Economics of money banking and financial markets

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Library of Congress Cataloguing-in-Publication Data
Mishkin, Frederic S.
The economics of money, banking, and financial markets / Frederic S. Mishkin.—7th ed.
p. cm. — (The Addison-Wesley series in economics)
Supplemented by a subscription to a companion web site.
Includes bibliographical references and index.
ISBN 0-321-12235-6
1. Finance. 2. Money. 3. Banks and banking. I. Title. II. Series.
HG173.M632 2004
332—dc21
2003041912
Copyright © 2004 by Frederic S. Mishkin. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical,
photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in
the United States of America.

To Sally



Introduction

1

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

Financial Markets

59

Understanding Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61
The Behavior of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85
The Risk and Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . .120
The Stock Market, the Theory of Rational Expectations,
and the Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .141

Financial Institutions

167

An Economic Analysis of Financial Structure . . . . . . . . . . . . . . . . . . . . . . . .169
Banking and the Management of Financial Institutions . . . . . . . . . . . . . . . . .201
Banking Industry: Structure and Competition . . . . . . . . . . . . . . . . . . . . . . . .229

Economic Analysis of Banking Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . .260
Nonbank Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287
Financial Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .309

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

International Finance and Monetary Policy

433

The Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .435
The International Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .462
Monetary Policy Strategy: The International Experience . . . . . . . . . . . . . . . .487


viii

Contents in Brief

Monetary Theory

515

The Demand for Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .517

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


Introduction

1

CHAPTER 1

WHY STUDY MONEY, BANKING, AND FINANCIAL MARKETS? . . . . . . . . . . . . . . . . .3

Appendix to Chapter 1

Defining Aggregate Output, Income, the Price Level,
and the Inflation Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20


x

Contents
CHAPTER 2

AN OVERVIEW OF THE FINANCIAL SYSTEM . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23

Following the Financial News Foreign Stock Market Indexes . . . . . . . . . . . . . . . .30

The Importance of Financial Intermediaries to Securities
Markets: An International Comparison . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31

CHAPTER 3

WHAT IS MONEY? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44

Birth of the Euro: Will It Benefit Europe? . . . . . . . . . . . . . . . . . . . . .49


Contents
Why Are Scandinavians So Far Ahead of Americans in
Using Electronic Payments? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .50

Are We Headed for a Cashless Society? . . . . . . . . . . . . . . . . . . . .52
Following the Financial News The Monetary Aggregates . . . . . . . . . . . . . . . . . . .54

Financial Markets

59

CHAPTER 4

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

Negative T-Bill Rates? Japan Shows the Way . . . . . . . . . . . . . . . . . . .69

Application Reading the Wall Street Journal: The Bond Page . . . . . . . . . . . . . . . . .72
Following the Financial News Bond Prices and Interest Rates . . . . . . . . . . . . . . .73

Helping Investors to Select Desired Interest-Rate Risk . . . . . . . . . . . . . . . . .79

With TIPS, Real Interest Rates Have Become Observable in the
United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .82

CHAPTER 5

THE BEHAVIOR OF INTEREST RATES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85

xi


xii

Contents

Application Changes in the Equilibrium Interest Rate Due to Expected
Inflation or Business Cycle Expansions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .99

Application Explaining Low Japanese Interest Rates . . . . . . . . . . . . . . . . . . . . . .103
Application Reading the Wall Street Journal “Credit Markets” Column . . . . . . . .103
Following the Financial News The “Credit Markets” Column . . . . . . . . . . . . . .104

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

Following the Financial News Forecasting Interest Rates . . . . . . . . . . . . . . . . . .111
Application Money and Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .112

CHAPTER 6

THE RISK AND TERM STRUCTURE OF INTEREST RATES . . . . . . . . . . . . . . . . . . .120

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


Contents

Application Effects of the Bush Tax Cut on Bond Interest Rates . . . . . . . . . . . . .127

Following the Financial News Yield Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . .128

Application Interpreting Yield Curves, 1980–2003 . . . . . . . . . . . . . . . . . . . . . . .137

CHAPTER 7

THE STOCK MARKET, THE THEORY OF RATIONAL EXPECTATIONS,
AND THE EFFICIENT MARKET HYPOTHESIS . . . . . . . . . . . . . . . . . . . . . . . . . . . .141

Application Monetary Policy and Stock Prices . . . . . . . . . . . . . . . . . . . . . . . . . .146
Application The September 11 Terrorist Attacks, the Enron Scandal,
and the Stock Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .146

Application Should Foreign Exchange Rates Follow a Random Walk? . . . . . . . .155

Application Practical Guide to Investing in the Stock Market . . . . . . . . . . . . . . .158

xiii

xiv

Contents
Following the Financial News Stock Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . .159
Should You Hire an Ape as Your Investment Adviser? . . . . . . . . . . . . . . . .160

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

Financial Institutions

167

CHAPTER 8

AN ECONOMIC ANALYSIS OF FINANCIAL STRUCTURE . . . . . . . . . . . . . . . . . . . .169

The Enron Implosion and the Arthur Andersen Conviction . . . . . . . . . . .178

Venture Capitalists and the High-Tech Sector . . . . . . . . . . . . . .183

Application Financial Development and Economic Growth . . . . . . . . . . . . . . . .187

Application Financial Crises in the United States . . . . . . . . . . . . . . . . . . . . . . . .191
Case Study of a Financial Crisis: The Great Depression . . . . . . . . . . . . . . .194
Application Financial Crises in Emerging-Market Countries:
Mexico, 1994–1995; East Asia, 1997–1998; and Argentina, 2001–2002 . . . . . . .194


Contents

CHAPTER 9

BANKING AND THE MANAGEMENT OF FINANCIAL INSTITUTIONS . . . . . . . . . . . .201

Application Strategies for Managing Bank Capital . . . . . . . . . . . . . . . . . . . . . . . .215
Application Did the Capital Crunch Cause a Credit Crunch in the
Early 1990s? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .216

Application Strategies for Managing Interest-Rate Risk . . . . . . . . . . . . . . . . . . . .222

Barings, Daiwa, Sumitomo, and Allied Irish:
Rogue Traders and the Principal–Agent Problem . . . . . . . . . . . . . . . . . . . . . . . . .225

CHAPTER 10

BANKING INDUSTRY: STRUCTURE AND COMPETITION . . . . . . . . . . . . . . . . . . . .229

Will “Clicks” Dominate “Bricks” in the Banking Industry? . . . .236

xv


xvi

Contents

Information Technology and Bank Consolidation . . . . . . . . . . .247

Comparison of Banking Structure in the United States
and Abroad . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .249

Ironic Birth of the Eurodollar Market . . . . . . . . . . . . . . . . . . . . . . .255

CHAPTER 11

ECONOMIC ANALYSIS OF BANKING REGULATION . . . . . . . . . . . . . . . . . . . . . . .260

The Spread of Government Deposit Insurance Throughout
the World: Is This a Good Thing? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .262

Basel 2: Is It Spinning Out of Control? . . . . . . . . . . . . . . . . . . . . . .265

Electronic Banking: New Challenges for Bank Regulation . . . . .270





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