The Economics Of Money, Banking, And Financial Markets (7th Ed) (pdf)

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Part II of this book focuses on financial markets, markets in which funds are trans- ferred from people who have an excess of available funds to people who have a short- age. Financial markets such as bond and stock markets are crucial to promoting greater economic efficiency by channeling funds from people who do not have a pro- ductive use for them to those who do. Indeed, well-functioning financial markets are a key factor in producing high economic growth, and poorly performing financial markets are one reason that many countries in the world remain desperately poor. Activities in financial markets also have direct effects on personal wealth,...

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Nội dung Text: The Economics Of Money, Banking, And Financial Markets (7th Ed) (pdf)

Seventh Edition
The Addison-Wesley Series in Economics Abel/Bernanke Gordon Parkin Macroeconomics Macroeconomics Economics Bade/Parkin Gregory Parkin/Bade Foundations of Microeconomics Essentials of Economics Economics in Action Software Bade/Parkin Gregory/Stuart Perloff Foundations of Macroeconomics Russian and Soviet Economic Performance Microeconomics Bierman/Fernandez and Structure Phelps Game Theory with Economic Applications Hartwick/Olewiler Health Economics Binger/Hoffman The Economics of Natural Resource Use Riddell/Shackelford/Stamos/ Microeconomics with Calculus Hubbard Schneider Boyer Money, the Financial System, Economics: A Tool for Critically Principles of Transportation Economics and the Economy Understanding Society Branson Hughes/Cain Ritter/Silber/Udell Macroeconomic Theory and Policy American Economic History Principles of Money, Banking, Husted/Melvin and Financial Markets Bruce Public Finance and the American Economy International Economics Rohlf Jehle/Reny Introduction to Economic Reasoning Byrns/Stone Economics Advanced Microeconomic Theory Ruffin/Gregory Klein Principles of Economics Carlton/Perloff Modern Industrial Organization Mathematical Methods Sargent for Economics Rational Expectations Caves/Frankel/Jones and Inflation World Trade and Payments: Krugman/Obstfeld An Introduction International Economics: Scherer Theory and Policy Industry Structure, Strategy, Chapman and Public Policy Environmental Economics: Laidler Theory, Application, and Policy The Demand for Money: Schotter Theories, Evidence, and Problems Microeconomics: Cooter/Ulen A Modern Approach Law and Economics Leeds/von Allmen The Economics of Sports Stock/Watson Downs Introduction to Econometrics An Economic Theory of Democracy Lipsey/Courant/Ragan Economics Studenmund Eaton/Mishkin Using Econometrics: Online Readings to Accompany McCarty Dollars and Sense: A Practical Guide The Economics of Money, Banking, and Financial Markets An Introduction to Economics Tietenberg Melvin Environmental and Natural Ehrenberg/Smith Resource Economics Modern Labor Economics International Money and Finance Tietenberg Ekelund/Tollison Environmental Economics and Policy Economics: Private Markets Miller and Public Choice Economics Today Todaro/Smith Miller/Benjamin/North Economic Development Fusfeld The Age of the Economist The Economics of Public Issues Waldman/Jensen Mills/Hamilton Industrial Organization: Gerber Theory and Practice International Economics Urban Economics Mishkin Williamson Ghiara Macroeconomics Learning Economics: The Economics of Money, Banking, and A Practical Workbook Financial Markets
Frederic S. Mishkin Columbia University
Editor in Chief: Denise Clinton Acquisitions Editor: Victoria Warneck Executive Development Manager: Sylvia Mallory Development Editor: Jane Tufts Production Supervisor: Meredith Gertz Text Design: Studio Montage Cover Design: Regina Hagen Kolenda and Studio Montage Composition: Argosy Publishing Senior Manufacturing Supervisor: Hugh Crawford Senior Marketing Manager: Barbara LeBuhn Cover images: © PhotoDisc Media Producer: Melissa Honig Supplements Editor: Diana Theriault Credits to copyrighted material appear on p. C-1, which constitutes a continuation of the copyright page. Library of Congress Cataloguing-in-Publication Data Mishkin, Frederic S. The economics of money, banking, and financial markets / Frederic S. Mishkin.—7th ed. p. cm. — (The Addison-Wesley series in economics) Supplemented by a subscription to a companion web site. Includes bibliographical references and index. ISBN 0-321-12235-6 1. Finance. 2. Money. 3. Banks and banking. I. Title. II. Series. HG173.M632 2004 332—dc21 2003041912 Copyright © 2004 by Frederic S. Mishkin. All rights reserved. No part of this publication may be repro- duced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. 1 2 3 4 5 6 7 8 9 10—DOW—06050403
To Sally
CONTENTS IN BRIEF PA RT I Introduction 1 1 Why Study Money, Banking, and Financial Markets? . . . . . . . . . . . . . . . . . . . .3 2 An Overview of the Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23 3 What Is Money? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44 PA RT I I Financial Markets 59 4 Understanding Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61 5 The Behavior of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85 6 The Risk and Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . .120 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .141 PA RT I I I Financial Institutions 167 8 An Economic Analysis of Financial Structure . . . . . . . . . . . . . . . . . . . . . . . .169 9 Banking and the Management of Financial Institutions . . . . . . . . . . . . . . . . .201 10 Banking Industry: Structure and Competition . . . . . . . . . . . . . . . . . . . . . . . .229 11 Economic Analysis of Banking Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . .260 12 Nonbank Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287 13 Financial Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .309 PA RT I V Central Banking and the Conduct of Monetary Policy 333 14 Structure of Central Banks and the Federal Reserve System . . . . . . . . . . . . .335 15 Multiple Deposit Creation and the Money Supply Process . . . . . . . . . . . . . .357 16 Determinants of the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .374 17 Tools of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .393 18 Conduct of Monetary Policy: Goals and Targets . . . . . . . . . . . . . . . . . . . . . .411 PA RT V International Finance and Monetary Policy 433 19 The Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .435 20 The International Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .462 21 Monetary Policy Strategy: The International Experience . . . . . . . . . . . . . . . .487 vii
viii Contents in Brief PA RT V I Monetary Theory 515 22 The Demand for Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .517 23 The Keynesian Framework and the ISLM Model . . . . . . . . . . . . . . . . . . . . . .536 24 Monetary and Fiscal Policy in the ISLM Model . . . . . . . . . . . . . . . . . . . . . . .561 25 Aggregate Demand and Supply Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . .582 26 Transmission Mechanisms of Monetary Policy: The Evidence . . . . . . . . . . . .603 27 Money and Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .632 28 Rational Expectations: Implications for Policy . . . . . . . . . . . . . . . . . . . . . . . .658
CONTENTS PA RT I Introduction 1 CHAPTER 1 WHY STUDY MONEY, BANKING, AND FINANCIAL MARKETS? . . . . . . . . . . . . . . . . .3 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Why Study Financial Markets? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 The Bond Market and Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 The Stock Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 The Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Why Study Banking and Financial Institutions? . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Structure of the Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Banks and Other Financial Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Financial Innovation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Why Study Money and Monetary Policy? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Money and Business Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Money and Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 Money and Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 Conduct of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 Fiscal Policy and Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 How We Will Study Money, Banking, and Financial Markets . . . . . . . . . . . . . . . . . .13 Exploring the Web . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14 Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17 Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . . .17 Appendix to Chapter 1 Defining Aggregate Output, Income, the Price Level, and the Inflation Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20 Aggregate Output and Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20 Real Versus Nominal Magnitudes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20 Aggregate Price Level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21 Growth Rates and the Inflation Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22 ix
x Contents CHAPTER 2 AN OVERVIEW OF THE FINANCIAL SYSTEM . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23 Function of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23 Structure of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25 Debt and Equity Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25 Primary and Secondary Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26 Exchanges and Over-the-Counter Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27 Money and Capital Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27 Internationalization of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28 International Bond Market, Eurobonds, and Eurocurrencies . . . . . . . . . . . . . . . . . . . . . . . .28 World Stock Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29 Function of Financial Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29 Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29 Following the Financial News Foreign Stock Market Indexes . . . . . . . . . . . . . . . .30 Box 1 Global: The Importance of Financial Intermediaries to Securities Markets: An International Comparison . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31 Risk Sharing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31 Asymmetric Information: Adverse Selection and Moral Hazard . . . . . . . . . . . . . . . . . . . . .32 Financial Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34 Depository Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34 Contractual Savings Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .35 Investment Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37 Regulation of the Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37 Increasing Information Available to Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39 Ensuring the Soundness of Financial Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39 Financial Regulation Abroad . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40 Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . . .41 CHAPTER 3 WHAT IS MONEY? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44 Meaning of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44 Functions of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45 Medium of Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45 Unit of Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .46 Store of Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .47 Evolution of the Payments System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48 Commodity Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48 Fiat Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48 Checks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48 Box 1 Global: Birth of the Euro: Will It Benefit Europe? . . . . . . . . . . . . . . . . . . . . .49 Electronic Payment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .50
Contents xi Box 2 E-Finance: Why Are Scandinavians So Far Ahead of Americans in Using Electronic Payments? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .50 E-Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .51 Measuring Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .51 The Federal Reserve’s Monetary Aggregates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .51 Box 3 E-Finance: Are We Headed for a Cashless Society? . . . . . . . . . . . . . . . . . . . .52 Following the Financial News The Monetary Aggregates . . . . . . . . . . . . . . . . . . .54 How Reliable Are the Money Data? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55 Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . . .56 PA RT I I Financial Markets 59 CHAPTER 4 UNDERSTANDING INTEREST RATES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61 Measuring Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61 Present Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61 Four Types of Credit Market Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .63 Yield to Maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .64 Box 1 Global: Negative T-Bill Rates? Japan Shows the Way . . . . . . . . . . . . . . . . . . .69 Other Measures of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .69 Current Yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .70 Yield on a Discount Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .71 Application Reading the Wall Street Journal: The Bond Page . . . . . . . . . . . . . . . . .72 Following the Financial News Bond Prices and Interest Rates . . . . . . . . . . . . . . .73 The Distinction Between Interest Rates and Returns . . . . . . . . . . . . . . . . . . . . . . . . .75 Maturity and the Volatility of Bond Returns: Interest-Rate Risk . . . . . . . . . . . . . . . . . . . . . .78 Box 2 Helping Investors to Select Desired Interest-Rate Risk . . . . . . . . . . . . . . . . .79 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .79 The Distinction Between Real and Nominal Interest Rates . . . . . . . . . . . . . . . . . . . .79 Box 3 With TIPS, Real Interest Rates Have Become Observable in the United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .82 Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . . .82 CHAPTER 5 THE BEHAVIOR OF INTEREST RATES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85 Determinants of Asset Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85 Wealth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .86
xii Contents Expected Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .86 Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .87 Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .87 Theory of Asset Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .87 Supply and Demand in the Bond Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .87 Demand Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .88 Supply Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .90 Market Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .90 Supply and Demand Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .91 Loanable Funds Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .91 Changes in Equilibrium Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .93 Shifts in the Demand for Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .93 Shifts in the Supply of Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .97 Application Changes in the Equilibrium Interest Rate Due to Expected Inflation or Business Cycle Expansions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .99 Changes in Expected Inflation: The Fisher Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .99 Business Cycle Expansion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .100 Application Explaining Low Japanese Interest Rates . . . . . . . . . . . . . . . . . . . . . .103 Application Reading the Wall Street Journal “Credit Markets” Column . . . . . . . .103 Following the Financial News The “Credit Markets” Column . . . . . . . . . . . . . .104 Supply and Demand in the Market for Money: The Liquidity Preference Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .105 Changes in Equilibrium Interest Rates in the Liquidity Reference Framework . . . . .107 Shifts in the Demand for Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .107 Shifts in the Supply of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .108 Application Changes in the Equilibrium Interest Rate Due to Changes in Income, the Price Level, or the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . .108 Changes in Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .108 Changes in the Price Level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .108 Changes in the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .109 Following the Financial News Forecasting Interest Rates . . . . . . . . . . . . . . . . . .111 Application Money and Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .112 Does a Higher Rate of Growth of the Money Supply Lower Interest Rates? . . . . . . . . . . . .114 Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .117 CHAPTER 6 THE RISK AND TERM STRUCTURE OF INTEREST RATES . . . . . . . . . . . . . . . . . . .120 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .120 Risk Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .120 Default Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .120 Application The Enron Bankruptcy and the Baa-Aaa Spread . . . . . . . . . . . . . . . .124
Contents xiii Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .125 Income Tax Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .125 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .127 Application Effects of the Bush Tax Cut on Bond Interest Rates . . . . . . . . . . . . .127 Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .127 Following the Financial News Yield Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . .128 Expectations Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .129 Segmented Markets Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .132 Liquidity Premium and Preferred Habitat Theories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .133 Evidence on the Term Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .136 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .137 Application Interpreting Yield Curves, 1980–2003 . . . . . . . . . . . . . . . . . . . . . . .137 Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .138 CHAPTER 7 THE STOCK MARKET, THE THEORY OF RATIONAL EXPECTATIONS, AND THE EFFICIENT MARKET HYPOTHESIS . . . . . . . . . . . . . . . . . . . . . . . . . . . .141 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .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 Security Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .144 Application Monetary Policy and Stock Prices . . . . . . . . . . . . . . . . . . . . . . . . . .146 Application The September 11 Terrorist Attacks, the Enron Scandal, and the Stock Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .146 The Theory of Rational Expectations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .147 Formal Statement of the Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .148 Rationale Behind the Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .149 Implications of the Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .149 The Efficient Markets Hypothesis: Rational Expectations in Financial Markets . . . .150 Rationale Behind the Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .151 Stronger Version of the Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . .152 Evidence on the Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . .153 Evidence in Favor of Market Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .153 Application Should Foreign Exchange Rates Follow a Random Walk? . . . . . . . .155 Evidence Against Market Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .156 Overview of the Evidence on the Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . .158 Application Practical Guide to Investing in the Stock Market . . . . . . . . . . . . . . .158 How Valuable Are Published Reports by Investment Advisers? . . . . . . . . . . . . . . . . . . . . .158
xiv Contents Following the Financial News Stock Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . .159 Box 1 Should You Hire an Ape as Your Investment Adviser? . . . . . . . . . . . . . . . .160 Should You Be Skeptical of Hot Tips? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .160 Do Stock Prices Always Rise When There Is Good News? . . . . . . . . . . . . . . . . . . . . . . . . .161 Efficient Market Prescription for the Investor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .161 Evidence on Rational Expectations in Other Markets . . . . . . . . . . . . . . . . . . . . . . .162 Application What Do the Black Monday Crash of 1987 and the Tech Crash of 2000 Tell Us About Rational Expectations and Efficient Markets? . . . .163 Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .164 PA RT I I I Financial Institutions 167 CHAPTER 8 AN ECONOMIC ANALYSIS OF FINANCIAL STRUCTURE . . . . . . . . . . . . . . . . . . . .169 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .169 Basic Puzzles About Financial Structure Throughout the World . . . . . . . . . . . . . . .169 Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .173 How Transaction Costs Influence Financial Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . .173 How Financial Intermediaries Reduce Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . .173 Asymmetric Information: Adverse Selection and Moral Hazard . . . . . . . . . . . . . . . .174 The Lemons Problem: How Adverse Selection Influences Financial Structure . . . . .175 Lemons in the Stock and Bond Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .175 Tools to Help Solve Adverse Selection Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .176 Box 1 The Enron Implosion and the Arthur Andersen Conviction . . . . . . . . . . .178 How Moral Hazard Affects the Choice Between Debt and Equity Contracts . . . . . .180 Moral Hazard in Equity Contracts: The Principal–Agent Problem . . . . . . . . . . . . . . . . . . .181 Tools to Help Solve the Principal–Agent Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .182 Box 2 E-Finance: Venture Capitalists and the High-Tech Sector . . . . . . . . . . . . . .183 How Moral Hazard Influences Financial Structure in Debt Markets . . . . . . . . . . . .184 Tools to Help Solve Moral Hazard in Debt Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . .184 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .186 Application Financial Development and Economic Growth . . . . . . . . . . . . . . . .187 Financial Crises and Aggregate Economic Activity . . . . . . . . . . . . . . . . . . . . . . . . .189 Factors Causing Financial Crises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .189 Application Financial Crises in the United States . . . . . . . . . . . . . . . . . . . . . . . .191 Box 3 Case Study of a Financial Crisis: The Great Depression . . . . . . . . . . . . . . .194 Application Financial Crises in Emerging-Market Countries: Mexico, 1994–1995; East Asia, 1997–1998; and Argentina, 2001–2002 . . . . . . .194 Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .199
Contents xv CHAPTER 9 BANKING AND THE MANAGEMENT OF FINANCIAL INSTITUTIONS . . . . . . . . . . . .201 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .201 The Bank Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .201 Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .201 Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .204 Basic Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .205 General Principles of Bank Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .208 Liquidity Management and the Role of Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .208 Asset Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .211 Liability Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .212 Capital Adequacy Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .213 Application Strategies for Managing Bank Capital . . . . . . . . . . . . . . . . . . . . . . . .215 Application Did the Capital Crunch Cause a Credit Crunch in the Early 1990s? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .216 Managing Credit Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .217 Screening and Monitoring . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .217 Long-Term Customer Relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .218 Loan Commitments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .219 Collateral and Compensating Balances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .219 Credit Rationing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .220 Managing Interest-Rate Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .220 Gap and Duration Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .221 Application Strategies for Managing Interest-Rate Risk . . . . . . . . . . . . . . . . . . . .222 Off-Balance-Sheet Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .223 Loan Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .223 Generation of Fee Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .223 Trading Activities and Risk Management Techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . .224 Box 1 Global: Barings, Daiwa, Sumitomo, and Allied Irish: Rogue Traders and the Principal–Agent Problem . . . . . . . . . . . . . . . . . . . . . . . . .225 Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .226 CHAPTER 10 BANKING INDUSTRY: STRUCTURE AND COMPETITION . . . . . . . . . . . . . . . . . . . .229 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .229 Historical Development of the Banking System . . . . . . . . . . . . . . . . . . . . . . . . . . . .229 Multiple Regulatory Agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .231 Financial Innovation and the Evolution of the Banking Industry . . . . . . . . . . . . . .232 Responses to Changes in Demand Conditions: Interest Rate Volatility . . . . . . . . . . . . . . .233 Responses to Changes in Supply Conditions: Information Technology . . . . . . . . . . . . . . .234 Box 1 E-Finance: Will “Clicks” Dominate “Bricks” in the Banking Industry? . . . .236 Avoidance of Existing Regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .237 Financial Innovation and the Decline of Traditional Banking . . . . . . . . . . . . . . . . . . . . . .239
xvi Contents Structure of the U.S. Commercial Banking Industry . . . . . . . . . . . . . . . . . . . . . . . .243 Restrictions on Branching . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .244 Response to Branching Restrictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .245 Bank Consolidation and Nationwide Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . .245 Box 2 E-Finance: Information Technology and Bank Consolidation . . . . . . . . . . .247 The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 . . . . . . . . . . . .248 What Will the Structure of the U.S. Banking Industry Look Like in the Future? . . . . . . . .248 Box 3 Global: Comparison of Banking Structure in the United States and Abroad . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .249 Are Bank Consolidation and Nationwide Banking Good Things? . . . . . . . . . . . . . . . . . . .249 Separation of the Banking and Other Financial Service Industries . . . . . . . . . . . . . .250 Erosion of Glass-Steagall . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .250 The Gramm-Leach-Bliley Financial Services Modernization Act of 1999: Repeal of Glass-Steagall . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .251 Implications for Financial Consolidation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .251 Separation of Banking and Other Financial Services Industries Throughout the World . . .251 Thrift Industry: Regulation and Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .252 Savings and Loan Associations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .252 Mutual Savings Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .253 Credit Unions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .253 International Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .253 Eurodollar Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .254 Box 4 Global: Ironic Birth of the Eurodollar Market . . . . . . . . . . . . . . . . . . . . . . .255 Structure of U.S. Banking Overseas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .255 Foreign Banks in the United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .256 Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .257 CHAPTER 11 ECONOMIC ANALYSIS OF BANKING REGULATION . . . . . . . . . . . . . . . . . . . . . . .260 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .260 Asymmetric Information and Banking Regulation . . . . . . . . . . . . . . . . . . . . . . . . . .260 Government Safety Net: Deposit Insurance and the FDIC . . . . . . . . . . . . . . . . . . . . . . . .260 Box 1 Global: The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .262 Restrictions on Asset Holdings and Bank Capital Requirements . . . . . . . . . . . . . . . . . . . .264 Bank Supervision: Chartering and Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .265 Box 2 Global: Basel 2: Is It Spinning Out of Control? . . . . . . . . . . . . . . . . . . . . . .265 Assessment of Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .267 Disclosure Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .268 Consumer Protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .269 Restrictions on Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .269 Box 3 E-Finance: Electronic Banking: New Challenges for Bank Regulation . . . . .270
Contents xvii International Banking Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .272 Problems in Regulating International Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .272 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .272 The 1980s U.S. Banking Crisis: Why? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .273 Early Stages of the Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .274 Later Stages of the Crisis: Regulatory Forbearance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .275 Competitive Equality in Banking Act of 1987 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .276 Political Economy of the Savings and Loan Crisis . . . . . . . . . . . . . . . . . . . . . . . . . .276 The Principal–Agent Problem for Regulators and Politicians . . . . . . . . . . . . . . . . . . . . . . .277 Savings and Loan Bailout: The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .278 Federal Deposit Insurance Corporation Improvement Act of 1991 . . . . . . . . . . . . .279 Banking Crises Throughout the World . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .280 Scandinavia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .280 Latin America . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .281 Russia and Eastern Europe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .282 Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .282 East Asia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .284 “Déjà Vu All Over Again” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .284 Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .284 CHAPTER 12 NONBANK FINANCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287 Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287 Life Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287 Property and Casualty Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .288 The Competitive Threat from the Banking Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . .290 Application Insurance Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .290 Screening . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .291 Risk-Based Premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .291 Restrictive Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .292 Prevention of Fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .292 Cancellation of Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .292 Deductibles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .292 Coinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .293 Limits on the Amount of Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .293 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .293 Pension Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .294 Private Pension Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .295 Public Pension Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .295 Box 1 Should Social Security Be Privatized? . . . . . . . . . . . . . . . . . . . . . . . . . . . . .296 Finance Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .296 Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .297
xviii Contents Box 2 E-Finance: Mutual Funds and the Internet . . . . . . . . . . . . . . . . . . . . . . . . .298 Money Market Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .299 Hedge Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .299 Box 3 The Long-Term Capital Management Debacle . . . . . . . . . . . . . . . . . . . . . .300 Government Financial Intermediation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .301 Federal Credit Agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .301 Box 4 Are Fannie Mae and Freddie Mac Getting Too Big for Their Britches? . . . .302 Securities Market Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .302 Investment Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .303 Following the Financial News New Securities Issues . . . . . . . . . . . . . . . . . . . . .304 Securities Brokers and Dealers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .304 Organized Exchanges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .305 Box 5 The Return of the Financial Supermarket? . . . . . . . . . . . . . . . . . . . . . . . . .305 Box 6 E-Finance: The Internet Comes to Wall Street . . . . . . . . . . . . . . . . . . . . . . .306 Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .306 CHAPTER 13 FINANCIAL DERIVATIVES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .309 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .309 Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .309 Interest-Rate Forward Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .310 Application Hedging with Interest-Rate Forward Contracts . . . . . . . . . . . . . . . .310 Pros and Cons of Forward Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .311 Financial Futures Contracts and Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .311 Following the Financial News Financial Futures . . . . . . . . . . . . . . . . . . . . . . . .312 Application Hedging with Financial Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . .314 Organization of Trading in Financial Futures Markets . . . . . . . . . . . . . . . . . . . . . . . . . . .315 The Globalization of Financial Futures Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .317 Explaining the Success of Futures Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .317 Application Hedging Foreign Exchange Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . .319 Hedging Foreign Exchange Risk with Forward Contracts . . . . . . . . . . . . . . . . . . . . . . . . .319 Hedging Foreign Exchange Risk with Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . . . .320 Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .320 Following the Financial News Futures Options . . . . . . . . . . . . . . . . . . . . . . . . .321 Option Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .322 Profits and Losses on Option and Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . .322 Application Hedging with Futures Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . .325
Contents xix Factors Affecting the Prices of Option Premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .326 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .327 Interest-Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .328 Interest-Rate Swap Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .328 Application Hedging with Interest-Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . .329 Advantages of Interest-Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .329 Disadvantages of Interest-Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .330 Financial Intermediaries in Interest-Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .330 Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .330 PA RT I V Central Banking and the Conduct of Monetary Policy 333 CHAPTER 14 STRUCTURE OF CENTRAL BANKS AND THE FEDERAL RESERVE SYSTEM . . . . . . .335 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .335 Origins of the Federal Reserve System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .335 Box 1 Inside the Fed: The Political Genius of the Founders of the Federal Reserve System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .336 Formal Structure of the Federal Reserve System . . . . . . . . . . . . . . . . . . . . . . . . . . .336 Federal Reserve Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .337 Box 2 Inside the Fed: The Special Role of the Federal Reserve Bank of New York . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .339 Member Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .340 Board of Governors of the Federal Reserve System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .340 Federal Open Market Committee (FOMC) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .341 Box 3 Inside the Fed: The Role of the Research Staff . . . . . . . . . . . . . . . . . . . . . . .342 The FOMC Meeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .343 Box 4 Inside the Fed: Green, Blue, and Beige: What Do These Colors Mean at the Fed? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .344 Informal Structure of the Federal Reserve System . . . . . . . . . . . . . . . . . . . . . . . . . .344 Box 5 Inside the Fed: The Role of Member Banks in the Federal Reserve System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .346 How Independent Is the Fed? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .346 Structure and Independence of Foreign Central Banks . . . . . . . . . . . . . . . . . . . . . .349 Bank of Canada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .349 Bank of England . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .349 Bank of Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .350 European Central Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .350 The Trend Toward Greater Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .351 Explaining Central Bank Behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .351
xx Contents Box 6 Inside the Fed: Federal Reserve Transparency . . . . . . . . . . . . . . . . . . . . . . .352 Should the Fed Be Independent? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .352 The Case for Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .352 The Case Against Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .354 Central Bank Independence and Macroeconomic Performance Throughout the World . . .354 Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .355 CHAPTER 15 MULTIPLE DEPOSIT CREATION AND THE MONEY SUPPLY PROCESS . . . . . . . . . .357 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .357 Four Players in the Money Supply Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .357 The Fed’s Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .358 Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .358 Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .359 Control of the Monetary Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .359 Federal Reserve Open Market Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .359 Shifts from Deposits into Currency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .363 Box 1 Global: Foreign Exchange Rate Intervention and the Monetary Base . . . . .363 Discount Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .364 Other Factors That Affect the Monetary Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .365 Overview of the Fed’s Ability to Control the Monetary Base . . . . . . . . . . . . . . . . . . . . . . .365 Multiple Deposit Creation: A Simple Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .365 Deposit Creation: The Single Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .366 Deposit Creation: The Banking System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .367 Deriving the Formula for Multiple Deposit Creation . . . . . . . . . . . . . . . . . . . . . . . . . . . . .370 Critique of the Simple Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .371 Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .372 CHAPTER 16 DETERMINANTS OF THE MONEY SUPPLY . . . . . . . . . . . . . . . . . . . . . . . . . . . . .374 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .374 The Money Supply Model and the Money Multiplier . . . . . . . . . . . . . . . . . . . . . . .375 Deriving the Money Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .375 Intuition Behind the Money Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .377 Factors that Determine the Money Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . .378 Changes in the Required Reserve Ratio r . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .378 Changes in the Currency Ratio c . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .379 Changes in the Excess Reserves Ratio e . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .379 Additional Factors That Determine the Money Supply . . . . . . . . . . . . . . . . . . . . . .381 Changes in the Nonborrowed Monetary Base MBn . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .382 Changes in the Discount Loans DL from the Fed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .382 Overview of the Money Supply Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .383 Application Explaining Movements in the Money Supply, 1980–2002 . . . . . . . .384