The Economics of Money, Banking, and Financial Markets, Twelfth Edition
By Frederic S. Mishkin
Contents in Detail:
PART 1 Introduction 51
CHAPTER 1
Why Study Money, Banking, and Financial Markets? 52
Why Study Financial Markets?……………………………………………………………………………………… 52
Debt Markets and Interest Rates………………………………………………………………………………..53
The Stock Market……………………………………………………………………………………………………53
Why Study Financial Institutions and Banking?…………………………………………………………… 55
Structure of the Financial System………………………………………………………………………………55
Banks and Other Financial Institutions……………………………………………………………………….56
Financial Innovation……………………………………………………………………………………………….56
Financial Crises………………………………………………………………………………………………………56
Why Study Money and Monetary Policy?……………………………………………………………………. 57
Money and Business Cycles………………………………………………………………………………………57
Money and Inflation………………………………………………………………………………………………..57
Money and Interest Rates………………………………………………………………………………………….59
Conduct of Monetary Policy……………………………………………………………………………………..59
Fiscal Policy and Monetary Policy………………………………………………………………………………60
Why Study International Finance?……………………………………………………………………………….. 61
The Foreign Exchange Market…………………………………………………………………………………..62
The International Financial System…………………………………………………………………………….63
Money, Banking, and Financial Markets and Your Career………………………………………….. 64
How We Will Study Money, Banking, and Financial Markets…………………………………….. 64
Exploring the Web………………………………………………………………………………………………….65
Concluding Remarks……………………………………………………………………………………………………… 65
Summary 65 • Key Terms 66 • Questions 66 • Applied Problems 67 •
Data Analysis Problems 67 • Web Exercises 68 • Web References 68
APPENDIX TO CHAPTER 1
Defining Aggregate Output, Income, the Price Level,
and the Inflation Rate 69
Aggregate Output and Income…………………………………………………………………………………….. 69
Real Versus Nominal Magnitudes………………………………………………………………………………… 69
Aggregate Price Level…………………………………………………………………………………………………….. 70
Growth Rates and the Inflation Rate……………………………………………………………………………. 71
CHAPTER 2
An Overview of the Financial System 72
Function of Financial Markets………………………………………………………………………………………. 72
Structure of Financial Markets………………………………………………………………………………………. 75
Debt and Equity Markets………………………………………………………………………………………….75
Primary and Secondary Markets………………………………………………………………………………..75
Exchanges and Over-the-Counter Markets…………………………………………………………………..76
Money and Capital Markets………………………………………………………………………………………77
Financial Market Instruments……………………………………………………………………………………….. 77
Money Market Instruments………………………………………………………………………………………77
Following the Financial News Money Market Rates 78
Capital Market Instruments………………………………………………………………………………………79
Following the Financial News Capital Market Interest Rates 80
Internationalization of Financial Markets……………………………………………………………………. 81
Global Are U.S. Capital Markets Losing Their Edge? 82
International Bond Market, Eurobonds, and Eurocurrencies………………………………………….82
World Stock Markets……………………………………………………………………………………………….83
Function of Financial Intermediaries: Indirect Finance………………………………………………. 83
Following the Financial News Foreign Stock Market Indexes 84
Transaction Costs……………………………………………………………………………………………………84
Global The Importance of Financial Intermediaries Relative to Securities Markets:
An International Comparison 85
Risk Sharing…………………………………………………………………………………………………………..86
Asymmetric Information: Adverse Selection and Moral Hazard………………………………………86
Economies of Scope and Conflicts of Interest………………………………………………………………88
Types of Financial Intermediaries…………………………………………………………………………………. 88
Depository Institutions…………………………………………………………………………………………….88
Contractual Savings Institutions………………………………………………………………………………..90
Investment Intermediaries………………………………………………………………………………………..91
Regulation of the Financial System………………………………………………………………………………. 92
Increasing Information Available to Investors……………………………………………………………….92
Ensuring the Soundness of Financial Intermediaries……………………………………………………..93
Financial Regulation Abroad……………………………………………………………………………………..95
Summary 95 • Key Terms 96 • Questions 96 • Applied Problems 97 •
Data Analysis Problems 98 • Web Exercises 98 • Web References 98
CHAPTER 3
What Is Money? 99
Meaning of Money………………………………………………………………………………………………………… 99
Functions of Money……………………………………………………………………………………………………..100
Medium of Exchange……………………………………………………………………………………………..100
Unit of Account…………………………………………………………………………………………………….101
Store of Value……………………………………………………………………………………………………….102
Evolution of the Payments System………………………………………………………………………………103
Commodity Money……………………………………………………………………………………………….103
Fiat Money…………………………………………………………………………………………………………..103
Checks………………………………………………………………………………………………………………..103
Electronic Payment………………………………………………………………………………………………..104
E-Money……………………………………………………………………………………………………………..104
FYI Are We Headed for a Cashless Society? 105
APPLICATION Will Bitcoin Become the Money of the Future?…………………………..105
Measuring Money…………………………………………………………………………………………………………106
The Federal Reserve’s Monetary Aggregates……………………………………………………………….106
Following the Financial News The Monetary Aggregates 107
FYI Where Are All the U.S. Dollars? 108
Summary 109 • Key Terms 110 • Questions 110 • Applied Problems 111 • Data Analysis
Problems 112 • Web Exercises 112 • Web References 112
PART 2 Financial Markets 113
CHAPTER 4
The Meaning of Interest Rates 114
Measuring Interest Rates……………………………………………………………………………………………..114
Present Value………………………………………………………………………………………………………..114
APPLICATION Simple Present Value………………………………………………………………..116
APPLICATION How Much Is That Jackpot Worth?……………………………………………116
Four Types of Credit Market Instruments………………………………………………………………….117
Yield to Maturity…………………………………………………………………………………………………..118
APPLICATION Yield to Maturity on a Simple Loan……………………………………………118
APPLICATION Yield to Maturity and the Yearly Payment on a Fixed-Payment Loan… 120
APPLICATION Yield to Maturity and Bond Price for a Coupon Bond………………….121
APPLICATION Yield to Maturity on a Perpetuity………………………………………………123
APPLICATION Yield to Maturity on a Discount Bond………………………………………..124
The Distinction Between Interest Rates and Returns…………………………………………………125
Global Negative Interest Rates? Japan First, Then the United States, Then Europe 126
Maturity and the Volatility of Bond Returns: Interest-Rate Risk……………………………………..128
Summary……………………………………………………………………………………………………………..129
The Distinction Between Real and Nominal Interest Rates………………………………………130
APPLICATION Calculating Real Interest Rates………………………………………………….131
Summary 133 • Key Terms 133 • Questions 133 • Applied Problems 134 • Data Analysis
Problems 135 • Web Exercises 135 • Web References 135
CHAPTER 4 APPENDIX
Measuring Interest-Rate Risk: Duration
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CHAPTER 5
The Behavior of Interest Rates 136
Determinants of Asset Demand…………………………………………………………………………………..136
Wealth…………………………………………………………………………………………………………………137
Expected Returns………………………………………………………………………………………………….137
Risk…………………………………………………………………………………………………………………….137
Liquidity……………………………………………………………………………………………………………..138
Theory of Portfolio Choice……………………………………………………………………………………..138
Supply and Demand in the Bond Market…………………………………………………………………..139
Demand Curve……………………………………………………………………………………………………..139
Supply Curve……………………………………………………………………………………………………….140
Market Equilibrium……………………………………………………………………………………………….141
Supply and Demand Analysis………………………………………………………………………………….142
Changes in Equilibrium Interest Rates………………………………………………………………………..142
Shifts in the Demand for Bonds……………………………………………………………………………….143
Shifts in the Supply of Bonds………………………………………………………………………………….146
APPLICATION Changes in the Interest Rate Due to a Change in
Expected Inflation: The Fisher Effect………………………………………………………148
APPLICATION Changes in the Interest Rate Due to a Business Cycle Expansion…..150
APPLICATION Explaining Current Low Interest Rates in Europe, Japan,
and the United States: Low Inflation and Secular Stagnation………………………151
Supply and Demand in the Market for Money:
The Liquidity Preference Framework…………………………………………………………………..152
Changes in Equilibrium Interest Rates in the Liquidity Preference Framework………155
Shifts in the Demand for Money………………………………………………………………………………155
Shifts in the Supply of Money…………………………………………………………………………………155
APPLICATION Changes in the Equilibrium Interest Rate Due to
Changes in Income, the Price Level, or the Money Supply…………………………156
Changes in Income………………………………………………………………………………………………..157
Changes in the Price Level………………………………………………………………………………………157
Changes in the Money Supply…………………………………………………………………………………157
Money and Interest Rates…………………………………………………………………………………………….158
APPLICATION Does a Higher Rate of Growth of the Money Supply
Lower Interest Rates?…………………………………………………………………………….160
Summary 163 • Key Terms 163 • Questions 163 • Applied Problems 164 •
Data Analysis Problems 165 • Web Exercises 166 • Web References 166
CHAPTER 5 APPENDIX 1
Models of Asset Pricing
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CHAPTER 5 APPENDIX 2
Applying the Asset Market Approach to a Commodity Market: The Case of Gold
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CHAPTER 5 APPENDIX 3
Loanable Funds Framework
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CHAPTER 6
The Risk and Term Structure of Interest Rates 167
Risk Structure of Interest Rates…………………………………………………………………………………….167
Default Risk………………………………………………………………………………………………………….167
FYI Conflicts of Interest at Credit-Rating Agencies and the Global Financial Crisis 171
APPLICATION The Global Financial Crisis and the Baa-Treasury Spread 172
Liquidity……………………………………………………………………………………………………………..172
Income Tax Considerations…………………………………………………………………………………….173
Summary……………………………………………………………………………………………………………..174
APPLICATION Effects of the Obama Tax Increase on Bond Interest Rates 174
Term Structure of Interest Rates…………………………………………………………………………………..175
Following the Financial News Yield Curves 175
Expectations Theory………………………………………………………………………………………………177
Segmented Markets Theory…………………………………………………………………………………….180
Liquidity Premium and Preferred Habitat Theories……………………………………………………..181
Evidence on the Term Structure………………………………………………………………………………184
FYI The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle 185
Summary……………………………………………………………………………………………………………..185
APPLICATION Interpreting Yield Curves, 1980–2017……………………………………….185
Summary 187 • Key Terms 187 • Questions 187 • Applied Problems 189 •
Data Analysis Problems 189 • Web Exercises 190 • Web References 190
CHAPTER 7
The Stock Market, the Theory of Rational Expectations,
and the Efficient Market Hypothesis 191
Computing the Price of Common Stock…………………………………………………………………….191
The One-Period Valuation Model…………………………………………………………………………….192
The Generalized Dividend Valuation Model……………………………………………………………….193
The Gordon Growth Model…………………………………………………………………………………….193
How the Market Sets Stock Prices……………………………………………………………………………….194
APPLICATION Monetary Policy and Stock Prices……………………………………………..196
APPLICATION The Global Financial Crisis and the Stock Market………………………196
The Theory of Rational Expectations…………………………………………………………………………..196
Formal Statement of the Theory………………………………………………………………………………198
Rationale Behind the Theory…………………………………………………………………………………..198
Implications of the Theory……………………………………………………………………………………..199
The Efficient Market Hypothesis: Rational Expectations in Financial Markets………..200
Rationale Behind the Hypothesis……………………………………………………………………………..201
Random-Walk Behavior of Stock Prices…………………………………………………………………….202
Global Should Foreign Exchange Rates Follow a Random Walk? 203
APPLICATION Practical Guide to Investing in the Stock Market…………………………203
How Valuable Are Reports Published by Investment Advisers?……………………………………..203
Should You Be Skeptical of Hot Tips?……………………………………………………………………….204
FYI Should You Hire an Ape as Your Investment Adviser? 205
Do Stock Prices Always Rise When There Is Good News?…………………………………………….205
Efficient Market Prescription for the Investor……………………………………………………………..205
Why the Efficient Market Hypothesis Does Not Imply That
Financial Markets Are Efficient…………………………………………………………………………….206
APPLICATION What Do Stock Market Crashes Tell Us About the Efficient
Market Hypothesis and the Efficiency of Financial Markets?………………………207
Behavioral Finance……………………………………………………………………………………………………….207
Summary 208 • Key Terms 209 • Questions 209 • Applied Problems 210 •
Data Analysis Problems 211 • Web Exercises 211 • Web References 211
CHAPTER 7 APPENDIX
Evidence on the Efficient Market Hypothesis
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PART 3 Financial Institutions 213
CHAPTER 8
An Economic Analysis of Financial Structure 214
Basic Facts About Financial Structure Throughout the World…………………………………..214
Transaction Costs………………………………………………………………………………………………………….217
How Transaction Costs Influence Financial Structure………………………………………………….217
How Financial Intermediaries Reduce Transaction Costs……………………………………………..218
Asymmetric Information: Adverse Selection and Moral Hazard………………………………219
The Lemons Problem: How Adverse Selection Influences Financial Structure……….219
Lemons in the Stock and Bond Markets…………………………………………………………………….220
Tools to Help Solve Adverse Selection Problems…………………………………………………………220
FYI The Enron Implosion 222
How Moral Hazard Affects the Choice Between Debt and Equity Contracts………….225
Moral Hazard in Equity Contracts: The Principal–Agent Problem………………………………….225
Tools to Help Solve the Principal–Agent Problem……………………………………………………….226
How Moral Hazard Influences Financial Structure in Debt Markets………………………..228
Tools to Help Solve Moral Hazard in Debt Contracts…………………………………………………..228
Summary……………………………………………………………………………………………………………..230
APPLICATION Financial Development and Economic Growth…………………………..231
FYI The Tyranny of Collateral 232
APPLICATION Is China a Counterexample to the Importance
of Financial Development?……………………………………………………………………..233
Summary 234 • Key Terms 235 • Questions 235 • Applied Problems 236 •
Data Analysis Problems 237 • Web Exercises 237 • Web References 237
CHAPTER 9
Banking and the Management of Financial Institutions 238
The Bank Balance Sheet……………………………………………………………………………………………….238
Liabilities……………………………………………………………………………………………………………..238
Assets………………………………………………………………………………………………………………….241
Basic Banking………………………………………………………………………………………………………………..242
General Principles of Bank Management……………………………………………………………………245
Liquidity Management and the Role of Reserves…………………………………………………………245
Asset Management…………………………………………………………………………………………………248
Liability Management…………………………………………………………………………………………….249
Capital Adequacy Management……………………………………………………………………………….250
APPLICATION Strategies for Managing Bank Capital………………………………………..252
APPLICATION How a Capital Crunch Caused a Credit Crunch During the
Global Financial Crisis…………………………………………………………………………..253
Managing Credit Risk……………………………………………………………………………………………………253
Screening and Monitoring………………………………………………………………………………………254
Long-Term Customer Relationships………………………………………………………………………….255
Loan Commitments……………………………………………………………………………………………….256
Collateral and Compensating Balances……………………………………………………………………..256
Credit Rationing……………………………………………………………………………………………………256
Managing Interest-Rate Risk………………………………………………………………………………………..257
Gap and Duration Analysis……………………………………………………………………………………..258
APPLICATION Strategies for Managing Interest-Rate Risk………………………………….259
Off-Balance-Sheet Activities………………………………………………………………………………………..259
Loan Sales……………………………………………………………………………………………………………260
Generation of Fee Income………………………………………………………………………………………260
Trading Activities and Risk Management Techniques…………………………………………………..260
Global Barings, Daiwa, Sumitomo, Société Générale, and JP Morgan Chase:
Rogue Traders and the Principal–Agent Problem 261
Summary 262 • Key Terms 263 • Questions 263 • Applied Problems 264 •
Data Analysis Problems 265 • Web Exercises 265 • Web References 266
CHAPTER 9 APPENDIX 1
Duration Gap Analysis
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CHAPTER 9 APPENDIX 2
Measuring Bank Performance
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CHAPTER 10
Economic Analysis of Financial Regulation 267
Asymmetric Information as a Rationale for Financial Regulation…………………………….267
Government Safety Net………………………………………………………………………………………….267
Global The Spread of Government Deposit Insurance Throughout the World:
Is This a Good Thing? 269
Drawbacks of the Government Safety Net…………………………………………………………………270
Types of Financial Regulation………………………………………………………………………………………272
Restrictions on Asset Holdings………………………………………………………………………………..272
Capital Requirements…………………………………………………………………………………………….273
Global Where Is the Basel Accord Heading After the Global Financial Crisis? 274
Prompt Corrective Action……………………………………………………………………………………….275
Financial Supervision: Chartering and Examination……………………………………………………275
Assessment of Risk Management……………………………………………………………………………..276
Disclosure Requirements………………………………………………………………………………………..277
Consumer Protection……………………………………………………………………………………………..278
Restrictions on Competition……………………………………………………………………………………278
Summary……………………………………………………………………………………………………………..279
Global International Financial Regulation 280
Summary 282 • Key Terms 283 • Questions 283 • Applied Problems 284 •
Data Analysis Problems 284 • Web Exercises 285 • Web References 285
CHAPTER 10 APPENDIX 1
The 1980s Banking and Savings and Loan Crisis
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CHAPTER 10 APPENDIX 2
Banking Crises Throughout the World
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CHAPTER 11
Banking Industry: Structure and Competition 286
Historical Development of the Banking System…………………………………………………………286
Multiple Regulatory Agencies………………………………………………………………………………….288
Financial Innovation and the Growth of the “Shadow Banking System”………………….289
Responses to Changes in Demand Conditions: Interest-Rate Volatility……………………………290
Responses to Changes in Supply Conditions: Information Technology…………………………..291
Securitization and the Shadow Banking System………………………………………………………….293
Avoidance of Existing Regulations……………………………………………………………………………295
FYI Bruce Bent and the Money Market Mutual Fund Panic of 2008 296
Financial Innovation and the Decline of Traditional Banking………………………………………..297
Structure of the U.S. Commercial Banking Industry…………………………………………………..300
Restrictions on Branching……………………………………………………………………………………….302
Response to Branching Restrictions………………………………………………………………………….302
Bank Consolidation and Nationwide Banking……………………………………………………………303
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994………………………305
What Will the Structure of the U.S. Banking Industry Look Like in the Future?………………305
Global Comparison of Banking Structure in the United States and Abroad 306
Are Bank Consolidation and Nationwide Banking Good Things?…………………………………..306
Separation of Banking and Other Financial Service Industries…………………………………307
Erosion of Glass-Steagall…………………………………………………………………………………………307
The Gramm-Leach-Bliley Financial Services Modernization Act of 1999:
Repeal of Glass-Steagall……………………………………………………………………………………..308
Implications for Financial Consolidation…………………………………………………………………..308
Separation of Banking and Other Financial Services Industries Throughout the World…….308
FYI The Global Financial Crisis and the Demise of Large,
Free-Standing Investment Banks 309
Thrift Industry: Regulation and Structure……………………………………………………………………309
Savings and Loan Associations…………………………………………………………………………………310
Mutual Savings Banks…………………………………………………………………………………………….310
Credit Unions……………………………………………………………………………………………………….310
International Banking…………………………………………………………………………………………………..311
Eurodollar Market…………………………………………………………………………………………………311
Global Ironic Birth of the Eurodollar Market 312
Structure of U.S. Banking Overseas…………………………………………………………………………..312
Foreign Banks in the United States…………………………………………………………………………..313
Summary 314 • Key Terms 315 • Questions 315 • Data Analysis Problems 316 •
Web Exercises 317 • Web References 317
CHAPTER 12
Financial Crises in Advanced Economies 318
Global The European Sovereign Debt Crisis 319
What Is a Financial Crisis?…………………………………………………………………………………………….319
Dynamics of Financial Crises……………………………………………………………………………………….320
Stage One: Initial Phase………………………………………………………………………………………….320
Stage Two: Banking Crisis……………………………………………………………………………………….322
Stage Three: Debt Deflation…………………………………………………………………………………….324
APPLICATION The Mother of All Financial Crises: The Great Depression…………..324
The U.S. Stock Market Crash…………………………………………………………………………………..324
Worldwide Decline in Asset Prices……………………………………………………………………………325
Bank Failures………………………………………………………………………………………………………..326
Economic Contraction and Debt Deflation………………………………………………………………..326
The Global Financial Crisis of 2007–2009…………………………………………………………………..327
Causes of the 2007–2009 Financial Crisis…………………………………………………………………327
FYI Collateralized Debt Obligations (CDOs) and Credit Default Swaps 328
Effects of the 2007–2009 Financial Crisis………………………………………………………………….329
Inside the Fed Was the Fed to Blame for the Housing Price Bubble? 330
Height of the 2007–2009 Financial Crisis…………………………………………………………………334
Government Intervention and the Recovery……………………………………………………………..335
Short-Term Responses and Recovery………………………………………………………………………..335
Global Latvia’s Different and Controversial Response: Expansionary Contraction 336
Stabilizing the Global Financial System:
Long-Term Responses……………………………………………………………………………………………337
Global Financial Regulatory Framework……………………………………………………………………337
Policy Areas at the National Level……………………………………………………………………………. 337
FYI The Libor Scandal 340
Future Regulations and Policy Areas at the International Level……………………………….340
Bilateral and Multilateral Supervisory Cooperation……………………………………………………..341
Collective Supervisory Cooperation………………………………………………………………………….341
Collectively Coordinated Macroeconomic Stability Plans……………………………………………..341
Self-Discipline………………………………………………………………………………………………………341
Summary 342 • Key Terms 343 • Questions 343 • Data Analysis Problems 344 •
Web Exercises 345
CHAPTER 13
Financial Crises in Emerging Economies 346
Dynamics of Financial Crises in Emerging Market Economies……………………………….. 346
Stage One: Initial Phase………………………………………………………………………………………….346
Stage Two: Currency Crisis……………………………………………………………………………………..350
Stage Three: Full-Fledged Financial Crisis…………………………………………………………………351
APPLICATION Crisis in South Korea, 1997–1998…………………………………………….352
Financial Liberalization and Globalization Mismanaged………………………………………………354
Perversion of the Financial Liberalization and Globalization
Process: Chaebols and the South Korean Crisis……………………………………………………..354
Stock Market Decline and Failure of Firms Increase Uncertainty…………………………………..356
Adverse Selection and Moral Hazard Problems Worsen, and the Economy Contracts……….356
Currency Crisis Ensues………………………………………………………………………………………….357
Final Stage: Currency Crisis Triggers Full-Fledged Financial Crisis……………………………….357
Recovery Commences……………………………………………………………………………………………358
Global China and the “Noncrisis” in 1997–1998 359
APPLICATION The Argentine Financial Crisis, 2001–2002………………………………..359
Severe Fiscal Imbalances………………………………………………………………………………………..359
Adverse Selection and Moral Hazard Problems Worsen……………………………………………….360
Bank Panic Begins…………………………………………………………………………………………………360
Currency Crisis Ensues………………………………………………………………………………………….361
Currency Crisis Triggers Full-Fledged Financial Crisis………………………………………………..361
Recovery Begins……………………………………………………………………………………………………364
Global When an Advanced Economy Is Like an Emerging Market Economy:
The Icelandic Financial Crisis of 2008 364
Preventing Emerging Market Financial Crises…………………………………………………………….365
Beef Up Prudential Regulation and Supervision of Banks…………………………………………….365
Encourage Disclosure and Market-Based Discipline…………………………………………………….365
Limit Currency Mismatch……………………………………………………………………………………….366
Sequence Financial Liberalization…………………………………………………………………………….366
Summary 366 • Key Terms 367 • Questions 367 • Data Analysis Problems 367 •
Web References 368
PART 4 Central Banking and the Conduct of Monetary Policy 369
CHAPTER 14
Central Banks 370
Origins Of The Central Banking System………………………………………………………………………370
Variations in The Functions and Structures
of Central Banks…………………………………………………………………………………………………….371
The European Central Bank, the Euro System, and the
European System of Central Banks………………………………………………………………………371
Global Who Should Own Central Banks? 372
Decision-making Bodies of the ECB…………………………………………………………………………374
Global The Importance of the Bundesbank Within the ECB 376
How Monetary Policy Is Conducted Within the ECB…………………………………………………..376
Global Are Non-Euro Central Banks Constrained by Membership In the EU? 377
The Federal Reserve System…………………………………………………………………………………….378
Comparing the ECB and the Fed……………………………………………………………………………..379
The Bank of England……………………………………………………………………………………………..379
Global Brexit and the BoE 380
Structure of Central Banks in Larger Economies………………………………………………………..381
Structure and Independence of Central Banks
in Emerging Market Economies……………………………………………………………………………383
Should Central Banks Be Independent……………………………………………………………………….384
The Case for Independence…………………………………………………………………………………….384
The Case Against Independence………………………………………………………………………………385
The Trend Toward Greater Independence………………………………………………………………….385
Summary 386 • Key Terms 386 • Questions 387 • Web Exercises 387
CHAPTER 15
The Money Supply Process 388
Three Players in the Money Supply Process……………………………………………………………….388
The Fed’s Balance Sheet……………………………………………………………………………………………….388
Liabilities……………………………………………………………………………………………………………..389
Assets………………………………………………………………………………………………………………….390
Control of the Monetary Base……………………………………………………………………………………..390
Federal Reserve Open Market Operations………………………………………………………………….391
Shifts from Deposits into Currency…………………………………………………………………………..392
Loans to Financial Institutions…………………………………………………………………………………393
Other Factors That Affect the Monetary Base……………………………………………………………..393
Overview of the Fed’s Ability to Control the Monetary Base………………………………………….394
Multiple Deposit Creation: A Simple Model………………………………………………………………395
Deposit Creation: The Single Bank…………………………………………………………………………..395
Deposit Creation: The Banking System……………………………………………………………………..396
Deriving the Formula for Multiple Deposit Creation…………………………………………………..399
Critique of the Simple Model………………………………………………………………………………….400
Factors That Determine the Money Supply………………………………………………………………..401
Changes in the Nonborrowed Monetary Base, MBn……………………………………………………..401
Changes in Borrowed Reserves, BR, from the Fed……………………………………………………….401
Changes in the Required Reserve Ratio, rr…………………………………………………………………402
Changes in Excess Reserves…………………………………………………………………………………….402
Changes in Currency Holdings………………………………………………………………………………..402
Overview of the Money Supply Process……………………………………………………………………..402
The Money Multiplier…………………………………………………………………………………………………..403
Deriving the Money Multiplier………………………………………………………………………………..403
Intuition Behind the Money Multiplier……………………………………………………………………..405
Money Supply Response to Changes in the Factors……………………………………………………..406
APPLICATION Quantitative Easing and the Money Supply, 2007–2017……………….407
Summary 409 • Key Terms 409 • Questions 409 • Applied Problems 410 •
Data Analysis Problems 411 • Web Exercises 411 • Web References 412
CHAPTER 15 APPENDIX 1
The Fed’s Balance Sheet and the Monetary Base
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CHAPTER 15 APPENDIX 2
The M2 Money Multiplier
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CHAPTER 15 APPENDIX 3
Explaining the Behavior of the Currency Ratio
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CHAPTER 15 APPENDIX 4
The Great Depression Bank Panics, 1930–1933, and the Money Supply
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CHAPTER 16
Tools of Monetary Policy 413
The Market for Reserves and the Federal Funds Rate……………………………………………….413
Demand and Supply in the Market for Reserves…………………………………………………………414
How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate………………….415
APPLICATION How the Federal Reserve’s Operating Procedures
Limit Fluctuations in the Federal Funds Rate……………………………………………419
Conventional Monetary Policy Tools………………………………………………………………………….420
Open Market Operations………………………………………………………………………………………..421
Inside the Fed A Day at the Trading Desk 422
Discount Policy and the Lender of Last Resort……………………………………………………………423
Inside the Fed Using Discount Policy to Prevent a Financial Panic 425
Reserve Requirements…………………………………………………………………………………………….426
Interest on Reserves……………………………………………………………………………………………….426
Relative Advantages of the Different Tools…………………………………………………………………427
Nonconventional Monetary Policy Tools and Quantitative Easing………………………….427
Liquidity Provision………………………………………………………………………………………………..428
Large-Scale Asset Purchases…………………………………………………………………………………….428
Inside the Fed Fed Lending Facilities During the Global Financial Crisis 429
Quantitative Easing Versus Credit Easing…………………………………………………………………..430
Forward Guidance…………………………………………………………………………………………………432
Negative Interest Rates on Banks’ Deposits………………………………………………………………..433
Monetary Policy Tools of the European Central Bank……………………………………………….434
Open Market Operations………………………………………………………………………………………..434
Lending to Banks…………………………………………………………………………………………………..434
Interest on Reserves……………………………………………………………………………………………….435
Reserve Requirements…………………………………………………………………………………………….435
Summary 435 • Key Terms 436 • Questions 436 • Applied Problems 437 •
Data Analysis Problems 438 • Web Exercises 438 • Web References 438
CHAPTER 17
The Conduct of Monetary Policy: Strategy and Tactics 439
The Price Stability Goal and the Nominal Anchor……………………………………………………..439
The Role of a Nominal Anchor………………………………………………………………………………..440
The Time-Inconsistency Problem…………………………………………………………………………….440
Other Goals of Monetary Policy………………………………………………………………………………….441
High Employment and Output Stability……………………………………………………………………441
Economic Growth…………………………………………………………………………………………………442
Stability of Financial Markets………………………………………………………………………………….442
Interest-Rate Stability……………………………………………………………………………………………..442
Stability in Foreign Exchange Markets………………………………………………………………………443
Should Price Stability Be the Primary Goal of Monetary Policy?……………………………..443
Hierarchical Versus Dual Mandates…………………………………………………………………………..443
Price Stability as the Primary, Long-Run Goal of Monetary Policy………………………………….444
Inflation Targeting…………………………………………………………………………………………………………444
Inflation Targeting in New Zealand, Canada, and the United Kingdom………………………….445
Advantages of Inflation Targeting…………………………………………………………………………….447
Disadvantages of Inflation Targeting…………………………………………………………………………449
The Evolution of the Federal Reserve’s Monetary Policy Strategy…………………………….450
The Fed’s “Just Do It” Monetary Policy Strategy………………………………………………………….450
The Long Road to Inflation Targeting……………………………………………………………………….452
Inside the Fed Ben Bernanke’s Advocacy of Inflation Targeting 453
Global The European Central Bank’s Monetary Policy Strategy 453
Lessons for Monetary Policy Strategy from the Global Financial Crisis……………………454
Implications for Inflation Targeting………………………………………………………………………….455
Should Central Banks Try to Stop Asset-Price Bubbles?…………………………………………….456
Two Types of Asset-Price Bubbles……………………………………………………………………………..456
The Debate Over Whether Central Banks Should Try to Pop Bubbles…………………………….457
Tactics: Choosing the Policy Instrument……………………………………………………………………..460
Criteria for Choosing the Policy Instrument………………………………………………………………462
Tactics: The Taylor Rule…………………………………………………………………………………………………463
Inside the Fed The Fed’s Use of the Taylor Rule 466
Inside the Fed Fed Watchers 466
Summary 467 • Key Terms 467 • Questions 468 • Applied Problems 469 •
Data Analysis Problems 469 • Web Exercises 470 • Web References 471
CHAPTER 17 APPENDIX 1
Monetary Targeting
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CHAPTER 17 APPENDIX 2
A Brief History of Federal Reserve Policymaking
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PART 5 International Finance and Monetary Policy 473
CHAPTER 18
The Foreign Exchange Market 474
Foreign Exchange Market…………………………………………………………………………………………….474
Following the Financial News Foreign Exchange Rates 475
What Are Foreign Exchange Rates?…………………………………………………………………………..475
Why Are Exchange Rates Important?………………………………………………………………………..475
How Is Foreign Exchange Traded?……………………………………………………………………………476
Exchange Rates in the Long Run………………………………………………………………………………….477
Theory of Purchasing Power Parity…………………………………………………………………………..477
APPLICATION Burgernomics: Big Macs and PPP………………………………………………479
Factors That Affect Exchange Rates in the Long Run……………………………………………………481
Exchange Rates in the Short Run: A Supply and Demand Analysis………………………….483
Supply Curve for Domestic Assets……………………………………………………………………………483
Demand Curve for Domestic Assets………………………………………………………………………….483
Equilibrium in the Foreign Exchange Market…………………………………………………………….485
Explaining Changes in Exchange Rates……………………………………………………………………….485
Shifts in the Demand for Domestic Assets…………………………………………………………………485
Recap: Factors That Change the Exchange Rate………………………………………………………….488
APPLICATION Effects of Changes in Interest Rates on the Equilibrium
Exchange Rate………………………………………………………………………………………490
APPLICATION The Global Financial Crisis and the Dollar………………………………..492
APPLICATION Brexit and the British Pound…………………………………………………….493
Summary 494 • Key Terms 495 • Questions 495 • Applied Problems 496 •
Data Analysis Problems 496 • Web Exercises 497 • Web References 497
APPENDIX TO CHAPTER 18
The Interest Parity Condition 498
Comparing Expected Returns on Domestic and Foreign Assets………………………………498
Interest Parity Condition………………………………………………………………………………………………500
CHAPTER 19
The International Financial System 502
Intervention in the Foreign Exchange Market……………………………………………………………502
Foreign Exchange Intervention and the Money Supply………………………………………………..502
Inside the Fed A Day at the Federal Reserve Bank of New York’s Foreign
Exchange Desk 503
Unsterilized Intervention………………………………………………………………………………………..505
Sterilized Intervention……………………………………………………………………………………………506
Balance of Payments…………………………………………………………………………………………………….506
Current Account…………………………………………………………………………………………………..507
Financial Account…………………………………………………………………………………………………507
Global Should We Worry About the Large U.S. Current Account Deficit? 508
Exchange Rate Regimes in the International Financial System…………………………………508
Gold Standard………………………………………………………………………………………………………509
The Bretton Woods System……………………………………………………………………………………..509
How a Fixed Exchange Rate Regime Works……………………………………………………………….510
Speculative Attacks………………………………………………………………………………………………..512
APPLICATION The Foreign Exchange Crisis of September 1992…………………………512
The Policy Trilemma………………………………………………………………………………………………514
APPLICATION How Did China Accumulate $4 Trillion of International Reserves?..515
Monetary Unions…………………………………………………………………………………………………..515
Managed Float………………………………………………………………………………………………………516
Global Will the Euro Survive? 516
Capital Controls…………………………………………………………………………………………………………….517
Controls on Capital Outflows………………………………………………………………………………….517
Controls on Capital Inflows……………………………………………………………………………………517
The Role of the IMF………………………………………………………………………………………………………518
Should the IMF Act as an International Lender of Last Resort?……………………………………..518
International Considerations and Monetary Policy…………………………………………………..519
Direct Effects of the Foreign Exchange Market on Monetary Policy………………………………..519
Exchange Rate Considerations…………………………………………………………………………………520
To Peg or Not to Peg: Exchange-Rate Targeting as an Alternative Monetary
Policy Strategy……………………………………………………………………………………………………….520
Advantages of Exchange-Rate Targeting…………………………………………………………………….520
Disadvantages of Exchange-Rate Targeting…………………………………………………………………521
When Is Exchange-Rate Targeting Desirable for Industrialized Countries?………………………523
When Is Exchange-Rate Targeting Desirable for Emerging Market Countries?…………………524
Currency Boards……………………………………………………………………………………………………524
Global Argentina’s Currency Board 525
Dollarization………………………………………………………………………………………………………..525
Summary 526 • Key Terms 527 • Questions 527 • Applied Problems 528 •
Data Analysis Problems 529 • Web Exercises 530 • Web References 530
PART 6 Monetary Theory 531
CHAPTER 20
Quantity Theory, Inflation, and the Demand for Money 532
Quantity Theory of Money…………………………………………………………………………………………..532
Velocity of Money and Equation of Exchange…………………………………………………………….532
From the Equation of Exchange to the Quantity Theory of Money………………………………..534
Quantity Theory and the Price Level………………………………………………………………………..535
Quantity Theory and Inflation………………………………………………………………………………..535
APPLICATION Testing the Quantity Theory of Money………………………………………536
Budget Deficits and Inflation……………………………………………………………………………………….538
Government Budget Constraint……………………………………………………………………………….538
Hyperinflation………………………………………………………………………………………………………540
APPLICATION The Zimbabwean Hyperinflation……………………………………………….540
Keynesian Theories of Money Demand……………………………………………………………………..541
Transactions Motive……………………………………………………………………………………………….541
Precautionary Motive……………………………………………………………………………………………..541
Speculative Motive………………………………………………………………………………………………..541
Putting the Three Motives Together………………………………………………………………………….541
Portfolio Theories of Money Demand………………………………………………………………………..542
Theory of Portfolio Choice and Keynesian Liquidity Preference…………………………………….543
Other Factors That Affect the Demand for Money……………………………………………………….543
Summary……………………………………………………………………………………………………………..544
Empirical Evidence for the Demand for Money………………………………………………………..544
Interest Rates and Money Demand…………………………………………………………………………..544
Stability of Money Demand…………………………………………………………………………………….545
Summary 546 • Key Terms 546 • Questions 546 • Applied Problems 548 •
Data Analysis Problems 548 • Web Exercises 549 • Web References 549
CHAPTER 20 APPENDIX 1
The Baumol-Tobin and Tobin Mean Variance Models of the Demand for Money
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CHAPTER 20 APPENDIX 2
Empirical Evidence on the Demand for Money
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CHAPTER 21
The IS Curve 550
Planned Expenditure and Aggregate Demand…………………………………………………………..550
The Components of Aggregate Demand……………………………………………………………………551
Consumption Expenditure……………………………………………………………………………………..551
FYI Meaning of the Word Investment 552
Planned Investment Spending…………………………………………………………………………………552
Government Purchases and Taxes…………………………………………………………………………….554
Net Exports………………………………………………………………………………………………………….555
Goods Market Equilibrium…………………………………………………………………………………………..556
Solving for Goods Market Equilibrium……………………………………………………………………..556
Deriving the IS Curve…………………………………………………………………………………………….557
Understanding the IS Curve…………………………………………………………………………………………557
What the IS Curve Tells Us: Intuition……………………………………………………………………….557
What the IS Curve Tells Us: Numerical Example………………………………………………………..557
Why the Economy Heads Toward Equilibrium…………………………………………………………..559
Factors that Shift the IS Curve………………………………………………………………………………………559
Changes in Government Purchases…………………………………………………………………………..559
APPLICATION The Vietnam War Buildup, 1964–1969………………………………………560
Changes in Taxes…………………………………………………………………………………………………..561
APPLICATION The Fiscal Stimulus Package of 2009…………………………………………562
Changes in Autonomous Spending…………………………………………………………………………..563
Changes in Financial Frictions………………………………………………………………………………..565
Summary of Factors That Shift the IS Curve………………………………………………………………565
Summary 565 • Key Terms 565 • Questions 566 • Applied Problems 567 • CHAPTER 22
The Monetary Policy and Aggregate Demand Curves 570
The Federal Reserve and Monetary Policy………………………………………………………………….570
The Monetary Policy Curve………………………………………………………………………………………….571
The Taylor Principle: Why the Monetary Policy Curve Has an Upward Slope………………….571
Shifts in the MP Curve……………………………………………………………………………………………573
Movements Along Versus Shifts in the MP Curve……………………………………………………….574
APPLICATION Movement Along the MP Curve: The Rise in the Federal
Funds Rate Target, 2004–2006………………………………………………………………..574
APPLICATION Shift in the MP Curve: Autonomous Monetary Easing at
the Onset of the Global Financial Crisis…………………………………………………..574
The Aggregate Demand Curve…………………………………………………………………………………….575
Deriving the Aggregate Demand Curve Graphically…………………………………………………….576
Factors That Shift the Aggregate Demand Curve…………………………………………………………576
FYI Deriving the Aggregate Demand Curve Algebraically 576
Summary 581 • Key Terms 581 • Questions 581 • Applied Problems 582 •
Data Analysis Problems 583 • Web Exercises 584 • Web References 584
CHAPTER 23
Aggregate Demand and Supply Analysis 585
Aggregate Demand……………………………………………………………………………………………………….585
Following the Financial News Aggregate Output, Unemployment, and Inflation 586
Deriving the Aggregate Demand Curve……………………………………………………………………..586
Factors That Shift the Aggregate Demand Curve…………………………………………………………587
FYI What Does Autonomous Mean? 588
Aggregate Supply………………………………………………………………………………………………………….591
Long-Run Aggregate Supply Curve…………………………………………………………………………..591
Short-Run Aggregate Supply Curve………………………………………………………………………….591
Price Stickiness and the Short-Run Aggregate Supply Curve…………………………………………593
Shifts in the Aggregate Supply Curves…………………………………………………………………………593
Shifts in the Long-Run Aggregate Supply Curve…………………………………………………………593
Shifts in the Short-Run Aggregate Supply Curve…………………………………………………………594
Equilibrium in Aggregate Demand and Supply Analysis…………………………………………..597
Short-Run Equilibrium…………………………………………………………………………………………..598
How the Short-Run Equilibrium Moves to the Long-Run Equilibrium over Time…………….598
Self-Correcting Mechanism……………………………………………………………………………………..601
Changes in Equilibrium: Aggregate Demand Shocks…………………………………………………601
APPLICATION The Volcker Disinflation, 1980–1986………………………………………..602
APPLICATION Negative Demand Shocks, 2001–2004……………………………………….604
Changes in Equilibrium: Aggregate Supply (Inflation) Shocks………………………………….604
Temporary Supply Shocks………………………………………………………………………………………604
APPLICATION Negative Supply Shocks, 1973–1975 and 1978–1980………………….607
Permanent Supply Shocks and Real Business Cycle Theory………………………………………….607
APPLICATION Positive Supply Shocks, 1995–1999……………………………………………610
Conclusions…………………………………………………………………………………………………………611
APPLICATION Negative Supply and Demand Shocks and the 2007–2009
Financial Crisis……………………………………………………………………………………..612
AD/AS Analysis of Foreign Business Cycle Episodes…………………………………………………..612
APPLICATION The United Kingdom and the 2007–2009 Financial Crisis…………..614
APPLICATION China and the 2007–2009 Financial Crisis…………………………………615
Summary 616 • Key Terms 617 • Questions 617 • Applied Problems 618 •
Data Analysis Problems 618 • Web Exercises 619 • Web References 619
APPENDIX TO CHAPTER 23
The Phillips Curve and the Short-Run Aggregate Supply Curve 620
The Phillips Curve…………………………………………………………………………………………………………620
Phillips Curve Analysis in the 1960s………………………………………………………………………..620
FYI The Phillips Curve Trade-Off and Macroeconomic Policy in the 1960s 622
The Friedman-Phelps Phillips Curve Analysis……………………………………………………………622
The Phillips Curve After the 1960s…………………………………………………………………………..624
The Modern Phillips Curve…………………………………………………………………………………….624
The Modern Phillips Curve with Adaptive (Backward-Looking) Expectations…………………625
The Short-Run Aggregate Supply Curve……………………………………………………………………..626
CHAPTER 23 APPENDIX 1
The Effects of Macroeconomic Shocks on Asset Prices
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CHAPTER 23 APPENDIX 2
Aggregate Demand and Supply: A Numerical Example
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CHAPTER 23 APPENDIX 3
The Algebra of the Aggregate Demand and Supply Model
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CHAPTER 23 APPENDIX 4
The Taylor Principle and Inflation Stability
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CHAPTER 24
Monetary Policy Theory 629
Response of Monetary Policy to Shocks……………………………………………………………………..629
Response to an Aggregate Demand Shock………………………………………………………………….630
Response to a Permanent Supply Shock…………………………………………………………………….632
Response to a Temporary Supply Shock……………………………………………………………………634
The Bottom Line: The Relationship Between Stabilizing Inflation and
Stabilizing Economic Activity……………………………………………………………………………..637
How Actively Should Policymakers Try to Stabilize Economic Activity?………………….637
Lags and Policy Implementation………………………………………………………………………………637
Inflation: Always and Everywhere a Monetary Phenomenon…………………………………..638
FYI The Activist/Nonactivist Debate Over the Obama Fiscal Stimulus Package 639
Causes of Inflationary Monetary Policy………………………………………………………………………639
High Employment Targets and Inflation……………………………………………………………………639
APPLICATION The Great Inflation…………………………………………………………………643
Monetary Policy at the Zero Lower Bound………………………………………………………………..645
Deriving the Aggregate Demand Curve with the Zero Lower Bound………………………………645
The Disappearance of the Self-Correcting Mechanism at the Zero Lower Bound………………647
APPLICATION Nonconventional Monetary Policy and Quantitative Easing…………648
Liquidity Provision………………………………………………………………………………………………..649
Asset Purchases and Quantitative Easing…………………………………………………………………..650
Management of Expectations…………………………………………………………………………………..651
APPLICATION Abenomics and the Shift in Japanese Monetary Policy in 2013……..652
Summary 654 • Key Terms 654 • Questions 655 • Applied Problems 656 •
Data Analysis Problems 656 • Web Exercises 657 • Web References 657
CHAPTER 25
The Role of Expectations in Monetary Policy 658
Lucas Critique of Policy Evaluation……………………………………………………………………………..658
Econometric Policy Evaluation………………………………………………………………………………..659
APPLICATION The Term Structure of Interest Rates………………………………………….659
Policy Conduct: Rules or Discretion?………………………………………………………………………….660
Discretion and the Time-Inconsistency Problem…………………………………………………………660
Types of Rules……………………………………………………………………………………………………….661
The Case for Rules…………………………………………………………………………………………………661
FYI The Political Business Cycle and Richard Nixon 662
The Case for Discretion………………………………………………………………………………………….662
Constrained Discretion…………………………………………………………………………………………..663
Global The Demise of Monetary Targeting in Switzerland 663
The Role of Credibility and a Nominal Anchor………………………………………………………….664
Benefits of a Credible Nominal Anchor……………………………………………………………………..664
Credibility and Aggregate Demand Shocks………………………………………………………………..665
Credibility and Aggregate Supply Shocks………………………………………………………………….667
APPLICATION A Tale of Three Oil Price Shocks……………………………………………….668
Credibility and Anti-Inflation Policy…………………………………………………………………………670
Global Ending the Bolivian Hyperinflation: A Successful Anti-Inflation Program 671
APPLICATION Credibility and the Reagan Budget Deficits…………………………………672
Approaches to Establishing Central Bank Credibility…………………………………………………673
Nominal GDP Targeting…………………………………………………………………………………………673
Inside the Fed The Appointment of Paul Volcker, Anti-Inflation Hawk 674
Appoint “Conservative” Central Bankers……………………………………………………………………674
Summary 675 • Key Terms 675 • Questions 675 • Applied Problems 676 •
Data Analysis Problems 677 • Web Exercises 677
CHAPTER 26
Transmission Mechanisms of Monetary Policy 678
Transmission Mechanisms of Monetary Policy…………………………………………………………..678
Traditional Interest-Rate Channels……………………………………………………………………………679
Other Asset Price Channels…………………………………………………………………………………….680
Credit View………………………………………………………………………………………………………….683
FYI Consumers’ Balance Sheets and the Great Depression 685
Why Are Credit Channels Likely to Be Important?……………………………………………………..686
APPLICATION The Great Recession…………………………………………………………………687
Lessons for Monetary Policy………………………………………………………………………………………..687
APPLICATION Applying the Monetary Policy Lessons to Japan’s
Two Lost Decades………………………………………………………………………………….689
Summary 690 • Key Terms 690 • Questions 690 • Applied Problems 691 •
Data Analysis Problems 692 • Web Exercises 692 • Web References 692
CHAPTER 26 APPENDIX
Evaluating Empirical Evidence: The Debate Over the Importance of Money in
Economic Fluctuations
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Glossary……………………………………………………………………………………………………………………….693
Index……………………………………………………………………………………………………………………………705
CHAPTER 1
The ISLM Model 1
Keynes’s Fixed Price Level Assumption and the IS Curve……………………………………………… 1
The LM Curve………………………………………………………………………………………………………… 1
Equilibrium in the Market for Money: The LM Curve……………………………………………………. 2
ISLM Approach to Aggregate Output and Interest Rates……………………………………………… 4
Factors That Cause the LM Curve to Shift……………………………………………………………………… 5
Changes in Equilibrium Level of the Interest Rate and Aggregate Output…………………. 7
Response to a Change in Monetary Policy……………………………………………………………………. 7
Response to a Change in Fiscal Policy…………………………………………………………………………. 8
APPLICATION The Economic Stimulus Act of 2008……………………………………………. 9
Effectiveness of Monetary Versus Fiscal Policy…………………………………………………………… 11
Monetary Policy Versus Fiscal Policy: The Case of Complete Crowding Out……………………. 11
APPLICATION Targeting Money Supply Versus Interest Rates……………………………. 13
ISLM Model in the Long Run……………………………………………………………………………………….. 16
Summary 18 • Key Terms 19 • Questions and Applied Problems 17 •
Web Exercises 19 • Web References 20
APPENDIX TO CHAPTER 1
Algebra of The ISLM Model 21
Basic Closed-Economy ISLM Model……………………………………………………………………………. 21
IS and LM Curves…………………………………………………………………………………………………. 22
Solution of the Model…………………………………………………………………………………………….. 22
Implications…………………………………………………………………………………………………………. 22
Open-Economy ISLM Model……………………………………………………………………………………….. 23
Implications…………………………………………………………………………………………………………………… 24
CHAPTER 2
Nonbank Finance 1
Insurance………………………………………………………………………………………………………………………….. 1
Life Insurance…………………………………………………………………………………………………………. 1
Property and Casualty Insurance……………………………………………………………………………….. 2
The Competitive Threat from the Banking Industry………………………………………………………. 4
Credit Insurance……………………………………………………………………………………………………… 4
FYI The AIG Blowup 5
FYI The Global Financial Crisis and the Monoline Insurers 6
APPLICATION Insurance Management……………………………………………………………… 6
Screening………………………………………………………………………………………………………………. 7
Risk-Based Premiums………………………………………………………………………………………………. 7
Restrictive Provisions……………………………………………………………………………………………….. 7
Prevention of Fraud…………………………………………………………………………………………………. 8
Cancellation of Insurance…………………………………………………………………………………………. 8
Deductibles……………………………………………………………………………………………………………. 8
Coinsurance…………………………………………………………………………………………………………… 8
Limits on the Amount of Insurance……………………………………………………………………………. 8
Summary……………………………………………………………………………………………………………….. 9
Pension Funds………………………………………………………………………………………………………………….. 9
Private Pension Plans……………………………………………………………………………………………… 10
Public Pension Plans………………………………………………………………………………………………. 10
FYI Should Social Security Be Privatized? 11
Finance Companies………………………………………………………………………………………………………. 12
Securities Market Operations………………………………………………………………………………………. 13
Investment Banking……………………………………………………………………………………………….. 13
Securities Brokers and Dealers…………………………………………………………………………………. 14
Organized Exchanges…………………………………………………………………………………………….. 14
Mutual Funds………………………………………………………………………………………………………………… 15
FYI Sovereign Wealth Funds: Are They a Danger? 16
Money Market Mutual Funds………………………………………………………………………………….. 17
Hedge Funds…………………………………………………………………………………………………………………. 17
Private Equity and Venture Capital Funds…………………………………………………………………… 18
Government Financial Intermediation……………………………………………………………………….. 19
Federal Credit Agencies………………………………………………………………………………………….. 19
FYI The Global Financial Crisis and the Bailout of Fannie Mae
and Freddie Mac 20
Summary 21 • Key Terms 22 • Questions 22 • Applied Problems 23 •
Data Analysis Problems 23 • Web Exercises 24 • Web References 24
CHAPTER 3
Financial Derivatives 1
Hedging……………………………………………………………………………………………………………………………. 1
Interest-Rate Forward Contracts…………………………………………………………………………………….. 2
APPLICATION Hedging with Interest-Rate Forward Contracts…………………………….. 2
Pros and Cons of Forward Contracts………………………………………………………………………….. 3
Financial Futures Contracts and Markets………………………………………………………………………. 4
APPLICATION Hedging with Financial Futures…………………………………………………… 5
Organization of Trading in Financial Futures Markets…………………………………………………… 7
The Globalization of Financial Futures Markets……………………………………………………………. 8
Explaining the Success of Futures Markets………………………………………………………………….. 8
APPLICATION Hedging Foreign Exchange Risk……………………………………………….. 10
Hedging Foreign Exchange Risk with Forward Contracts…………………………………………….. 10
Hedging Foreign Exchange Risk with Futures Contracts……………………………………………… 10
Options………………………………………………………………………………………………………………………….. 11
Option Contracts…………………………………………………………………………………………………… 12
Profits and Losses on Option and Futures Contracts…………………………………………………… 12
APPLICATION Hedging with Futures Options………………………………………………….. 15
Factors Affecting Option Premiums………………………………………………………………………….. 16
Summary……………………………………………………………………………………………………………… 17
Swaps……………………………………………………………………………………………………………………………… 18
Interest-Rate Swap Contracts…………………………………………………………………………………… 18
APPLICATION Hedging with Interest-Rate Swaps……………………………………………… 19
Advantages of Interest-Rate Swaps……………………………………………………………………………. 19
Disadvantages of Interest-Rate Swaps………………………………………………………………………… 20
Financial Intermediaries in Interest-Rate Swaps………………………………………………………….. 20
Credit Derivatives………………………………………………………………………………………………………….. 20
Credit Options……………………………………………………………………………………………………… 21
Credit Swaps………………………………………………………………………………………………………… 21
Credit-Linked Notes………………………………………………………………………………………………. 22
APPLICATION Lessons from the Global Financial Crisis: When Are Financial Derivatives
Likely to Be a Worldwide Ticking Time Bomb? 22
Summary 24 • Key Terms 24 • Questions 25 • Applied Problems 25 •
Data Analysis Problems 26 • Web Exercises 27 • Web References 27
CHAPTER 4
Conflicts of Interest in the Financial Industry 1
What Are Conflicts of Interest, and Why Are They Important?…………………………………… 2
Why Do We Care About Conflicts of Interest?……………………………………………………………… 2
Ethics and Conflicts of Interest……………………………………………………………………………………….. 2
Types of Conflicts of Interest…………………………………………………………………………………………… 3
Underwriting and Research in Investment Banking………………………………………………………. 3
Auditing and Consulting in Accounting Firms…………………………………………………………….. 4
Credit Assessment and Consulting in Credit-Rating Agencies…………………………………………. 4
FYI The Collapse of Arthur Andersen 5
Universal Banking…………………………………………………………………………………………………… 5
FYI Why Do Issuers of Securities Pay to Have Their Securities Rated? 6
FYI Banksters 7
Can the Market Limit Exploitation of Conflicts of Interest?…………………………………………. 7
What Has Been Done to Remedy Conflicts of Interest?………………………………………………. 9
Sarbanes-Oxley Act of 2002……………………………………………………………………………………… 9
Global Legal Settlement of 2002………………………………………………………………………………. 10
Dodd-Frank Bill of 2010………………………………………………………………………………………… 11
A Framework for Evaluating Policies to Remedy Conflicts of Interest……………………… 11
Approaches to Remedying Conflicts of Interest………………………………………………………….. 12
APPLICATION Evaluating Sarbanes-Oxley, the Global Legal Settlement,
and the Dodd-Frank Bill…………………………………………………………………………. 14
Summary 16 • Key Terms 17 • Questions 17 • Web Exercises 18 •
Web References 18
CHAPTER APPENDICES
Chapter 4: Measuring Interest-Rate Risk: Duration
Chapter 5: Models of Asset Pricing
Chapter 5: Applying the Asset Market Approach to a Commodity Market: The Case of Gold
Chapter 5: Loanable Funds Framework
Chapter 7: Evidence on the Efficient Market Hypothesis
Chapter 9: Duration Gap Analysis
Chapter 9: Measuring Bank Performance
Chapter 10: The 1980s Banking and Savings and Loan Crisis
Chapter 10: Banking Crises Throughout the World
Chapter 15: The Fed’s Balance Sheet and the Monetary Base
Chapter 15: The M2 Money Multiplier
Chapter 15: Explaining the Behavior of the Currency Ratio
Chapter 15: The Great Depression Bank Panics, 1930–1933, and the Money Supply
Chapter 17: Monetary Targeting
Chapter 17: A Brief History of Federal Reserve Policymaking
Chapter 20: The Baumol-Tobin and Tobin Mean-Variance Models of the Demand for Money
Chapter 20: Empirical Evidence on the Demand for Money
Chapter 23: The Effects of Macroeconomic Shocks on Asset Prices
Chapter 23: Aggregate Demand and Supply: A Numerical Example
Chapter 23: The Algebra of the Aggregate Demand and Supply Model
Chapter 23: The Taylor Principle and Inflation Stability
Chapter 26: Evaluating Empirical Evidence: The Debate Over the Importance of
Money in Economic Fluctuations