

Tactics: Choosing the Policy lnstnunent

...... 4 0 8

Crircria for Choosing the Policy Instrument.

... 4 10

Tactics: The Taylor Rule

Inside the Fed

xxi

...... 4 12

Fed Watchers

4I 4

Central Banks' Response to Asset-Price Bubbles: Lessons from the Subprime Crisis

4 15

Two Types ofA.ssel-Price Bubbles

4 15

Should Ccmral Banks Respond to Bubbles'

4 16

Should Monetary Policy Try to Prick Asset-Price Bubbles'

4 17

Arc Other Types of Policy Responses Appropriate'

...... 4 17

Fed Policy Procedures: Historical Perspective

..... 4 18

The Early Years: Discount Policy as the Primary Tool

4 18

Discovery of Open 1.farkct Operations

4 19

The GreaL Depression

4 19

Inside the Fed

Bank Panics of 1930-19 33: W hy Did the Fed Let Them Happen'

Reserve Requirements as a Polley Tool

42 0
. 420

War Finance and the Pegging of Interest Rates: 1942- 195 1

....... 42 1

Targeting Money Market Conditions: the 1950s and 1960s

42 1

Targeting Monetary Aggregates: the 1970s

422

New Fed Operating Procedures: October 1979-0crobcr 1982

423

De-Emphasis of .Monetary Aggregates: October 1982-Early 1990s

424

Federal Funds Targeting Again: Early 1990s and Beyond

425

Preemptive StrikesAgainst Infiation

425

Preemptive Strikes Against. Economic Downturns and Financial Disruptions:
LTCM, Enron, ancl thc Subprime Meltdown
lnH:'rnaLional Considerations
Summary 42 7

•

Key Terms 4 28

Web Exercises 42 9

PARTS

•

•

Questions and Problems 42 8

Web References 42 9

International Financ e and Monetary Policy

43 1

CHAPTER 17

The Foreign Exchange Market 433
Foreign Exchange Market

...... 4 33

\Vhat Arc Foreign Exchange Rates?

Following the Financial News

Foreign Exchange Rates

\Vhy Arc Exchange Rates Important?

How Is Foreign Exchange Traded?

Exchange Rates in the Long Run
Law of One Price
Theory of Purchasing Power Parity

434
435
436
. 436
...... 437
...... 437
437


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Why the Theory of Purchasing Power Parity Cannot Fully Explain Exchange Rates

439

Factors That Affect Exchange Rates in the Long Run

439

Exchange Rates in the Short Run: A Supply and Demand Analysis

440

Supply Curve for Domestic A.sscts

442

Demand Curve for Domesr.ic Assets

. 442

Equilibrium in the Foreign Exchange tvtarkct.

..... 443

Explaining Changes in Exchange Rates

...... 4 4 3

ShifLS in the Demand for Domcsrk Asscrs

443

Recap: Factors That Change the Exchange Rate

446

Application Changes in the Equilibrium Exchange Rate: Two Examples .

448

Changes in Interest Rates

448

Changes in the 1..foncy Supply

. 449

Exchange Rate Overshooting

450

Application Why Are Exchange Rates So Volatile?

452

Application The Dollar and Interest Rates,197 3 -20 0 8

...... 452

Application The Subprime Crisis and the Dollar

454

Application Reading the Wall Street]oumal: The "Currency

Trading" Column ......... . .................................... 454

Following the Financial News
Summary

456

•

Key Terms

Web Exercises 457

•

The '·Currency Trading" Column
456

•

455

Questions and Problems 456

Web References 457

APPENDIX TO CHAPTER 17

The Interest Parity Condition

459

Comparing Expected Returns on Domestic and Foreign Assets

459

Interest Parity Condition

461

CHAPTER 18

The International Financial System 463
Intervention in the Foreign Exchange Market

...... 4 6 3

Foreign Exchange Imcrvcmion and the t-,.,toncy Supply

Inside the Fed

463

A Day at the Federal Reserve Bank of )lew York's
Foreign Exchange Desk

464

Unsterilizcd Inr.ervcntion

...... 466

Sr.crilizcd lnr.ervention

...... 467

Balance of Payments ................................................ 4 6 8

Global

W hy the Large U.S. Current Account Deficit Worries Economists

Exchange Rate Regimes i n the International Financial System

470

The Bretton Woods System
The Euro's Challenge to the Dollar

How a Fixed Exchange Rate Regime \Vorks

..... 4 7 0
470

Gold Standard

Global

469

47 1
472


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Application How Did China Accumulate Over $2 Trillion

474

of International Reserves/.

Managed Float

475

European Monetary System (EMS)

476

Application The Foreign Exchange Crisis of September 1 992 ............... 477
Application Recent Foreign Exchange Crises in Emerging Market Countries:
Mexico 1 994,East Asia 1 997,Brazil 1 999,and Argentina 20 0 2

. 478

Capital Controls ................................................... 4 8 0
Controls o n Capilal Oull1ows

480

Controls on Capilal Inflows

480

The Role of the 1:11 F

4 H1

Should the IMF Be an International Lender of Last Reson'

48 1

How Should the lMF Operate'

. 482

Global The Subprime Financial Crisis and the l M F

484

International Considerations and Monetary Policy ......................... 4 8 4
Direct Effects o f the Foreign Exchange Market o n the 1.foncy Supply

484

Balance-of-Payments Considerations

485

Exchange Rate Considnations

485

To Peg or Not to Peg: Exchange-Rate Targeting as an Alternative
....... 4 H6

Monetary Policy Strategy
Advantages of Exchange-Rate Targeting

486

Disadvamages of Exchange-Rate Targ,cr_ing

487

'vVhcn Is Exchange-Rate Targeting Desirable for Industrialized Countries?

489

\Vhcn Is Exchange-Rate Targeting Desirable for Emerging 1\.farkct Coumrics?

489

Currency Boards

490
490

Dollarization
Global Argentina's Currency Board
Summary 4 92

•

•

Key Terms 4 9 3

Web Exercises 4 9 4

PART 6

491

•

Questions and Problems 4 9 3

•

Web References 4 9 5

Monetary Theory

497

CHAPTER 19

The Demand for Money

499

Quantity Theory of :11oney

499

Velocity of Money and Equation of Exchange

500

Quantity Theory

50 1

Quantity Theory of Money Demand

50 1

Is Velocity a Constant?

....... 502

Keyness Liquidity Preference Theory

....... 5 0 3

Transacrions tviotive

504

Precautionary "tviotive

504


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Spcculalivc tvloLive

504

Putting the Three "tvlorivcs Together

505

Further Developments in the Keynesian Approach

507

Transactions Demand

507

Prccamionary Demand

. 509

Speculative Demand

..... 509

Friedman's Modern Quantity Theol)' of Money

...... 511

Distinguishing Between the Friedman and Keynesian Theories

512

Empirical Evidence on the Demand for Money

515

Interest Rates ancl 1-ioncy Demand

5 15

Stability of 1..foney Demand
Summary 516

5 16

Key Tenns 517

•

•

Web Exercises 518

Questions and Problems 517

•

Web References 518

CHAPTER 20

The JSIM Model

519

Determination of Aggregate Output

...... 519

Consumer Expenditure and the Consumption Function

520

lnvcsLmem Spending

522

FYI

Investment

Meaning of the Word

52 3

Equilibrium and the Keynesian Cross Diagram

...... 523
525

Expenuilllre Multiplier

Application The Collapse of Investment Spending and the Great Depression

. . . . .

527

Governmcnl's Role

52H

Role of Inrcrnarional Trade

530
53 1

Summary of Lhe DL'lmninanls of AggregaLe Oulpul
The

lSLM Model

..... 534

Equilibrium in Lhe Goods Markel: The IS Curve

... 534

Equilibrium in Lhe MarkeL for Money: The LM Curve

ISLM Approach to
Summary 5 4 1

•

537

Aggregate Output and Interest Rates
Key Terms 5 4 1

Web Exercises 542

•

•

539

Questions and Problems 5 4 1

•

Web References 542

CHAPTER 2 1

Monetary and Fiscal Policy in the ISIM. Model
Factors That Cause The

Factors That Cause The

IS

543

Curve to Shift

LM Curve to

Shift

54 3
546

Changes in Equilibrium Level of the Interest Rate and Aggregate Output ........ 548
Response to a Change in "tvloncr.ary Policy

548

Response Lo a Change in Fiscal Policy

549

Application The Economic Stimulus Act of 20 0 8
Effectiveness of Monetary Versus Fiscal Policy

Monetary Policy Versus Fiscal Policy: The Case of Complete Crowding Out

... 550
...... 552
...... 552

Application Targeting Money Supply Versus Interest Rates ................. 554


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ISLM Model in the

...... 557

Long Run

ISLM Model and the

Aggregate Demand Curve

...... 559

Deriving the Aggregate Demand Curve

560

Factors That Cause the Aggregate Demand Curve to Shift
Summary 5 6 3

•

Key Terms 5 6 3

Web Exercises 5 6 4

•

•

56 1

Questions and Problems 5 6 3

Web References 5 6 4

CHAPTER 22

Aggregate Demand and Supply Analysis 5 65
565

Aggregate Demand

Following the Financial News

Aggregate Output, Unemploymem,
and the Price Level

566

Deriving the Aggregate Demand Curve

....... 566

Factors That Shift the Aggregate Demand Curve

567
56H

Aggregate Supply
Long-Run Aggregate Supply Curve .

56H

Short-Run Aggregate Supply Curve.

570

Shifts in the Short-Run Aggregate Supply Curve

57 1

Factors That Shift the Short-Run Aggregate Supply Curve

57 1

Equilibrium in Aggregate Supply and Demand Analysis

...... 574

Equilibrium in the Shan Run

.... 574

Equilibrium in the Long Run

575

Changes in Equilibrium Caused by Aggregate Demand Shocks

577

Changes in Equilibrium Caused by Aggregate Supply Shocks

578

Shifts in the Long-Run Aggregate Supply Curve: Real Business Cycle Theory
579

and Hyslcresis
Conclusions

580

Application Explaining Past Business Cycle Episodes

...... 580

Viemam War Buildup, 1964-1970

......... 580

Negative Supply Shocks, 1973-1975 and 1978-1980

58 1

Favorable Supply Shocks, 1995-1999

582

Negative Demand Shocks, 2001-2004

582

The Perfect Storm of 2007-2008: Negative Supply Shocks and the Subprime
Financial Crisis
Summary 5 8 4

•

583
Key Terms 5 8 4

Web Exercises 5HS

•

•

Questions and Problems 585

•

Web References 5H6

CHAPTER 23

Transmission Mechanisms of Monetary Policy: The Evidence 587
Framework for Evaluating Empirical Evidence

5H7

Structural f\.fodel Evidence

588

Reduced-Form Evidence

588

Advamagcs and Disadvantages of 5Lrucr.ural tvioclcl Evidence

589

Advantages and Disadvantages of Reduced-Form Evidence

589

FYI

Perils of Reverse Causation· A Russian Folk Tale

590