Economics of Money, Banking and Financial Markets, Business School Edition, 5th Edition
Frederic S. Mishkin
Contents
PART 1 Introduction 1
CHAPTER 1
Why Study Money, Banking, and Financial Markets? 2
Why Study Financial Markets?…………………………………………………………………………………………2
Debt Markets and Interest Rates………………………………………………………………………………….3
The Stock Market……………………………………………………………………………………………………..3
Why Study Financial Institutions and Banking?………………………………………………………………5
Structure of the Financial System………………………………………………………………………………..5
Banks and Other Financial Institutions…………………………………………………………………………6
Financial Innovation…………………………………………………………………………………………………6
Financial Crises………………………………………………………………………………………………………..6
Why Study Money and Monetary Policy?……………………………………………………………………….7
Money and Business Cycles………………………………………………………………………………………..7
Money and Inflation………………………………………………………………………………………………….7
Money and Interest Rates……………………………………………………………………………………………9
Conduct of Monetary Policy……………………………………………………………………………………….9
Fiscal Policy and Monetary Policy………………………………………………………………………………10
Why Study International Finance?……………………………………………………………………………….. 11
The Foreign Exchange Market…………………………………………………………………………………..12
The International Financial System…………………………………………………………………………….13
Money, Banking, and Financial Markets and Your Career………………………………………….. 14
How We Will Study Money, Banking, and Financial Markets…………………………………….. 14
Exploring the Web………………………………………………………………………………………………….15
Concluding Remarks……………………………………………………………………………………………………… 15
Summary 15 • Key Terms 16 • Questions 16 • Applied Problems 17 •
Data Analysis Problems 17 • Web Exercises 18 • Web References 18
APPENDIX TO CHAPTER 1
Defining Aggregate Output, Income, the Price Level,
and the Inflation Rate 19
Aggregate Output and Income…………………………………………………………………………………….. 19
Real Versus Nominal Magnitudes………………………………………………………………………………… 19
Aggregate Price Level…………………………………………………………………………………………………….. 20
Growth Rates and the Inflation Rate……………………………………………………………………………. 21
CHAPTER 2
An Overview of the Financial System 22
Function of Financial Markets………………………………………………………………………………………. 22
Structure of Financial Markets………………………………………………………………………………………. 25
Debt and Equity Markets………………………………………………………………………………………….25
Primary and Secondary Markets………………………………………………………………………………..25
Exchanges and Over-the-Counter Markets…………………………………………………………………..26
Money and Capital Markets………………………………………………………………………………………27
Financial Market Instruments……………………………………………………………………………………….. 27
Money Market Instruments………………………………………………………………………………………27
Following the Financial News Money Market Rates 28
Capital Market Instruments………………………………………………………………………………………29
Following the Financial News Capital Market Interest Rates 30
Internationalization of Financial Markets……………………………………………………………………. 31
Global Are U.S. Capital Markets Losing Their Edge? 32
International Bond Market, Eurobonds, and Eurocurrencies………………………………………….32
World Stock Markets……………………………………………………………………………………………….33
Function of Financial Intermediaries: Indirect Finance………………………………………………. 33
Following the Financial News Foreign Stock Market Indexes 34
Transaction Costs……………………………………………………………………………………………………34
Global The Importance of Financial Intermediaries Relative to Securities Markets:
An International Comparison 35
Risk Sharing…………………………………………………………………………………………………………..36
Asymmetric Information: Adverse Selection and Moral Hazard………………………………………36
Economies of Scope and Conflicts of Interest………………………………………………………………38
Types of Financial Intermediaries…………………………………………………………………………………. 38
Depository Institutions…………………………………………………………………………………………….38
Contractual Savings Institutions………………………………………………………………………………..40
Investment Intermediaries………………………………………………………………………………………..41
Regulation of the Financial System………………………………………………………………………………. 42
Increasing Information Available to Investors……………………………………………………………….42
Ensuring the Soundness of Financial Intermediaries……………………………………………………..43
Financial Regulation Abroad……………………………………………………………………………………..45
Summary 45 • Key Terms 46 • Questions 46 • Applied Problems 47 •
Data Analysis Problems 48 • Web Exercises 48 • Web References 48
CHAPTER 3
What Is Money? 49
Meaning of Money………………………………………………………………………………………………………… 49
Functions of Money………………………………………………………………………………………………………. 50
Medium of Exchange……………………………………………………………………………………………….50
Unit of Account………………………………………………………………………………………………………51
Store of Value…………………………………………………………………………………………………………52
Evolution of the Payments System……………………………………………………………………………….. 53
Commodity Money…………………………………………………………………………………………………53
Fiat Money…………………………………………………………………………………………………………….53
Checks………………………………………………………………………………………………………………….53
Electronic Payment………………………………………………………………………………………………….54
E-Money……………………………………………………………………………………………………………….54
FYI Are We Headed for a Cashless Society? 55
APPLICATION Will Bitcoin Become the Money of the Future?…………………………….55
Measuring Money………………………………………………………………………………………………………….. 56
The Federal Reserve’s Monetary Aggregates…………………………………………………………………56
Following the Financial News The Monetary Aggregates 57
FYI Where Are All the U.S. Dollars? 58
Summary 59 • Key Terms 60 • Questions 60 • Applied Problems 61 •
Data Analysis Problems 62 • Web Exercises 62 • Web References 62
PART 2 Financial Markets 63
CHAPTER 4
The Meaning of Interest Rates 64
Measuring Interest Rates………………………………………………………………………………………………. 64
Present Value………………………………………………………………………………………………………….64
APPLICATION Simple Present Value…………………………………………………………………66
APPLICATION How Much Is That Jackpot Worth?…………………………………………….66
Four Types of Credit Market Instruments……………………………………………………………………67
Yield to Maturity…………………………………………………………………………………………………….68
APPLICATION Yield to Maturity on a Simple Loan……………………………………………..68
APPLICATION Yield to Maturity and the Yearly Payment on a Fixed-Payment Loan…….70
APPLICATION Yield to Maturity and the Bond Price for a Coupon Bond………………71
APPLICATION Yield to Maturity on a Perpetuity………………………………………………..73
APPLICATION Yield to Maturity on a Discount Bond………………………………………….74
The Distinction Between Interest Rates and Returns………………………………………………….. 75
Global Negative Interest Rates? Japan First, Then the United States, Then Europe 76
Maturity and the Volatility of Bond Returns: Interest-Rate Risk……………………………………….78
Summary……………………………………………………………………………………………………………….79
The Distinction Between Real and Nominal Interest Rates……………………………………….. 80
APPLICATION Calculating Real Interest Rates……………………………………………………81
Summary 83 • Key Terms 83 • Questions 83 • Applied Problems 84 •
Data Analysis Problems 85 • Web Exercises 85 • Web References 85
CHAPTER 4 APPENDIX
Measuring Interest-Rate Risk: Duration
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CHAPTER 5
The Behavior of Interest Rates 86
Determinants of Asset Demand……………………………………………………………………………………. 86
Wealth…………………………………………………………………………………………………………………..87
Expected Returns……………………………………………………………………………………………………87
Risk………………………………………………………………………………………………………………………87
Liquidity……………………………………………………………………………………………………………….88
Theory of Portfolio Choice……………………………………………………………………………………….88
Supply and Demand in the Bond Market……………………………………………………………………. 89
Demand Curve……………………………………………………………………………………………………….89
Supply Curve…………………………………………………………………………………………………………90
Market Equilibrium…………………………………………………………………………………………………91
Supply and Demand Analysis……………………………………………………………………………………92
Changes in Equilibrium Interest Rates…………………………………………………………………………. 92
Shifts in the Demand for Bonds…………………………………………………………………………………93
Shifts in the Supply of Bonds……………………………………………………………………………………96
APPLICATION Changes in the Interest Rate Due to a Change in Expected
Inflation: The Fisher Effect……………………………………………………… 98
APPLICATION Changes in the Interest Rate Due to a Business Cycle Expansion…..100
APPLICATION Explaining Current Low Interest Rates in Europe, Japan, and the
United States: Low Inflation and Secular Stagnation…………………… 101
Supply and Demand in the Market for Money:
The Liquidity Preference Framework…………………………………………………………………..102
Changes in Equilibrium Interest Rates in the Liquidity Preference Framework………105
Shifts in the Demand for Money………………………………………………………………………………105
Shifts in the Supply of Money…………………………………………………………………………………105
APPLICATION Changes in the Equilibrium Interest Rate Due to Changes
in Income, the Price Level, or the Money Supply……………………….. 106
Changes in Income………………………………………………………………………………………………..107
Changes in the Price Level………………………………………………………………………………………107
Changes in the Money Supply…………………………………………………………………………………107
Money and Interest Rates…………………………………………………………………………………………….108
APPLICATION Does a Higher Rate of Growth of the Money Supply Lower
Interest Rates?………………………………………………………………………………………..110
Summary 113 • Key Terms 113 • Questions 113 • Applied Problems 114 •
Data Analysis Problems 115 • Web Exercises 116 • Web References 116
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 117
Risk Structure of Interest Rates…………………………………………………………………………………….117
Default Risk………………………………………………………………………………………………………….117
FYI Conflicts of Interest at Credit-Rating Agencies and the Global
Financial Crisis 121
APPLICATION The Global Financial Crisis and the Baa-Treasury Spread…………….122
Liquidity……………………………………………………………………………………………………………..122
Income Tax Considerations…………………………………………………………………………………….123
Summary……………………………………………………………………………………………………………..124
APPLICATION Effects of the Obama Tax Increase on Bond Interest Rates……………124
Term Structure of Interest Rates…………………………………………………………………………………..125
Following the Financial News Yield Curves 125
Expectations Theory………………………………………………………………………………………………127
Segmented Markets Theory…………………………………………………………………………………….130
Liquidity Premium and Preferred Habitat Theories……………………………………………………..131
Evidence on the Term Structure………………………………………………………………………………134
FYI The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle 135
Summary……………………………………………………………………………………………………………..135
APPLICATION Interpreting Yield Curves, 1980–2017……………………………………….135
Summary 137 • Key Terms 137 • Questions 137 • Applied Problems 139 •
Data Analysis Problems 139 • Web Exercises 140 • Web References 140
CHAPTER 7
The Stock Market, the Theory of Rational Expectations,
and the Efficient Market Hypothesis 141
Computing the Price of Common Stock…………………………………………………………………….141
The One-Period Valuation Model…………………………………………………………………………….142
The Generalized Dividend Valuation Model……………………………………………………………….143
The Gordon Growth Model…………………………………………………………………………………….143
How the Market Sets Stock Prices……………………………………………………………………………….144
APPLICATION Monetary Policy and Stock Prices……………………………………………..146
APPLICATION The Global Financial Crisis and the Stock Market………………………146
The Theory of Rational Expectations…………………………………………………………………………..146
Formal Statement of the Theory………………………………………………………………………………148
Rationale Behind the Theory…………………………………………………………………………………..148
Implications of the Theory……………………………………………………………………………………..149
The Efficient Market Hypothesis: Rational Expectations in Financial Markets………..150
Rationale Behind the Hypothesis……………………………………………………………………………..151
Random-Walk Behavior of Stock Prices…………………………………………………………………….152
Global Should Foreign Exchange Rates Follow a Random Walk? 153
APPLICATION Practical Guide to Investing in the Stock Market…………………………153
How Valuable Are Published Reports by Investment Advisers?……………………………………..153
Should You Be Skeptical of Hot Tips?……………………………………………………………………….154
FYI Should You Hire an Ape as Your Investment Adviser? 155
Do Stock Prices Always Rise When There Is Good News?…………………………………………….155
Efficient Market Prescription for the Investor……………………………………………………………..155
Why the Efficient Market Hypothesis Does Not Imply That Financial
Markets Are Efficient……………………………………………………………………………..156
APPLICATION What Do Stock Market Crashes Tell Us About the Efficient
Market Hypothesis and the Efficiency of Financial Markets?………………………157
Behavioral Finance……………………………………………………………………………………………………….157
Summary 158 • Key Terms 159 • Questions 159 • Applied Problems 160 •
Data Analysis Problems 161 • Web Exercises 161 • Web References 161
CHAPTER 7 APPENDIX
Evidence on the Efficient Market Hypothesis
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PART 3 Financial Institutions 163
CHAPTER 8
An Economic Analysis of Financial Structure 164
Basic Facts About Financial Structure Throughout the World…………………………………..164
Transaction Costs………………………………………………………………………………………………………….167
How Transaction Costs Influence Financial Structure………………………………………………….167
How Financial Intermediaries Reduce Transaction Costs……………………………………………..168
Asymmetric Information: Adverse Selection and Moral Hazard………………………………169
The Lemons Problem: How Adverse Selection Influences Financial Structure……….169
Lemons in the Stock and Bond Markets…………………………………………………………………….170
Tools to Help Solve Adverse Selection Problems…………………………………………………………170
FYI The Enron Implosion 172
How Moral Hazard Affects the Choice Between Debt and Equity Contracts………….175
Moral Hazard in Equity Contracts: The Principal–Agent Problem………………………………….175
Tools to Help Solve the Principal–Agent Problem……………………………………………………….176
How Moral Hazard Influences Financial Structure in Debt Markets………………………..178
Tools to Help Solve Moral Hazard in Debt Contracts…………………………………………………..178
Summary……………………………………………………………………………………………………………..180
APPLICATION Financial Development and Economic Growth…………………………..181
FYI The Tyranny of Collateral 182
APPLICATION Is China a Counterexample to the Importance of Financial
Development?………………………………………………………………………… 183
Summary 184 • Key Terms 185 • Questions 185 • Applied Problems 186 •
Data Analysis Problems 187 • Web Exercises 187 • Web References 187
CHAPTER 9
Banking and the Management of Financial Institutions 188
The Bank Balance Sheet……………………………………………………………………………………………….188
Liabilities……………………………………………………………………………………………………………..188
Assets………………………………………………………………………………………………………………….191
Basic Banking………………………………………………………………………………………………………………..192
General Principles of Bank Management……………………………………………………………………195
Liquidity Management and the Role of Reserves…………………………………………………………195
Asset Management…………………………………………………………………………………………………198
Liability Management…………………………………………………………………………………………….199
Capital Adequacy Management……………………………………………………………………………….200
APPLICATION Strategies for Managing Bank Capital………………………………………..202
APPLICATION How a Capital Crunch Caused a Credit Crunch During
the Global Financial Crisis………………………………………………………. 203
Managing Credit Risk……………………………………………………………………………………………………203
Screening and Monitoring………………………………………………………………………………………204
Long-Term Customer Relationships………………………………………………………………………….205
Loan Commitments……………………………………………………………………………………………….206
Collateral and Compensating Balances……………………………………………………………………..206
Credit Rationing……………………………………………………………………………………………………206
Managing Interest-Rate Risk………………………………………………………………………………………..207
Gap and Duration Analysis……………………………………………………………………………………..208
APPLICATION Strategies for Managing Interest-Rate Risk………………………………….209
Off-Balance-Sheet Activities………………………………………………………………………………………..209
Loan Sales……………………………………………………………………………………………………………210
Generation of Fee Income………………………………………………………………………………………210
Trading Activities and Risk Management Techniques…………………………………………………..210
Global Barings, Daiwa, Sumitomo, Société Générale, and JP Morgan Chase:
Rogue Traders and the Principal–Agent Problem 211
Summary 212 • Key Terms 213 • Questions 213 • Applied Problems 214 • Data Analysis
Problems 215 • Web Exercises 215 • Web References 216
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 217
Asymmetric Information as a Rationale for Financial Regulation…………………………….217
Government Safety Net………………………………………………………………………………………….217
Global The Spread of Government Deposit Insurance Throughout the World:
Is This a Good Thing? 219
Drawbacks of the Government Safety Net…………………………………………………………………220
Types of Financial Regulation………………………………………………………………………………………222
Restrictions on Asset Holdings………………………………………………………………………………..222
Capital Requirements…………………………………………………………………………………………….223
Global Where Is the Basel Accord Heading After the Global
Financial Crisis? 224
Prompt Corrective Action……………………………………………………………………………………….225
Financial Supervision: Chartering and Examination……………………………………………………225
Assessment of Risk Management……………………………………………………………………………..226
Disclosure Requirements………………………………………………………………………………………..227
Consumer Protection……………………………………………………………………………………………..228
Restrictions on Competition……………………………………………………………………………………228
Summary……………………………………………………………………………………………………………..229
Global International Financial Regulation 230
Summary 232 • Key Terms 233 • Questions 233 • Applied Problems 234 •
Data Analysis Problems 234 • Web Exercises 235 • Web References 235
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 236
Historical Development of the Banking System…………………………………………………………236
Multiple Regulatory Agencies………………………………………………………………………………….238
Financial Innovation and the Growth of the “Shadow
Banking System”…………………………………………………………………………………………………….239
Responses to Changes in Demand Conditions: Interest-Rate Volatility……………………………240
Responses to Changes in Supply Conditions: Information Technology…………………………..241
Securitization and the Shadow Banking System………………………………………………………….243
Avoidance of Existing Regulations……………………………………………………………………………245
FYI Bruce Bent and the Money Market Mutual Fund Panic of 2008 246
Financial Innovation and the Decline of Traditional Banking………………………………………..247
Structure of the U.S. Commercial Banking Industry…………………………………………………..250
Restrictions on Branching……………………………………………………………………………………….252
Response to Branching Restrictions………………………………………………………………………….252
Bank Consolidation and Nationwide Banking……………………………………………………………253
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994………………………255
What Will the Structure of the U.S. Banking Industry Look Like in the Future?………………255
Global Comparison of Banking Structure in the United States and Abroad 256
Are Bank Consolidation and Nationwide Banking Good Things?…………………………………..256
Separation of the Banking and Other Financial Service Industries…………………………..257
Erosion of Glass-Steagall…………………………………………………………………………………………257
The Gramm-Leach-Bliley Financial Services Modernization Act of 1999:
Repeal of Glass-Steagall……………………………………………………………………………..258
Implications for Financial Consolidation…………………………………………………………………..258
Separation of Banking and Other Financial Services Industries Throughout the World…….258
FYI The Global Financial Crisis and the Demise of Large, Free-Standing
Investment Banks 259
Thrift Industry: Regulation and Structure……………………………………………………………………259
Savings and Loan Associations…………………………………………………………………………………260
Mutual Savings Banks…………………………………………………………………………………………….260
Credit Unions……………………………………………………………………………………………………….260
International Banking…………………………………………………………………………………………………..261
Eurodollar Market…………………………………………………………………………………………………261
Global Ironic Birth of the Eurodollar Market 262
Structure of U.S. Banking Overseas…………………………………………………………………………..262
Foreign Banks in the United States…………………………………………………………………………..263
Summary 264 • Key Terms 265 • Questions 265 • Data Analysis Problems 266 •
Web Exercises 267 • Web References 267
CHAPTER 12
Financial Crises 268
What Is a Financial Crisis?…………………………………………………………………………………………….268
Dynamics of Financial Crises……………………………………………………………………………………….269
Stage One: Initial Phase………………………………………………………………………………………….269
Stage Two: Banking Crisis……………………………………………………………………………………….271
Stage Three: Debt Deflation…………………………………………………………………………………….272
APPLICATION The Mother of All Financial Crises: The Great Depression…………..273
Stock Market Crash……………………………………………………………………………………………….273
Bank Panics………………………………………………………………………………………………………….273
Continuing Decline in Stock Prices………………………………………………………………………….274
Debt Deflation………………………………………………………………………………………………………274
International Dimensions……………………………………………………………………………………….275
The Global Financial Crisis of 2007–2009…………………………………………………………………..275
Causes of the 2007–2009 Financial Crisis…………………………………………………………………275
FYI Collateralized Debt Obligations (CDOs) 276
Effects of the 2007–2009 Financial Crisis………………………………………………………………….277
Inside the Fed Was the Fed to Blame for the Housing Price Bubble? 278
Global The European Sovereign Debt Crisis 281
Height of the 2007–2009 Financial Crisis…………………………………………………………………282
Government Intervention and the Recovery………………………………………………………………283
Global Worldwide Government Bailouts During the 2007–2009
Financial Crisis 283
Response of Financial Regulation………………………………………………………………………………..284
Macroprudential Versus Microprudential Supervision…………………………………………………284
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010…………………………285
Too-Big-to-Fail and Future Regulation……………………………………………………………………….286
What Can Be Done About the Too-Big-to-Fail Problem?………………………………………………287
Beyond Dodd-Frank: Where Might Regulation Head in the Future?………………………………287
Summary 289 • Key Terms 290 • Questions 290 • Data Analysis Problems 291 •
Web Exercises 292 • Web References 292
CHAPTER 13
Nonbank Finance 293
Insurance……………………………………………………………………………………………………………………….293
Life Insurance……………………………………………………………………………………………………….293
Property and Casualty Insurance……………………………………………………………………………..294
The Competitive Threat from the Banking Industry…………………………………………………….296
Credit Insurance……………………………………………………………………………………………………296
FYI The AIG Blowup 297
FYI The Global Financial Crisis and the Monoline Insurers 298
APPLICATION Insurance Management……………………………………………………………298
Screening…………………………………………………………………………………………………………….299
Risk-Based Premiums…………………………………………………………………………………………….299
Restrictive Provisions……………………………………………………………………………………………..299
Prevention of Fraud……………………………………………………………………………………………….300
Cancellation of Insurance……………………………………………………………………………………….300
Deductibles………………………………………………………………………………………………………….300
Coinsurance…………………………………………………………………………………………………………300
Limits on the Amount of Insurance………………………………………………………………………….300
Summary……………………………………………………………………………………………………………..301
Pension Funds……………………………………………………………………………………………………………….301
Private Pension Plans……………………………………………………………………………………………..302
Public Pension Plans………………………………………………………………………………………………302
FYI Should Social Security Be Privatized? 303
Finance Companies………………………………………………………………………………………………………304
Securities Market Operations………………………………………………………………………………………305
Investment Banking……………………………………………………………………………………………….305
Securities Brokers and Dealers…………………………………………………………………………………306
Organized Exchanges…………………………………………………………………………………………….306
Mutual Funds………………………………………………………………………………………………………………..307
FYI Sovereign Wealth Funds: Are They a Danger? 308
Money Market Mutual Funds………………………………………………………………………………….309
Hedge Funds…………………………………………………………………………………………………………………309
Private Equity and Venture Capital Funds…………………………………………………………………..310
Government Financial Intermediation……………………………………………………………………….311
Federal Credit Agencies………………………………………………………………………………………….311
FYI The Global Financial Crisis and the Bailout of Fannie Mae
and Freddie Mac 312
Summary 313 • Key Terms 314 • Questions 314 • Applied Problems 315 •
Data Analysis Problems 315 • Web Exercises 316 • Web References 316
CHAPTER 14
Financial Derivatives 317
Hedging…………………………………………………………………………………………………………………………317
Interest-Rate Forward Contracts………………………………………………………………………………….318
APPLICATION Hedging with Interest-Rate Forward Contracts…………………………..318
Pros and Cons of Forward Contracts………………………………………………………………………..319
Financial Futures Contracts and Markets……………………………………………………………………320
APPLICATION Hedging with Financial Futures………………………………………………..321
Organization of Trading in Financial Futures Markets…………………………………………………323
The Globalization of Financial Futures Markets………………………………………………………….324
Explaining the Success of Futures Markets………………………………………………………………..324
APPLICATION Hedging Foreign Exchange Risk……………………………………………….326
Hedging Foreign Exchange Risk with Forward Contracts…………………………………………….326
Hedging Foreign Exchange Risk with Futures Contracts……………………………………………..326
Options………………………………………………………………………………………………………………………….327
Options Contracts…………………………………………………………………………………………………328
Profits and Losses on Option and Futures Contracts…………………………………………………..328
APPLICATION Hedging with Future Options…………………………………………………..331
Factors Affecting Option Premiums………………………………………………………………………….332
Summary……………………………………………………………………………………………………………..333
Swaps……………………………………………………………………………………………………………………………..334
Interest-Rate Swap Contracts…………………………………………………………………………………..334
APPLICATION Hedging with Interest-Rate Swaps……………………………………………..335
Advantages of Interest-Rate Swaps……………………………………………………………………………335
Disadvantages of Interest-Rate Swaps………………………………………………………………………..336
Financial Intermediaries in Interest-Rate Swaps………………………………………………………….336
Credit Derivatives………………………………………………………………………………………………………….336
Credit Options……………………………………………………………………………………………………..337
Credit Swaps………………………………………………………………………………………………………..337
Credit-Linked Notes………………………………………………………………………………………………338
APPLICATION Lessons from the Global Financial Crisis: When Are
Financial Derivatives Likely to Be a Worldwide
Ticking Time Bomb?………………………………………………………………. 338
Summary 340 • Key Terms 340 • Questions 341 • Applied Problems 341 •
Data Analysis Problems 342 • Web Exercises 343 • Web References 343
CHAPTER 15
Conflicts of Interest in the Financial Industry 344
What Are Conflicts of Interest, and Why Are They Important?………………………………..345
Why Do We Care About Conflicts of Interest?……………………………………………………………345
Ethics and Conflicts of Interest…………………………………………………………………………………….345
Types of Conflicts of Interest………………………………………………………………………………………..346
Underwriting and Research in Investment Banking…………………………………………………….346
Auditing and Consulting in Accounting Firms…………………………………………………………..347
Credit Assessment and Consulting in Credit-Rating Agencies……………………………………….347
FYI The Collapse of Arthur Andersen 348
Universal Banking…………………………………………………………………………………………………348
FYI Why Do Issuers of Securities Pay to Have Their Securities Rated? 349
FYI Banksters 350
Can the Market Limit Exploitation of Conflicts of Interest?………………………………………350
What Has Been Done to Remedy Conflicts of Interest?……………………………………………352
Sarbanes-Oxley Act of 2002……………………………………………………………………………………353
Global Legal Settlement of 2002………………………………………………………………………………353
Dodd-Frank Bill of 2010………………………………………………………………………………………..354
A Framework for Evaluating Policies to Remedy
Conflicts of Interest……………………………………………………………………………………………….354
Approaches to Remedying Conflicts of Interest………………………………………………………….355
APPLICATION Evaluating Sarbanes-Oxley, the Global Legal Settlement,
and the Dodd-Frank Bill…………………………………………………………. 357
Summary 359 • Key Terms 360 • Questions 360 • Web Exercises 361 •
Web References 361
PART 4 Central Banking and the Conduct of Monetary Policy 363
CHAPTER 16
Central Banks and the Federal Reserve System 364
Origins of the Federal Reserve System………………………………………………………………………..364
Inside the Fed The Political Genius of the Founders of the Federal
Reserve System 365
Structure of the Federal Reserve System…………………………………………………………………….365
Federal Reserve Banks……………………………………………………………………………………………366
Inside the Fed The Special Role of the Federal Reserve Bank of New York 368
Member Banks……………………………………………………………………………………………………..369
Board of Governors of the Federal Reserve System………………………………………………………370
Federal Open Market Committee (FOMC)………………………………………………………………..370
Inside the Fed The Role of the Research Staff 371
Inside the Fed The FOMC Meeting 372
Inside the Fed Green, Blue, Teal, and Beige: What Do These Colors Mean at
the Fed? 373
Why the Chair of the Board of Governors Really Runs the Show…………………………………..373
Inside the Fed Styles of Federal Reserve Chairs: Bernanke and Yellen Versus
Greenspan 374
How Independent Is the Fed?……………………………………………………………………………………..375
Should the Fed Be Independent?………………………………………………………………………………..377
The Case for Independence…………………………………………………………………………………….377
The Case Against Independence………………………………………………………………………………378
Central Bank Independence and Macroeconomic Performance
Throughout the World………………………………………………………………………………………379
Explaining Central Bank Behavior……………………………………………………………………………….379
Inside the Fed The Evolution of the Fed’s Communication Strategy 380
Structure and Independence of the European Central Bank……………………………………381
Differences Between the European System of Central Banks and the
Federal Reserve System……………………………………………………………………………………..381
Governing Council………………………………………………………………………………………………..382
How Independent Is the ECB?…………………………………………………………………………………382
Structure and Independence of Other Foreign Central Banks………………………………….383
Bank of Canada…………………………………………………………………………………………………….383
Bank of England……………………………………………………………………………………………………383
Bank of Japan……………………………………………………………………………………………………….384
The Trend Toward Greater Independence 385
Summary 385 • Key Terms 386 • Questions 386 • Data Analysis Problems 387 •
Web Exercises 387 • Web References 387
CHAPTER 17
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 17 APPENDIX 1
The Fed’s Balance Sheet and the Monetary Base
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CHAPTER 17 APPENDIX 2
The M2 Money Multiplier
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CHAPTER 17 APPENDIX 3
Explaining the Behavior of the Currency Ratio
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CHAPTER 17 APPENDIX 4
The Great Depression Bank Panics, 1930–1933, and the Money Supply
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CHAPTER 18
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 19
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 19 APPENDIX 1
Monetary Targeting
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CHAPTER 19 APPENDIX 2
A Brief History of Federal Reserve Policymaking
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PART 5 International Finance and Monetary Policy 473
CHAPTER 20
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 20
The Interest Parity Condition 498
Comparing Expected Returns on Domestic and Foreign Assets …………..498
Interest Parity Condition ………..500
CHAPTER 21
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 22
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 22 APPENDIX 1
The Baumol-Tobin and Tobin Mean Variance Models of the
Demand for Money
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CHAPTER 22 APPENDIX 2
Empirical Evidence on the Demand for Money
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CHAPTER 23
Aggregate Demand and Supply Analysis 550
Aggregate Demand……………………………………………………………………………………………………….550
Following the Financial News Aggregate Output, Unemployment,
and Inflation 551
Deriving the Aggregate Demand Curve……………………………………………………………………..551
Factors That Shift the Aggregate Demand Curve…………………………………………………………552
FYI What Does Autonomous Mean? 553
Aggregate Supply………………………………………………………………………………………………………….556
Long-Run Aggregate Supply Curve…………………………………………………………………………..556
Short-Run Aggregate Supply Curve………………………………………………………………………….556
Price Stickiness and the Short-Run Aggregate Supply Curve…………………………………………558
Shifts in the Aggregate Supply Curves…………………………………………………………………………558
Shifts in the Long-Run Aggregate Supply Curve…………………………………………………………558
Shifts in the Short-Run Aggregate Supply Curve…………………………………………………………559
Equilibrium in Aggregate Demand and Supply Analysis…………………………………………..562
Short-Run Equilibrium…………………………………………………………………………………………..563
How the Short-Run Equilibrium Moves to the Long-Run Equilibrium
over Time………………………………………………………………………………………………………..563
Self-Correcting Mechanism……………………………………………………………………………………..566
Changes in Equilibrium: Aggregate Demand Shocks…………………………………………………566
APPLICATION The Volcker Disinflation, 1980–1986………………………………………..567
APPLICATION Negative Demand Shocks, 2001–2004……………………………………….569
Changes in Equilibrium: Aggregate Supply (Inflation) Shocks………………………………….569
Temporary Supply Shocks………………………………………………………………………………………569
APPLICATION Negative Supply Shocks, 1973–1975 and 1978–1980………………….572
Permanent Supply Shocks and Real Business Cycle Theory………………………………………….572
APPLICATION Positive Supply Shocks, 1995–1999…………………………………………..575
Conclusions…………………………………………………………………………………………………………576
APPLICATION Negative Supply and Demand Shocks and the 2007–2009
Financial Crisis……………………………………………………………………………………..577
AD/AS Analysis of Foreign Business Cycle Episodes…………………………………………………..577
APPLICATION The United Kingdom and the 2007–2009 Financial Crisis…………..579
APPLICATION China and the 2007–2009 Financial Crisis…………………………………580
Summary 581 • Key Terms 582 • Questions 582 • Applied Problems 583 •
Data Analysis Problems 583 • Web Exercises 584 • Web References 584
APPENDIX TO CHAPTER 23
The Phillips Curve and the Short-Run Aggregate Supply Curve 585
The Phillips Curve…………………………………………………………………………………………………………585
Phillips Curve Analysis in the 1960s………………………………………………………………………..585
FYI The Phillips Curve Trade-off and Macroeconomic Policy in the 1960s 587
The Friedman-Phelps Phillips Curve Analysis……………………………………………………………587
The Phillips Curve After the 1960s…………………………………………………………………………..589
The Modern Phillips Curve…………………………………………………………………………………….589
The Modern Phillips Curve with Adaptive (Backward-Looking) Expectations…………………590
The Short-Run Aggregate Supply Curve……………………………………………………………………..591
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 594
Response of Monetary Policy to Shocks……………………………………………………………………..594
Response to an Aggregate Demand Shock………………………………………………………………….595
Response to a Permanent Supply Shock…………………………………………………………………….597
Response to a Temporary Supply Shock……………………………………………………………………599
The Bottom Line: The Relationship Between Stabilizing Inflation and Stabilizing
Economic Activity…………………………………………………………………………………………….602
How Actively Should Policymakers Try to Stabilize Economic Activity?………………….602
Lags and Policy Implementation………………………………………………………………………………602
Inflation: Always and Everywhere a Monetary Phenomenon…………………………………..603
FYI The Activist/Nonactivist Debate Over the Obama Fiscal
Stimulus Package 604
Causes of Inflationary Monetary Policy………………………………………………………………………604
High Employment Targets and Inflation……………………………………………………………………604
APPLICATION The Great Inflation…………………………………………………………………608
Monetary Policy at the Zero Lower Bound………………………………………………………………..610
Deriving the Aggregate Demand Curve with the Zero Lower Bound………………………………610
The Disappearance of the Self-Correcting Mechanism at the Zero Lower Bound………………612
APPLICATION Nonconventional Monetary Policy and
Quantitative Easing……………………………………………………………………………….613
Liquidity Provision………………………………………………………………………………………………..614
Asset Purchases and Quantitative Easing…………………………………………………………………..615
Management of Expectations…………………………………………………………………………………..616
APPLICATION Abenomics and the Shift in Japanese Monetary
Policy in 2013……………………………………………………………………………………….617
Summary 619 • Key Terms 619 • Questions 620 • Applied Problems 621 •
Data Analysis Problems 621 • Web Exercises 622 • Web References 622
CHAPTER 25
Transmission Mechanisms of Monetary Policy 623
Transmission Mechanisms of Monetary Policy…………………………………………………………..623
Traditional Interest-Rate Channels……………………………………………………………………………624
Other Asset Price Channels…………………………………………………………………………………….625
Credit View………………………………………………………………………………………………………….628
FYI Consumers’ Balance Sheets and the Great Depression 630
Why Are Credit Channels Likely to Be Important?……………………………………………………..631
APPLICATION The Great Recession………………………………………………………………..632
Lessons for Monetary Policy………………………………………………………………………………………..632
APPLICATION Applying the Monetary Policy Lessons to Japan’s
Two Lost Decades………………………………………………………………………………….634
Summary 635 • Key Terms 635 • Questions 635 • Applied Problems 636 •
Data Analysis Problems 637 • Web Exercises 637 • Web References 637
CHAPTER 25 APPENDIX
Evaluating Empirical Evidence: The Debate Over the Importance of
Money in Economic Fluctuations
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Glossary……………………………………………………………………………………………………………………….G-1
Index……………………………………………………………………………………………………………………………..I-1