Features
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THE ECONOMICS OF
MONEY, BANKING, AND
FINANCIAL MARKETS
13E
FREDERIC S. MISHKIN
Mishkin
Available separately for purchase is MyLab Economics for Mishkin, the teaching and learning platform that
empowers instructors to personalize learning for every student. When combined with Pearson’s trusted
educational content, this optional suite helps deliver the desired learning outcomes.
THIRTEENTH
EDITION
• Compelling new material on the coronavirus pandemic has been added to many sections,
applications, and boxes throughout the book—casting a spotlight on the importance of banks, financial
markets, and monetary policy to the health of the economy. These include a new application on the
coronavirus stock market crash of 2020 (Chapter 7), and the likelihood that the pandemic could lead to
another financial crisis (Chapter 12).
• Coverage of other new developments in the field of money and banking keep the text current
and relevant. They include:
■
A new application on the effects of the Trump tax cuts on bond interest rates (Chapter 6), which
shows how supply and demand analysis of the bond market can be used to explain the effect of taxes
on different interest rates
■
A new Global box on the variation in central banks’ activism and the method of intervention on foreign
exchange markets (Chapter 19). In addition, Chapters 18 and 19 have been heavily updated to include
new running examples
■
A new FYI box on Modern Monetary Theory (Chapter 20), which discusses this new theory that
argues that the Green New Deal can be easily paid for by having the Federal Reserve buy government
bonds to fund the resulting large budget deficits
• Compelling material on the operational structure and roles of major central banks around
the world (Chapter 14)—the European Central Bank, the People’s Bank of China, and the Bank of Japan—
helps students understand who makes the decisions to then have a better idea of how those decisions are
made.
The Economics of Money, Banking, and
Financial Markets
The Economics of Money, Banking and Financial Markets brings a fresh perspective to today’s major questions
surrounding financial policy. Influenced by his term as Governor of the Federal Reserve, Frederic Mishkin
offers students a unique viewpoint and informed insight into the monetary policy process, the regulation
and supervision of the financial system, and the internationalization of financial markets. Easy-to-follow
graphics, crisp definitions, and a thoroughly accessible text highlight the applications of economics, making
them relatable through everyday examples and concerns. The thirteenth edition of this bestseller provides
more rigor and clarity through internationally relevant topics and examples.
GLOBAL
EDITION
GLOB AL
EDITION
GLOBAL
EDITION
This is a special edition of an established title widely used by colleges and
universities throughout the world. Pearson published this exclusive edition
for the benefit of students outside the United States and Canada. If you
purchased this book within the United States or Canada, you should be aware
that it has been imported without the approval of the Publisher or Author.
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APPLYING THEORY TO THE REAL WORLD:
APPLICATIONS AND BOXES
Global Boxes
Inside the Fed Boxes
Are U.S. Capital Markets Losing Their Edge?, p. 80
The Importance of Financial Intermediaries Relative to
Securities Markets: An International Comparison,
p. 83
Negative Interest Rates? Japan First, Then the United
States, Then Europe, p. 124
Should Foreign Exchange Rates Follow a Random
Walk?, p. 201
Barings, Daiwa, Sumitomo, Société Générale, and JP
Morgan Chase: Rogue Traders and the Principal–
Agent Problem, p. 259
The Spread of Government Deposit Insurance
­Throughout the World: Is This a Good Thing?,
p. 266
Where Is the Basel Accord Heading After the Global
Financial Crisis?, p. 271
International Financial Regulation, p. 277
Comparison of Banking Structure in the United States
and Abroad, p. 303
Ironic Birth of the Eurodollar Market, p. 309
The European Sovereign Debt Crisis, p. 316
Latvia’s Different and Controversial Response:
­Expansionary Contraction, p. 334
China and the “Noncrisis” in 1997–1998, p. 355
When an Advanced Economy Is Like an Emerging
Market Economy: The Icelandic Financial Crisis of
2008, p. 360
Who Should Own Central Banks?, p. 367
The Importance of the Bundesbank within the ECB,
p. 372
Are Non-Euro Central Banks Constrained by
­Membership of the EU?, p. 374
Brexit and the BoE, p. 376
The European Central Bank’s Monetary Policy
Strategy, p. 449
Variation in Central Banks’ Activism and Method of
Intervention on Foreign Exchange Markets, p. 492
Should We Worry About the Large and Recurrent
Trade Deficit?, p. 497
Will the Euro Survive?, p. 505
Argentina’s Currency Board, p. 514
The Demise of Monetary Targeting in Switzerland, p. 647
Ending the Bolivian Hyperinflation: A Successful AntiInflation Program, p. 655
Was the Fed to Blame for the Housing Price Bubble?,
p. 327
A Day at the Trading Desk, p. 418
Using Discount Policy to Prevent a Financial Panic, p. 421
Fed Lending Facilities During the Global Financial and
Coronavirus Crises, p. 425
Ben Bernanke’s Advocacy of Inflation Targeting, p. 449
The Fed’s New Monetary Policy Strategy: Average
Inflation Targeting, p. 452
The Fed’s Use of the Taylor Rule, p. 462
The Appointment of Paul Volcker, Anti-Inflation
Hawk, p. 657
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FYI Boxes
Are We Headed for a Cashless Society?, p. 103
Where Are All the U.S. Dollars?, p. 106
Conflicts of Interest at Credit-Rating Agencies and the
Global Financial Crisis, p. 169
The Yield Curve as a Forecasting Tool for Inflation and
the Business Cycle, p. 183
Should You Hire an Ape as Your Investment Adviser?,
p. 203
The Enron Implosion, p. 220
The Tyranny of Collateral, p. 230
Bruce Bent and the Money Market Mutual Fund Panic
of 2008, p. 294
The Global Financial Crisis and the Demise of Large,
Free-Standing Investment Banks, p. 306
Collateralized Debt Obligations (CDOs) and Credit
Default Swaps, p. 325
The LIBOR Scandal, p. 337
Modern Monetary Theory, p. 528
Meaning of the Word Investment, p. 540
Deriving the Aggregate Demand Curve Algebraically,
p. 563
What Does Autonomous Mean?, p. 578
The Phillips Curve Trade-Off and Macroeconomic
Policy in the 1960s, p. 609
The Activist/Nonactivist Debate Over the Obama Fiscal
Stimulus Package, p. 623
The Political Business Cycle and Richard Nixon, p. 646
Consumers’ Balance Sheets and the Great Depression,
p. 669
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THE ECONOMICS OF
MONEY, BANKING, AND
FINANCIAL MARKETS
Thirteenth Edition
Global Edition
Frederic S. Mishkin
Columbia University
Harlow, England • London • New York • Boston • San Francisco • Toronto • Sydney • Dubai • Singapore • Hong Kong
Tokyo • Seoul • Taipei • New Delhi • Cape Town • Sao Paulo • Mexico City • Madrid • Amsterdam • Munich • Paris • Milan
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© Pearson Education Limited 2022
The rights of Frederic S. Mishkin, to be identified as the author of this work, has been asserted by him in accordance
with the Copyright, Designs and Patents Act 1988.
Authorized adaptation from the U.S. edition, entitled The Economics of Money, Banking, and Financial Markets, 13th
Edition, ISBN 978-0-13-689435-3 by Frederic S. Mishkin, published by Pearson Education © 2022.
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About the Author
Frederic S. Mishkin is the Alfred Lerner Professor of Banking and Financial
Institutions at the Graduate School of Business, Columbia University. He
is also a Research Associate at the National Bureau of Economic Research,
co-director of the U.S. Monetary Policy Forum, a member of the Squam
Lake Working Group on Financial Reform, and past president of the Eastern
Economics Association. Since receiving his Ph.D. from the Massachusetts
Institute of Technology in 1976, he has taught at the University of Chicago,
Northwestern University, Princeton University, and Columbia. He has also
received an honorary professorship from the People’s (Renmin) University of
China. From 1994 to 1997, he was Executive Vice President and Director of
Research at the Federal Reserve Bank of New York and an associate economist
of the Federal Open Market Committee of the Federal Reserve System. From
September 2006 to August 2008, he was a member (governor) of the Board
of Governors of the Federal Reserve System.
Professor Mishkin’s research focuses on monetary policy and its impact
on financial markets and the aggregate economy. He is the author of more
than twenty books, including Macroeconomics: Policy and Practice, Second
Edition (Pearson, 2015); Financial Markets and Institutions, Ninth Edition (Pearson,
2018); Monetary Policy Strategy (MIT Press, 2007); The Next Great Globalization: How
Disadvantaged Nations Can Harness Their Financial Systems to Get Rich (Princeton
University Press, 2006); Inflation Targeting: Lessons from the International Experience
(Princeton University Press, 1999); Money, Interest Rates, and Inflation (Edward Elgar,
1993); and A Rational Expectations Approach to Macroeconometrics: Testing Policy
Ineffectiveness and Efficient Markets Models (University of Chicago Press, 1983). In
addition, he has published more than 200 articles in such journals as American Economic
Review, Journal of Political Economy, Econometrica, Quarterly Journal of Economics, Journal
of Finance, and Journal of Monetary Economics.
Professor Mishkin has served on the editorial board of American Economic Review
and has been an associate editor at Journal of Business and Economic Statistics, Journal of
Applied Econometrics, Journal of Economic Perspectives, Journal of International Money and
Finance, and Journal of Money, Credit and Banking; he also served as the editor of the
Federal Reserve Bank of New York’s Economic Policy Review. He is currently an associate
editor (member of the editorial board) at six academic journals, including International
Finance; Finance India; Review of Development Finance; Borsa Economic Review; PSU
Research Review and Emerging Markets; and Finance and Trade. He has been a consultant
to the Board of Governors of the Federal Reserve System, the World Bank, and the
International Monetary Fund, as well as to many central banks throughout the world.
He was also a member of the International Advisory Board to the Financial Supervisory
Service of South Korea and an advisor to the Institute for Monetary and Economic
Research at the Bank of Korea. Professor Mishkin was a Senior Fellow at the Federal
Deposit Insurance Corporation’s Center for Banking Research and was an academic
consultant to and serves on the Economic Advisory Panel and Monetary Advisory Panel
of the Federal Reserve Bank of New York.
7
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Brief Contents
PART 1
Introduction
49
1 Why Study Money, Banking, and Financial Markets?....................................................50
2 An Overview of the Financial System..................................................................................70
3 What Is Money?..........................................................................................................................97
PART 2
Financial Markets
111
4 The Meaning of Interest Rates.............................................................................................112
5 The Behavior of Interest Rates.............................................................................................134
6 The Risk and Term Structure of Interest Rates................................................................165
7 The Stock Market, the Theory of Rational Expectations, and the
Efficient Market Hypothesis..................................................................................................189
PART 3
Financial Institutions 211
8 An Economic Analysis of Financial Structure..................................................................212
9 Banking and the Management of Financial Institutions.............................................236
10 Economic Analysis of Financial Regulation.....................................................................264
11 Banking Industry: Structure and Competition................................................................283
12 Financial Crises in Advanced Economies.........................................................................315
13 Financial Crises in Emerging Market Economies...........................................................342
PART 4
Central Banking and the Conduct of Monetary Policy
365
14 Central Banks.............................................................................................................................366
15 The Money Supply Process...................................................................................................384
16 Tools of Monetary Policy.......................................................................................................409
17 The Conduct of Monetary Policy: Strategy and Tactics...............................................435
PART 5
International Finance and Monetary Policy
467
18 The Foreign Exchange Market..............................................................................................468
19 The International Financial System....................................................................................491
PART 6
Monetary Theory
519
20 Quantity Theory, Inflation, and the Demand for Money............................................520
21 The IS Curve................................................................................................................................538
22 The Monetary Policy and Aggregate Demand Curves.................................................557
23 Aggregate Demand and Supply Analysis.........................................................................572
24 Monetary Policy Theory.........................................................................................................615
25 The Role of Expectations in Monetary Policy.................................................................642
26 Transmission Mechanisms of Monetary Policy..............................................................661
9
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10
Brief Contents
Additional Chapters on MyLab Economics
1 Nonbank Finance
2 Financial Derivatives
3 Conflicts of Interest in the Financial Services Industry
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Contents in Detail
PART 1
Introduction
49
CHAPTER 1
Why Study Money, Banking, and Financial Markets? 50
1.1 Why Study Financial Markets? ..............................................................................................50
Debt Markets and Interest Rates ........................................................................................... 51
The Stock Market ................................................................................................................. 51
1.2 Why Study Financial Institutions and Banking? ..............................................................53
Structure of the Financial System ......................................................................................... 54
Banks and Other Financial Institutions ................................................................................. 54
Financial Innovation ............................................................................................................ 54
Financial Crises .................................................................................................................... 55
1.3 Why Study Money and Monetary Policy? ........................................................................55
Money and Business Cycles .................................................................................................. 55
Money and Inflation ............................................................................................................. 56
Money and Interest Rates ...................................................................................................... 58
Conduct of Monetary Policy ................................................................................................. 58
Fiscal Policy and Monetary Policy ......................................................................................... 59
1.4 Why Study International Finance? ......................................................................................60
The Foreign Exchange Market .............................................................................................. 61
The International Financial System ....................................................................................... 62
1.5 Money, Banking, and Financial Markets and Your Career ..........................................62
1.6 How We Will Study Money, Banking, and Financial Markets ....................................63
Concluding Remarks .........................................................................................................................64
Summary 64 • Key Terms 64 • Questions 64 • Applied Problems 65 • Data Analysis Problems 66
APPENDIX TO CHAPTER 1
Defining Aggregate Output, Income, the Price Level,
and the Inflation Rate 67
Aggregate Output and Income.......................................................................................................67
Real Versus Nominal Magnitudes.................................................................................................67
Aggregate Price Level.........................................................................................................................68
Growth Rates and the Inflation Rate.............................................................................................69
CHAPTER 2
An Overview of the Financial System
70
2.1 Function of Financial Markets ..............................................................................................70
2.2 Structure of Financial Markets ..............................................................................................73
Debt and Equity Markets ...................................................................................................... 73
Primary and Secondary Markets ........................................................................................... 73
11
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Contents in Detail
Exchanges and Over-the-Counter Markets ............................................................................ 74
Money and Capital Markets .................................................................................................. 75
2.3 Financial Market Instruments ...............................................................................................75
Money Market Instruments .................................................................................................. 75
Following the Financial News Money Market Rates
76
Capital Market Instruments .................................................................................................. 77
Following the Financial News Capital Market Interest Rates
78
2.4 Internationalization of Financial Markets .........................................................................79
Global Are U.S. Capital Markets Losing Their Edge?
80
International Bond Market, Eurobonds, and Eurocurrencies ................................................ 80
World Stock Markets ............................................................................................................ 81
2.5 Function of Financial Intermediaries: Indirect Finance ...............................................81
Following the Financial News Foreign Stock Market Indexes
82
Transaction Costs ................................................................................................................. 82
Global The Importance of Financial Intermediaries Relative to Securities Markets:
An International Comparison 83
Risk Sharing ......................................................................................................................... 84
Asymmetric Information: Adverse Selection and Moral Hazard ............................................ 84
Economies of Scope and Conflicts of Interest ....................................................................... 86
2.6 Types of Financial Intermediaries ........................................................................................86
Depository Institutions ......................................................................................................... 86
Contractual Savings Institutions ........................................................................................... 88
Investment Intermediaries .................................................................................................... 89
2.7 Regulation of the Financial System .....................................................................................90
Increasing Information Available to Investors ........................................................................ 90
Ensuring the Soundness of Financial Intermediaries ............................................................. 91
Financial Regulation Abroad ................................................................................................. 93
Summary 93 • Key Terms 94 • Questions 94 • Applied Problems 95 • Data Analysis Problems 96
CHAPTER 3
What Is Money? 97
3.1 Meaning of Money ...................................................................................................................97
3.2 Functions of Money .................................................................................................................98
Medium of Exchange ............................................................................................................ 98
Unit of Account .................................................................................................................... 99
Store of Value ..................................................................................................................... 100
3.3 Evolution of the Payments System ....................................................................................101
Commodity Money ............................................................................................................ 101
Fiat Money ......................................................................................................................... 101
Checks ............................................................................................................................... 101
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Contents in Detail
13
Electronic Payment ............................................................................................................. 102
E-Money ............................................................................................................................ 102
FYI Are We Headed for a Cashless Society?
103
APPLICATION Will Bitcoin or Other Cryptocurrencies Become
the Money of the Future?.................................................................................. 103
3.4 Measuring Money ...................................................................................................................104
The Federal Reserve’s Monetary Aggregates ........................................................................ 105
Following the Financial News The Monetary Aggregates
FYI Where Are All the U.S. Dollars?
105
106
Summary 107 • Key Terms 108 • Questions 108 • Applied Problems 109 • Data Analysis Problems 110
PART 2
Financial Markets
111
CHAPTER 4
The Meaning of Interest Rates 112
4.1 Measuring Interest Rates ......................................................................................................112
Present Value ...................................................................................................................... 113
APPLICATION Simple Present Value ........................................................................ 114
APPLICATION How Much Is That Jackpot Worth? ................................................. 115
Four Types of Credit Market Instruments ........................................................................... 115
Yield to Maturity ................................................................................................................ 116
APPLICATION Yield to Maturity on a Simple Loan ................................................. 116
APPLICATION Yield to Maturity and the Yearly Payment on a
Fixed-Payment Loan ......................................................................................... 118
APPLICATION Yield to Maturity and Bond Price for a Coupon Bond ..................... 119
APPLICATION Yield to Maturity on a Perpetuity ..................................................... 121
APPLICATION Yield to Maturity on a Discount Bond ............................................. 122
4.2 The Distinction Between Interest Rates and Returns ..................................................123
Global Negative Interest Rates? Japan First, Then the United States,
Then Europe 124
Maturity and the Volatility of Bond Returns: Interest-Rate Risk ........................................... 126
Summary ............................................................................................................................ 127
4.3 The Distinction Between Real and Nominal Interest Rates ......................................128
APPLICATION Calculating Real Interest Rates ......................................................... 129
Summary 131 • Key Terms 131 • Questions 131 • Applied Problems 132 • Data Analysis Problems 133
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Contents in Detail
CHAPTER 4 APPENDIX
Measuring Interest-Rate Risk: Duration
Go to MyLab Economics
CHAPTER 5
The Behavior of Interest Rates 134
5.1 Determinants of Asset Demand .........................................................................................134
Wealth ................................................................................................................................ 135
Expected Returns ............................................................................................................... 135
Risk .................................................................................................................................... 135
Liquidity ............................................................................................................................ 136
Theory of Portfolio Choice ................................................................................................. 136
5.2 Supply and Demand in the Bond Market .......................................................................137
Demand Curve ................................................................................................................... 137
Supply Curve ..................................................................................................................... 138
Market Equilibrium ............................................................................................................ 139
Supply and Demand Analysis ............................................................................................. 140
5.3 Changes in Equilibrium Interest Rates .............................................................................140
Shifts in the Demand for Bonds .......................................................................................... 140
Shifts in the Supply of Bonds ............................................................................................. 144
APPLICATION Changes in the Interest Rate Due to a Change in
Expected Inflation: The Fisher Effect .............................................................. 146
APPLICATION Changes in the Interest Rate Due to a Business Cycle Expansion.... 148
APPLICATION Explaining Current Low Interest Rates in Europe, Japan,
and the United States: Low Inflation and Secular Stagnation .......................... 149
5.4 Supply and Demand in the Market for Money:
The Liquidity Preference Framework ................................................................................150
5.5 Changes in Equilibrium Interest Rates in the Liquidity
Preference Framework ...........................................................................................................153
Shifts in the Demand for Money ......................................................................................... 153
Shifts in the Supply of Money ............................................................................................ 153
APPLICATION Changes in the Equilibrium Interest Rate Due to
Changes in Income, the Price Level, or the Money Supply ............................. 154
Changes in Income ............................................................................................................. 155
Changes in the Price Level .................................................................................................. 155
Changes in the Money Supply ............................................................................................ 155
5.6 Money and Interest Rates ....................................................................................................156
APPLICATION Does a Higher Rate of Growth of the
Money Supply Lower Interest Rates? ............................................................... 158
Summary 161 • Key Terms 161 • Questions 161 • Applied Problems 162 • Data Analysis Problems 163
CHAPTER 5 APPENDIX
Loanable Funds Framework
Go to MyLab Economics
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15
CHAPTER 6
The Risk and Term Structure of Interest Rates 165
6.1 Risk Structure of Interest Rates ...........................................................................................165
Default Risk ........................................................................................................................ 166
FYI Conflicts of Interest at Credit-Rating Agencies and the Global Financial Crisis
169
APPLICATION The Coronavirus Pandemic and the Baa–Treasury Spread ............... 170
Liquidity ............................................................................................................................ 170
Income Tax Considerations ................................................................................................ 171
Summary ............................................................................................................................ 172
APPLICATION Effects of the Trump Tax Cuts on Bond Interest Rates .................... 172
6.2 Term Structure of Interest Rates .........................................................................................173
Following the Financial News Yield Curves
173
Expectations Theory ........................................................................................................... 175
Segmented Markets Theory ................................................................................................ 178
Liquidity Premium and Preferred Habitat Theories ............................................................. 179
Evidence on the Term Structure ......................................................................................... 182
FYI The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle 183
Summary ............................................................................................................................ 183
APPLICATION Interpreting Yield Curves, 1980–2020 ............................................. 183
Summary 185 • Key Terms 185 • Questions 185 • Applied Problems 187 • Data Analysis Problems 187
CHAPTER 7
The Stock Market, the Theory of Rational Expectations,
and the Efficient Market Hypothesis 189
7.1 Computing the Price of Common Stock .........................................................................189
The One-Period Valuation Model ....................................................................................... 190
The Generalized Dividend Valuation Model ........................................................................ 191
The Gordon Growth Model ................................................................................................ 191
7.2 How the Market Sets Stock Prices .....................................................................................192
APPLICATION Monetary Policy and Stock Prices .................................................... 194
APPLICATION The Coronavirus Stock Market Crash of 2020 ................................. 194
7.3 The Theory of Rational Expectations ................................................................................194
Formal Statement of the Theory ......................................................................................... 196
Rationale Behind the Theory .............................................................................................. 196
Implications of the Theory ................................................................................................. 197
7.4 The Efficient Market Hypothesis: Rational Expectations in Financial Markets ...198
Rationale Behind the Hypothesis ........................................................................................ 199
Random-Walk Behavior of Stock Prices .............................................................................. 200
Global Should Foreign Exchange Rates Follow a Random Walk?
201
APPLICATION Practical Guide to Investing in the Stock Market ............................. 201
How Valuable Are Reports Published by Investment Advisers? ........................................... 201
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Contents in Detail
Should You Be Skeptical of Hot Tips? ................................................................................. 202
FYI Should You Hire an Ape as Your Investment Adviser?
203
Do Stock Prices Always Rise When There Is Good News? ................................................... 203
Efficient Market Prescription for the Investor ...................................................................... 203
7.5 Why the Efficient Market Hypothesis Does Not Imply That
Financial Markets Are Efficient ............................................................................................204
APPLICATION What Do Stock Market Crashes Tell Us
About the Efficient Market Hypothesis and the Efficiency
of Financial Markets? ....................................................................................... 205
7.6 Behavioral Finance .................................................................................................................205
Summary 206 • Key Terms 207 • Questions 207 • Applied Problems 208 • Data Analysis Problems 209
PART 3
Financial Institutions 211
CHAPTER 8
An Economic Analysis of Financial Structure
212
8.1 Basic Facts About Financial Structure Throughout The World ................................212
8.2 Transaction Costs .....................................................................................................................215
How Transaction Costs Influence Financial Structure ......................................................... 215
How Financial Intermediaries Reduce Transaction Costs .................................................... 216
8.3 Asymmetric Information: Adverse Selection and Moral Hazard ............................217
8.4 The Lemons Problem: How Adverse Selection Influences Financial Structure .217
Lemons in the Stock and Bond Markets .............................................................................. 218
Tools to Help Solve Adverse Selection Problems ................................................................. 219
FYI The Enron Implosion 220
8.5 How Moral Hazard Affects the Choice Between Debt and Equity Contracts .....223
Moral Hazard in Equity Contracts: The Principal–Agent Problem ....................................... 223
Tools to Help Solve the Principal–Agent Problem ............................................................... 224
8.6 How Moral Hazard Influences Financial Structure in Debt Markets .....................226
Tools to Help Solve Moral Hazard in Debt Contracts .......................................................... 226
Summary ............................................................................................................................ 228
APPLICATION Financial Development and Economic Growth ............................... 229
FYI The Tyranny of Collateral
230
APPLICATION Is China a Counterexample to the Importance of Financial
Development? ................................................................................................... 231
Summary 232 • Key Terms 233 • Questions 233 • Applied Problems 234 • Data Analysis Problems 235
CHAPTER 9
Banking and the Management of Financial Institutions 236
9.1 The Bank Balance Sheet ........................................................................................................236
Liabilities ............................................................................................................................ 236
Assets ................................................................................................................................. 239
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17
9.2 Basic Banking ............................................................................................................................240
9.3 General Principles of Bank Management .......................................................................243
Liquidity Management and the Role of Reserves ................................................................. 243
Asset Management .............................................................................................................. 246
Liability Management ......................................................................................................... 247
Capital Adequacy Management .......................................................................................... 248
APPLICATION Strategies for Managing Bank Capital .............................................. 250
APPLICATION How a Capital Crunch Caused a Credit Crunch During the
Global Financial Crisis ..................................................................................... 251
9.4 Managing Credit Risk .............................................................................................................251
Screening and Monitoring .................................................................................................. 252
Long-Term Customer Relationships .................................................................................... 253
Loan Commitments ............................................................................................................ 254
Collateral and Compensating Balances ............................................................................... 254
Credit Rationing ................................................................................................................. 254
9.5 Managing Interest-Rate Risk ...............................................................................................255
Gap and Duration Analysis ................................................................................................. 256
APPLICATION Strategies for Managing Interest-Rate Risk ....................................... 257
9.6 Off-Balance-Sheet Activities ................................................................................................257
Loan Sales .......................................................................................................................... 258
Generation of Fee Income .................................................................................................. 258
Trading Activities and Risk Management Techniques .......................................................... 258
Global Barings, Daiwa, Sumitomo, Société Générale, and JP Morgan Chase:
Rogue Traders and the Principal–Agent Problem 259
Summary 260 • Key Terms 261 • Questions 261 • Applied Problems 262 • Data Analysis Problem 263
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
264
10.1 Asymmetric Information as a Rationale for Financial Regulation .......................264
Government Safety Net ...................................................................................................... 264
Global The Spread of Government Deposit Insurance Throughout the World:
Is This a Good Thing? 266
Drawbacks of the Government Safety Net .......................................................................... 267
10.2 Types of Financial Regulation ...........................................................................................269
Restrictions on Asset Holdings ........................................................................................... 269
Capital Requirements ......................................................................................................... 270
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Global Where Is the Basel Accord Heading After the Global Financial Crisis? 271
Prompt Corrective Action ................................................................................................... 272
Financial Supervision: Chartering and Examination ........................................................... 272
Assessment of Risk Management ........................................................................................ 273
Disclosure Requirements .................................................................................................... 274
Consumer Protection .......................................................................................................... 275
Restrictions on Competition ............................................................................................... 275
Summary ............................................................................................................................ 276
Global International Financial Regulation
277
Summary 279 • Key Terms 280 • Questions 280 • Applied Problems 281 • Data Analysis Problems 281
CHAPTER 10 APPENDIX
Banking Crises Throughout the World
Go to MyLab Economics
CHAPTER 11
Banking Industry: Structure and Competition 283
11.1 Historical Development of the Banking System ........................................................283
Multiple Regulatory Agencies ............................................................................................. 285
11.2 Financial Innovation and the Growth of the “Shadow Banking System” ...........286
Responses to Changes in Demand Conditions: Interest-Rate Volatility ................................ 287
Responses to Changes in Supply Conditions: Information Technology ............................... 288
Securitization and the Shadow Banking System .................................................................. 290
Avoidance of Existing Regulations ...................................................................................... 292
FYI Bruce Bent and the Money Market Mutual Fund Panic of 2008 294
Financial Innovation and the Decline of Traditional Banking .............................................. 294
11.3 Structure of the U.S. Commercial Banking Industry .................................................297
Restrictions on Branching ................................................................................................... 299
Response to Branching Restrictions .................................................................................... 299
11.4 Bank Consolidation and Nationwide Banking ...........................................................300
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 .......................... 302
What Will the Structure of the U.S. Banking Industry Look Like in the Future? ................. 302
Global Comparison of Banking Structure in the United States and Abroad 303
Are Bank Consolidation and Nationwide Banking Good Things? ........................................ 303
11.5 Separation of Banking and Other Financial Service Industries .............................304
Erosion of Glass-Steagall ..................................................................................................... 304
The Gramm-Leach-Bliley Financial Services Modernization Act of 1999: Repeal of
Glass-Steagall ................................................................................................................ 305
Implications for Financial Consolidation ............................................................................ 305
Separation of Banking and Other Financial Services Industries Throughout the World ...... 305
FYI The Global Financial Crisis and the Demise of Large, Free-Standing
Investment Banks 306
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11.6 Thrift Industry: Regulation and Structure .....................................................................306
Savings and Loan Associations ............................................................................................ 307
Mutual Savings Banks ......................................................................................................... 307
Credit Unions ..................................................................................................................... 307
11.7 International Banking ..........................................................................................................308
Eurodollar Market .............................................................................................................. 308
Global Ironic Birth of the Eurodollar Market
309
Structure of U.S. Banking Overseas ..................................................................................... 309
Foreign Banks in the United States ..................................................................................... 310
Summary 311 • Key Terms 312 • Questions 312 • Data Analysis Problems 313
CHAPTER 12
Financial Crises in Advanced Economies 315
Global The European Sovereign Debt Crisis
316
12.1 What is a Financial Crisis? ..................................................................................................316
12.2 Dynamics of Financial Crises ............................................................................................317
Stage One: Initial Phase ...................................................................................................... 317
Stage Two: Banking Crisis ................................................................................................... 319
Stage Three: Debt Deflation ................................................................................................ 321
APPLICATION The Mother of All Financial Crises: The Great Depression ............. 321
The U.S. Stock Market Crash .............................................................................................. 321
Worldwide Decline in Asset Prices ...................................................................................... 321
Bank Failures ...................................................................................................................... 323
Economic Contraction and Debt Deflation ......................................................................... 323
12.3 The Global Financial Crisis of 2007–2009 ....................................................................323
Causes of the 2007–2009 Financial Crisis .......................................................................... 324
FYI Collateralized Debt Obligations (CDOs) and Credit Default Swaps
325
Effects of the 2007–2009 Financial Crisis ........................................................................... 326
Inside the Fed Was the Fed to Blame for the Housing Price Bubble?
327
Height of the 2007–2009 Financial Crisis .......................................................................... 330
APPLICATION Could the Coronavirus Pandemic Have Led to a Financial Crisis?........332
12.4 Government Intervention and the Recovery ..............................................................333
Short-Term Responses and Recovery .................................................................................. 333
Global Latvia’s Different and Controversial Response: Expansionary Contraction 334
12.5 Stabilizing the Global Financial System: Long-Term Responses ...........................334
Global Financial Regulatory Framework ............................................................................. 334
Policy Areas at the National Level ....................................................................................... 335
FYI The LIBOR Scandal
337
12.6 Future Regulations and Policy Areas at the International Level ...........................337
Bilateral and Multilateral Supervisory Cooperation ............................................................. 338
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Collective Supervisory Cooperation .................................................................................... 338
Collectively Coordinated Macroeconomic Stability Plans .................................................... 338
Self-Discipline .................................................................................................................... 338
Summary 339 • Key Terms 340 • Questions 340 • Data Analysis Problems 341
CHAPTER 13
Financial Crises in Emerging Market Economies 342
13.1 Dynamics of Financial Crises in Emerging Market Economies ........................... 342
Stage One: Initial Phase...................................................................................................... 343
Stage Two: Currency Crises................................................................................................ 346
Stage Three: Full-Fledged Financial Crisis.......................................................................... 347
APPLICATION Crisis in South Korea, 1997–1998................................................... 348
Financial Liberalization and Globalization Mismanaged..................................................... 349
Perversion of the Financial Liberalization and Globalization Process: Chaebols and the
South Korean Crisis....................................................................................................... 350
Stock Market Decline and Failure of Firms Increase Uncertainty........................................ 352
Adverse Selection and Moral Hazard Problems Worsen and the Economy Contracts.......... 353
Currency Crisis Ensues...................................................................................................... 353
Final Stage: Currency Crisis Triggers Full-Fledged Financial Crisis.................................... 353
Recovery Commences........................................................................................................ 355
Global China and the “Noncrisis” in 1997–1998
355
APPLICATION The Argentine Financial Crisis, 2001–2002.................................... 356
Severe Fiscal Imbalances.................................................................................................... 356
Adverse Selection and Moral Hazard Problems Worsen...................................................... 356
Bank Panic Begins.............................................................................................................. 357
Currency Crisis Ensues...................................................................................................... 357
Currency Crisis Triggers Full-Fledged Financial Crisis....................................................... 357
Recovery Begins................................................................................................................. 359
Global When an Advanced Economy Is Like an Emerging Market Economy:
The Icelandic Financial Crisis of 2008 360
13.2 Preventing Emerging Market Financial Crises............................................................ 361
Beef Up Prudential Regulation and Supervision of Banks................................................... 361
Encourage Disclosure and Market-Based Discipline............................................................ 362
Limit Currency Mismatch................................................................................................... 362
Sequence Financial Liberalization....................................................................................... 362
Summary 363 • Key Terms 363 • Questions 363 • Data Analysis Problems 364
PART 4
Central Banking and the Conduct of Monetary Policy
365
CHAPTER 14
Central Banks 366
14.1 Origins of the Central Banking System ..........................................................................366
Global Who Should Own Central Banks?
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14.2 Variations in the Functions and Structures of Central Banks .................................368
The European Central Bank, the Euro System, and the European System
of Central Banks ............................................................................................................ 368
Decision-making Bodies of the ECB ................................................................................... 369
How Monetary Policy Is Conducted within the ECB ........................................................... 372
Global The Importance of the Bundesbank within the ECB
372
Global Are Non-Euro Central Banks Constrained by Membership of the EU?
374
The Federal Reserve System ................................................................................................ 374
Difference between the ECB and the Fed ............................................................................ 375
The Bank of England .......................................................................................................... 376
Global Brexit and the BoE
376
14.3 Structure of Central Banks of Larger Economies .......................................................377
The Bank of Canada ........................................................................................................... 377
The Bank of Japan .............................................................................................................. 378
The People’s Bank of China ................................................................................................. 379
14.4 Structure and Independence of Central Banks of Emerging
Market Economies ...............................................................................................................380
14.5 Central Banks Independence ...........................................................................................380
The Case for Independence ................................................................................................ 381
The Case against Independence .......................................................................................... 381
The Trend toward Greater Independence ............................................................................ 381
Summary 382 • Key Terms 383 • Questions 383 • Data Analysis Problems 383
CHAPTER 15
The Money Supply Process
384
15.1 Three Players in the Money Supply Process ................................................................384
15.2 The Fed’s Balance Sheet .....................................................................................................385
Liabilities ............................................................................................................................ 385
Assets ................................................................................................................................. 386
15.3 Control of the Monetary Base ..........................................................................................387
Federal Reserve Open Market Operations ........................................................................... 387
Shifts from Deposits into Currency ..................................................................................... 388
Loans to Financial Institutions ............................................................................................ 389
Other Factors That Affect the Monetary Base ...................................................................... 390
Overview of the Fed’s Ability to Control the Monetary Base ................................................ 390
15.4 Multiple Deposit Creation: A Simple Model ...............................................................391
Deposit Creation: The Single Bank ..................................................................................... 391
Deposit Creation: The Banking System ............................................................................... 392
Deriving the Formula for Multiple Deposit Creation .......................................................... 395
Critique of the Simple Model ............................................................................................. 396
15.5 Factors that Determine the Money Supply .................................................................397
Changes in the Nonborrowed Monetary Base, MBn ............................................................. 397
Changes in Borrowed Reserves, BR, from the Fed ............................................................... 397
Changes in the Required Reserve Ratio, rr .......................................................................... 397
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Changes in Excess Reserves ................................................................................................ 398
Changes in Currency Holdings ........................................................................................... 398
15.6 Overview of the Money Supply Process .......................................................................398
15.7 The Money Multiplier .........................................................................................................399
Deriving the Money Multiplier ........................................................................................... 399
Intuition Behind the Money Multiplier ............................................................................... 401
Money Supply Response to Changes in the Factors ............................................................. 402
APPLICATION Quantitative Easing and the Money Supply During the
Global Financial and the Coronavirus Crises................................................... 403
Summary 405 • Key Terms 406 • Questions 406 • Applied Problems 407 • Data Analysis Problems 408
CHAPTER 15 APPENDIX 1
The Fed’s Balance Sheet and the Monetary Base
Go to MyLab Economics
CHAPTER 15 APPENDIX 2
The M2 Money Multiplier
Go to MyLab Economics
CHAPTER 15 APPENDIX 3
Explaining the Behavior of the Currency Ratio
Go to MyLab Economics
CHAPTER 15 APPENDIX 4
The Great Depression Bank Panics, 1930–1933, and the Money Supply
Go to MyLab Economics
CHAPTER 16
Tools of Monetary Policy
409
16.1 The Market for Reserves and the Federal Funds Rate ..............................................409
Demand and Supply in the Market for Reserves ................................................................. 410
How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate ..................... 411
APPLICATION How the Federal Reserve’s Operating Procedures Limit
Fluctuations in the Federal Funds Rate ........................................................... 415
16.2 Conventional Monetary Policy Tools .............................................................................416
Open Market Operations .................................................................................................... 417
Inside the Fed A Day at the Trading Desk
418
Discount Policy and the Lender of Last Resort .................................................................... 419
Inside the Fed Using Discount Policy to Prevent a Financial Panic
421
Reserve Requirements ......................................................................................................... 422
Interest on Excess Reserves ................................................................................................. 422
16.3 Nonconventional Monetary Policy Tools and Quantitative Easing in the
Wake of the Global Financial Crisis and the Coronavirus Pandemic ....................423
Liquidity Provision ............................................................................................................. 423
Large-Scale Asset Purchases ................................................................................................ 424
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Inside the Fed Fed Lending Facilities During the Global Financial and
Coronavirus Crises 425
Quantitative Easing Versus Credit Easing ............................................................................ 426
Forward Guidance .............................................................................................................. 428
Negative Interest Rates on Banks’ Deposits ......................................................................... 429
16.4 Monetary Policy Tools of the European Central Bank .............................................430
Open Market Operations .................................................................................................... 430
Lending to Banks ................................................................................................................ 431
Interest on Excess Reserves ................................................................................................. 431
Reserve Requirements ......................................................................................................... 431
Summary 431 • Key Terms 432 • Questions 432 • Applied Problems 433 • Data Analysis Problems 434
CHAPTER 17
The Conduct of Monetary Policy: Strategy and Tactics 435
17.1 The Price Stability Goal and the Nominal Anchor ....................................................435
The Role of a Nominal Anchor ........................................................................................... 436
The Time-Inconsistency Problem ....................................................................................... 436
17.2 Other Goals of Monetary Policy ......................................................................................437
High Employment and Output Stability ............................................................................. 437
Economic Growth .............................................................................................................. 438
Stability of Financial Markets ............................................................................................. 438
Interest-Rate Stability .......................................................................................................... 438
Stability in Foreign Exchange Markets ................................................................................ 439
17.3 Should Price Stability be the Primary Goal of Monetary Policy? .........................439
Hierarchical Versus Dual Mandates ..................................................................................... 439
Price Stability as the Primary, Long-Run Goal of Monetary Policy ....................................... 440
17.4 Inflation Targeting ................................................................................................................440
Inflation Targeting in New Zealand, Canada, and the United Kingdom .............................. 441
Advantages of Inflation Targeting ....................................................................................... 443
Disadvantages of Inflation Targeting ................................................................................... 445
17.5 The Evolution of the Federal Reserve’s Monetary Policy Strategy .......................446
The Fed’s “Just Do It” Monetary Policy Strategy .................................................................. 446
The Long Road to Inflation Targeting ................................................................................. 448
Inside the Fed Ben Bernanke’s Advocacy of Inflation Targeting
449
Global The European Central Bank’s Monetary Policy Strategy 449
17.6 Lessons for Monetary Policy Strategy from the Global Financial Crisis .............450
Implications for Inflation Targeting .................................................................................... 451
Inside the Fed The Fed’s New Monetary Policy Strategy: Average Inflation
Targeting 452
17.7 Should Central Banks Try to Stop Asset-Price Bubbles? ..........................................453
Two Types of Asset-Price Bubbles ........................................................................................ 453
The Debate over Whether Central Banks Should Try to Pop Bubbles .................................. 454
17.8 Tactics: Choosing the Policy Instrument .......................................................................457
Criteria for Choosing the Policy Instrument ....................................................................... 459
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17.9 Tactics: The Taylor Rule .......................................................................................................460
Inside the Fed The Fed’s Use of the Taylor Rule
462
Summary 463 • Key Terms 464 • Questions 464 • Applied Problems 465 • Data Analysis Problems 465
CHAPTER 17 APPENDIX 1
Monetary Targeting
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CHAPTER 17 APPENDIX 2
A Brief History of Federal Reserve Policymaking
Go to MyLab Economics
PART 5
International Finance and Monetary Policy
467
CHAPTER 18
The Foreign Exchange Market 468
18.1 Foreign Exchange Market ..................................................................................................468
Following the Financial News Foreign Exchange Rates
469
What Are Foreign Exchange Rates? ..................................................................................... 469
Why Are Exchange Rates Important? .................................................................................. 469
How Is Foreign Exchange Traded? ...................................................................................... 470
18.2 Exchange Rates in the Long Run .....................................................................................471
Theory of Purchasing Power Parity ..................................................................................... 471
APPLICATION Burgernomics: Big Macs and PPP .................................................... 473
Factors That Affect Exchange Rates in the Long Run ........................................................... 475
18.3 Exchange Rates in the Short Run: A Supply and Demand Analysis ....................477
Supply Curve for Domestic Assets ...................................................................................... 477
Demand Curve for Domestic Assets .................................................................................... 478
Equilibrium in the Foreign Exchange Market ..................................................................... 479
18.4 Explaining Changes in Exchange Rates .........................................................................479
Shifts in the Demand for Domestic Assets .......................................................................... 479
Recap: Factors That Change the Exchange Rate .................................................................. 482
APPLICATION Effects of Changes in Interest Rates on the Equilibrium
Exchange Rate .................................................................................................. 484
APPLICATION The Global Financial Crisis and the Dollar ..................................... 486
APPLICATION Brexit and the British Pound ............................................................ 487
Summary 488 • Key Terms 489 • Questions 489 • Applied Problems 490 • Data Analysis Problems 490
APPENDIX TO CHAPTER 18
The Interest Parity Condition
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CHAPTER 19
The International Financial System 491
19.1 Intervention in the Foreign Exchange Market ............................................................491
Foreign Exchange Intervention and the Money Supply ....................................................... 491
Global Variation in Central Banks’ Activism and Method of Intervention on
Foreign Exchange Markets 492
Unsterilized Intervention .................................................................................................... 494
Sterilized Intervention ........................................................................................................ 495
19.2 Balance of Payments ...........................................................................................................495
Current Account ................................................................................................................ 496
Financial Account .............................................................................................................. 496
Global Should We Worry About the Large and Recurrent Trade Deficit?
497
19.3 Exchange Rate Regimes in the International Financial System ............................498
Gold Standard .................................................................................................................... 498
The Bretton Woods System ................................................................................................. 498
How a Fixed Exchange Rate Regime Works ........................................................................ 499
Speculative Attacks ............................................................................................................. 501
APPLICATION The Foreign Exchange Crisis of September 1992 ............................ 501
The Policy Trilemma ........................................................................................................... 503
APPLICATION How Did China Accumulate $4 Trillion of International Reserves? ........504
Monetary Unions ................................................................................................................ 504
Managed Float .................................................................................................................... 505
Global Will the Euro Survive?
505
19.4 Capital Controls ....................................................................................................................506
Controls on Capital Outflows ............................................................................................. 506
Controls on Capital Inflows ............................................................................................... 506
19.5 The Role of the IMF .............................................................................................................507
Should the IMF Act as an International Lender of Last Resort? ........................................... 507
19.6 International Considerations and Monetary Policy ..................................................508
Direct Effects of the Foreign Exchange Market on Monetary Policy ..................................... 508
Exchange Rate Considerations ............................................................................................ 509
19.7 To PEG or Not to Peg: Exchange-Rate Targeting as an Alternative
Monetary Policy Strategy ......................................................................................................509
Advantages of Exchange-Rate Targeting .............................................................................. 509
Disadvantages of Exchange-Rate Targeting .......................................................................... 510
When Is Exchange-Rate Targeting Desirable for Industrialized Countries? .......................... 512
When Is Exchange-Rate Targeting Desirable for Emerging Market Countries? .................... 513
Currency Boards ................................................................................................................. 513
Global Argentina’s Currency Board
514
Dollarization ...................................................................................................................... 514
Summary 515 • Key Terms 516 • Questions 516 • Applied Problems 517 • Data Analysis Problems 518
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PART 6
Monetary Theory 519
CHAPTER 20
Quantity Theory, Inflation, and the Demand for Money
520
20.1 Quantity Theory of Money ...............................................................................................520
Velocity of Money and Equation of Exchange ..................................................................... 520
From the Equation of Exchange to the Quantity Theory of Money ..................................... 522
Quantity Theory and the Price Level .................................................................................. 522
Quantity Theory and Inflation ........................................................................................... 523
APPLICATION Testing the Quantity Theory of Money ............................................ 524
20.2 Budget Deficits and Inflation ............................................................................................526
Government Budget Constraint .......................................................................................... 526
FYI Modern Monetary Theory
528
Hyperinflation .................................................................................................................... 528
APPLICATION The Zimbabwean Hyperinflation ..................................................... 529
20.3 Keynesian Theories of Money Demand .......................................................................529
Transactions Motive ............................................................................................................ 530
Precautionary Motive .......................................................................................................... 530
Speculative Motive ............................................................................................................. 530
Putting the Three Motives Together .................................................................................... 530
20.4 Portfolio Theories of Money Demand ..........................................................................531
Theory of Portfolio Choice and Keynesian Liquidity Preference .......................................... 531
Other Factors That Affect the Demand for Money ............................................................... 532
Summary ............................................................................................................................ 532
20.5 Empirical Evidence on the Demand for Money ........................................................533
Interest Rates and Money Demand ..................................................................................... 533
Stability of Money Demand ................................................................................................ 534
Summary 534 • Key Terms 535 • Questions 535 • Applied Problems 536 • Data Analysis Problems 537
CHAPTER 21
The IS Curve 538
21.1 Planned Expenditure and Aggregate Demand ...........................................................538
21.2 The Components of Aggregate Demand .....................................................................539
Consumption Expenditure ................................................................................................. 539
FYI Meaning of the Word Investment
540
Planned Investment Spending ............................................................................................ 540
Government Purchases and Taxes ....................................................................................... 542
Net Exports ........................................................................................................................ 543
21.3 Goods Market Equilibrium ................................................................................................544
Solving for Goods Market Equilibrium ............................................................................... 544
Deriving the IS Curve ......................................................................................................... 545
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21.4 Understanding the IS Curve ..............................................................................................545
What the IS Curve Tells Us: Intuition ................................................................................. 545
What the IS Curve Tells Us: Numerical Example ................................................................ 545
Why the Economy Heads Toward Equilibrium ................................................................... 547
21.5 Factors that Shift the IS Curve ..........................................................................................547
Changes in Government Purchases ..................................................................................... 547
APPLICATION The Vietnam War Buildup, 1964–1969 ............................................ 548
Changes in Taxes ................................................................................................................ 549
APPLICATION The Fiscal Stimulus Package of 2009 ............................................... 550
Changes in Autonomous Spending ..................................................................................... 551
Changes in Financial Frictions ........................................................................................... 553
Summary of Factors That Shift the IS Curve ....................................................................... 553
Summary 553 • Key Terms 553 • Questions 554 • Applied Problems 555 • Data Analysis Problems 556
CHAPTER 22
The Monetary Policy and Aggregate Demand Curves 557
22.1 The Federal Reserve and Monetary Policy ..................................................................557
22.2 The Monetary Policy Curve ..............................................................................................558
Why the Monetary Policy Curve Has an Upward Slope....................................................... 558
Shifts in the MP Curve ........................................................................................................ 559
Movements Along Versus Shifts in the MP Curve ................................................................ 560
APPLICATION Movements Along the MP Curve: The Rise in the Federal
Funds Rate Target, 2004–2006 and 2015–2019 ............................................... 561
APPLICATION Shift in the MP Curve: Autonomous Monetary Easing During
the Global Financial and Coronavirus Crises .................................................. 561
22.3 The Aggregate Demand Curve .........................................................................................562
Deriving the Aggregate Demand Curve Graphically ............................................................ 563
FYI Deriving the Aggregate Demand Curve Algebraically
563
Factors That Shift the Aggregate Demand Curve ................................................................. 565
Summary 568 • Key Terms 568 • Questions 568 • Applied Problems 570 • Data Analysis Problems 571
CHAPTER 23
Aggregate Demand and Supply Analysis 572
23.1 Business Cycles and Inflation ...........................................................................................572
Business Cycles .................................................................................................................. 572
Inflation ............................................................................................................................. 575
23.2 Aggregate Demand ..............................................................................................................576
Components of Aggregate Demand .................................................................................... 576
Following the Financial News Aggregate Output, Unemployment, and Inflation 576
Deriving the Aggregate Demand Curve ............................................................................... 577
Factors That Shift the Aggregate Demand Curve ................................................................. 577
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FYI What Does Autonomous Mean?
578
23.3 Aggregate Supply ..................................................................................................................581
Long-Run Aggregate Supply Curve ..................................................................................... 581
Short-Run Aggregate Supply Curve .................................................................................... 582
Price Stickiness and the Short-Run Aggregate Supply Curve ............................................... 584
23.4 Shifts in the Aggregate Supply Curves ...........................................................................584
Shifts in the Long-Run Aggregate Supply Curve ................................................................. 584
Shifts in the Short-Run Aggregate Supply Curve ................................................................. 585
23.5 Equilibrium in Aggregate Demand and Supply Analysis ........................................588
Short-Run Equilibrium ....................................................................................................... 589
Aggregate Demand and Supply Analysis Using an Aggregate Output Index ........................ 589
How the Short-Run Equilibrium Moves to the Long-Run Equilibrium over Time ............... 590
Self-Correcting Mechanism ................................................................................................. 593
23.6 Changes in Equilibrium: Aggregate Demand Shocks ...............................................593
APPLICATION The Volcker Disinflation, 1980–1986 .............................................. 595
23.7 Changes in Equilibrium: Aggregate Supply (Inflation) Shocks ..............................596
APPLICATION Negative Supply Shocks, 1973–1975 and 1978–1980 ..................... 598
23.8 Conclusions from Aggregate Demand and Supply Analysis .................................599
APPLICATION AD/AS Analysis of the Great Recession of 2007–2009 ..................... 600
APPLICATION An AD/AS Analysis of the Covid-19 Recession ................................ 601
Summary 604 • Key Terms 604 • Questions 605 • Applied Problems 605 • Data Analysis Problems 606
APPENDIX TO CHAPTER 23
The Phillips Curve and the Short-Run Aggregate Supply Curve 607
23.A1 The Phillips Curve...............................................................................................................607
Phillips Curve Analysis in the 1960s................................................................................... 607
The Friedman-Phelps Phillips Curve Analysis..................................................................... 608
FYI The Phillips Curve Trade-Off and Macroeconomic Policy in the 1960s 609
The Phillips Curve After the 1960s...................................................................................... 611
The Modern Phillips Curve................................................................................................. 611
The Modern Phillips Curve with Adaptive (Backward-Looking) Expectations..................... 612
23.A2 The Short-Run Aggregate Supply Curve.....................................................................613
CHAPTER 23 APPENDIX 1
The Effects of Macroeconomic Shocks on Asset Prices
Go to MyLab Economics
CHAPTER 23 APPENDIX 2
Aggregate Demand and Supply: A Numerical Example
Go to MyLab Economics
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CHAPTER 24
Monetary Policy Theory 615
24.1 Response of Monetary Policy to Shocks ......................................................................615
Response to an Aggregate Demand Shock ........................................................................... 616
Response to a Supply Shock ............................................................................................... 617
The Bottom Line: The Relationship Between Stabilizing Inflation and
Stabilizing Economic Activity ........................................................................................ 620
24.2 How Actively Should Policymakers Try to Stabilize Economic Activity? ...........621
Lags and Policy Implementation ......................................................................................... 622
FYI The Activist/Nonactivist Debate over the Obama Fiscal Stimulus Package 623
24.3 Inflation: Always and Everywhere a Monetary Phenomenon ...............................623
24.4 Causes of Inflationary Monetary Policy ........................................................................624
High Employment Targets and Inflation ............................................................................. 625
APPLICATION The Great Inflation .......................................................................... 628
24.5 Monetary Policy at the Effective Lower Bound ..........................................................630
Deriving the Aggregate Demand Curve with the Effective Lower Bound ............................. 630
The Disappearance of the Self-Correcting Mechanism at the Effective Lower Bound ........... 632
APPLICATION Nonconventional Monetary Policy and Quantitative Easing ........... 633
Liquidity Provision ............................................................................................................. 634
Asset Purchases and Quantitative Easing ............................................................................ 635
Management of Expectations .............................................................................................. 636
APPLICATION Abenomics and the Shift in Japanese Monetary Policy in 2013 ....... 636
Summary 639 • Key Terms 639 • Questions 639 • Applied Problems 640 • Data Analysis Problems 641
CHAPTER 25
The Role of Expectations in Monetary Policy
642
25.1 Lucas Critique of Policy Evaluation ................................................................................642
Econometric Policy Evaluation ........................................................................................... 643
APPLICATION The Term Structure of Interest Rates ............................................... 643
25.2 Policy Conduct: Rules or Discretion? .............................................................................644
Discretion and the Time-Inconsistency Problem ................................................................. 644
Types of Rules ..................................................................................................................... 645
The Case for Rules .............................................................................................................. 645
FYI The Political Business Cycle and Richard Nixon
646
The Case for Discretion ...................................................................................................... 646
Constrained Discretion ....................................................................................................... 647
Global The Demise of Monetary Targeting in Switzerland
647
25.3 The Role of Credibility and a Nominal Anchor ..........................................................648
Benefits of a Credible Nominal Anchor ............................................................................... 648
Credibility and Aggregate Demand Shocks ......................................................................... 649
Credibility and Aggregate Supply Shocks ........................................................................... 651
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Contents in Detail
APPLICATION A Tale of Three Oil Price Shocks ..................................................... 652
Credibility and Anti-Inflation Policy ................................................................................... 654
Global Ending the Bolivian Hyperinflation: A Successful Anti-Inflation Program 655
25.4 Approaches to Establishing Central Bank Credibility ...............................................656
Nominal GDP Targeting ..................................................................................................... 656
Appoint “Conservative” Central Bankers ............................................................................. 657
Inside the Fed The Appointment of Paul Volcker, Anti-Inflation Hawk
657
Summary 658 • Key Terms 658 • Questions 659 • Applied Problems 660 • Data Analysis Problems 660
CHAPTER 26
Transmission Mechanisms of Monetary Policy
661
26.1 Transmission Mechanisms of Monetary Policy ..........................................................662
Traditional Interest-Rate Channels ...................................................................................... 662
Other Asset Price Channels ................................................................................................ 663
Credit View ........................................................................................................................ 666
FYI Consumers’ Balance Sheets and the Great Depression
669
Why Are Credit Channels Likely to Be Important? ............................................................. 670
APPLICATION The Great Recession ......................................................................... 670
26.2 Lessons for Monetary Policy .............................................................................................671
APPLICATION Applying the Monetary Policy Lessons to Japan’s Two Lost Decades .......672
Summary 673 • Key Terms 673 • Questions 674 • Applied Problems 675 • Data Analysis Problems 675
Chapter 26 APPENDIX
Evaluating Empirical Evidence: The Debate Over the Importance of Money in
Economic Fluctuations
Go to MyLab Economics
Glossary ....................................................................................................................................... 677
Index ............................................................................................................................................ 689
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Contents in Detail
31
Additional Contents on MyLab Economics
The following chapters and appendices are available on MyLab Economics
CHAPTER 1
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
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Contents in Detail
CHAPTER 2
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
Options Contracts................................................................................................................ 12
Profits and Losses on Option and Futures Contracts............................................................ 12
APPLICATION Hedging with Future 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 Time Bomb? 22
Summary 24 • Key Terms 24 • Questions 25 • Applied Problems 25 • Data Analysis Problems 26
CHAPTER 3
Conflicts of Interest in the Financial Services 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
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Contents in Detail
FYI The Collapse of Arthur Andersen
5
Universal Banking.................................................................................................................. 5
FYI Why Do Issuers of Securities Pay to Have Their Securities Rated?
FYI Banksters
6
7
Can the Market Limit Exploitations of Conflicts of Interest?................................................. 7
What Has Been Done to Remedy Conflicts of Interest?......................................................... 9
Sarbanes-Oxley Act of 2002................................................................................................. 10
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
CHAPTER APPENDICES IN MYLAB ECONOMICS
Chapter 4: Measuring Interest-Rate Risk: Duration
Chapter 5: Loanable Funds Framework
Chapter 9: Duration Gap Analysis
Chapter 9: Measuring Bank Performance
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 18: The Interest Parity Condition
Chapter 23: The Effects of Macroeconomic Shocks on Asset Prices
Chapter 23: Aggregate Demand and Supply: A Numerical Example
Chapter 26: Evaluating Empirical Evidence: The Debate Over the Importance of
Money in Economic Fluctuations
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Preface
There has never been a more exciting time to teach money and banking. The recent
worldwide financial crisis and the coronavirus pandemic cast a spotlight on the
importance of banks, financial markets, and monetary policy to the health of our
economy. I experienced this firsthand when I served as a Governor of the Federal
Reserve System from 2006 to 2008, and in this book, I emphasize the rich tapestry of
recent economic events to enliven the study of money, banking, and financial markets.
NEW TO THIS EDITION
This text has undergone a major revision with new material in every part of the book,
including updating of all data through 2020 whenever possible. However, it continues
to retain the basic hallmarks that have made it the best-selling textbook on money and
banking over the past twelve editions. As with past editions, this thirteenth edition
uses basic economic principles to explain financial markets, financial institutions, and
monetary policy with rigor and clarity. With each edition, I update content and features
based on market feedback from economics professors and students using the book as
well as the latest world financial episodes. For the past several editions, the digital assets
for this book, which are available on MyLab Economics, have evolved and expanded.
Compelling New Material on the Coronavirus Pandemic
The coronavirus pandemic that spread throughout the world in 2020 is one of the
signature events of the twenty-first century. This has required the addition of many
timely new sections, applications, and boxes throughout the book.
• A new application which uses the analysis of the risk structure of interest rates to
explain the effect of the coronavirus pandemic on the Baa-Treasury spread (Chapter 6).
• A new application on the coronavirus stock market crash of 2020 (Chapter 7),
which illustrates how stock market prices are set.
• A new application on whether the coronavirus pandemic could have led to a financial crisis (Chapter 12) shows how to apply the analysis of the dynamics of financial crises to explain when financial crises might occur in the future.
• A new application on the effects of quantitative easing on the money supply during
the coronavirus crisis (Chapter 15), which shows how to apply the model of the
money supply process to recent data.
• An update to the section on nonconventional monetary policy tools and quantitative easing (Chapter 16) to discuss how they were used during the coronavirus
pandemic.
• An updated Inside the Fed box on Fed lending facilities during the coronavirus
crisis (Chapter 16).
• An update on the application discussing shifts in the MP curve (Chapter 22) to
explain why the actions taken at the onset of the coronavirus pandemic were an
autonomous monetary easing.
• A new application that shows how AD/AS analysis can explain what happened during the Coronavirus Recession (Chapter 23).
35
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Preface
A More Real-World Approach to Monetary Theory
Part 6 of the text, Monetary Theory, has been substantially revised to make the analysis
more real world by using actual data when conducting AD/AS analysis of business
cycle episodes. Chapter 23 has been revised in two major ways. It now starts with an
entirely new section, Business Cycles, that discusses what aggregate demand and supply
analysis is trying to explain, that is, cyclical fluctuations in output, unemployment,
and inflation. The AD/AS analysis is then developed using an aggregate output index
(where 100 is potential GDP), which replaces aggregate output on the horizontal axis
of the AD/AS diagram. This approach has two important advantages over the analysis
in previous editions. First, it enables AD/AS diagrams to be a little simpler because the
long-run aggregate supply curve does not have to be shown in the diagram because
its position is always the same at an aggregate output index of 100. Second, and far
more important, doing the analysis with an aggregate output index enables the AD/AS
diagram to use actual data when it is used to describe what happened during particular
business cycle episodes, such as the Great Recession and the Covid-19 recession. This
change makes AD/AS analysis far more relevant to students because they now see that
it can explain actual data and is not just a theoretical construct. This new approach is
then used throughout the rest of the chapters in the monetary policy part of the book.
Additional New Material on Financial Markets and Money
Other new developments in the money and banking field have prompted me to add the
following new boxes and applications that keep the text current.
• A revision of the application on whether bitcoin or other cryptocurrencies will
become the money of the future (Chapter 3) enables students to better understand
the attributes of money.
• A new application on the effects of the Trump tax cuts on bond interest rates
(Chapter 6), which shows how supply and demand analysis of the bond market
can be used to explain the effect of taxes on different interest rates.
• A new FYI box on Modern Monetary Theory (Chapter 20), which discusses this
new theory that argues that the Green New Deal can be easily paid for by having the
Federal Reserve buy government bonds to fund the resulting large budget deficits.
• An addition of another rationale for explaining why the monetary policy curve
slopes upward (Chapter 22).
SOLVING TEACHING AND LEARNING CHALLENGES
It’s important for students to understand the models, key terms, and equations in any
economics textbook. However, students can get bogged down in this detail and miss
the bigger picture. The content, structure, and features of this book were designed
based on market feedback and many years of teaching experience to build students’
skill in applying these elements––models, terms, and equations––to real-world events.
A01_MISH9481_13_GE_FM.indd 36
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Preface
37
Students also learn to apply what they learn to decisions that are directly relevant to
their lives, such as what might happen to interest rates on car loans or mortgages, and
why events might affect the unemployment rate, which can have a major impact on
how easy it is for them to get a job.
Hallmark Learning Features
Here is an overview of the hallmark features of the book that solve teaching problems
and facilitate student learning.
348
PART 4
• A unifying, analytic framework uses a few basic economic principles that enable
students to develop a disciplined, logical way of analyzing the structure of financial
markets and understanding foreign exchange changes, financial institution management, and the role of monetary policy in the economy.
• A careful, step-by-step development of economic models (the approach used in
the best principles of economics textbooks), which makes it easier for students to
learn.
• Graphs and Mini-Lecture Videos with detailed captions help students clearly
understand the interrelationships among the plotted variables and the principles
of analysis. For analytic figures, these mini-lectures build up each graph step-bystep and explain the intuition necessary to fully understand the theory behind the
graph. The mini-lectures are an invaluable study tool for students who typically
learn better when they see and hear economic analysis rather than read it.
Central Banking and the Conduct of Monetary Policy
Mini-lecture
FIGURE 4
Response to a Change in
Required Reserves
When the Fed raises reserve
requirements, required
reserves increase, which
raises the demand for
reserves. The demand curve
shifts from Rd1 to Rd2, the
equilibrium moves from
point 1 to point 2, and the
federal funds rate rises from
i1ff to i2ff .
Federal
Funds Rate
R1s
id
Step 2. and
the federal
funds rate
rises.
i ff2
1
i ff
Step 1. Increasing
the reserve requirement causes the
demand curve to
shift to the right . . .
2
1
R2d
ioer
R1d
NBR
Quantity of
Reserves, R
Reserve
Requirements
required reserve
ratiothroughout
increases, required
• The complete
integration When
of an the
international
perspective
the text
reserves
increase
andofhence
theboxes.
quantity
of reserves
for any
given
through
the use
Global
These
present demanded
interesting increases
material with
an interinterest
rate.
Thus
a
rise
in
the
required
reserve
ratio
shifts
the
demand
curve
to
the
national focus.
right from Rd1 to Rd2 in Figure 4, moves the equilibrium from point 1 to point 2, and in
turn raises the federal funds rate from i1ff to i2ff . The result is that when the Fed raises
reserve requirements, the federal funds rate rises.3
Similarly, a decline in the required reserve ratio lowers the quantity of reserves
demanded, shifts the demand curve to the left, and causes the federal funds rate to fall.
When the Fed decreases reserve requirements, the federal funds rate falls.
A01_MISH9481_13_GE_FM.indd 37
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Interest on Excess Reserves The effect of a change in the interest rate paid
by
38
334
Preface
P
ART 3
Financial Institutions
386
PART 4
Central Banking and the Conduct of Monetary Policy
Global
Although central bankers have not supported raising the inflation target above the 2%
Latvia’slevel,
Different
and Controversial Response: Expansionary Contraction
the effective-lower-bound problem suggests that allowing inflation expectations to
fall below 2% could be very costly: it would raise the real interest rate when interest rates
After gaining independence
from
the USSR
1991,afterthe
IMF
otherdemand
international
organizations,
the
hit the
effective
lowerinbound
there
is aand
negative
shock that
hits the economy.
Latvia’s stabilization policies
andthough
fiscal the
programs
population
adamantly
a political
decision
to keep
Even
Federal Reserve
adopted
a 2% took
inflation
objective,
inflation
had
enabled it to join the European
Union below
(EU) in2%
2004
currency
pegged
and adoptsoa severe
austerity
been running
for a the
number
of years
afterwards,
the Fed
becameproconand the Eurozone in cerned
2014. that
Central
elements inflation
of gram.
Latvians voluntarily
the lead
layofftoofinflation
25%
the persistent
undershoots
of the 2% endured
target could
Latvia’s economic policies
were a lowdeclining
budget deficit
of state
workers,
40% salary
social
expectations
below 2%.
As a result,
in August
2020,cuts,
afterand
the huge
Fed had
conand a fixed exchange rate
against
the Euro.
During policy
expenditure
The strongthat
nationalistic
ducted
a study
of its monetary
strategy,reductions.
Jay Powell announced
the Fed was
this period, while double-digit
growth
rates attracted
which
stood
in extreme
contrast
to target.
the mass
modifying
its inflation
target tostance,
be a 2%
average,
rather
than a 2%
annual
How
huge capital inflows, the
was changes
overheated
rebellions
of Spain,
Portugal, in
prompted
thiseconomy
modification
the Fed’s
monetary
policyGreece,
strategyand
is described
the Inside
with consumer credit, real-estate
loans,
wages,
international
and Inflation
Nordic Targeting.”
donors to
the Fed box,
“Thehigh
Fed’s
New Monetary
Policyorganizations
Strategy: Average
and real-estate speculation. As foreign banks held finance Latvia’s needs. After a massive contraction
Flexibility
of Inflation
Targeting
We have
seen that GDP
inflation
targeting
as actu60% of assets, the Latvian
banking sector
was highly
of over 25%,
the country’s
started
to grow
to
ally
practiced
would
be
better
described
as
“flexible
inflation
targeting.”
However,
affected by the global crisis. In 2007, after its col- its near pre-crisis levels. Where some may consider
before the
global financial
crisis,Latvia
this flexibility
involved
someexpansionary
short-run devilapse, Parex Bank, the country’s
second-largest
bank,
a successful
modelallowing
of painful
ations
of
inflation
from
the
inflation
target
to
promote
output
stability
as
well
price
was nationalized by the government. Latvia needed contraction, others consider it inapplicable
to as
other
stability.
Two
lessons
from
the
crisis—that
financial
instability
can
have
devastating
€7.5 billion, or 37% of its GDP, to recapitalize banks nations as it was a politically motivated decision to
effects requirements.
on the economy
and that
achieving
price and output stability does not ensure
and to meet external financing
Defying
access
the Eurozone.
financial stability—have led to a recognition that central banks need to pay more attention to financial stability, not only in designing inflation-targeting regimes but also in
any
monetary
framework.
Particularly
in this regard
is the issue
of
• Inside
thepolicy
Fed boxes
give students
a feelimportant
for the operation
and structure
of the
through
the Reserve.
banking
sector.
Germany
and Francebubbles,
didn’t provide
any
stimulus
how
central
banks
should
respond
to asset-price
the topic
wefiscal
discuss
next. in
Federal
2008, but in 2009 enacted tax cuts and introduced fiscal stimuli equivalent to 1.5% and
0.7% of their GDP, respectively. Some other Eastern European nations followed different
contractive fiscal policies. The case of Latvia, discussed in the Global box “Latvia’s Different
Controversial
Response:
Expansionary
is interesting
since the
Theand
Fed’s
New Monetary
Policy
Strategy:Contraction,”
Average Inflation
Targeting
country followed a different path of fiscal austerity, giving rise to a heated debate.
Inside the Fed
The Federal Reserve’s original 2% point-target for the 2% level because past undershoots of the tarinflation was one in which bygones are bygones: that get would be made up over time by pursuing easier
is, it would continue to try to achieve a 2% annual monetary policy. The second advantage of this new
inflation rate no matter what had happened to infla- monetary policy strategy is that it would generate an
tion in the past. The Fed announcement in August automatic stabilizer for the economy. When a nega2020 that it would now target an average infla- tive shock which caused inflation to fall below the 2%
LO 12.5
Summarize
long-term
to financial
regulation
thatwould
occurred
tion rate of 2% meant that
bygones
were no the
longer
targetchanges
occurs, average
inflation
targeting
com-in
response
to the
global
crisisthe
of Fed
2007–2009.
bygones because past inflation
would
affect
its financial
target mit
to temporarily raise inflation to above 2%.
in the short run. If inflation had been running below Inflation expectations would then likely rise above the
The prior
extent
spillover
effects 2%
from
thetemporarily,
affected zones
the previously
the 2% target level, as it had
to of
2020,
then averlevel
thustolowering
the realrisk-averse
interest
financial
markets
has
revealed
an
interconnectedness
and
contagiousness
between
age inflation would fall below 2% and so to raise the rate automatically even if the Fed did not or could
not
financial
markets,
which
necessitates
a
globally
binding
and
wide-ranging
regulatory
average back to 2%, the Fed would seek to achieve lower the federal funds rate.
framework.
in ofaddition
individual
emergency,
national
packages
an inflation rate above 2%
for a shortThus,
period
time. to the
There
is one major
objection
to this bailout
new monetary
extended
to
rescue
national
economies
and
financial
sectors,
global
leaders
simultaneThis would require the Fed to pursue easier mon- policy strategy. If the Fed allowed inflation to temously
rushed
to build
and rise
robust
global
etary policy than it would
have
otherwise.
If aonmore
the stable
porarily
above
the financial
2% level,system.
there might be conother hand, inflation had been running above 2%, cerns that the Fed is no longer committed to keep
then the Fed would temporarily
for an inflation
inflation at
the 2% level in the long run. To avoid this
Globalshoot
Financial
Regulatory
Framework
rate below 2% and pursue a tighter monetary policy. problem, the Fed would need to convince the public
The construction
a global
framework
is resilient
shocks would
requires
There are two major advantages
to this of
new
mon- financial
that an overshoot
of that
the 2%
inflation to
objective
reducing
the
hazardous
effect
of
financial
instruments
and
reigning
in
of
financial
etary policy strategy. First, it would make it less likely not weaken the Fed’s commitment to stabilize inflainstitutions’
risk-taking
activities.
involves
a combination
of national and global
that inflation expectations
would drift
down below
tionThis
at the
2% level
in the long run.
12.5 STABILIZING THE GLOBAL FINANCIAL SYSTEM:
LONG-TERM RESPONSES
M12_MISH9481_13_GE_C12.indd
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CHAPTER 12
Financial Crises
Preface
283
39
With the government bailouts, the Fed’s extraordinary actions, and fiscal stimulus,
a •bull
market in stocks
got under
waythan
starting
in March
2009 (seehow
Figure
and credit
Applications,
numbering
more
50, which
demonstrate
the5),
analysis
prespreads
began
(Figure
6). With
recoveryreal-world
of financial
markets, the economy
sented
can to
befall
used
to explain
manythe
important
situations.
also started to recover, but unfortunately the pace of recovery has been slow.
A P P L I C AT I O N
Could the Coronavirus Pandemic
Have Led to a Financial Crisis?
The coronavirus pandemic in 2020 had the potential to trigger a financial crisis as serious as
the 2007–2009 global financial crisis. With the start of the lockdown of the U.S. economy
in March 2020, the stock market crashed, falling by more than a third, unemployment skyrocketed, and many otherwise healthy firms now faced the prospect of being unable to pay
their bills or pay back their loans. The framework we laid out in our discussion of Figure 1
can be used to analyze how the coronavirus pandemic provided the seeds for another financial crisis, 12 years after the previous one, and why it didn’t become the next financial crisis.
All the factors that potentially lead to a financial crisis, shown in the first row of
Figure 1, came into play when the pandemic became severe in March 2020. The lock• FYI
boxes
highlight
dramatic
historical
interesting
and intriguing
down
dealt
a serious
blow
to the income
of episodes,
both businesses
and ideas,
households,
making
factslikely
related
the content
of unable
the chapter.
it more
thattothey
would be
to pay back their loans. A severe deterioration
462
PART 6
Monetary
Theoryinstitutions balance sheets thus became a real possibility, which could have
in financial
led to severe restrictions on lending. The stock market crash resulted in more than a
35% decline in stock prices, and the sharp decline in income of a multitude of businesses produced a sharp drop in the net worth of firms, which would increase both
adverse selection and moral hazard. The high degree of uncertainty about the spread
Modern Monetary
Theory
of the virus and how long it would disrupt the economy increased the asymmetry of
information, making it harder to assess credit risks.
Modern Monetary Theory argues
that the
Newcrisis
growth
theplanted,
money supply
wouldcredit
then spreads,
cause very
The seeds
of Green
a financial
were of
then
and indeed,
such
Deal can be easily paidasfor
having the spread
Federaldoubled,
high inflation.
theby
Baa-Treasury
shooting up from 2 percentage points in FebruReserve buy governmentary
bonds
fund
Financing
of the23,
Green
NewAlthough
Deal by the
purto a to
peak
ofthe
4.3resulting
percentage points
on March
2020.
the Fed’s
coronavirus
large budget deficits. Aspandemic
our analysis
suggests,to trigger
chase of
governmentfinancial
bonds would
thus
be “free”
had here
the potential
a full-fledged
crisis in
thenot
United
States,
Modern Monetary Theory
that The
the large
because
it wouldresponse
likely result
in very
high federal
inflation.
this isdidcorrect
not occur.
reason was
the massive
by both
the U.S.
govbudget deficit resulting from
a large
in govMostBoth
mainstream
economists,
on thegovernleft,
ernment
andincrease
the Federal
Reserve.
the Federal
Reserve even
and those
the federal
ernment spending can bement
paidreacted
for by awith
central
bank’s suchspeed
as Paul
rejected
Modern Monunprecedented
onceKrugman,
the Worldhave
Health
Organization
(WHO)
purchases of governmentannounced
bonds. However,
ignoresof the
etarycoronavirus
Theory along
thenow
linesbediscussed
Their
that theitspread
could
classified above.
as a pandemic
that this financing of a persistent
deficit
a criticisms
are much
in keeping
the its
economics
on March budget
11, 2020.
On by
March
15, the Federal
Reserve
not onlywith
slashed
policy rate
central bank’s purchase (federal
of government
bonds
leadsbut adage
“There is no
thing asprograms
a free lunch.”
A Greenthe
funds rate)
to zero
also embarked
onsuch
large-scale
to stabilize
to an expansion in thefinancial
money markets
supply. (see
The Chapter
result 15).
NewAfter
Deal earlier
would legislation
need to be to
paid
for bymoney
higher for
taxes
at
provide
public
of massive government health
spending
financed
cen-27, some
point in passed
the future
inflation
is topackage
be avoided,
measures,
on by
March
the Congress
the iflargest
rescue
in U.S.
tral bank purchases of government
bonds (Coronavirus
can thus and
so should
be evaluated
whether Act.
it is productive
history, the CARES
Aid,
Relief, and
EconomiconSecurity)
This massive
be very rapid growth of$2the
money
supply.provided
As the loans
spending
that will
for businesses
itself or have
sufficient
bentrillion
package
and grants
topay
small
and
large corporaquantity theory of money
indicates,
this governments,
very rapid efits
for theinsociety
that make it
worth theand
cost.direct paytions,
aid to state
increases
unemployment
insurance,
ments of $1,200 to most taxpayers, with an additional $500 per child.
The coronavirus pandemic had the potential to unleash another financial crisis, with
disastrous effects on the U.S. economy. However, the combination of Federal Reserve and
U.S. government policies helped shore up businesses, and the Baa-Treasury spread began
End-of-chapter
questions
and applied
problems,pandemic
numbering
more
600,
to•decline.
As of this writing,
the impact
of the coronavirus
on the
U.S.than
economy
help
students
learn
the
subject
matter
by
applying
economic
concepts.
◆
is
still uncertain,
but the likelihood
of aThis
financial
crisisofhasfinancing
decreasedissubstantially.
replaced
by high-powered
money.
method
somewhat inaccu-
FYI
M12_MISH4353_13_SE_C12.indd 283
A01_MISH9481_13_GE_FM.indd 39
rately referred to as printing money because high-powered money (the monetary
base) is created in the process. The use of the word printing is misleading because no
new currency is actually printed; instead, the monetary base increases when the central bank conducts open market purchases, just as it would increase if more currency
were put into circulation.
We thus see that a budget deficit can lead to an increase in the money supply if
it is financed by the creation of high-powered money. However, because the quantity
14/10/20 9:59 AM
theory of money explains inflation only in the long run, in order to produce inflation,
02/07/2021
the budget deficit must be persistent—that is, it must last for a substantial period
of 20:58
KEY TERMS
agency theory, p. 217
collateral, p. 215
costly state verification, p. 224
free-rider problem, p. 219
40
Preface
incentive-compatible, p. 227
net worth (equity capital), p. 222
principal–agent problem, p. 223
private-equity firm, p. 225
restrictive covenants, p. 215
secured debt, p. 215
state-owned banks, p. 231
unsecured debt, p. 215
venture capital firm, p. 225
QUESTIONS
1. For each of the following countries, identify the single
most important (largest) and least important (smallest)
source of external funding: United States; Germany;
Japan; Canada. Comment on the similarities and differences among the countries’ funding sources.
2. How can economies of scale help explain the existence
of financial intermediaries?
3. “The lemons problem applies not only to corporate debt
but also to government debt.” Is this statement true or
false? Explain.
4. Why are financial intermediaries willing to engage
in information collection activities when investors in
financial instruments may be unwilling to do so?
7. Suppose you have data about two groups of countries,
one with efficient legal systems and the other with slow,
costly, and inefficient legal systems. Which group of countries would you expect to exhibit higher living standards?
8. After Fabrizio compares the measures of corruption
and living standards of some countries, he sees a direct
relationship between these measures. Explain the relationship between these measures.
9. Mario has two close friends: Gianluigi and Rebecca. On
the one hand, Gianluigi has just put all his life savings
into a restaurant. On the other hand, Rebecca, who has
a regular job, has not done so. Both ask Mario for a loan.
Should he be more willing to lend to Gianluigi or Rebecca
if there is no other difference between them? Why?
5. Alessandro goes to his local
bank in Milan, SKILLS
intending
DEVELOPING
CAREER
10. What steps can the government take to reduce asymto buy a certificate of deposit with his savings. Explain
information
problems and
the financial
unifying,
analytic
andmetric
step-by-step
development
ofhelp
economic
models in
why he would not offer The
a loan,
at an interest
rate framework
that
system
function
more
smoothly
and
efficiently?
this
text
enable
students
to
develop
the
critical
thinking
skills
they
need
to
successfully
is higher than the rate the bank pays on certificates of
their
careers.
The
money,
banking,
and information
financial markets
is particularly
11.
How can
asymmetric
problems
lead to a
deposit (but lower than pursue
the rate the
bank
charges
forstudy of
valuable
if awho
student
financial
bank
panic? sector. However, even if their interests
student loans), to the next
individual
enterswants
the a job in the
lie elsewhere,
students benefit by12.understanding
why interest rates rise or fall, helping
bank and applies for a student
loan.
In March 2020, the Prime Minister of Lebanon confirmed
them to loan
make
now or
to wait
until
that to
theborrow
country would
default
on its
debtlater.
for theKnowing
first
6. Kabir just applied for a mortgage
in decisions
the State about whether
how
banks
and
other
financial
institutions
are
managed
may
help
students
get a better
time. According to an official statement, the country
Bank of India (SBI). The loan officer tells him that
theyas need
to borrow or when
theypaysupply
funds.due
Knowledge
could not
a €1.35them
billionwith
Eurobond
that month.of
to get the loan, he must deal
leave when
the house
collateral
how
financial
markets
work
can
enable
students
to
make
better
investment
decisions,
Obviously, many investors were left holding bonds
with the bank until he pays back the loan. Which
whether
for
themselves
or
for
the
companies
they
work
for.
priced at a fraction of their previous value. Comment on
problem of asymmetric information is the bank trying
the effects of information asymmetries on government
to solve?
Career Skill Features
This text also has additional features, discussed below, which directly develop career
skills.
M08B_MISH9481_13_GE_C08.indd 233
A01_MISH9481_13_GE_FM.indd 40
• A special feature called “Following the Financial News,” is included to encourage
14/06/2021 18:35
reading of a financial newspaper. Following the Financial News boxes introduce
students to relevant news articles and data that are reported daily in the press and
teach students how to interpret these data. Being able to think critically about what
is reported in the financial press is a skill that can make students far more effective
in their future jobs.
02/07/2021 20:58
We have seen how risk, liquidity, and tax considerations (collectively embedded in the
risk structure) can influence interest rates. Another factor that influences the interest rate
on a bond is its term to maturity: Bonds with identical risk, liquidity, and tax characteristics may have different interest rates because their times remaining to maturity are different. A plot of the yields on bonds with differing terms to maturity but the same risk,
liquidity, and tax considerations is called a yield curve, and it describes thePreface
term structure
41
of interest rates for particular types of bonds, such as government bonds. The Following
Following the Financial News
Yield Curves
Many newspapers and Internet sites such as http://
www.finance.yahoo.com publish a daily plot of the
yield curves for Treasury securities. An example for
May 22, 2020, is presented here. The numbers on
the vertical axis indicate the interest rate for the Treasury security, with the maturity term given on the
horizontal axis, with “m” denoting “month” and “y”
denoting “year.”
Interest Rate
(%)
5
4
3
2
1
0
M06_MISH4353_13_SE_C06.indd 125
A01_MISH9481_13_GE_FM.indd 41
1m
3m
6m
1y
2y
3y
5y
10 y
20 y
30 y
Maturity
• Real Time Data in a high percentage of the in-text data figures are labeled Real09/10/20 3:33 PM
Time Data. For these figures, students can see the latest data in the enhanced Pearson e-text, using the Federal Reserve Bank of St. Louis’s FRED database and learn
where they can access this data when they need to throughout their career.
• Real-Time Data Analysis Problems, included in MyLab Economics, which ask
students to apply up-to-the-minute data, taken from the St. Louis Federal Reserve
Bank’s FRED database, so that they can understand what is happening in the economy in real time. These problems, marked with Real-time Data Analysis, ask the
student to download data from the Federal Reserve Bank of St. Louis FRED website
and then use the data to answer questions about current issues in money and banking. In MyLab Economics, these easy-to-assign and automatically graded Real-Time
Data Analysis exercises communicate directly with the FRED site, so that students
see updated data every time new data is posted by FRED. Thus the Real-Time Data
Analysis exercises offer a no-fuss solution for instructors who want to make the
most current data a central part of their macroeconomics course. These exercises
will give students practice manipulating data, a skill that employers value highly.
02/07/2021 20:58
42
48
Preface
PART 1
Introduction
DATA ANALYSIS PROBLEMS
The Problems update with real-time data in MyLab Economics
and are available for practice or instructor assignment.
1. Real-time Data Analysis Go to the St. Louis Federal
Reserve FRED database, and find data on federal debt held
by the Federal Reserve (FDHBFRBN), by private investors
(FDHBPIN), and by international and foreign investors
(FDHBFIN). Using these series, calculate the total amount
held and the percentage held in each of the three categories
for the most recent quarter available. Repeat for the first
quarter of 2000, and compare the results.
2. Real-time Data Analysis Go to the St. Louis Federal
Reserve FRED database, and find data on the total assets of
all commercial banks (TLAACBM027SBOG) and the total
assets of money market mutual funds (MMMFFAQ027S).
Transform the commercial bank assets series to quarterly
by adjusting the Frequency setting to “Quarterly.” Calculate
the percent increase in growth of assets for each series,
from January 2000 to the most recent quarter available.
Which of the two financial intermediaries has experienced
the most percentage growth?
FLEXIBILITY AND MODULARITY
In using previous editions, adopters, reviewers, and survey respondents have
continually praised this text’s flexibility and modularity—that is, the option to pick
and choose which chapters to cover and in what order to cover them. Flexibility and
modularity are especially important in the money and banking course because there are
as many ways to teach this course as there are instructors. To satisfy the diverse needs
of instructors, the text achieves flexibility as follows:
• Core chapters provide the basic analysis used throughout the book, and other
chapters or sections of chapters can be used or omitted according to instructor
preferences. For example, Chapter 2 introduces the financial system and basic concepts such as transaction costs, adverse selection, and moral hazard. After covering
Chapter 2, the instructor may decide to give more detailed coverage of financial
structure by assigning Chapter 8 or may choose to skip Chapter 8 and take any of a
number of different paths through the book.
• The text allows instructors to cover the most important issues in monetary theory
even if they do not wish to present a detailed development of the IS, MP, and AD
curves (provided in Chapters 21 and 22). Instructors who want to teach a more
complete treatment of monetary theory can make use of these chapters.
• Part 6 on monetary theory can easily be taught before Part 4 of the text if the
instructor wishes to give students a deeper understanding of the rationale behind
monetary policy.
• Chapter 26 on the transmission mechanisms of monetary policy can be taught at
many different points in the course—either with Part 4, when monetary policy
is discussed, or with Chapter 21 or Chapter 23, when the concept of aggregate
demand is developed. Transmission mechanisms of monetary policy can also be
taught as a special topic at the end of the course.
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43
Preface
• The international approach of the text, accomplished through marked international sections within chapters as well as separate chapters on the foreign exchange
market and the international monetary system, is comprehensive yet flexible.
Although many instructors will teach all the international material, others will not.
Instructors who wish to put less emphasis on international topics can easily skip
Chapter 18 on the foreign exchange market and Chapter 19 on the international
financial system and monetary policy. The international sections within chapters
are self-contained and can be omitted with little loss of continuity.
To illustrate how this book can be used for courses with varying emphases, several
course outlines are suggested for a one-semester teaching schedule. More detailed
information about how the text can be used flexibly in your course is available in the
Instructor’s Manual.
• General Money and Banking Course: Chapters 1–5, 9–14, 16, 17, 23–24, with a
choice of 5 of the remaining 11 chapters
• General Money and Banking Course with an International Emphasis: Chapters 1–5,
9–14, 16–19, 23–24, with a choice of 3 of the remaining 9 chapters
• Financial Markets and Institutions Course: Chapters 1–12, with a choice of 7 of the
remaining 13 chapters
• Monetary Theory and Policy Course: Chapters 1–5, 14–17, 20–25, with a choice of 4
of the remaining 10 chapters
A More Finance-Oriented Approach—the former Business
School Edition
We are providing additional chapters in MyLab Economics that will serve instructors
and students who previously used the Business School edition. In offering these
chapters, we are offering all of the chapters that instructors would want to cover in a
typical semester––regardless of where the course is offered. The additional chapters
include nonbank finance, financial derivatives, and conflicts of interest in the financial
industry.
Appendices and Additional Resources
Additional resources for the Thirteenth Edition of The Economics of Money, Banking, and
Financial Markets include: (1) the three unique chapters that were previously found
in the Business School Edition; (2) a chapter on financial crises in emerging market
economies; and (3) fifteen appendices that cover additional topics and more technical
material that instructors might want to include in their courses. This content can be
accessed in MyLab Economics. Instructors can either use these chapters and appendices
in class to supplement the material in the textbook or recommend them to students
who want to expand their knowledge of the money and banking field.
A01_MISH9481_13_GE_FM.indd 43
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44
Preface
INSTRUCTOR TEACHING RESOURCES
This program comes with the following teaching resources.
Supplements available to
instructors at www.
pearsonglobaleditions.com
Features of the supplement
The Instructor’s Resource Manual • Sample course outlines
was prepared by the author and
• Chapter outlines
includes the following features:
• Answers to questions and problems in the text
The Test Bank includes the
following features:
• More than 2,500 multiple-choice and essay test items, many with graphs
• Questions are connected to the AACSB learning standards (Written
and Oral Communication; Ethical Understanding and Reasoning;
Analytical Thinking; Information Technology; Interpersonal Relations
and Teamwork; Diverse and Multicultural Work; Reflective Thinking;
Application of Knowledge)
The Testgen enables instructors
to produce exams efficiently:
• This product consists of the multiple-choice and essay questions provided
in the online Test Bank, and offers editing capabilities
The PowerPoint Presentation
includes the following features:
• All of the tables and graphs presented in the text
• Detailed lecture notes for all the course material
• Instructors who prefer to teach with a blackboard can use these
PowerPoint slides as their own class notes; for those who prefer to teach
with visual aids, the PowerPoint slides afford them the flexibility to do so
ACKNOWLEDGMENTS
As always in so large a project, there are many people to thank. My gratitude goes especially to Chris DeJohn, my editor, and Samantha Lewis, my product manager. Also, I
would like to thank Carolyn Philips and Kathy Smith for their contributions as well.
From marketing, I want to thank Nayke Heine and Ashley DePace. I also have been
assisted by comments from my colleagues at Columbia and from my students.
In addition, I have been guided by the thoughtful commentary of outside reviewers
and correspondents, especially Jim Eaton and Aaron Jackson. Their feedback has made
this a better book. In particular, I thank the following professors who reviewed the text
in preparation for this edition and previous editions:
Burt Abrams, University of Delaware
Francis W. Ahking, University of
­Connecticut
Reena Ahuja, Flagler College
Mohammad Iqbal Ahmed, Texas State
University
A01_MISH9481_13_GE_FM.indd 44
Mohammed Akacem, Metropolitan
State College of Denver
Stefania Albanesi, Columbia University
Nancy Anderson, Mississippi College
Muhammad Anwar, University of
­Massachusetts
02/07/2021 20:58
Preface
Harjit K. Arora, Le Moyne College
Bob Barnes, Northern Illinois
­University
Stacie Beck, University of Delaware
Larry Belcher, Stetson University
Thomas Bernardin, Smith College
Gerry Bialka, University of North
Florida
Daniel K. Biederman, University of
North Dakota
John Bishop, East Carolina University
Daniel Blake, California State
­University, Northridge
Robert Boatler, Texas Christian
­University
Henning Bohn, University of California,
Santa Barbara
Michael W. Brandl, University of Texas
at Austin
Oscar T. Brookins, Northeastern
­University
William Walter Brown, California State
University, Northridge
James L. Butkiewicz, University of
­Delaware
Colleen M. Callahan, Lehigh University
Ray Canterbery, Florida State University
Mike Carew, Baruch University
Tina Carter, University of Florida
Sergio Castello, University of Mobile
Matthew S. Chambers, Towson
­University
Jen-Chi Cheng, Wichita State
­University
Chi-Young Choi, University of Texas,
Arlington
Patrick Crowley, Middlebury College
Sarah E. Culver, University of Alabama,
Birmingham
Julie Dahlquist, University of Texas,
San Antonio
Maria Davis, San Antonio College
Michael DeDad, Indiana University
Ranjit S. Dighe, State University of
New York, Oswego
Richard Douglas, Bowling Green
­University
Ram Sewak Dubey, Montclair State
­University
A01_MISH9481_13_GE_FM.indd 45
45
Donald H. Dutkowsky, Syracuse
­University
Richard Eichhorn, Colorado State
­University
Paul Emberton, Southwest Texas State
University
Erick Eschker, Humboldt State
­University
Diego Escobari, The University of
Texas–Pan American
Robert Eyler, Sonoma State University
L. S. Fan, Colorado State University
Imran Farooqi, University of Iowa
Sasan Fayazmanesh, California State
University, Fresno
Dennis Fixler, George Washington
­University
Gary Fleming, Roanoke College
Grant D. Forsyth, Eastern Washington
University
Layton W. Franko, Queens College
Timothy Fuerst, Bowling Green State
University
Marc Fusaro, Arkansas Tech University
James Gale, Michigan Technological
University
Shirley Gedeon, University of Vermont
Edgar Ghossoub, University of Texas,
San Antonio
Mark Gibson, Washington State
­University
Lance Girton, University of Utah
Stuart M. Glosser, University of
­Wisconsin, Whitewater
Fred C. Graham, American University
Jo Anna Gray, University of Oregon
David Gulley, Bentley University
Ralph Gunderson, University of
­Wisconsin
Daniel Haak, Stanford University
Larbi Hammami, McGill University
Bassan Harik, Western Michigan
­University
J. C. Hartline, Rutgers University
Scott Hein, Texas Tech
Robert Stanley Herren, North Dakota
State University
Jane Himarios, University of Texas,
Arlington
02/07/2021 20:58
46
Preface
Chad Hogan, University of Michigan
Linda Hooks, Washington and Lee
­University
James Hueng, Western Michigan
­University
Dar-Yeh Hwang, National Taiwan
­University
Jayvanth Ishwaran, Stephen F. Austin
State University
Aaron Jackson, Bentley University
Jonatan Jelen, Queens College and City
College of CUNY
U Jin Jhun, State University of New
York, Oswego
Jingze Jiang, Edinboro University
Frederick L. Joutz, George Washington
University
Ahmed Kalifa, Colorado State
­University
Bryce Kanago, University of Northern
Iowa
Magda Kandil, International Monetary
Fund
Theodore Kariotis, Towson University
George G. Kaufman, Loyola University
Chicago
Richard H. Keehn, University of
­Wisconsin, Parkside
Elizabeth Sawyer Kelly, University of
Wisconsin, Madison
Kathy Kelly, University of Texas,
­Arlington
Michael Kelsay, University of Missouri,
Kansas City
Hyeongwoo Kim, Auburn University
Paul Kubik, DePaul University
Sungkyu Kwak, Washburn University
Fritz Laux, Northeastern State
­University
Jim Lee, Fort Hays State University
Robert Leeson, University of Western
Ontario
Mary H. Lesser, Lenoir–Rhyne
­University
Ting Levy, Florida Atlantic University
Tony Lima, California State University,
Hayward
Fiona Maclachlan, Manhattan College
Elham Mafi-Kreft, Indiana University
A01_MISH9481_13_GE_FM.indd 46
Bernard Malamud, University of
Nevada, Las Vegas
James Maloy, University of Pittsburgh
James Marchand, Mercer University
Marvin Margolis, Millersville University
Elaine McBeth, College of William and
Mary
Stephen McCafferty, Ohio State
­University
James McCown, Ohio State University
Robin McCutcheon, Marshall
­University
Cheryl McGaughey, Angelo State
­University
William McLean, Oklahoma State
­University
W. Douglas McMillin, Louisiana State
University
William Merrill, Iowa State University
Carrie Meyer, George Mason University
Stephen M. Miller, University of
­Connecticut
Masoud Moghaddam, Saint Cloud State
University
Thomas S. Mondschean, DePaul
­University
George Monokroussos, University of
Albany
Shahriar Mostashari, Campbell
­University
Clair Morris, U.S. Naval Academy
Jon Nadenichek, California State
­University, Northridge
John Nader, Grand Valley State
­University
Andrew Nahlik, Illinois College
Hiranya K. Nath, Sam Houston State
University
Leonce Ndikumana, University of
­Massachusetts, Amherst
Ray Nelson, Brigham Young University
Inder P. Nijhawan, Fayetteville State
University
Nick Noble, Miami University of Ohio
Dennis O’Toole, Virginia
­Commonwealth University
Miyoung Oh, Iowa State University
William R. Parke, University of North
Carolina, Chapel Hill
02/07/2021 20:58
Preface
Mark J. Perry, University of Michigan,
Flint
Chung Pham, University of New
­Mexico
Marvin M. Phaup, George Washington
University
Andy Prevost, Ohio University
Ganga P. Ramdas, Lincoln University
Ronald A. Ratti, University of Missouri,
Columbia
Hans Rau, Ball State University
Prosper Raynold, Miami University
Javier Reyes, Texas A&M University
Stefan Ruediger, Arizona State
­University
Jack Russ, San Diego State University
Steve Russell, IUPUI
Robert S. Rycroft, Mary Washington
College
Joe Santos, South Dakota State
­University
Lynn Schneider, Auburn University,
Montgomery
Walter Schwarm, Colorado State
­University
John Shea, University of Maryland
Wei Simi, Baruch College – CUNY
Harinder Singh, Grand Valley State
­University
Rajesh Singh, Iowa State University
Richard Stahl, Louisiana State
­University
Burak Sungu, Miami University
Larry Taylor, Lehigh University
Leigh Tesfatsion, Iowa State University
Aditi Thapar, New York University
Frederick D. Thum, University of Texas,
Austin
47
Robert Tokle, Idaho State University
Demetri Tsanacas, Ferrum College and
Hollins University
C. Van Marrewijk, Erasmus University
Rubina Vohra, New Jersey City
­University
Christopher J. Waller, Indiana
­University
Yongsheng Wang, Washington and
­Jefferson College
Chao Wei, George Washington
­University
Maurice Weinrobe, Clark University
James R. Wible, University of New
Hampshire
Philip R. Wiest, George Mason
­University
William Wilkes, Athens State
­University
Thomas Williams, William Paterson
University
Elliot Willman, New Mexico State
­University
Donald Wills, University of
­Washington, Tacoma
Laura Wolff, Southern Illinois
­University, Edwardsville
JaeJoon Woo, DePaul University
Robert Wright, University of Virginia
Ben T. Yu, California State University,
Northridge
Ky H. Yuhn, Florida Atlantic
­University
Ed Zajicek, Winston-Salem State
­University
David Zalewski, Providence College
Liping Zheng, Drake University
Jeffrey Zimmerman, Methodist College
Finally, I want to thank my wife, Sally; my son, Matthew; my daughter, Laura; my
three god-daughters, Glenda, Alba, and Norma; and my seven grandchildren, Roby,
Sofia, Sammy, Sarita, Adrian, Olivia, and Ellis, all of whom provide me with a warm
and happy environment that enables me to do my work, and also my father, Sidney,
now deceased, who a long time ago put me on the path that led to this book.
Frederic S. Mishkin
A01_MISH9481_13_GE_FM.indd 47
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48
Preface
GLOBAL EDITION ACKNOWLEDGMENTS
We would like to thank the people who have contributed towards developing this book
for the global markets and who have put in effort to update this global edition for students across the world.
Monal Abdel-Baki, Durban University
Olivier Butzbach, Seconda Università
degli Studi di Napoli
Rezart Erindi, Seconda Università degli
Studi di Napoli
We would also like to thank the individuals who provided valuable feedback to
improve the Global Edition.
Mahmoud Elmarzouky, University of
Portsmouth
Ruud Gerards, Maastricht University
Søren H. Ravn, University of
­Copenhagen
Lim Thien Sang, Universiti Malaysia
Sabah
A01_MISH9481_13_GE_FM.indd 48
Min Kok Seet, National University of
Singapore
Pasztor Szabolcs, National University of
Public Service
Alexander Tziamalis, Sheffield Hallam
University
02/07/2021 20:58
1
PART
M01A_MISH9481_13_GE_P01.indd 49
Introduction
Crisis and Response: The Global Financial
and the Covid-19 Crises
In August 2007, financial markets began to seize up, and over the next
two years the world economy experienced a global financial crisis that
was the most severe since the Great Depression years of the 1930s.
Housing prices plummeted, the stock market crashed, unemployment
skyrocketed, and both businesses and households found they couldn’t
get credit. Not only did the central bank of the United States, the
Federal Reserve, respond by sharply lowering interest rates and
intervening in credit markets to provide them with massive amounts
of liquidity but the federal government also entered into the act with
a $700 billion bailout of weakened financial institutions and huge
fiscal stimulus packages totaling over $1 trillion. However, even with
these aggressive actions aimed at stabilizing the financial system and
boosting the economy, it took ten years before the U.S. economy
returned to full employment. The financial systems and economies of
many governments throughout the world were also in tatters.
In 2020, the world economy was hit by another crisis, but this time
the source was not man-made, but from a strain of coronavirus that
originated in Wuhan, China. On March 11, 2020, the World Health
Organization (WHO) declared a world pandemic, and economies all
over the world began to lock down and the stock market crashed.
The Federal Reserve stepped in by again lowering interest rates and
by providing massive amounts of liquidity to shore up the financial
system and stimulate lending by banks and other institutions.
The U.S. Congress then passed a series of fiscal stimulus packages
exceeding $3 trillion, the largest ones in U.S. history. Despite these
efforts, by April 2020, the unemployment rate had risen to 14.7%, the
highest level since the Great Depression of the 1930s.
The aftermath of the global financial and the coronavirus crises
demonstrates the importance of banks and financial systems to economic
well-being, as well as the major role of money in the economy. Part 1
of this book provides an introduction to the study of money, banking,
and financial markets. Chapter 1 outlines a road map of the book
and discusses why it is so worthwhile to study money, banking, and
financial markets. Chapter 2 provides a general overview of the financial
system. Chapter 3 then explains what money is and how it is measured.
02/06/2021 20:41
1
Learning Objectives
1.1 Recognize the
importance of financial
markets in the economy.
1.2 Describe how
financial intermediation
and financial innovation
affect banking and the
economy.
1.3 Identify the basic
links among monetary
policy, the business
cycle, and economic
variables.
1.4 Explain the importance of exchange rates
in a global economy.
1.5 Explain how the
study of money, banking, and financial markets may advance your
career.
1.6 Describe how the
text approaches the
teaching of money,
banking, and financial
markets.
Why Study Money,
Banking, and Financial
Markets?
Preview
Y
ou have just heard on the evening news that the Federal Reserve is raising the
federal funds rate by 12 of a percentage point. What effect might this have on the
interest rate of an automobile loan when you finance your purchase of a sleek
new sports car? Does it mean that a house will be more or less affordable in the future?
Will it make it easier or harder for you to get a job next year?
This book provides answers to these and other questions by examining how financial markets (such as those for bonds, stocks, and foreign exchange) and financial institutions (banks, insurance companies, mutual funds, and other institutions) work and
by exploring the role of money in the economy. Financial markets and institutions
affect not only your everyday life but also the flow of trillions of dollars of funds
throughout our economy, which in turn affects business profits, the production of
goods and services, and even the economic well-being of countries other than the
United States. What happens to financial markets, financial institutions, and money is
of great concern to politicians and can have a major impact on elections. The study of
money, banking, and financial markets will reward you with an understanding of many
exciting issues. In this chapter, we provide a road map of this book by outlining these
issues and exploring why they are worth studying.
1.1 WHY STUDY FINANCIAL MARKETS?
LO 1.1 Recognize the importance of financial markets in the economy.
Part 2 of this book focuses on financial markets—markets in which funds are transferred from people who have an excess of available funds to people who have a shortage. 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 productive 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 a direct effect on personal wealth, the behavior of
businesses and consumers, and the cyclical performance of the economy.
50
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51
Debt Markets and Interest Rates
A security (also called a financial instrument) is a claim on the issuer’s future income or
assets (any financial claim or piece of property that is subject to ownership). A bond is
a debt security that promises to make periodic payments for a specified period of time.1
Debt markets, also often generically referred to as bond markets, are especially important to economic activity because they enable corporations and governments to borrow
money to finance their activities, and because it is where interest rates are determined.
An interest rate is the cost of borrowing or the price paid for the rental of funds (usually expressed as a percentage of the rental of $100 per year). Many types of interest
rates are found in the economy—mortgage interest rates, car loan rates, and interest
rates on many different types of bonds.
Interest rates are important on a number of levels. On a personal level, high interest rates might deter you from buying a house or a car because the cost of financing
would be high. Conversely, high interest rates might encourage you to save because
you can earn more interest income by putting aside some of your earnings as savings.
On a more general level, interest rates have an impact on the overall health of the
economy because they affect not only consumers’ willingness to spend or save but also
businesses’ investment decisions. High interest rates, for example, might cause a corporation to postpone building a new plant that would provide more jobs.
Because changes in interest rates affect individuals, financial institutions, businesses, and the overall economy, it is important to explain substantial fluctuations in
interest rates over the past 40 years. For example, the interest rate on three-month
Treasury bills peaked at over 16% in 1981. This interest rate fell to below 1% in 2004
and rose to 5% by 2007. It then fell to near zero from 2009 to 2015, then rose to above
2% in 2018, only to fall back to near zero again when the coronavirus pandemic led to
the Covid-19 recession in March 2020.
Because different interest rates have a tendency to move in unison, economists frequently lump interest rates together and refer to “the” interest rate. As Figure 1 shows,
however, interest rates on several types of bonds can differ substantially. The interest
rate on three-month Treasury bills, for example, fluctuates more than the other interest rates and is lower on average. The interest rate on Baa (medium-quality) corporate
bonds is higher, on average, than the other interest rates, and the spread between it and
the other rates became larger in the 1970s, narrowed in the 1990s, rose briefly in the
early 2000s, narrowed again, and then rose sharply starting in the summer of 2007.
It then began to decline toward the end of 2009, returning to low levels by 2018, and
then rose again during the Covid-19 recession in 2020.
In Chapter 2 we study the role of bond markets in the economy, and in Chapters 4
through 6 we examine what an interest rate is, how the common movements in interest
rates come about, and why the interest rates on different bonds vary.
The Stock Market
A common stock (typically called simply a stock) represents a share of ownership in
a corporation. It is a security that is a claim on the earnings and assets of the corporation. Issuing stock and selling it to the public is a way for corporations to raise funds
1
The definition of bond used throughout this book is the broad one commonly used in academic settings, which
covers both short- and long-term debt instruments. However, some practitioners in financial markets use the word
bond to describe only specific long-term debt instruments such as corporate bonds or U.S. Treasury bonds.
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52
P A R T 1 Introduction
Real-time data
Interest Rate
(% annual rate)
20
15
Corporate Baa Bonds
10
U.S. Government
Long-Term Bonds
5
Three-Month
Treasury Bills
0
1950
FIGURE 1
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
2020
Interest Rates on Selected Bonds, 1950–2020
Although different interest rates have a tendency to move in unison, they often differ substantially, and the
spreads between them fluctuate.
Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/TB3MS; https://fred.stlouisfed.org/
series/GS10; https://fred.stlouisfed.org/series/BAA
to finance their activities. The stock market, in which claims on the earnings of corporations (shares of stock) are traded, is the most widely followed financial market in
almost every country that has one; that’s why it’s often called simply “the market.” A
big swing in the prices of shares in the stock market is always a major story on the evening news. People often speculate on where the market is heading and get very excited
when they can brag about their latest “big killing,” but they become depressed when
they suffer a big loss. The attention the market receives can probably be best explained
by one simple fact: It is a place where people can get rich—or poor—very quickly.
As Figure 2 indicates, stock prices are extremely volatile. After rising steadily during the 1980s, the market experienced the worst one-day drop in its entire history on
October 19, 1987—“Black Monday”—with the Dow Jones Industrial Average (DJIA)
falling by 22%. From then until 2000, the stock market experienced one of the greatest rises (often referred to as a “bull market”) in its history, with the Dow climbing to
a peak of over 11,000. With the collapse of the high-tech bubble in 2000, the stock
market fell sharply, dropping by over 30% by late 2002. It then rose to an all-time high
above the 14,000 level in 2007, only to fall by over 50% of its value to a low below
7,000 in 2009. Another bull market then began, with the Dow reaching a peak just
short of 30,000 in February 2020. The stock market then crashed in the wake of the
coronavirus pandemic, falling by over 25% in the space of a month. These considerable fluctuations in stock prices affect the size of people’s wealth and, as a result, their
willingness to spend.
The stock market is also an important factor in business investment decisions,
because the price of shares affects the amount of funds that can be raised by selling
newly issued stock to finance investment spending. A higher price for a firm’s shares
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53
Real-time data
Dow Jones
Industrial Average
28,000
26,000
24,000
22,000
20,000
18,000
16,000
14,000
12,000
10,000
8,000
6,000
4,000
2,000
0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020
FIGURE 2
Stock Prices as Measured by the Dow Jones Industrial Average, 1950–2020.
Stock prices are extremely volatile.
Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/DJIA
means that the firm can raise a larger amount of funds, which it can then use to buy
production facilities and equipment.
In Chapter 2 we examine the role the stock market plays in the financial system,
and in Chapter 7 we return to the issue of how stock prices behave and respond to
information in the marketplace.
1.2 WHY STUDY FINANCIAL INSTITUTIONS AND BANKING?
LO 1.2 Describe how financial intermediation and financial innovation affect banking
and the economy.
Part 3 of this book focuses on financial institutions and the business of banking. Banks
and other financial institutions are what make financial markets work. Without them,
financial markets would not be able to move funds from people who save to people
who have productive investment opportunities. Thus financial institutions play a crucial role in the economy.
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P A R T 1 Introduction
Structure of the Financial System
The financial system is complex, comprising many different types of private sector
financial institutions, including banks, insurance companies, mutual funds, finance
companies, and investment banks, all of which are heavily regulated by the government. If an individual wanted to make a loan to IBM or General Motors, for example,
he or she would not go directly to the president of the company and offer a loan.
Instead, the individual would lend to such a company indirectly through financial
intermediaries, which are institutions that borrow funds from people who have saved
and in turn make loans to people who need funds.
Why are financial intermediaries so crucial to well-functioning financial markets?
Why do they extend credit to one party but not to another? Why do they usually write
complicated legal documents when they extend loans? Why are they the most heavily
regulated businesses in the economy?
We answer these questions in Chapter 8 by developing a coherent framework for
analyzing financial structure in the United States and in the rest of the world.
Banks and Other Financial Institutions
Banks are financial institutions that accept deposits and make loans. The term banks
includes firms such as commercial banks, savings and loan associations, mutual savings banks, and credit unions. Banks are the financial intermediaries that the average
person interacts with most frequently. A person who needs a loan to buy a house or
a car usually obtains it from a local bank. Most Americans keep a large portion of
their financial wealth in banks in the form of checking accounts, savings accounts, or
other types of bank deposits. Because banks are the largest financial intermediaries in
our economy, they deserve the most careful study. However, banks are not the only
important financial institutions. Indeed, in recent years, other financial institutions,
such as insurance companies, finance companies, pension funds, mutual funds, and
investment banks, have been growing at the expense of banks, so we need to study
them as well.
In Chapter 9, we examine how banks and other financial institutions manage their
assets and liabilities to make profits. In Chapter 10, we extend the economic analysis in
Chapter 8 to understand why financial regulation takes the form it does and what can
go wrong in the regulatory process. In Chapter 11, we look at the banking industry and
examine how the competitive environment has changed this industry. We also learn
why some financial institutions have been growing at the expense of others.
Financial Innovation
In Chapter 11, we also study financial innovation, the development of new financial
products and services. We will see why and how financial innovation takes place, with
particular emphasis on how the dramatic improvements in information technology
have led to new financial products and the ability to deliver financial services electronically through what has become known as e-finance. We also study financial innovation because it shows us how creative thinking on the part of financial institutions can
lead to higher profits but can also sometimes result in financial disasters. By studying
how financial institutions have been creative in the past, we obtain a better grasp of
how they may be creative in the future. This knowledge provides us with useful clues
about how the financial system may change over time.
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55
Financial Crises
At times, the financial system seizes up and produces financial crises, which are major
disruptions in financial markets that are characterized by sharp declines in asset prices
and the failures of many financial and nonfinancial firms. Financial crises have been a
feature of capitalist economies for hundreds of years and are typically followed by severe
business cycle downturns. Starting in August 2007, the U.S. economy was hit by the worst
financial crisis since the Great Depression. Defaults in subprime residential mortgages led
to major losses in financial institutions, producing not only numerous bank failures but
also the demise of Bear Stearns and Lehman Brothers, two of the largest investment banks
in the United States. The crisis produced the worst economic downturn since the Great
Depression, and as a result, it is now referred to as the “Great Recession.”
We discuss why these crises occur and why they do so much damage to the economy in Chapter 12.
1.3 WHY STUDY MONEY AND MONETARY POLICY?
LO 1.3 Identify the basic links among monetary policy, the business cycle, and economic
variables.
Money, also referred to as the money supply, is defined as anything that is generally
accepted as payment for goods or services or in the repayment of debts. Money is linked
to changes in economic variables that affect all of us and are important to the health of
the economy. The final two parts of this book examine the role of money in the economy.
Money and Business Cycles
During 1981–1982, the total production of goods and services (called aggregate output) in the U.S. economy fell and the unemployment rate (the percentage of the
available labor force unemployed) rose to over 10%. After 1982, the economy began to
expand rapidly, and by 1989, the unemployment rate had declined to 5%. In 1990, the
eight-year expansion came to an end, with the unemployment rate rising to above 7%.
The economy bottomed out in 1991, and the subsequent recovery was the longest in
U.S. history up to that time, with the unemployment rate falling to around 4%. A mild
economic downturn began in March 2001, with unemployment rising to 6%; the economy began to recover in November 2001, with unemployment eventually declining to
a low of 4.4%. Starting in December 2007, the economy went into a steep economic
downturn and unemployment rose to over 10% before the economy slowly began to
recover in June 2009. By early 2020, the unemployment rate had fallen to 3.5%, only
to rise sharply starting in March 2020, with the onset of the Covid-19 recession.
Why did the economy undergo such pronounced fluctuations? Evidence suggests
that money plays an important role in generating business cycles, the upward and
downward movement of aggregate output produced in the economy. Business cycles
affect all of us in immediate and important ways. When output is rising, for example,
it is easier to find a good job; when output is falling, finding a good job might be difficult. Figure 3 shows the movements of the rate of growth of the money supply over
the 1950–2020 period, with the shaded areas representing recessions, or periods of
declining aggregate output. We see that the rate of money growth declined before most
recessions, indicating that changes in money growth might be a driving force behind
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P A R T 1 Introduction
Real-time data
Money
Growth Rate
(% annual rate)
20
15
Money Growth
Rate (M2)
10
5
0
1950
FIGURE 3
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
2020
Money Growth (M2 Annual Rate) and the Business Cycle in the United States, 1950–2020
Although money growth has declined before almost every recession, not every decline in the rate of
money growth is followed by a recession. Shaded areas represent recessions.
Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/M2SL
business cycle fluctuations. However, declines in the rate of money growth are often
not followed by a recession.
We explore how money and monetary policy might affect aggregate output in
Chapters 20 through 26 (Part 6) of this book, where we study monetary theory, the
theory that relates the quantity of money and monetary policy to changes in aggregate
economic activity and inflation.
Money and Inflation
The movie you paid $10 to see last week would have set you back only a dollar or two
30 years ago. In fact, for $10, you probably could have had dinner, seen the movie, and
bought yourself a big bucket of hot buttered popcorn. As shown in Figure 4, which illustrates the movement of average prices in the U.S. economy from 1950 to 2020, the prices
of most items are quite a bit higher now than they were then. The average price of goods
and services in an economy is called the aggregate price level or, more simply, the price
level (a more precise definition is found in the appendix to this chapter). From 1960 to
2020, the price level has increased more than sevenfold. Inflation, a continual increase in
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57
Real-time data
Index (2012 5 100)
200
175
150
125
100
75
Aggregate Price Level
(GDP Deflator)
50
Money Supply
(M2)
25
0
1960
FIGURE 4
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
2020
Aggregate Price Level and the Money Supply in the United States, 1960–2020
From 1960 to 2020, the price level has increased more than sevenfold.
Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/M2SL; https://fred.stlouisfed.org/
series/GDPDEF
the price level, affects individuals, businesses, and the government. It is generally regarded
as an important problem to be solved and is often at the top of political and policymaking
agendas. To solve the inflation problem, we need to know something about its causes.
What explains inflation? One clue to answering this question is found in Figure 4,
which plots the money supply versus the price level. As we can see, the price level and
the money supply generally rise together. These data seem to indicate that a continuing
increase in the money supply might be an important factor in causing the continuing
increase in the price level that we call inflation.
Further evidence that inflation may be tied to continuing increases in the money
supply is found in Figure 5, which plots the average inflation rate (the rate of change
of the price level, usually measured as a percentage change per year) for a number of
countries over the ten-year period 2009–2019 against the average rate of money growth
over the same period. As you can see, a positive association exists between inflation and
the growth rate of the money supply: The countries with high money growth rates,
such as Russia and Turkey, tend to have higher inflation rates. By contrast, Japan and
the Euro area experienced low inflation rates over the same period, and their rates of
money growth were low. Such evidence led Milton Friedman, a Nobel laureate in economics, to make the famous statement, “Inflation is always and everywhere a monetary
phenomenon.”2 We look at the quantity of money and monetary policy’s role in creating
inflation in Chapters 20 and 24.
2
M01B_MISH9481_13_GE_C01.indd 57
Milton Friedman, Dollars and Deficits (Upper Saddle River, NJ: Prentice Hall, 1968), 39.
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58
P A R T 1 Introduction
Average Inflation Rate
(% annual rate)
10
South Africa
9
Turkey
8
Russia
7
Indonesia
6
Brazil
5
Mexico
4
3
United
Kingdom
United States
2
1
0
South Korea
Euro area
Canada
Japan
2
4
6
8
10
12
14
16
18
20
Average Money Growth Rate
(% annual rate)
FIGURE 5
Average Inflation Rate Versus Average Rate of Money Growth for Selected Countries,
2009–2019
A positive association can be seen between the ten-year averages of inflation and the growth rate of the
money supply: Countries with high money growth rates tend to have higher inflation rates.
Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/
Money and Interest Rates
In addition to other factors, money plays an important role in interest-rate fluctuations,
which are of great concern to businesses and consumers. Figure 6 shows changes in the
interest rate on long-term Treasury bonds and the rate of money growth from 1950 to
2020. As the money growth rate rose in the 1960s and 1970s, the long-term bond rate
rose with it. However, the relationship between money growth and interest rates has
been less clear-cut since 1980. We analyze the relationship between money growth and
interest rates when we examine the behavior of interest rates in Chapter 5.
Conduct of Monetary Policy
Because money affects many economic variables that are important to the well-being
of our economy, politicians and policymakers throughout the world care about the
conduct of monetary policy, the management of money and interest rates. The organization responsible for the conduct of a nation’s monetary policy is the central bank.
The United States’ central bank is the Federal Reserve System (also called simply
“the Fed”). In Chapters 14 through 17 (Part 4), we study how central banks such as
the Federal Reserve System can affect the quantity of money and interest rates in the
economy, and then we look at how monetary policy is actually conducted in the United
States and elsewhere.
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C H A P T E R 1 Why Study Money, Banking, and Financial Markets?
Real-time data
Interest
Rate (%)
22
Money Growth Rate
(% annual rate)
22
20
18
16
20
Money Growth Rate (M2 )
18
16
14
14
12
12
10
10
8
8
6
6
4
Interest Rate
4
2
2
0
0
22
22
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020
FIGURE 6
Money Growth (M2 Annual Rate) and Interest Rates (Long-Term U.S. Treasury Bonds),
1950–2020
As the money growth rate rose in the 1960s and 1970s, the long-term bond rate rose with it. However, the
relationship between money growth and interest rates has been less clear-cut since 1980.
Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/M2SL; https://fred.stlouisfed.org/
series/GS10
Fiscal Policy and Monetary Policy
Fiscal policy involves decisions about government spending and taxation. A budget
deficit is an excess of government expenditures with respect to tax revenues for a particular time period, typically a year, while a budget surplus arises when tax revenues
exceed government expenditures. The government must finance any budget deficit by
borrowing, whereas a budget surplus leads to a lower government debt burden. As
Figure 7 shows, the budget deficit, relative to the size of the U.S. economy, peaked in
1983 at 6% of national output (as calculated by the gross domestic product, or GDP,
a measure of aggregate output described in the appendix to this chapter). Since then,
the budget deficit at first declined to less than 3% of GDP, rose again to 5% of GDP by
the early 1990s, and fell subsequently, leading to budget surpluses from 1999 to 2001.
In the aftermath of the terrorist attacks of September 11, 2001, the war in Iraq that
began in March 2003, and the 2007–2009 financial crisis, the budget swung back into
deficit, with deficits at one point exceeding 10% of GDP and then falling substantially
thereafter. The budget deficit then rose starting in 2016 and shot up sharply when the
coronavirus pandemic hit the economy in 2020. What to do about budget deficits has
been the subject of legislation and the source of bitter battles between the president and
Congress in recent years.
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P A R T 1 Introduction
Percent of GDP
4
3
2
1
Surplus
0
1
2
3
4
Deficit
5
6
7
8
9
10
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020
FIGURE 7
Government Budget Surplus or Deficit as a Percentage of Gross Domestic Product,
1950–2019
The budget deficit, relative to the size of the U.S. economy, has fluctuated substantially over the years. It
rose to 6% of GDP in 1983 and then fell, eventually leading to budget surpluses from 1999 to 2001. Subsequently, budget deficits climbed, peaking at nearly 10% of GDP in 2009, fell substantially thereafter, and
then rose starting in 2016.
Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/FYFSGDA188S
You may have read statements in newspapers or heard on TV that budget surpluses
are a good thing, while deficits are undesirable. In Chapter 20, we examine why deficits
might result in a higher rate of money growth, a higher rate of inflation, and higher
interest rates.
1.4 WHY STUDY INTERNATIONAL FINANCE?
LO 1.4 Explain the importance of exchange rates in a global economy.
The globalization of financial markets has accelerated at a rapid pace in recent years.
Financial markets have become increasingly integrated throughout the world. American companies often borrow in foreign financial markets, and foreign companies borrow in U.S. financial markets. Banks and other financial institutions, such as JPMorgan
Chase, Citigroup, UBS, and Deutsche Bank, have become increasingly international,
with operations in many countries throughout the world. Part 5 of this book explores
the foreign exchange market and the international financial system.
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C H A P T E R 1 Why Study Money, Banking, and Financial Markets?
The Foreign Exchange Market
For funds to be transferred from one country to another, they have to be converted
from the currency of the country of origin (say, dollars) into the currency of the country they are going to (say, euros). The foreign exchange market is where this conversion takes place, so it is instrumental in moving funds between countries. It is also
important because it is where the foreign exchange rate, or the price of one country’s
currency in terms of another’s, is determined.
Figure 8 shows the exchange rate for the U.S. dollar from 1973 to 2020 (measured as the value of the U.S. dollar in terms of a basket of major foreign currencies).
The fluctuations in prices in this market have been substantial: The dollar’s value rose
slightly until 1976 and then reached a low point in the 1978–1980 period. From 1980
to early 1985, the dollar’s value appreciated dramatically and then declined again,
reaching another low in 1995. The dollar subsequently appreciated until 2002 and
then depreciated substantially from 2002 until 2011, with only a temporary upturn in
2008 and 2009. From 2011 until 2020, the dollar appreciated again to values near its
previous peak in 2002.
What have these fluctuations in the exchange rate meant to the American public
and businesses? A change in the exchange rate has a direct effect on American consumers because it affects the cost of imports. In 2001, when the euro was worth around
85 cents, 100 euros of European goods (say, French wine) cost $85. When the dollar
subsequently weakened, raising the cost of one euro to a peak of nearly $1.50, the
same 100 euros of wine now cost $150. Thus a weaker dollar leads to more expensive
foreign goods, makes vacationing abroad more expensive, and raises the cost of indulging your desire for imported delicacies. When the value of the dollar drops, Americans
decrease their purchases of foreign goods and increase their consumption of domestic
goods (such as travel within the United States or American-made wine).
Real-time data
Index
(March 1973 5 100)
150
135
120
105
90
75
1975
FIGURE 8
1980
1985
1990
1995
2000
2005
2010
2015
2020
Exchange Rate of the U.S. Dollar, 1973–2020
The value of the U.S. dollar relative to other currencies has fluctuated substantially over the years.
Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/TWEXM and https://fred.stlouisfed.
org/series/DTWEXBGS
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P A R T 1 Introduction
Conversely, a strong dollar means that U.S. goods exported abroad will cost more
in foreign countries, and hence foreigners will buy fewer of them. Exports of steel, for
example, declined when the dollar strengthened during the 1980–1985, 1995–2002,
and 2011–2020 periods. A strong dollar benefited American consumers by making foreign goods cheaper but hurt American businesses and eliminated some jobs by cutting
both domestic and foreign sales of the businesses’ products. The decline in the value of
the dollar from 1985 to 1995 and from 2002 to 2011 had the opposite effect: It made
foreign goods more expensive but made American businesses more competitive. Fluctuations in the foreign exchange markets have major consequences for the American
economy.
In Chapter 18, we study how exchange rates are determined in the foreign exchange
market, in which dollars are bought and sold for foreign currencies.
The International Financial System
The tremendous increase in capital flows among countries has heightened the international financial system’s impact on domestic economies. Issues we will explore in
Chapter 19 include:
• How does a country’s decision to fix its exchange rate to that of another nation
shape the conduct of monetary policy?
• What is the impact of capital controls that restrict mobility of capital across national
borders on domestic financial systems and the performance of the economy?
• What role should international financial institutions, such as the International
Monetary Fund, play in the international financial system?
1.5 MONEY, BANKING, AND FINANCIAL MARKETS AND
YOUR CAREER
LO 1.5 Explain how the study of money, banking, and financial markets may advance
your career.
Before taking this class, you might have asked yourself the practical question, “How
will the study of money, banking, and financial markets help my career?” For some of
you, the answer is straightforward. Financial institutions are among the largest employers in the country, and studying money, banking, and financial markets can help you
get a good job in the financial sector.
Even if your interests lie elsewhere, the study of money, banking, and financial
institutions can help advance your career because at many times in your life, as an
employee or the owner of a business, the critical thinking skills learned in this study
will improve your performance. For example, understanding monetary policy may help
you predict when interest rates will rise or fall, helping you to make decisions about
whether it is better to borrow now or to wait until later. Knowing how banks and
other financial institutions are managed may help you get a better deal when you need
to borrow from them or if you decide to supply them with funds. Knowledge of how
financial markets work may enable you to make better investment decisions, whether
for yourself or for the company you work for.
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C H A P T E R 1 Why Study Money, Banking, and Financial Markets?
63
1.6 HOW WE WILL STUDY MONEY, BANKING, AND
FINANCIAL MARKETS
LO 1.6 Describe how the text approaches the teaching of money, banking, and financial
markets.
This textbook stresses the “economic way of thinking” by developing a unifying framework in which you will study money, banking, and financial markets. This analytic
framework uses a few basic economic concepts to organize your thinking about the
determination of asset prices, the structure of financial markets, bank management,
and the role of money in the economy. It encompasses the following basic concepts:
• A simplified approach to the demand for assets
• The concept of equilibrium
• Basic supply and demand analysis to explain behavior of financial markets
• The search for profits
• An approach to financial structure based on transaction costs and asymmetric
information
• Aggregate supply and demand analysis
The unifying framework used in this book will keep your knowledge from becoming obsolete and make the material more interesting. It will enable you to learn what
really matters without having to memorize a mass of dull facts that you will forget soon
after the final exam. This framework will also provide you with the tools you need to
understand trends in the financial marketplace and in variables such as interest rates,
exchange rates, inflation, and aggregate output.
To help you understand and apply the unifying analytic framework, simple models
are constructed in which the variables held constant are carefully delineated. Each step
in the derivation of the model is clearly and carefully laid out, and the models are then
used to explain various phenomena by focusing on changes in one variable at a time,
holding all other variables constant.
To reinforce the models’ usefulness, this text uses case studies, applications, and
special-interest boxes to present evidence that supports or casts doubts on the theories
being discussed. This exposure to real-life events and empirical data should dissuade
you from thinking that all economists do is make abstract assumptions and develop
theories that have little to do with actual behavior.
To function better financially in the real world outside the classroom, you must
have the tools with which to follow the financial news that is reported in leading financial publications and on the Web. To help and encourage you to read the financial
news, this book contains special boxed inserts titled “Following the Financial News”
that provide detailed information and definitions to help you evaluate data that are discussed frequently in the media. This text also allows you to view the most current data
for a high percentage of the in-text data figures using the Federal Reserve Bank of St.
Louis’s FRED database. Figures for which you can do this are labeled Real-Time Data.
To master any field, you need to practice, practice, practice. To help you in this
endeavor, this book contains over 700 end-of-chapter questions and applied problems
that ask you to apply the analytic concepts you have learned to real-world issues. In
addition, at the end of almost every chapter there are several real-time data analysis problems, which ask you to download the most recent data from the Federal Reserve Bank of
St. Louis’s FRED database and then use these data to answer interesting questions.
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P A R T 1 Introduction
CONCLUDING REMARKS
The study of money, banking, and financial markets is an exciting field that directly affects
your life and career. Interest rates influence the earnings you make on your savings and the
payments on loans you may seek for a car or a house, and monetary policy may affect your
job prospects and the prices you will pay for goods in the future. Your study of money,
banking, and financial markets will introduce you to many of the controversies related
to economic policy that are hotly debated in the political arena and will help you gain a
clearer understanding of the economic phenomena you hear about in the news media. The
knowledge you gain will stay with you and benefit you long after this course is over.
SUMMARY
1. Activities in financial markets directly affect individuals’
wealth, the behavior of businesses, and the efficiency of
our economy. Three financial markets deserve particular attention: the bond market (where interest rates are
determined), the stock market (which has a major effect
on people’s wealth and on firms’ investment decisions),
and the foreign exchange market (because fluctuations
in the foreign exchange rate have major consequences
for the U.S. economy).
2. Banks and other financial institutions channel funds from
people who might not put them to productive use to people who can do so and thus play a crucial role in improving the efficiency of the economy. When the financial
system seizes up and produces a financial crisis, financial
firms fail, which causes severe damage to the economy.
3. Money and monetary policy appear to have a major
influence on inflation, business cycles, and interest rates.
Because these economic variables are so important to
the health of the economy, we need to understand how
monetary policy is and should be conducted. We also
need to study government fiscal policy because it can be
an influential factor in the conduct of monetary policy.
4. The study of money, banking, and financial markets
can help advance your career by helping you get a highpaying job in the financial sector, decide when you or
your firm should borrow, get a better deal from financial institutions, or make better investment decisions.
5. This textbook stresses the “economic way of thinking”
by developing a unifying analytic framework in which
to study money, banking, and financial markets, using
a few basic economic principles. The textbook also
emphasizes the interaction of theoretical analysis and
empirical data.
KEY TERMS
aggregate income, p. 67
aggregate output, p. 55
aggregate price level, p. 56
asset, p. 51
banks, p. 54
bond, p. 51
budget deficit, p. 59
budget surplus, p. 59
business cycles, p. 55
central bank, p. 58
common stock, p. 51
e-finance, p. 54
Federal Reserve System (the Fed), p. 58
financial crises, p. 55
financial innovation, p. 54
financial intermediaries, p. 54
financial markets, p. 50
fiscal policy, p. 59
foreign exchange market, p. 61
foreign exchange rate, p. 61
gross domestic product (GDP), p. 67
inflation, p. 56
inflation rate, p. 57
interest rate, p. 51
monetary policy, p. 58
monetary theory, p. 56
money (money supply), p. 55
recession, p. 55
security, p. 51
stock, p. 51
unemployment rate, p. 55
QUESTIONS
1. What is the typical relationship among interest rates on
three-month Treasury bills, long-term Treasury bonds,
and Baa corporate bonds?
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2. What effect does high volatility of financial markets
have on people’s willingness to spend?
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C H A P T E R 1 Why Study Money, Banking, and Financial Markets?
3. Explain the main difference between a bond and a common stock.
4. What is the main role of a financial intermediary? Name
two financial intermediaries.
5. What was the main cause of the global 2020 recession?
6. Can you think of a reason why people in general do
not lend money to one another to buy a house or a car?
How would your answer explain the existence of banks?
7. Why are banks important to the financial system?
8. Can you date the latest financial crisis in the United
States or in Europe? Are there reasons to think that
these crises might have been related? Why?
14. Germany is one of the few countries that has
­maintained a budget surplus in the last five years, and
according to Reuters, the federal government made a
record surplus of €13.5 billion in 2019. How does a
budget surplus arise?
15. How would a fall in the value of the pound sterling
affect British consumers?
16. How would an increase in the value of the pound sterling affect American businesses?
17. How can changes in foreign exchange rates affect the
profitability of financial institutions?
9. Has the inflation rate in the United States increased or
decreased in the past few years? What about interest rates?
18. According to Figure 8, in which years would you have
chosen to visit the Grand Canyon in Arizona rather
than the Tower of London?
10. If history repeats itself and we see a decline in the rate
of money growth, what might you expect to happen to
a. real output?
b. the inflation rate?
c. interest rates?
19. When the dollar is worth more in relation to currencies
of other countries, are you more likely to buy Americanmade or foreign-made jeans? Are U.S. companies that
manufacture jeans happier when the dollar is strong or
when it is weak? What about an American company that is
in the business of importing jeans into the United States?
11. When interest rates decrease, how might businesses and
consumers change their economic behavior?
12. Is everybody worse off when interest rates rise?
13. What is the main role of a central bank? Why are
central banks, like the European Central Bank (ECB),
important to financial analysts?
20. While much of the Japanese government debt is held
by domestic investors, some of it is also held by foreign
investors. How do the fluctuations in the Japanese yen
affect the value of that debt held by foreigners?
APPLIED PROBLEMS
21. The following table lists the foreign exchange between
euros (€) and British pounds (£) during October 2020.
Which day would have been the best for converting
Date
€/£
10/1/2020
1.086
10/2/2020
1.084
10/5/2020
€100 into British pounds? Which day would have
been the worst? What would the difference be in
pounds?
Date
€/£
0.92
10/16/2020
1.034
0.97
0.92
10/19/2020
1.033
0.97
1.081
0.93
10/20/2020
1.05
0.95
10/6/2020
1.07
0.93
10/21/2020
1.06
0.94
10/7/2020
1.051
0.95
10/22/2020
1.07
0.93
10/8/2020
1.042
0.96
10/23/2020
1.086
0.92
10/9/2020
1.04
0.96
10/26/2020
1.09
0.92
10/12/2020
1.038
0.96
10/27/2020
1.091
0.92
10/13/2020
1.037
0.96
10/28/2020
1.1
0.91
10/14/2020
1.036
0.97
10/29/2020
1.12
0.89
10/15/2020
1.035
0.97
10/30/2020
1.1
0.91
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P A R T 1 Introduction
DATA ANALYSIS PROBLEMS
The Problems update with real-time data in MyLab Economics
and are available for practice or instructor assignment.
1. Real-time Data Analysis Go to the St. Louis Federal
Reserve FRED database, and find data on the threemonth Treasury bill rate (TB3MS), the three-month
AA nonfinancial commercial paper rate (CPN3M), the
30-year Treasury bond rate (GS30), the 30-year conventional mortgage rate (MORTGAGE30US), and the
NBER recession indicators (USREC). For the mortgage
rate indicator, set the frequency to “monthly.”
a. In general, how do these interest rates
behave during recessions and during expansionary periods?
b. In general, how do the three-month rates
compare to the 30-year rates? How do the
Treasury rates compare to the respective
commercial paper and mortgage rates?
c. For the most recent available month of data,
take the average of each of the three-month
rates and compare it to the average of the
three-month rates from January 2000. How
do the averages compare?
d. For the most recent available month of data,
take the average of each of the 30-year rates
M01B_MISH9481_13_GE_C01.indd 66
and compare it to the average of the 30-year
rates from January 2000. How do the averages compare?
2. Real-time Data Analysis Go to the St. Louis Federal
Reserve FRED database, and find data on the M1 money
supply (M1SL) and the 10-year Treasury bond rate
(GS10). Add the two series into a single graph by using
the “Add Data Series” feature. Transform the M1 money
supply variable into the M1 growth rate by adjusting
the units for the M1 money supply to “Percent Change
from Year Ago.”
a. In general, how have the growth rate of the
M1 money supply and the 10-year Treasury
bond rate behaved during recessions and
during expansionary periods since the year
2000?
b. In general, is there an obvious, stable relationship between money growth and the
10-year interest rate since the year 2000?
c. Compare the money growth rate and the
10-year interest rate for the most recent
month available to the rates for January
2000. How do the rates compare?
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APPENDIX TO
CHAPTER
1
Defining Aggregate Output,
Income, the Price Level,
and the Inflation Rate
B
ecause these terms are used so frequently throughout the text, we need to have a
clear understanding of the definitions of aggregate output, income, the price level,
and the inflation rate.
AGGREGATE OUTPUT AND INCOME
The most commonly reported measure of aggregate output, the gross domestic product
(GDP), is the market value of all final goods and services produced in a country during the course of a year. This measure excludes two sets of items that at first glance you
might think it would include. Purchases of goods that have been produced in the past,
whether a Rembrandt painting or a house built 20 years ago, are not counted as part of
GDP; nor are purchases of stocks or bonds. Neither of these categories enters into the
GDP because these categories do not include goods and services produced during the
course of the year. Intermediate goods, which are used up in producing final goods and
services, such as the sugar in a candy bar or the energy used to produce steel, are also
not counted separately as part of the GDP. Because the value of the final goods already
includes the value of the intermediate goods, to count them separately would be to
count them twice.
Aggregate income, the total income of factors of production (land, labor, and capital) from producing goods and services in the economy during the course of the year, is
best thought of as being equal to aggregate output. Because the payments for final
goods and services must eventually flow back to the owners of the factors of production
as income, income payments must equal payments for final goods and services. For
example, if the economy has an aggregate output of $10 trillion, total income payments
in the economy (aggregate income) are also $10 trillion.
REAL VERSUS NOMINAL MAGNITUDES
When the total value of final goods and services is calculated using current prices, the
resulting GDP measure is referred to as nominal GDP. The word nominal indicates that
values are measured using current prices. If all prices doubled but actual production
of goods and services remained the same, nominal GDP would double, even though
people would not enjoy the benefits of twice as many goods and services. As a result,
nominal variables can be misleading measures of economic well-being.
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P A R T 1 Introduction
A more reliable measure of economic production expresses values in terms of prices
for an arbitrary base year, currently 2009. GDP measured with constant prices is
referred to as real GDP, the word real indicating that values are measured in terms of
fixed prices. Real variables thus measure the quantities of goods and services and do not
change because prices have changed, but rather only if actual quantities have changed.
A brief example will make the distinction clearer. Suppose that you have a nominal
income of $30,000 in 2022 and that your nominal income was $15,000 in 2012. If all
prices doubled between 2012 and 2022, are you better off? The answer is no: Although
your income has doubled, your $30,000 buys you only the same amount of goods because
prices have also doubled. A real income measure indicates that your income in terms of
the goods it can buy is the same. Measured in 2012 prices, the $30,000 of nominal income
in 2022 turns out to be only $15,000 of real income. Because your real income is actually
the same for the two years, you are no better or worse off in 2022 than you were in 2012.
Because real variables measure quantities in terms of real goods and services, they
are typically of more interest than nominal variables. In this text, discussion of aggregate output or aggregate income always refers to real measures (such as real GDP).
AGGREGATE PRICE LEVEL
In this chapter, we defined the aggregate price level as a measure of average prices
in the economy. Three measures of the aggregate price level are commonly encountered in economic data. The first is the GDP deflator, which is defined as nominal GDP
divided by real GDP. Thus, if 2022 nominal GDP is $10 trillion but 2022 real GDP in
2012 prices is $9 trillion,
GDP deflator =
$10 trillion
= 1.11
$9 trillion
The GDP deflator equation indicates that, on average, prices have risen 11% since
2012. Typically, measures of the price level are presented in the form of a price index,
which expresses the price level for the base year (in our example, 2012) as 100. Thus
the GDP deflator for 2022 would be 111.
Another popular measure of the aggregate price level (which officials in the Fed
frequently focus on) is the PCE deflator, which is similar to the GDP deflator and is
defined as nominal personal consumption expenditures (PCE) divided by real PCE.
The measure of the aggregate price level that is most frequently reported in the
press is the consumer price index (CPI). The CPI is measured by pricing a “basket” of
goods and services bought by a typical urban household. If, over the course of the year,
the cost of this basket of goods and services rises from $500 to $600, the CPI has risen
by 20%. The CPI is also expressed as a price index with the base year equal to 100.
The CPI, the PCE deflator, and the GDP deflator measures of the price level can be
used to convert or deflate a nominal magnitude into a real magnitude. This is accomplished
by dividing the nominal magnitude by the price index. In our example, in which the GDP
deflator for 2022 is 1.11 (expressed as an index value of 111), real GDP for 2022 equals
$10 trillion
= $9 trillion in 2012 prices
1.11
which corresponds to the real GDP figure for 2022 assumed earlier.
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C H A P T E R 1 Defining Aggregate Output, Income, the Price Level, and the Inflation Rate
69
GROWTH RATES AND THE INFLATION RATE
The media often talk about the economy’s growth rate, and particularly the growth rate
of real GDP. A growth rate is defined as the percentage change in a variable, that is,
growth rate of x =
xt - xt - 1
* 100
xt - 1
where t indicates today and t - 1 indicates a year earlier.
For example, if real GDP grew from $9 trillion in 2022 to $9.5 trillion in 2023,
then the GDP growth rate for 2023 would be 5.6%:
GDP growth rate =
$9.5 trillion - $9 trillion
* 100 = 5.6%
$9 trillion
The inflation rate is defined as the growth rate of the aggregate price level. Thus, if
the GDP deflator rose from 111 in 2022 to 113 in 2023, the inflation rate using the
GDP deflator would be 1.8%:
inflation rate =
113 - 111
* 100 = 1.8%
111
If the growth rate is for a period of less than one year, it is usually reported on an
annualized basis; that is, it is converted to the growth rate over a year’s time, assuming
that the growth rate remains constant. For GDP, which is reported quarterly, the annualized growth rate would be approximately four times the percentage change in GDP
from the previous quarter. For example, if GDP rose 12% from the first quarter of 2022
to the second quarter of 2022, then the annualized GDP growth rate for the second
quarter of 2022 would be reported as 2%( = 4 * 12%). (A more accurate calculation
would be 2.02%, because a precise quarterly growth rate should be compounded on a
quarterly basis.)
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2
Learning Objectives
2.1 Compare and
contrast direct and
indirect finance.
2.2 Identify the structure
and components of
financial markets.
2.3 List and describe the
different types of financial
market instruments.
2.4 Recognize the
international dimensions
of financial markets.
2.5 Summarize the roles
of transaction costs, risk
sharing, and information
costs as they relate to
financial intermediaries.
2.6 List and describe
the different types of
financial intermediaries.
2.7 Identify the reasons
for and list the types
of financial market
regulations.
An Overview of the
Financial System
Preview
I
nez the Inventor has designed a low-cost robot that cleans the house (even does the
windows!), washes the car, and mows the lawn, but she has no funds to put her
wonderful invention into production. Walter the Widower has plenty of savings,
which he and his wife accumulated over the years. If Inez and Walter could get together
so that Walter could provide funds to Inez, Inez’s robot would see the light of day, and
the economy would be better off: We would have cleaner houses, shinier cars, and
more beautiful lawns.
Financial markets (bond and stock markets) and financial intermediaries (such as
banks, insurance companies, and pension funds) serve the basic function of getting
people like Inez and Walter together so that funds can move from those who have a
surplus of funds (Walter) to those who have a shortage of funds (Inez). More realistically, when Apple invents a better iPad, it may need funds to bring its new product to
market. Similarly, when a local government needs to build a road or a school, it may
require more funds than local property taxes provide. Well-functioning financial markets and financial intermediaries are crucial to economic health.
To study the effects of financial markets and financial intermediaries on the
economy, we need to acquire an understanding of their general structure and operation. In this chapter, we learn about the major financial intermediaries and the
instruments that are traded in financial markets, as well as how these markets are
regulated.
This chapter presents an overview of the fascinating study of financial markets and
institutions. We return to a more detailed treatment of the regulation, structure, and
evolution of the financial system in Chapters 8 through 12.
2.1 FUNCTION OF FINANCIAL MARKETS
LO 2.1 Compare and contrast direct and indirect finance.
Financial markets perform the essential economic function of channeling funds from
households, firms, and governments that have saved surplus funds by spending less
than their income to those that have a shortage of funds because they wish to spend
more than their income. This function is shown schematically in Figure 1. Those who
have saved and are lending funds, the lender-savers, are at the left, and those who must
70
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C H A P T E R 2 An Overview of the Financial System
71
Mini-lecture
INDIRECT FINANCE
Financial
Intermediaries
FUNDS
FUNDS
FUNDS
Lender-Savers
1. Households
2. Business firms
3. Government
4. Foreigners
FUNDS
Financial
Markets
FUNDS
Borrower-Spenders
1. Business firms
2. Government
3. Households
4. Foreigners
DIRECT FINANCE
FIGURE 1
Flows of Funds Through the Financial System
The arrows show that funds flow from lender-savers to borrower-spenders via two routes: direct finance, in
which borrowers borrow funds directly from financial markets by selling securities, and indirect finance, in
which a financial intermediary borrows funds from lender-savers and then uses these funds to make loans
to borrower-spenders.
borrow funds to finance their spending, the borrower-spenders, are at the right. The
principal lender-savers are households, but business enterprises and the government
(particularly state and local government), as well as foreigners and their governments,
sometimes also find themselves with excess funds and so lend them out. The most
important borrower-spenders are businesses and the government (particularly the federal government), but households and foreigners also borrow to finance their purchases
of cars, furniture, and houses. The arrows show that funds flow from lender-savers to
borrower-spenders via two routes.
In direct finance (the route at the bottom of Figure 1), borrowers borrow funds
directly from lenders in financial markets by selling the lenders securities (also called
financial instruments), which are claims on the borrower’s future income or assets. Securities are assets for the person who buys them but liabilities (IOUs or debts) for the
individual or firm that sells (issues) them. For example, if Ford needs to borrow funds
to pay for a new factory to manufacture electric cars, it might borrow the funds from
savers by selling them a bond, a debt security that promises to make periodic payments
for a specified period of time, or a stock, a security that entitles the owner to a share of
the company’s profits and assets.
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