The Economics of Money, Banking, and Financial Markets, 12th Edition PDF by Frederic S. Mishkin

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The Economics of Money, Banking, and Financial Markets, Twelfth Edition

 By Frederic S. Mishkin

The Economics of Money, Banking, and Financial Markets 12th Edition

Contents in Detail

PART 1 Introduction 51

CHAPTER 1

Why Study Money, Banking, and Financial Markets? 52

Why Study Financial Markets?……………………………………………………………………………………… 52

Debt Markets and Interest Rates………………………………………………………………………………..53

The Stock Market……………………………………………………………………………………………………53

Why Study Financial Institutions and Banking?…………………………………………………………… 55

Structure of the Financial System………………………………………………………………………………55

Banks and Other Financial Institutions……………………………………………………………………….56

Financial Innovation……………………………………………………………………………………………….56

Financial Crises………………………………………………………………………………………………………56

Why Study Money and Monetary Policy?……………………………………………………………………. 57

Money and Business Cycles………………………………………………………………………………………57

Money and Inflation………………………………………………………………………………………………..57

Money and Interest Rates………………………………………………………………………………………….59

Conduct of Monetary Policy……………………………………………………………………………………..59

Fiscal Policy and Monetary Policy………………………………………………………………………………60

Why Study International Finance?……………………………………………………………………………….. 61

The Foreign Exchange Market…………………………………………………………………………………..62

The International Financial System…………………………………………………………………………….63

Money, Banking, and Financial Markets and Your Career………………………………………….. 64

How We Will Study Money, Banking, and Financial Markets…………………………………….. 64

Exploring the Web………………………………………………………………………………………………….65

Concluding Remarks……………………………………………………………………………………………………… 65

Summary 65 • Key Terms 66 • Questions 66 • Applied Problems 67 •

Data Analysis Problems 67 • Web Exercises 68 • Web References 68

APPENDIX TO CHAPTER 1

Defining Aggregate Output, Income, the Price Level,

and the Inflation Rate 69

Aggregate Output and Income…………………………………………………………………………………….. 69

Real Versus Nominal Magnitudes………………………………………………………………………………… 69

Aggregate Price Level…………………………………………………………………………………………………….. 70

Growth Rates and the Inflation Rate……………………………………………………………………………. 71

CHAPTER 2

An Overview of the Financial System 72

Function of Financial Markets………………………………………………………………………………………. 72

Structure of Financial Markets………………………………………………………………………………………. 75

Debt and Equity Markets………………………………………………………………………………………….75

Primary and Secondary Markets………………………………………………………………………………..75

Exchanges and Over-the-Counter Markets…………………………………………………………………..76

Money and Capital Markets………………………………………………………………………………………77

Financial Market Instruments……………………………………………………………………………………….. 77

Money Market Instruments………………………………………………………………………………………77

Following the Financial News Money Market Rates 78

Capital Market Instruments………………………………………………………………………………………79

Following the Financial News Capital Market Interest Rates 80

Internationalization of Financial Markets……………………………………………………………………. 81

Global Are U.S. Capital Markets Losing Their Edge? 82

International Bond Market, Eurobonds, and Eurocurrencies………………………………………….82

World Stock Markets……………………………………………………………………………………………….83

Function of Financial Intermediaries: Indirect Finance………………………………………………. 83

Following the Financial News Foreign Stock Market Indexes 84

Transaction Costs……………………………………………………………………………………………………84

Global The Importance of Financial Intermediaries Relative to Securities Markets:

An International Comparison 85

Risk Sharing…………………………………………………………………………………………………………..86

Asymmetric Information: Adverse Selection and Moral Hazard………………………………………86

Economies of Scope and Conflicts of Interest………………………………………………………………88

Types of Financial Intermediaries…………………………………………………………………………………. 88

Depository Institutions…………………………………………………………………………………………….88

Contractual Savings Institutions………………………………………………………………………………..90

Investment Intermediaries………………………………………………………………………………………..91

Regulation of the Financial System………………………………………………………………………………. 92

Increasing Information Available to Investors……………………………………………………………….92

Ensuring the Soundness of Financial Intermediaries……………………………………………………..93

Financial Regulation Abroad……………………………………………………………………………………..95

Summary 95 • Key Terms 96 • Questions 96 • Applied Problems 97 •

Data Analysis Problems 98 • Web Exercises 98 • Web References 98

CHAPTER 3

What Is Money? 99

Meaning of Money………………………………………………………………………………………………………… 99

Functions of Money……………………………………………………………………………………………………..100

Medium of Exchange……………………………………………………………………………………………..100

Unit of Account…………………………………………………………………………………………………….101

Store of Value……………………………………………………………………………………………………….102

Evolution of the Payments System………………………………………………………………………………103

Commodity Money……………………………………………………………………………………………….103

Fiat Money…………………………………………………………………………………………………………..103

Checks………………………………………………………………………………………………………………..103

Electronic Payment………………………………………………………………………………………………..104

E-Money……………………………………………………………………………………………………………..104

FYI Are We Headed for a Cashless Society? 105

APPLICATION Will Bitcoin Become the Money of the Future?…………………………..105

Measuring Money…………………………………………………………………………………………………………106

The Federal Reserve’s Monetary Aggregates……………………………………………………………….106

Following the Financial News The Monetary Aggregates 107

FYI Where Are All the U.S. Dollars? 108

Summary 109 • Key Terms 110 • Questions 110 • Applied Problems 111 • Data Analysis

Problems 112 • Web Exercises 112 • Web References 112

PART 2 Financial Markets 113

CHAPTER 4

The Meaning of Interest Rates 114

Measuring Interest Rates……………………………………………………………………………………………..114

Present Value………………………………………………………………………………………………………..114

APPLICATION Simple Present Value………………………………………………………………..116

APPLICATION How Much Is That Jackpot Worth?……………………………………………116

Four Types of Credit Market Instruments………………………………………………………………….117

Yield to Maturity…………………………………………………………………………………………………..118

APPLICATION Yield to Maturity on a Simple Loan……………………………………………118

APPLICATION Yield to Maturity and the Yearly Payment on a Fixed-Payment Loan… 120

APPLICATION Yield to Maturity and Bond Price for a Coupon Bond………………….121

APPLICATION Yield to Maturity on a Perpetuity………………………………………………123

APPLICATION Yield to Maturity on a Discount Bond………………………………………..124

The Distinction Between Interest Rates and Returns…………………………………………………125

Global Negative Interest Rates? Japan First, Then the United States, Then Europe 126

Maturity and the Volatility of Bond Returns: Interest-Rate Risk……………………………………..128

Summary……………………………………………………………………………………………………………..129

The Distinction Between Real and Nominal Interest Rates………………………………………130

APPLICATION Calculating Real Interest Rates………………………………………………….131

Summary 133 • Key Terms 133 • Questions 133 • Applied Problems 134 • Data Analysis

Problems 135 • Web Exercises 135 • Web References 135

CHAPTER 4 APPENDIX

Measuring Interest-Rate Risk: Duration

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CHAPTER 5

The Behavior of Interest Rates 136

Determinants of Asset Demand…………………………………………………………………………………..136

Wealth…………………………………………………………………………………………………………………137

Expected Returns………………………………………………………………………………………………….137

Risk…………………………………………………………………………………………………………………….137

Liquidity……………………………………………………………………………………………………………..138

Theory of Portfolio Choice……………………………………………………………………………………..138

Supply and Demand in the Bond Market…………………………………………………………………..139

Demand Curve……………………………………………………………………………………………………..139

Supply Curve……………………………………………………………………………………………………….140

Market Equilibrium……………………………………………………………………………………………….141

Supply and Demand Analysis………………………………………………………………………………….142

Changes in Equilibrium Interest Rates………………………………………………………………………..142

Shifts in the Demand for Bonds……………………………………………………………………………….143

Shifts in the Supply of Bonds………………………………………………………………………………….146

APPLICATION Changes in the Interest Rate Due to a Change in

Expected Inflation: The Fisher Effect………………………………………………………148

APPLICATION Changes in the Interest Rate Due to a Business Cycle Expansion…..150

APPLICATION Explaining Current Low Interest Rates in Europe, Japan,

and the United States: Low Inflation and Secular Stagnation………………………151

Supply and Demand in the Market for Money:

The Liquidity Preference Framework…………………………………………………………………..152

Changes in Equilibrium Interest Rates in the Liquidity Preference Framework………155

Shifts in the Demand for Money………………………………………………………………………………155

Shifts in the Supply of Money…………………………………………………………………………………155

APPLICATION Changes in the Equilibrium Interest Rate Due to

Changes in Income, the Price Level, or the Money Supply…………………………156

Changes in Income………………………………………………………………………………………………..157

Changes in the Price Level………………………………………………………………………………………157

Changes in the Money Supply…………………………………………………………………………………157

Money and Interest Rates…………………………………………………………………………………………….158

APPLICATION Does a Higher Rate of Growth of the Money Supply

Lower Interest Rates?…………………………………………………………………………….160

Summary 163 • Key Terms 163 • Questions 163 • Applied Problems 164 •

Data Analysis Problems 165 • Web Exercises 166 • Web References 166

CHAPTER 5 APPENDIX 1

Models of Asset Pricing

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CHAPTER 5 APPENDIX 2

Applying the Asset Market Approach to a Commodity Market: The Case of Gold

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CHAPTER 5 APPENDIX 3

Loanable Funds Framework

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CHAPTER 6

The Risk and Term Structure of Interest Rates 167

Risk Structure of Interest Rates…………………………………………………………………………………….167

Default Risk………………………………………………………………………………………………………….167

FYI Conflicts of Interest at Credit-Rating Agencies and the Global Financial Crisis 171

APPLICATION The Global Financial Crisis and the Baa-Treasury Spread 172

Liquidity……………………………………………………………………………………………………………..172

Income Tax Considerations…………………………………………………………………………………….173

Summary……………………………………………………………………………………………………………..174

APPLICATION Effects of the Obama Tax Increase on Bond Interest Rates 174

Term Structure of Interest Rates…………………………………………………………………………………..175

Following the Financial News Yield Curves 175

Expectations Theory………………………………………………………………………………………………177

Segmented Markets Theory…………………………………………………………………………………….180

Liquidity Premium and Preferred Habitat Theories……………………………………………………..181

Evidence on the Term Structure………………………………………………………………………………184

FYI The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle 185

Summary……………………………………………………………………………………………………………..185

APPLICATION Interpreting Yield Curves, 1980–2017……………………………………….185

Summary 187 • Key Terms 187 • Questions 187 • Applied Problems 189 •

Data Analysis Problems 189 • Web Exercises 190 • Web References 190

CHAPTER 7

The Stock Market, the Theory of Rational Expectations,

and the Efficient Market Hypothesis 191

Computing the Price of Common Stock…………………………………………………………………….191

The One-Period Valuation Model…………………………………………………………………………….192

The Generalized Dividend Valuation Model……………………………………………………………….193

The Gordon Growth Model…………………………………………………………………………………….193

How the Market Sets Stock Prices……………………………………………………………………………….194

APPLICATION Monetary Policy and Stock Prices……………………………………………..196

APPLICATION The Global Financial Crisis and the Stock Market………………………196

The Theory of Rational Expectations…………………………………………………………………………..196

Formal Statement of the Theory………………………………………………………………………………198

Rationale Behind the Theory…………………………………………………………………………………..198

Implications of the Theory……………………………………………………………………………………..199

The Efficient Market Hypothesis: Rational Expectations in Financial Markets………..200

Rationale Behind the Hypothesis……………………………………………………………………………..201

Random-Walk Behavior of Stock Prices…………………………………………………………………….202

Global Should Foreign Exchange Rates Follow a Random Walk? 203

APPLICATION Practical Guide to Investing in the Stock Market…………………………203

How Valuable Are Reports Published by Investment Advisers?……………………………………..203

Should You Be Skeptical of Hot Tips?……………………………………………………………………….204

FYI Should You Hire an Ape as Your Investment Adviser? 205

Do Stock Prices Always Rise When There Is Good News?…………………………………………….205

Efficient Market Prescription for the Investor……………………………………………………………..205

Why the Efficient Market Hypothesis Does Not Imply That

Financial Markets Are Efficient…………………………………………………………………………….206

APPLICATION What Do Stock Market Crashes Tell Us About the Efficient

Market Hypothesis and the Efficiency of Financial Markets?………………………207

Behavioral Finance……………………………………………………………………………………………………….207

Summary 208 • Key Terms 209 • Questions 209 • Applied Problems 210 •

Data Analysis Problems 211 • Web Exercises 211 • Web References 211

CHAPTER 7 APPENDIX

Evidence on the Efficient Market Hypothesis

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PART 3 Financial Institutions 213

CHAPTER 8

An Economic Analysis of Financial Structure 214

Basic Facts About Financial Structure Throughout the World…………………………………..214

Transaction Costs………………………………………………………………………………………………………….217

How Transaction Costs Influence Financial Structure………………………………………………….217

How Financial Intermediaries Reduce Transaction Costs……………………………………………..218

Asymmetric Information: Adverse Selection and Moral Hazard………………………………219

The Lemons Problem: How Adverse Selection Influences Financial Structure……….219

Lemons in the Stock and Bond Markets…………………………………………………………………….220

Tools to Help Solve Adverse Selection Problems…………………………………………………………220

FYI The Enron Implosion 222

How Moral Hazard Affects the Choice Between Debt and Equity Contracts………….225

Moral Hazard in Equity Contracts: The Principal–Agent Problem………………………………….225

Tools to Help Solve the Principal–Agent Problem……………………………………………………….226

How Moral Hazard Influences Financial Structure in Debt Markets………………………..228

Tools to Help Solve Moral Hazard in Debt Contracts…………………………………………………..228

Summary……………………………………………………………………………………………………………..230

APPLICATION Financial Development and Economic Growth…………………………..231

FYI The Tyranny of Collateral 232

APPLICATION Is China a Counterexample to the Importance

of Financial Development?……………………………………………………………………..233

Summary 234 • Key Terms 235 • Questions 235 • Applied Problems 236 •

Data Analysis Problems 237 • Web Exercises 237 • Web References 237

CHAPTER 9

Banking and the Management of Financial Institutions 238

The Bank Balance Sheet……………………………………………………………………………………………….238

Liabilities……………………………………………………………………………………………………………..238

Assets………………………………………………………………………………………………………………….241

Basic Banking………………………………………………………………………………………………………………..242

General Principles of Bank Management……………………………………………………………………245

Liquidity Management and the Role of Reserves…………………………………………………………245

Asset Management…………………………………………………………………………………………………248

Liability Management…………………………………………………………………………………………….249

Capital Adequacy Management……………………………………………………………………………….250

APPLICATION Strategies for Managing Bank Capital………………………………………..252

APPLICATION How a Capital Crunch Caused a Credit Crunch During the

Global Financial Crisis…………………………………………………………………………..253

Managing Credit Risk……………………………………………………………………………………………………253

Screening and Monitoring………………………………………………………………………………………254

Long-Term Customer Relationships………………………………………………………………………….255

Loan Commitments……………………………………………………………………………………………….256

Collateral and Compensating Balances……………………………………………………………………..256

Credit Rationing……………………………………………………………………………………………………256

Managing Interest-Rate Risk………………………………………………………………………………………..257

Gap and Duration Analysis……………………………………………………………………………………..258

APPLICATION Strategies for Managing Interest-Rate Risk………………………………….259

Off-Balance-Sheet Activities………………………………………………………………………………………..259

Loan Sales……………………………………………………………………………………………………………260

Generation of Fee Income………………………………………………………………………………………260

Trading Activities and Risk Management Techniques…………………………………………………..260

Global Barings, Daiwa, Sumitomo, Société Générale, and JP Morgan Chase:

Rogue Traders and the Principal–Agent Problem 261

Summary 262 • Key Terms 263 • Questions 263 • Applied Problems 264 •

Data Analysis Problems 265 • Web Exercises 265 • Web References 266

CHAPTER 9 APPENDIX 1

Duration Gap Analysis

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CHAPTER 9 APPENDIX 2

Measuring Bank Performance

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CHAPTER 10

Economic Analysis of Financial Regulation 267

Asymmetric Information as a Rationale for Financial Regulation…………………………….267

Government Safety Net………………………………………………………………………………………….267

Global The Spread of Government Deposit Insurance Throughout the World:

Is This a Good Thing? 269

Drawbacks of the Government Safety Net…………………………………………………………………270

Types of Financial Regulation………………………………………………………………………………………272

Restrictions on Asset Holdings………………………………………………………………………………..272

Capital Requirements…………………………………………………………………………………………….273

Global Where Is the Basel Accord Heading After the Global Financial Crisis? 274

Prompt Corrective Action……………………………………………………………………………………….275

Financial Supervision: Chartering and Examination……………………………………………………275

Assessment of Risk Management……………………………………………………………………………..276

Disclosure Requirements………………………………………………………………………………………..277

Consumer Protection……………………………………………………………………………………………..278

Restrictions on Competition……………………………………………………………………………………278

Summary……………………………………………………………………………………………………………..279

Global International Financial Regulation 280

Summary 282 • Key Terms 283 • Questions 283 • Applied Problems 284 •

Data Analysis Problems 284 • Web Exercises 285 • Web References 285

CHAPTER 10 APPENDIX 1

The 1980s Banking and Savings and Loan Crisis

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CHAPTER 10 APPENDIX 2

Banking Crises Throughout the World

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CHAPTER 11

Banking Industry: Structure and Competition 286

Historical Development of the Banking System…………………………………………………………286

Multiple Regulatory Agencies………………………………………………………………………………….288

Financial Innovation and the Growth of the “Shadow Banking System”………………….289

Responses to Changes in Demand Conditions: Interest-Rate Volatility……………………………290

Responses to Changes in Supply Conditions: Information Technology…………………………..291

Securitization and the Shadow Banking System………………………………………………………….293

Avoidance of Existing Regulations……………………………………………………………………………295

FYI Bruce Bent and the Money Market Mutual Fund Panic of 2008 296

Financial Innovation and the Decline of Traditional Banking………………………………………..297

Structure of the U.S. Commercial Banking Industry…………………………………………………..300

Restrictions on Branching……………………………………………………………………………………….302

Response to Branching Restrictions………………………………………………………………………….302

Bank Consolidation and Nationwide Banking……………………………………………………………303

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994………………………305

What Will the Structure of the U.S. Banking Industry Look Like in the Future?………………305

Global Comparison of Banking Structure in the United States and Abroad 306

Are Bank Consolidation and Nationwide Banking Good Things?…………………………………..306

Separation of Banking and Other Financial Service Industries…………………………………307

Erosion of Glass-Steagall…………………………………………………………………………………………307

The Gramm-Leach-Bliley Financial Services Modernization Act of 1999:

Repeal of Glass-Steagall……………………………………………………………………………………..308

Implications for Financial Consolidation…………………………………………………………………..308

Separation of Banking and Other Financial Services Industries Throughout the World…….308

FYI The Global Financial Crisis and the Demise of Large,

Free-Standing Investment Banks 309

Thrift Industry: Regulation and Structure……………………………………………………………………309

Savings and Loan Associations…………………………………………………………………………………310

Mutual Savings Banks…………………………………………………………………………………………….310

Credit Unions……………………………………………………………………………………………………….310

International Banking…………………………………………………………………………………………………..311

Eurodollar Market…………………………………………………………………………………………………311

Global Ironic Birth of the Eurodollar Market 312

Structure of U.S. Banking Overseas…………………………………………………………………………..312

Foreign Banks in the United States…………………………………………………………………………..313

Summary 314 • Key Terms 315 • Questions 315 • Data Analysis Problems 316 •

Web Exercises 317 • Web References 317

CHAPTER 12

Financial Crises in Advanced Economies 318

Global The European Sovereign Debt Crisis 319

What Is a Financial Crisis?…………………………………………………………………………………………….319

Dynamics of Financial Crises……………………………………………………………………………………….320

Stage One: Initial Phase………………………………………………………………………………………….320

Stage Two: Banking Crisis……………………………………………………………………………………….322

Stage Three: Debt Deflation…………………………………………………………………………………….324

APPLICATION The Mother of All Financial Crises: The Great Depression…………..324

The U.S. Stock Market Crash…………………………………………………………………………………..324

Worldwide Decline in Asset Prices……………………………………………………………………………325

Bank Failures………………………………………………………………………………………………………..326

Economic Contraction and Debt Deflation………………………………………………………………..326

The Global Financial Crisis of 2007–2009…………………………………………………………………..327

Causes of the 2007–2009 Financial Crisis…………………………………………………………………327

FYI Collateralized Debt Obligations (CDOs) and Credit Default Swaps 328

Effects of the 2007–2009 Financial Crisis………………………………………………………………….329

Inside the Fed Was the Fed to Blame for the Housing Price Bubble? 330

Height of the 2007–2009 Financial Crisis…………………………………………………………………334

Government Intervention and the Recovery……………………………………………………………..335

Short-Term Responses and Recovery………………………………………………………………………..335

Global Latvia’s Different and Controversial Response: Expansionary Contraction 336

Stabilizing the Global Financial System:

Long-Term Responses……………………………………………………………………………………………337

Global Financial Regulatory Framework……………………………………………………………………337

Policy Areas at the National Level……………………………………………………………………………. 337

FYI The Libor Scandal 340

Future Regulations and Policy Areas at the International Level……………………………….340

Bilateral and Multilateral Supervisory Cooperation……………………………………………………..341

Collective Supervisory Cooperation………………………………………………………………………….341

Collectively Coordinated Macroeconomic Stability Plans……………………………………………..341

Self-Discipline………………………………………………………………………………………………………341

Summary 342 • Key Terms 343 • Questions 343 • Data Analysis Problems 344 •

Web Exercises 345

CHAPTER 13

Financial Crises in Emerging Economies 346

Dynamics of Financial Crises in Emerging Market Economies……………………………….. 346

Stage One: Initial Phase………………………………………………………………………………………….346

Stage Two: Currency Crisis……………………………………………………………………………………..350

Stage Three: Full-Fledged Financial Crisis…………………………………………………………………351

APPLICATION Crisis in South Korea, 1997–1998…………………………………………….352

Financial Liberalization and Globalization Mismanaged………………………………………………354

Perversion of the Financial Liberalization and Globalization

Process: Chaebols and the South Korean Crisis……………………………………………………..354

Stock Market Decline and Failure of Firms Increase Uncertainty…………………………………..356

Adverse Selection and Moral Hazard Problems Worsen, and the Economy Contracts……….356

Currency Crisis Ensues………………………………………………………………………………………….357

Final Stage: Currency Crisis Triggers Full-Fledged Financial Crisis……………………………….357

Recovery Commences……………………………………………………………………………………………358

Global China and the “Noncrisis” in 1997–1998 359

APPLICATION The Argentine Financial Crisis, 2001–2002………………………………..359

Severe Fiscal Imbalances………………………………………………………………………………………..359

Adverse Selection and Moral Hazard Problems Worsen……………………………………………….360

Bank Panic Begins…………………………………………………………………………………………………360

Currency Crisis Ensues………………………………………………………………………………………….361

Currency Crisis Triggers Full-Fledged Financial Crisis………………………………………………..361

Recovery Begins……………………………………………………………………………………………………364

Global When an Advanced Economy Is Like an Emerging Market Economy:

The Icelandic Financial Crisis of 2008 364

Preventing Emerging Market Financial Crises…………………………………………………………….365

Beef Up Prudential Regulation and Supervision of Banks…………………………………………….365

Encourage Disclosure and Market-Based Discipline…………………………………………………….365

Limit Currency Mismatch……………………………………………………………………………………….366

Sequence Financial Liberalization…………………………………………………………………………….366

Summary 366 • Key Terms 367 • Questions 367 • Data Analysis Problems 367 •

Web References 368

PART 4 Central Banking and the Conduct of Monetary Policy 369

CHAPTER 14

Central Banks 370

Origins Of The Central Banking System………………………………………………………………………370

Variations in The Functions and Structures

of Central Banks…………………………………………………………………………………………………….371

The European Central Bank, the Euro System, and the

European System of Central Banks………………………………………………………………………371

Global Who Should Own Central Banks? 372

Decision-making Bodies of the ECB…………………………………………………………………………374

Global The Importance of the Bundesbank Within the ECB 376

How Monetary Policy Is Conducted Within the ECB…………………………………………………..376

Global Are Non-Euro Central Banks Constrained by Membership In the EU? 377

The Federal Reserve System…………………………………………………………………………………….378

Comparing the ECB and the Fed……………………………………………………………………………..379

The Bank of England……………………………………………………………………………………………..379

Global Brexit and the BoE 380

Structure of Central Banks in Larger Economies………………………………………………………..381

Structure and Independence of Central Banks

in Emerging Market Economies……………………………………………………………………………383

Should Central Banks Be Independent……………………………………………………………………….384

The Case for Independence…………………………………………………………………………………….384

The Case Against Independence………………………………………………………………………………385

The Trend Toward Greater Independence………………………………………………………………….385

Summary 386 • Key Terms 386 • Questions 387 • Web Exercises 387

CHAPTER 15

The Money Supply Process 388

Three Players in the Money Supply Process……………………………………………………………….388

The Fed’s Balance Sheet……………………………………………………………………………………………….388

Liabilities……………………………………………………………………………………………………………..389

Assets………………………………………………………………………………………………………………….390

Control of the Monetary Base……………………………………………………………………………………..390

Federal Reserve Open Market Operations………………………………………………………………….391

Shifts from Deposits into Currency…………………………………………………………………………..392

Loans to Financial Institutions…………………………………………………………………………………393

Other Factors That Affect the Monetary Base……………………………………………………………..393

Overview of the Fed’s Ability to Control the Monetary Base………………………………………….394

Multiple Deposit Creation: A Simple Model………………………………………………………………395

Deposit Creation: The Single Bank…………………………………………………………………………..395

Deposit Creation: The Banking System……………………………………………………………………..396

Deriving the Formula for Multiple Deposit Creation…………………………………………………..399

Critique of the Simple Model………………………………………………………………………………….400

Factors That Determine the Money Supply………………………………………………………………..401

Changes in the Nonborrowed Monetary Base, MBn……………………………………………………..401

Changes in Borrowed Reserves, BR, from the Fed……………………………………………………….401

Changes in the Required Reserve Ratio, rr…………………………………………………………………402

Changes in Excess Reserves…………………………………………………………………………………….402

Changes in Currency Holdings………………………………………………………………………………..402

Overview of the Money Supply Process……………………………………………………………………..402

The Money Multiplier…………………………………………………………………………………………………..403

Deriving the Money Multiplier………………………………………………………………………………..403

Intuition Behind the Money Multiplier……………………………………………………………………..405

Money Supply Response to Changes in the Factors……………………………………………………..406

APPLICATION Quantitative Easing and the Money Supply, 2007–2017……………….407

Summary 409 • Key Terms 409 • Questions 409 • Applied Problems 410 •

Data Analysis Problems 411 • Web Exercises 411 • Web References 412

CHAPTER 15 APPENDIX 1

The Fed’s Balance Sheet and the Monetary Base

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CHAPTER 15 APPENDIX 2

The M2 Money Multiplier

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CHAPTER 15 APPENDIX 3

Explaining the Behavior of the Currency Ratio

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CHAPTER 15 APPENDIX 4

The Great Depression Bank Panics, 1930–1933, and the Money Supply

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CHAPTER 16

Tools of Monetary Policy 413

The Market for Reserves and the Federal Funds Rate……………………………………………….413

Demand and Supply in the Market for Reserves…………………………………………………………414

How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate………………….415

APPLICATION How the Federal Reserve’s Operating Procedures

Limit Fluctuations in the Federal Funds Rate……………………………………………419

Conventional Monetary Policy Tools………………………………………………………………………….420

Open Market Operations………………………………………………………………………………………..421

Inside the Fed A Day at the Trading Desk 422

Discount Policy and the Lender of Last Resort……………………………………………………………423

Inside the Fed Using Discount Policy to Prevent a Financial Panic 425

Reserve Requirements…………………………………………………………………………………………….426

Interest on Reserves……………………………………………………………………………………………….426

Relative Advantages of the Different Tools…………………………………………………………………427

Nonconventional Monetary Policy Tools and Quantitative Easing………………………….427

Liquidity Provision………………………………………………………………………………………………..428

Large-Scale Asset Purchases…………………………………………………………………………………….428

Inside the Fed Fed Lending Facilities During the Global Financial Crisis 429

Quantitative Easing Versus Credit Easing…………………………………………………………………..430

Forward Guidance…………………………………………………………………………………………………432

Negative Interest Rates on Banks’ Deposits………………………………………………………………..433

Monetary Policy Tools of the European Central Bank……………………………………………….434

Open Market Operations………………………………………………………………………………………..434

Lending to Banks…………………………………………………………………………………………………..434

Interest on Reserves……………………………………………………………………………………………….435

Reserve Requirements…………………………………………………………………………………………….435

Summary 435 • Key Terms 436 • Questions 436 • Applied Problems 437 •

Data Analysis Problems 438 • Web Exercises 438 • Web References 438

CHAPTER 17

The Conduct of Monetary Policy: Strategy and Tactics 439

The Price Stability Goal and the Nominal Anchor……………………………………………………..439

The Role of a Nominal Anchor………………………………………………………………………………..440

The Time-Inconsistency Problem…………………………………………………………………………….440

Other Goals of Monetary Policy………………………………………………………………………………….441

High Employment and Output Stability……………………………………………………………………441

Economic Growth…………………………………………………………………………………………………442

Stability of Financial Markets………………………………………………………………………………….442

Interest-Rate Stability……………………………………………………………………………………………..442

Stability in Foreign Exchange Markets………………………………………………………………………443

Should Price Stability Be the Primary Goal of Monetary Policy?……………………………..443

Hierarchical Versus Dual Mandates…………………………………………………………………………..443

Price Stability as the Primary, Long-Run Goal of Monetary Policy………………………………….444

Inflation Targeting…………………………………………………………………………………………………………444

Inflation Targeting in New Zealand, Canada, and the United Kingdom………………………….445

Advantages of Inflation Targeting…………………………………………………………………………….447

Disadvantages of Inflation Targeting…………………………………………………………………………449

The Evolution of the Federal Reserve’s Monetary Policy Strategy…………………………….450

The Fed’s “Just Do It” Monetary Policy Strategy………………………………………………………….450

The Long Road to Inflation Targeting……………………………………………………………………….452

Inside the Fed Ben Bernanke’s Advocacy of Inflation Targeting 453

Global The European Central Bank’s Monetary Policy Strategy 453

Lessons for Monetary Policy Strategy from the Global Financial Crisis……………………454

Implications for Inflation Targeting………………………………………………………………………….455

Should Central Banks Try to Stop Asset-Price Bubbles?…………………………………………….456

Two Types of Asset-Price Bubbles……………………………………………………………………………..456

The Debate Over Whether Central Banks Should Try to Pop Bubbles…………………………….457

Tactics: Choosing the Policy Instrument……………………………………………………………………..460

Criteria for Choosing the Policy Instrument………………………………………………………………462

Tactics: The Taylor Rule…………………………………………………………………………………………………463

Inside the Fed The Fed’s Use of the Taylor Rule 466

Inside the Fed Fed Watchers 466

Summary 467 • Key Terms 467 • Questions 468 • Applied Problems 469 •

Data Analysis Problems 469 • Web Exercises 470 • Web References 471

CHAPTER 17 APPENDIX 1

Monetary Targeting

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CHAPTER 17 APPENDIX 2

A Brief History of Federal Reserve Policymaking

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PART 5 International Finance and Monetary Policy 473

CHAPTER 18

The Foreign Exchange Market 474

Foreign Exchange Market…………………………………………………………………………………………….474

Following the Financial News Foreign Exchange Rates 475

What Are Foreign Exchange Rates?…………………………………………………………………………..475

Why Are Exchange Rates Important?………………………………………………………………………..475

How Is Foreign Exchange Traded?……………………………………………………………………………476

Exchange Rates in the Long Run………………………………………………………………………………….477

Theory of Purchasing Power Parity…………………………………………………………………………..477

APPLICATION Burgernomics: Big Macs and PPP………………………………………………479

Factors That Affect Exchange Rates in the Long Run……………………………………………………481

Exchange Rates in the Short Run: A Supply and Demand Analysis………………………….483

Supply Curve for Domestic Assets……………………………………………………………………………483

Demand Curve for Domestic Assets………………………………………………………………………….483

Equilibrium in the Foreign Exchange Market…………………………………………………………….485

Explaining Changes in Exchange Rates……………………………………………………………………….485

Shifts in the Demand for Domestic Assets…………………………………………………………………485

Recap: Factors That Change the Exchange Rate………………………………………………………….488

APPLICATION Effects of Changes in Interest Rates on the Equilibrium

Exchange Rate………………………………………………………………………………………490

APPLICATION The Global Financial Crisis and the Dollar………………………………..492

APPLICATION Brexit and the British Pound…………………………………………………….493

Summary 494 • Key Terms 495 • Questions 495 • Applied Problems 496 •

Data Analysis Problems 496 • Web Exercises 497 • Web References 497

APPENDIX TO CHAPTER 18

The Interest Parity Condition 498

Comparing Expected Returns on Domestic and Foreign Assets………………………………498

Interest Parity Condition………………………………………………………………………………………………500

CHAPTER 19

The International Financial System 502

Intervention in the Foreign Exchange Market……………………………………………………………502

Foreign Exchange Intervention and the Money Supply………………………………………………..502

Inside the Fed A Day at the Federal Reserve Bank of New York’s Foreign

Exchange Desk 503

Unsterilized Intervention………………………………………………………………………………………..505

Sterilized Intervention……………………………………………………………………………………………506

Balance of Payments…………………………………………………………………………………………………….506

Current Account…………………………………………………………………………………………………..507

Financial Account…………………………………………………………………………………………………507

Global Should We Worry About the Large U.S. Current Account Deficit? 508

Exchange Rate Regimes in the International Financial System…………………………………508

Gold Standard………………………………………………………………………………………………………509

The Bretton Woods System……………………………………………………………………………………..509

How a Fixed Exchange Rate Regime Works……………………………………………………………….510

Speculative Attacks………………………………………………………………………………………………..512

APPLICATION The Foreign Exchange Crisis of September 1992…………………………512

The Policy Trilemma………………………………………………………………………………………………514

APPLICATION How Did China Accumulate $4 Trillion of International Reserves?..515

Monetary Unions…………………………………………………………………………………………………..515

Managed Float………………………………………………………………………………………………………516

Global Will the Euro Survive? 516

Capital Controls…………………………………………………………………………………………………………….517

Controls on Capital Outflows………………………………………………………………………………….517

Controls on Capital Inflows……………………………………………………………………………………517

The Role of the IMF………………………………………………………………………………………………………518

Should the IMF Act as an International Lender of Last Resort?……………………………………..518

International Considerations and Monetary Policy…………………………………………………..519

Direct Effects of the Foreign Exchange Market on Monetary Policy………………………………..519

Exchange Rate Considerations…………………………………………………………………………………520

To Peg or Not to Peg: Exchange-Rate Targeting as an Alternative Monetary

Policy Strategy……………………………………………………………………………………………………….520

Advantages of Exchange-Rate Targeting…………………………………………………………………….520

Disadvantages of Exchange-Rate Targeting…………………………………………………………………521

When Is Exchange-Rate Targeting Desirable for Industrialized Countries?………………………523

When Is Exchange-Rate Targeting Desirable for Emerging Market Countries?…………………524

Currency Boards……………………………………………………………………………………………………524

Global Argentina’s Currency Board 525

Dollarization………………………………………………………………………………………………………..525

Summary 526 • Key Terms 527 • Questions 527 • Applied Problems 528 •

Data Analysis Problems 529 • Web Exercises 530 • Web References 530

PART 6 Monetary Theory 531

CHAPTER 20

Quantity Theory, Inflation, and the Demand for Money 532

Quantity Theory of Money…………………………………………………………………………………………..532

Velocity of Money and Equation of Exchange…………………………………………………………….532

From the Equation of Exchange to the Quantity Theory of Money………………………………..534

Quantity Theory and the Price Level………………………………………………………………………..535

Quantity Theory and Inflation………………………………………………………………………………..535

APPLICATION Testing the Quantity Theory of Money………………………………………536

Budget Deficits and Inflation……………………………………………………………………………………….538

Government Budget Constraint……………………………………………………………………………….538

Hyperinflation………………………………………………………………………………………………………540

APPLICATION The Zimbabwean Hyperinflation……………………………………………….540

Keynesian Theories of Money Demand……………………………………………………………………..541

Transactions Motive……………………………………………………………………………………………….541

Precautionary Motive……………………………………………………………………………………………..541

Speculative Motive………………………………………………………………………………………………..541

Putting the Three Motives Together………………………………………………………………………….541

Portfolio Theories of Money Demand………………………………………………………………………..542

Theory of Portfolio Choice and Keynesian Liquidity Preference…………………………………….543

Other Factors That Affect the Demand for Money……………………………………………………….543

Summary……………………………………………………………………………………………………………..544

Empirical Evidence for the Demand for Money………………………………………………………..544

Interest Rates and Money Demand…………………………………………………………………………..544

Stability of Money Demand…………………………………………………………………………………….545

Summary 546 • Key Terms 546 • Questions 546 • Applied Problems 548 •

Data Analysis Problems 548 • Web Exercises 549 • Web References 549

CHAPTER 20 APPENDIX 1

The Baumol-Tobin and Tobin Mean Variance Models of the Demand for Money

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CHAPTER 20 APPENDIX 2

Empirical Evidence on the Demand for Money

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CHAPTER 21

The IS Curve 550

Planned Expenditure and Aggregate Demand…………………………………………………………..550

The Components of Aggregate Demand……………………………………………………………………551

Consumption Expenditure……………………………………………………………………………………..551

FYI Meaning of the Word Investment 552

Planned Investment Spending…………………………………………………………………………………552

Government Purchases and Taxes…………………………………………………………………………….554

Net Exports………………………………………………………………………………………………………….555

Goods Market Equilibrium…………………………………………………………………………………………..556

Solving for Goods Market Equilibrium……………………………………………………………………..556

Deriving the IS Curve…………………………………………………………………………………………….557

Understanding the IS Curve…………………………………………………………………………………………557

What the IS Curve Tells Us: Intuition……………………………………………………………………….557

What the IS Curve Tells Us: Numerical Example………………………………………………………..557

Why the Economy Heads Toward Equilibrium…………………………………………………………..559

Factors that Shift the IS Curve………………………………………………………………………………………559

Changes in Government Purchases…………………………………………………………………………..559

APPLICATION The Vietnam War Buildup, 1964–1969………………………………………560

Changes in Taxes…………………………………………………………………………………………………..561

APPLICATION The Fiscal Stimulus Package of 2009…………………………………………562

Changes in Autonomous Spending…………………………………………………………………………..563

Changes in Financial Frictions………………………………………………………………………………..565

Summary of Factors That Shift the IS Curve………………………………………………………………565

Summary 565 • Key Terms 565 • Questions 566 • Applied Problems 567 • CHAPTER 22

The Monetary Policy and Aggregate Demand Curves 570

The Federal Reserve and Monetary Policy………………………………………………………………….570

The Monetary Policy Curve………………………………………………………………………………………….571

The Taylor Principle: Why the Monetary Policy Curve Has an Upward Slope………………….571

Shifts in the MP Curve……………………………………………………………………………………………573

Movements Along Versus Shifts in the MP Curve……………………………………………………….574

APPLICATION Movement Along the MP Curve: The Rise in the Federal

Funds Rate Target, 2004–2006………………………………………………………………..574

APPLICATION Shift in the MP Curve: Autonomous Monetary Easing at

the Onset of the Global Financial Crisis…………………………………………………..574

The Aggregate Demand Curve…………………………………………………………………………………….575

Deriving the Aggregate Demand Curve Graphically…………………………………………………….576

Factors That Shift the Aggregate Demand Curve…………………………………………………………576

FYI Deriving the Aggregate Demand Curve Algebraically 576

Summary 581 • Key Terms 581 • Questions 581 • Applied Problems 582 •

Data Analysis Problems 583 • Web Exercises 584 • Web References 584

CHAPTER 23

Aggregate Demand and Supply Analysis 585

Aggregate Demand……………………………………………………………………………………………………….585

Following the Financial News Aggregate Output, Unemployment, and Inflation 586

Deriving the Aggregate Demand Curve……………………………………………………………………..586

Factors That Shift the Aggregate Demand Curve…………………………………………………………587

FYI What Does Autonomous Mean? 588

Aggregate Supply………………………………………………………………………………………………………….591

Long-Run Aggregate Supply Curve…………………………………………………………………………..591

Short-Run Aggregate Supply Curve………………………………………………………………………….591

Price Stickiness and the Short-Run Aggregate Supply Curve…………………………………………593

Shifts in the Aggregate Supply Curves…………………………………………………………………………593

Shifts in the Long-Run Aggregate Supply Curve…………………………………………………………593

Shifts in the Short-Run Aggregate Supply Curve…………………………………………………………594

Equilibrium in Aggregate Demand and Supply Analysis…………………………………………..597

Short-Run Equilibrium…………………………………………………………………………………………..598

How the Short-Run Equilibrium Moves to the Long-Run Equilibrium over Time…………….598

Self-Correcting Mechanism……………………………………………………………………………………..601

Changes in Equilibrium: Aggregate Demand Shocks…………………………………………………601

APPLICATION The Volcker Disinflation, 1980–1986………………………………………..602

APPLICATION Negative Demand Shocks, 2001–2004……………………………………….604

Changes in Equilibrium: Aggregate Supply (Inflation) Shocks………………………………….604

Temporary Supply Shocks………………………………………………………………………………………604

APPLICATION Negative Supply Shocks, 1973–1975 and 1978–1980………………….607

Permanent Supply Shocks and Real Business Cycle Theory………………………………………….607

APPLICATION Positive Supply Shocks, 1995–1999……………………………………………610

Conclusions…………………………………………………………………………………………………………611

APPLICATION Negative Supply and Demand Shocks and the 2007–2009

Financial Crisis……………………………………………………………………………………..612

AD/AS Analysis of Foreign Business Cycle Episodes…………………………………………………..612

APPLICATION The United Kingdom and the 2007–2009 Financial Crisis…………..614

APPLICATION China and the 2007–2009 Financial Crisis…………………………………615

Summary 616 • Key Terms 617 • Questions 617 • Applied Problems 618 •

Data Analysis Problems 618 • Web Exercises 619 • Web References 619

APPENDIX TO CHAPTER 23

The Phillips Curve and the Short-Run Aggregate Supply Curve 620

The Phillips Curve…………………………………………………………………………………………………………620

Phillips Curve Analysis in the 1960s………………………………………………………………………..620

FYI The Phillips Curve Trade-Off and Macroeconomic Policy in the 1960s 622

The Friedman-Phelps Phillips Curve Analysis……………………………………………………………622

The Phillips Curve After the 1960s…………………………………………………………………………..624

The Modern Phillips Curve…………………………………………………………………………………….624

The Modern Phillips Curve with Adaptive (Backward-Looking) Expectations…………………625

The Short-Run Aggregate Supply Curve……………………………………………………………………..626

CHAPTER 23 APPENDIX 1

The Effects of Macroeconomic Shocks on Asset Prices

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CHAPTER 23 APPENDIX 2

Aggregate Demand and Supply: A Numerical Example

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CHAPTER 23 APPENDIX 3

The Algebra of the Aggregate Demand and Supply Model

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CHAPTER 23 APPENDIX 4

The Taylor Principle and Inflation Stability

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CHAPTER 24

Monetary Policy Theory 629

Response of Monetary Policy to Shocks……………………………………………………………………..629

Response to an Aggregate Demand Shock………………………………………………………………….630

Response to a Permanent Supply Shock…………………………………………………………………….632

Response to a Temporary Supply Shock……………………………………………………………………634

The Bottom Line: The Relationship Between Stabilizing Inflation and

Stabilizing Economic Activity……………………………………………………………………………..637

How Actively Should Policymakers Try to Stabilize Economic Activity?………………….637

Lags and Policy Implementation………………………………………………………………………………637

Inflation: Always and Everywhere a Monetary Phenomenon…………………………………..638

FYI The Activist/Nonactivist Debate Over the Obama Fiscal Stimulus Package 639

Causes of Inflationary Monetary Policy………………………………………………………………………639

High Employment Targets and Inflation……………………………………………………………………639

APPLICATION The Great Inflation…………………………………………………………………643

Monetary Policy at the Zero Lower Bound………………………………………………………………..645

Deriving the Aggregate Demand Curve with the Zero Lower Bound………………………………645

The Disappearance of the Self-Correcting Mechanism at the Zero Lower Bound………………647

APPLICATION Nonconventional Monetary Policy and Quantitative Easing…………648

Liquidity Provision………………………………………………………………………………………………..649

Asset Purchases and Quantitative Easing…………………………………………………………………..650

Management of Expectations…………………………………………………………………………………..651

APPLICATION Abenomics and the Shift in Japanese Monetary Policy in 2013……..652

Summary 654 • Key Terms 654 • Questions 655 • Applied Problems 656 •

Data Analysis Problems 656 • Web Exercises 657 • Web References 657

CHAPTER 25

The Role of Expectations in Monetary Policy 658

Lucas Critique of Policy Evaluation……………………………………………………………………………..658

Econometric Policy Evaluation………………………………………………………………………………..659

APPLICATION The Term Structure of Interest Rates………………………………………….659

Policy Conduct: Rules or Discretion?………………………………………………………………………….660

Discretion and the Time-Inconsistency Problem…………………………………………………………660

Types of Rules……………………………………………………………………………………………………….661

The Case for Rules…………………………………………………………………………………………………661

FYI The Political Business Cycle and Richard Nixon 662

The Case for Discretion………………………………………………………………………………………….662

Constrained Discretion…………………………………………………………………………………………..663

Global The Demise of Monetary Targeting in Switzerland 663

The Role of Credibility and a Nominal Anchor………………………………………………………….664

Benefits of a Credible Nominal Anchor……………………………………………………………………..664

Credibility and Aggregate Demand Shocks………………………………………………………………..665

Credibility and Aggregate Supply Shocks………………………………………………………………….667

APPLICATION A Tale of Three Oil Price Shocks……………………………………………….668

Credibility and Anti-Inflation Policy…………………………………………………………………………670

Global Ending the Bolivian Hyperinflation: A Successful Anti-Inflation Program 671

APPLICATION Credibility and the Reagan Budget Deficits…………………………………672

Approaches to Establishing Central Bank Credibility…………………………………………………673

Nominal GDP Targeting…………………………………………………………………………………………673

Inside the Fed The Appointment of Paul Volcker, Anti-Inflation Hawk 674

Appoint “Conservative” Central Bankers……………………………………………………………………674

Summary 675 • Key Terms 675 • Questions 675 • Applied Problems 676 •

Data Analysis Problems 677 • Web Exercises 677

CHAPTER 26

Transmission Mechanisms of Monetary Policy 678

Transmission Mechanisms of Monetary Policy…………………………………………………………..678

Traditional Interest-Rate Channels……………………………………………………………………………679

Other Asset Price Channels…………………………………………………………………………………….680

Credit View………………………………………………………………………………………………………….683

FYI Consumers’ Balance Sheets and the Great Depression 685

Why Are Credit Channels Likely to Be Important?……………………………………………………..686

APPLICATION The Great Recession…………………………………………………………………687

Lessons for Monetary Policy………………………………………………………………………………………..687

APPLICATION Applying the Monetary Policy Lessons to Japan’s

Two Lost Decades………………………………………………………………………………….689

Summary 690 • Key Terms 690 • Questions 690 • Applied Problems 691 •

Data Analysis Problems 692 • Web Exercises 692 • Web References 692

CHAPTER 26 APPENDIX

Evaluating Empirical Evidence: The Debate Over the Importance of Money in

Economic Fluctuations

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Glossary……………………………………………………………………………………………………………………….693

Index……………………………………………………………………………………………………………………………705

CHAPTER 1

The ISLM Model 1

Keynes’s Fixed Price Level Assumption and the IS Curve……………………………………………… 1

The LM Curve………………………………………………………………………………………………………… 1

Equilibrium in the Market for Money: The LM Curve……………………………………………………. 2

ISLM Approach to Aggregate Output and Interest Rates……………………………………………… 4

Factors That Cause the LM Curve to Shift……………………………………………………………………… 5

Changes in Equilibrium Level of the Interest Rate and Aggregate Output…………………. 7

Response to a Change in Monetary Policy……………………………………………………………………. 7

Response to a Change in Fiscal Policy…………………………………………………………………………. 8

APPLICATION The Economic Stimulus Act of 2008……………………………………………. 9

Effectiveness of Monetary Versus Fiscal Policy…………………………………………………………… 11

Monetary Policy Versus Fiscal Policy: The Case of Complete Crowding Out……………………. 11

APPLICATION Targeting Money Supply Versus Interest Rates……………………………. 13

ISLM Model in the Long Run……………………………………………………………………………………….. 16

Summary 18 • Key Terms 19 • Questions and Applied Problems 17 •

Web Exercises 19 • Web References 20

APPENDIX TO CHAPTER 1

Algebra of The ISLM Model 21

Basic Closed-Economy ISLM Model……………………………………………………………………………. 21

IS and LM Curves…………………………………………………………………………………………………. 22

Solution of the Model…………………………………………………………………………………………….. 22

Implications…………………………………………………………………………………………………………. 22

Open-Economy ISLM Model……………………………………………………………………………………….. 23

Implications…………………………………………………………………………………………………………………… 24

CHAPTER 2

Nonbank Finance 1

Insurance………………………………………………………………………………………………………………………….. 1

Life Insurance…………………………………………………………………………………………………………. 1

Property and Casualty Insurance……………………………………………………………………………….. 2

The Competitive Threat from the Banking Industry………………………………………………………. 4

Credit Insurance……………………………………………………………………………………………………… 4

FYI The AIG Blowup 5

FYI The Global Financial Crisis and the Monoline Insurers 6

APPLICATION Insurance Management……………………………………………………………… 6

Screening………………………………………………………………………………………………………………. 7

Risk-Based Premiums………………………………………………………………………………………………. 7

Restrictive Provisions……………………………………………………………………………………………….. 7

Prevention of Fraud…………………………………………………………………………………………………. 8

Cancellation of Insurance…………………………………………………………………………………………. 8

Deductibles……………………………………………………………………………………………………………. 8

Coinsurance…………………………………………………………………………………………………………… 8

Limits on the Amount of Insurance……………………………………………………………………………. 8

Summary……………………………………………………………………………………………………………….. 9

Pension Funds………………………………………………………………………………………………………………….. 9

Private Pension Plans……………………………………………………………………………………………… 10

Public Pension Plans………………………………………………………………………………………………. 10

FYI Should Social Security Be Privatized? 11

Finance Companies………………………………………………………………………………………………………. 12

Securities Market Operations………………………………………………………………………………………. 13

Investment Banking……………………………………………………………………………………………….. 13

Securities Brokers and Dealers…………………………………………………………………………………. 14

Organized Exchanges…………………………………………………………………………………………….. 14

Mutual Funds………………………………………………………………………………………………………………… 15

FYI Sovereign Wealth Funds: Are They a Danger? 16

Money Market Mutual Funds………………………………………………………………………………….. 17

Hedge Funds…………………………………………………………………………………………………………………. 17

Private Equity and Venture Capital Funds…………………………………………………………………… 18

Government Financial Intermediation……………………………………………………………………….. 19

Federal Credit Agencies………………………………………………………………………………………….. 19

FYI The Global Financial Crisis and the Bailout of Fannie Mae

and Freddie Mac 20

Summary 21 • Key Terms 22 • Questions 22 • Applied Problems 23 •

Data Analysis Problems 23 • Web Exercises 24 • Web References 24

CHAPTER 3

Financial Derivatives 1

Hedging……………………………………………………………………………………………………………………………. 1

Interest-Rate Forward Contracts…………………………………………………………………………………….. 2

APPLICATION Hedging with Interest-Rate Forward Contracts…………………………….. 2

Pros and Cons of Forward Contracts………………………………………………………………………….. 3

Financial Futures Contracts and Markets………………………………………………………………………. 4

APPLICATION Hedging with Financial Futures…………………………………………………… 5

Organization of Trading in Financial Futures Markets…………………………………………………… 7

The Globalization of Financial Futures Markets……………………………………………………………. 8

Explaining the Success of Futures Markets………………………………………………………………….. 8

APPLICATION Hedging Foreign Exchange Risk……………………………………………….. 10

Hedging Foreign Exchange Risk with Forward Contracts…………………………………………….. 10

Hedging Foreign Exchange Risk with Futures Contracts……………………………………………… 10

Options………………………………………………………………………………………………………………………….. 11

Option Contracts…………………………………………………………………………………………………… 12

Profits and Losses on Option and Futures Contracts…………………………………………………… 12

APPLICATION Hedging with Futures Options………………………………………………….. 15

Factors Affecting Option Premiums………………………………………………………………………….. 16

Summary……………………………………………………………………………………………………………… 17

Swaps……………………………………………………………………………………………………………………………… 18

Interest-Rate Swap Contracts…………………………………………………………………………………… 18

APPLICATION Hedging with Interest-Rate Swaps……………………………………………… 19

Advantages of Interest-Rate Swaps……………………………………………………………………………. 19

Disadvantages of Interest-Rate Swaps………………………………………………………………………… 20

Financial Intermediaries in Interest-Rate Swaps………………………………………………………….. 20

Credit Derivatives………………………………………………………………………………………………………….. 20

Credit Options……………………………………………………………………………………………………… 21

Credit Swaps………………………………………………………………………………………………………… 21

Credit-Linked Notes………………………………………………………………………………………………. 22

APPLICATION Lessons from the Global Financial Crisis: When Are Financial Derivatives

Likely to Be a Worldwide Ticking Time Bomb? 22

Summary 24 • Key Terms 24 • Questions 25 • Applied Problems 25 •

Data Analysis Problems 26 • Web Exercises 27 • Web References 27

CHAPTER 4

Conflicts of Interest in the Financial Industry 1

What Are Conflicts of Interest, and Why Are They Important?…………………………………… 2

Why Do We Care About Conflicts of Interest?……………………………………………………………… 2

Ethics and Conflicts of Interest……………………………………………………………………………………….. 2

Types of Conflicts of Interest…………………………………………………………………………………………… 3

Underwriting and Research in Investment Banking………………………………………………………. 3

Auditing and Consulting in Accounting Firms…………………………………………………………….. 4

Credit Assessment and Consulting in Credit-Rating Agencies…………………………………………. 4

FYI The Collapse of Arthur Andersen 5

Universal Banking…………………………………………………………………………………………………… 5

FYI Why Do Issuers of Securities Pay to Have Their Securities Rated? 6

FYI Banksters 7

Can the Market Limit Exploitation of Conflicts of Interest?…………………………………………. 7

What Has Been Done to Remedy Conflicts of Interest?………………………………………………. 9

Sarbanes-Oxley Act of 2002……………………………………………………………………………………… 9

Global Legal Settlement of 2002………………………………………………………………………………. 10

Dodd-Frank Bill of 2010………………………………………………………………………………………… 11

A Framework for Evaluating Policies to Remedy Conflicts of Interest……………………… 11

Approaches to Remedying Conflicts of Interest………………………………………………………….. 12

APPLICATION Evaluating Sarbanes-Oxley, the Global Legal Settlement,

and the Dodd-Frank Bill…………………………………………………………………………. 14

Summary 16 • Key Terms 17 • Questions 17 • Web Exercises 18 •

Web References 18

CHAPTER APPENDICES

Chapter 4: Measuring Interest-Rate Risk: Duration

Chapter 5: Models of Asset Pricing

Chapter 5: Applying the Asset Market Approach to a Commodity Market: The Case of Gold

Chapter 5: Loanable Funds Framework

Chapter 7: Evidence on the Efficient Market Hypothesis

Chapter 9: Duration Gap Analysis

Chapter 9: Measuring Bank Performance

Chapter 10: The 1980s Banking and Savings and Loan Crisis

Chapter 10: Banking Crises Throughout the World

Chapter 15: The Fed’s Balance Sheet and the Monetary Base

Chapter 15: The M2 Money Multiplier

Chapter 15: Explaining the Behavior of the Currency Ratio

Chapter 15: The Great Depression Bank Panics, 1930–1933, and the Money Supply

Chapter 17: Monetary Targeting

Chapter 17: A Brief History of Federal Reserve Policymaking

Chapter 20: The Baumol-Tobin and Tobin Mean-Variance Models of the Demand for Money

Chapter 20: Empirical Evidence on the Demand for Money

Chapter 23: The Effects of Macroeconomic Shocks on Asset Prices

Chapter 23: Aggregate Demand and Supply: A Numerical Example

Chapter 23: The Algebra of the Aggregate Demand and Supply Model

Chapter 23: The Taylor Principle and Inflation Stability

Chapter 26: Evaluating Empirical Evidence: The Debate Over the Importance of

Money in Economic Fluctuations

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