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

One of the best-selling textbook on money and banking.

Frederic S. Mishkin

850 Pages

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  • Frederic S. Mishkin   
  • 850 Pages   
  • 18 Feb 2015
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    Seventh Edition read more..

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    Abel/Bernanke Macroeconomics Bade/Parkin Foundations of Microeconomics Bade/Parkin Foundations of Macroeconomics Bierman/Fernandez Game Theory with Economic Applications Binger/Hoffman Microeconomics with Calculus Boyer Principles of Transportation Economics Branson Macroeconomic Theory and Policy Bruce Public Finance and the American Economy Byrns/Stone Economics Carlton/Perloff Modern Industrial Organization read more..

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    Frederic S. Mishkin Columbia University read more..

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    Editor in Chief: Denise Clinton Acquisitions Editor: Victoria Warneck Executive Development Manager: Sylvia Mallory Development Editor: Jane Tufts Production Supervisor: Meredith Gertz Text Design: Studio Montage Cover Design: Regina Hagen Kolenda and Studio Montage Composition: Argosy Publishing Senior Manufacturing Supervisor: Hugh Crawford Senior Marketing Manager: Barbara LeBuhn Cover images: © read more..

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    To Sally read more..

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    read more..

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    Introduction 1 1 Why Study Money, Banking, and Financial Markets? . . . . . . . . . . . . . . . . . . . .3 2 An Overview of the Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23 3 What Is Money? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . read more..

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    Monetary Theory 515 22 The Demand for Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .517 23 The Keynesian Framework and the ISLM Model . . . . . . . . . . . . . . . . . . . . . .536 24 Monetary and Fiscal Policy in the ISLM Model . . . . . . . . . . . . . . read more..

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    Introduction 1 CHAPTER 1 WHY STUDY MONEY, BANKING, AND FINANCIAL MARKETS? . . . . . . . . . . . . . . . . . 3 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Why Study Financial Markets? . . . . . . . . . . . read more..

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    CHAPTER 2 AN OVERVIEW OF THE FINANCIAL SYSTEM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23 Function of Financial Markets . . . . . . . read more..

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    Box 2 E-Finance: Why Are Scandinavians So Far Ahead of Americans in Using Electronic Payments? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .50 E-Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . read more..

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    Expected Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .86 Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . read more..

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    Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .125 Income Tax Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .125 Summary read more..

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    Following the Financial News Stock Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . .159 Box 1 Should You Hire an Ape as Your Investment Adviser? . . . . . . . . . . . . . . . .160 Should You Be Skeptical of Hot Tips? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . read more..

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    CHAPTER 9 BANKING AND THE MANAGEMENT OF FINANCIAL INSTITUTIONS . . . . . . . . . . . . 201 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .201 The Bank Balance Sheet . . . . . . . . . . . . . . . . . . . . . . read more..

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    Structure of the U.S. Commercial Banking Industry . . . . . . . . . . . . . . . . . . . . . . . .243 Restrictions on Branching . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .244 Response to Branching Restrictions . . . . . . . . . . . . . . . read more..

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    International Banking Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .272 Problems in Regulating International Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .272 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . read more..

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    Box 2 E-Finance: Mutual Funds and the Internet . . . . . . . . . . . . . . . . . . . . . . . . .298 Money Market Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .299 Hedge Funds . . . . . . . . . . . . . . . . . . . . . . . read more..

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    Factors Affecting the Prices of Option Premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .326 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .327 Interest-Rate Swaps . . . . . . read more..

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    Box 6 Inside the Fed: Federal Reserve Transparency . . . . . . . . . . . . . . . . . . . . . . .352 Should the Fed Be Independent? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .352 The Case for Independence . . . . . . . . . . . . . . . . . . . . . . . . . . read more..

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    Application The Great Depression Bank Panics, 1930–1933 . . . . . . . . . . . . . . . .387 Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .390 CHAPTER 17 TOOLS OF MONETARY POLICY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393 Preview . . . read more..

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    Fed Policy Procedures: Historical Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . .419 The Early Years: Discount Policy as the Primary Tool . . . . . . . . . . . . . . . . . . . . . . . . . . . .420 Discovery of Open Market Operations . . . . . . . . . . . . . . . . . . . . . . read more..

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    Application Changes in the Equilibrium Exchange Rate: Two Examples . . . . . .452 Changes in Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .452 Changes in the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . read more..

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    CHAPTER 21 MONETARY POLICY STRATEGY: THE INTERNATIONAL EXPERIENCE . . . . . . . . . . . 487 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .487 The Role of a Nominal Anchor . . . . . . . . . . . . . . . . . . . . read more..

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    Precautionary Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .527 Speculative Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .527 Friedman’s Modern read more..

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    CHAPTER 25 AGGREGATE DEMAND AND SUPPLY ANALYSIS . . . . . . . . . . . . . . . . . . . . . . . . . 582 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .582 Aggregate Demand . . . . . . . . . . . . . . . . read more..

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    Historical Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .615 Overview of the Monetarist Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .615 Box 3 Real Business Cycle Theory and the Debate read more..

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    CHAPTER 28 RATIONAL EXPECTATIONS: IMPLICATIONS FOR POLICY . . . . . . . . . . . . . . . . . . . 658 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .658 The Lucas Critique of Policy Evaluation . . . . . . . . . . . . read more..

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    I have continually strived to improve this textbook with each new edition, and the Seventh Edition of The Economics of Money, Banking, and Financial Markets is no exception. The text has undergone a major revision, but it retains the basic hall- marks that have made it the best-selling textbook on money and banking in the past six editions: • A unifying, analytic framework read more..

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    In light of continuing changes in financial markets and institutions, I have added the following new material to keep the text current: • Extensive discussion of recent corporate scandals and the collapse of Enron, including their impact on the economy (Chapters 6, 7, 11, and 26) • Discussion of the role of venture capitalists in the high-tech sector (Chapter 8) • read more..

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    has been as valuable as in the realm of money, banking, and financial markets. Data that were once difficult and tedious to collect are now readily available. To help stu- dents appreciate what they can access online, I have added a number of new features: 1. Web Exercises. This edition adds all-new end-of-chapter Web Exercises. These require that students collect information read more..

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    Chapter 15: The Fed’s Balance Sheet and the Monetary Base Chapter 16: The M2 Money Multiplier Chapter 16: Explaining the Behavior of the Currency Ratio Chapter 22: A Mathematical Treatment of the Baumol-Tobin and Tobin Mean Variance Model Chapter 22: Empirical Evidence on the Demand for Money Chapter 24: Algebra of the ISLM Model Chapter 25: Aggregate Supply and the Phillips read more..

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    • Financial Markets and Institutions Course: Chapters 1–13, with a choice of 6 of the remaining 15 chapters. • Monetary Theory and Policy Course: Chapters 1–5, 14, 15, 17, 18, 21, 25–28, with a choice of 5 of the remaining 14 chapters. Pedagogical Aids In teaching theory or its applications, a textbook must be a solid motivational tool. To this end, I have read more..

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    17. Marginal Web references point the student to Web sites that provide infor- mation or data that supplement the text material. 18. Glossary at the back of the book provides definitions of all the key terms. 19. Answers section at the back of the book provides solutions to half of the ques- tions and problems (marked by *). An Easier Way to Teach Money, Banking, and read more..

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    answers to questions and problems in the text. In addition, the manual contains my Lecture Notes, numbering more than 300, in transparency master format; these notes comprehensively outline the major points covered in the textbook. 2. Instructor’s Resource CD-ROM, which conveniently holds the MS Word files to the Instructor’s Manual, the Computerized Test Bank, and the MS read more..

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    well as access to a variety of scholarly journals and publications, a complete year of search for full-text articles from the New York Times, and a “Best of the Web” Link Library of peer-reviewed Web sites • eThemes of the Times—thematically related articles from the New York Times, accompanied by critical-thinking questions • Readings on Money, Banking, and Financial read more..

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    James L. Butkiewicz, University of Delaware Colleen M. Callahan, Lehigh University Ray Canterbery, Florida State University Sergio Castello, University of Mobile Jen-Chi Cheng, Wichita State University Patrick Crowley, Middlebury College Sarah E. Culver, University of Alabama, Birmingham Maria Davis, San Antonio College Ranjit S. Dighe, State University of New York, Oswego Richard Douglas, Bowling read more..

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    Cheryl McGaughey, Angelo 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 Clair Morris, U.S. Naval Academy Jon Nadenichek, California State University, Northridge John Nader, read more..

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    Pa r t I Introduction read more..

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    PREVIEW On the evening news you have just heard that the Federal Reserve is raising the fed- eral funds rate by 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 read more..

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    period of time.1 The bond market is especially important to economic activity because it enables corporations or governments to borrow to finance their activities and because it is where interest rates are determined. An interest rate is the cost of bor- rowing or the price paid for the rental of funds (usually expressed as a percentage of the rental of $100 per year). There read more..

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    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) cor- porate bonds is higher, on average, than the other interest rates, and the spread between it and the other rates became read more..

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    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 con- sumers 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 read more..

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    1995–2001 periods. A strong dollar benefited American consumers by making for- eign goods cheaper but hurt American businesses and eliminated some jobs by cut- ting both domestic and foreign sales of their products. The decline in the value of the dollar from 1985 to 1995 and 2001 to 2002 had the opposite effect: It made foreign goods more expensive, but made American read more..

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    complicated legal documents when they extend loans? Why are they the most heav- ily 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 are financial institutions that accept deposits and make loans. Included under the term banks read more..

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    to changes in economic variables that affect all of us and are important to the health of the economy. The final two parts of the book examine the role of money in the economy. In 1981–1982, 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 read more..

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    changes in money might also be a driving force behind business cycle fluctuations. However, not every decline in the rate of money growth is followed by a recession. We explore how money might affect aggregate output in Chapters 22 through 28, where we study monetary theory, the theory that relates changes in the quantity of money to changes in aggregate economic activity read more..

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    What explains inflation? One clue to answering this question is found in Figure 5, which plots the money supply and the price level. As we can see, the price level and the money supply generally move closely 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 read more..

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    In addition to other factors, money plays an important role in interest-rate fluctua- tions, which are of great concern to businesses and consumers. Figure 7 shows the changes in the interest rate on long-term Treasury bonds and the rate of money growth. As the money growth rate rose in the 1960s and 1970s, the long-term bond rate rose with it. However, the relationship read more..

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    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 over 5% by 1989, and fell subsequently, leading to budget surpluses from 1999 to 2001. In the aftermath of the terrorist attacks of September 11, 2001, the budget has swung back again into deficit. What to do about budget read more..

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    • 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 for- get read more..

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    A sample Web exercise has been included in this chapter. This is an especially important example, since it demonstrates how to export data from a web site into Microsoft® Excel for further analysis. We suggest you work through this problem on your own so that you will be able to perform this activity when prompted in subse- quent Web exercises. You have been hired by read more..

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    b. While you have located an accurate source of historical interest rate data, getting it onto a spreadsheet will be very tedious. You recall that Excel will let you convert text data into columns. Begin by highlighting the two columns of data (the year and rate). Right-click on the mouse and choose COPY . Now open Excel and put the cursor in a cell. Click PASTE . Now read more..

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    Concluding Remarks The topic of money, banking, and financial markets is an exciting field that directly affects your life—interest rates influence earnings on your savings and the payments on loans you may seek on a car or a house, and monetary policy may affect your job prospects and the prices of goods in the future. Your study of money, banking, and financial markets read more..

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    18 PA R T I Introduction Key Terms aggregate income (appendix), p. 20 aggregate output, p. 9 aggregate price level, p. 10 asset, p. 3 banks, p. 8 bond, p. 3 budget deficit, p. 12 budget surplus, p. 12 business cycles, p. 9 central bank, p. 12 common stock, p. 5 e-finance, p. 8 Federal Reserve System (the Fed), p. 12 financial intermediaries, p. 7 financial markets, p. 3 read more..

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    CHAPTER 1 Why Study Money, Banking, and Financial Markets? 19 *12. How does a fall in the value of the pound sterling affect British consumers? 13. How does an increase in the value of the pound ster- ling affect American businesses? *14. Looking at Figure 3, in what years would you have chosen to visit the Grand Canyon in Arizona rather than the Tower of London? 15. When read more..

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    20 Because 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 read more..

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    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. A more reliable measure of economic well-being expresses values in terms of prices for an arbitrary base year, currently 1996. GDP measured with constant prices is referred to as real GDP, the word real indicating that values read more..

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    in which the GDP deflator for 2004 is 1.11 (expressed as an index value of 111), real GDP for 2004 equals which corresponds to the real GDP figure for 2004 mentioned earlier. 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 read more..

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    PREVIEW Inez the Inventor has designed a low-cost robot that cleans house (even does win- dows), washes the car, and mows the lawn, but she has no funds to put her wonder- ful invention into production. Walter the Widower has plenty of savings, which he and his wife accumulated over the years. If we could get Inez and Walter together so that Walter could provide funds read more..

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    The most important borrower-spenders are businesses and the government (particu- larly 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 read more..

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    purchase a new tool that will shorten the time it takes him to build a house, thereby earning an extra $200 per year. If you could get in touch with Carl, you could lend him the $1,000 at a rental fee (interest) of $100 per year, and both of you would be better off. You would earn $100 per year on your $1,000, instead of the zero amount that you would earn read more..

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    dollar amounts at regular intervals (interest and principal payments) until a specified date (the maturity date), when a final payment is made. The maturity of a debt instrument is the number of years (term) until that instrument’s expiration date. A debt instrument is short-term if its maturity is less than a year and long-term if its maturity is ten years or longer. Debt read more..

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    issued the security acquires no new funds. A corporation acquires new funds only when its securities are first sold in the primary market. Nonetheless, secondary mar- kets serve two important functions. First, they make it easier and quicker to sell these financial instruments to raise cash; that is, they make the financial instruments more liquid. The increased liquidity of these read more..

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    held by financial intermediaries such as insurance companies and pension funds, which have little uncertainty about the amount of funds they will have available in the future.1 Internationalization of Financial Markets The growing internationalization of financial markets has become an important trend. Before the 1980s, U.S. financial markets were much larger than financial markets out- side read more..

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    Eurobond only if it is sold outside the countries that have adopted the euro. In fact, most Eurobonds are not denominated in euros but are instead denominated in U.S. dollars. Similarly, Eurodollars have nothing to do with euros, but are instead U.S. dollars deposited in banks outside the United States. Until recently, the U.S. stock market was by far the largest in the read more..

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    investment opportunity. You have the cash and would like to lend him the money, but to protect your investment, you have to hire a lawyer to write up the loan contract that specifies how much interest Carl will pay you, when he will make these interest payments, and when he will repay you the $1,000. Obtaining the contract will cost you $500. When you figure in this read more..

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    how to find a good lawyer to produce an airtight loan contract, and this contract can be used over and over again in its loan transactions, thus lowering the legal cost per transaction. Instead of a loan contract (which may not be all that well written) cost- ing $500, a bank can hire a topflight lawyer for $5,000 to draw up an airtight loan contract that can be read more..

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    Low transaction costs allow financial intermediaries to do risk sharing at low cost, enabling them to earn a profit on the spread between the returns they earn on risky assets and the payments they make on the assets they have sold. This process of risk sharing is also sometimes referred to as asset transformation, because in a sense, risky assets are turned into safer read more..

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    know your aunts well. You are more likely to lend to Aunt Sheila than to Aunt Louise because Aunt Sheila would be hounding you for the loan. Because of the possibility of adverse selection, you might decide not to lend to either of your aunts, even though there are times when Aunt Louise, who is an excellent credit risk, might need a loan for a worthwhile investment. read more..

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    equipped than individuals to screen out bad credit risks from good ones, thereby reducing losses due to adverse selection. In addition, financial intermediaries have high earnings because they develop expertise in monitoring the parties they lend to, thus reducing losses due to moral hazard. The result is that financial intermediaries can afford to pay lender-savers interest or provide read more..

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    tutions were constrained in their activities and mostly made mortgage loans for resi- dential housing. Over time, these restrictions have been loosened so that the distinction between these depository institutions and commercial banks has blurred. These inter- mediaries have become more alike and are now more competitive with each other. Credit Unions. These financial institutions, numbering read more..

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    out in benefits in the coming years, they do not have to worry as much as depository institutions about losing funds. As a result, the liquidity of assets is not as important a consideration for them as it is for depository institutions, and they tend to invest their funds primarily in long-term securities such as corporate bonds, stocks, and mortgages. Life Insurance read more..

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    Pension Funds and Government Retirement Funds. Private pension funds and state and local retirement funds provide retirement income in the form of annuities to employ- ees who are covered by a pension plan. Funds are acquired by contributions from employers or from employees, who either have a contribution automatically deducted from their paychecks or contribute voluntarily. The largest read more..

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    38 PA R T I Introduction Table 3 Principal Regulatory Agencies of the U.S. Financial System Regulatory Agency Securities and Exchange Commission (SEC) Commodities Futures Trading Commission (CFTC) Office of the Comptroller of the Currency National Credit Union Administration (NCUA) State banking and insurance commissions Federal Deposit Insurance Corporation (FDIC) Federal Reserve System Office of read more..

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    Asymmetric information in financial markets means that investors may be subject to adverse selection and moral hazard problems that may hinder the efficient operation of financial markets. Risky firms or outright crooks may be the most eager to sell secu- rities to unwary investors, and the resulting adverse selection problem may keep investors out of financial markets. Furthermore, read more..

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    intermediaries from holding certain risky assets, or at least from holding a greater quantity of these risky assets than is prudent. For example, commercial banks and other depository institutions are not allowed to hold common stock because stock prices experience substantial fluctuations. Insurance companies are allowed to hold common stock, but their holdings cannot exceed a certain read more..

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    and restricted them to certain geographic regions. (These restrictions were abolished by legislation in 1994.) U.S. banks are also the most restricted in the range of assets they may hold. Banks abroad frequently hold shares in commercial firms; in Japan and Germany, those stakes can be sizable. CHAPTER 2 An Overview of the Financial System 41 Summary 1. The basic function of read more..

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    42 PA R T I Introduction equities, p. 26 Eurobond, p. 28 Eurocurrencies, p. 28 Eurodollars, p. 28 exchanges, p. 27 financial intermediation, p. 29 financial panic, p. 39 foreign bonds, p. 28 intermediate-term, p. 26 investment bank, p. 26 liabilities, p. 24 liquid, p. 27 liquidity services, p. 31 long-term, p. 26 maturity, p. 26 money market, p. 27 moral hazard, p. 33 over-the-counter read more..

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    1. One of the single best sources of information about financial institutions is the U.S. Flow of Funds report produced by the Federal Reserve. This document con- tains data on most financial intermediaries. Go to Go to the most current release. You may have to load Acrobat Reader if your computer does not already have it. The site has a link read more..

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    Here we examine the securities (instruments) traded in financial markets. We first focus on the instruments traded in the money market and then turn to those traded in the capital market. Because of their short terms to maturity, the debt instruments traded in the money market undergo the least price fluctuations and so are the least risky investments. The money market has read more..

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    are an extremely important source of funds for commercial banks, from corporations, money market mutual funds, charitable institutions, and government agencies. Commercial Paper. Commercial paper is a short-term debt instrument issued by large banks and well-known corporations, such as General Motors and AT&T. Before the 1960s, corporations usually borrowed their short-term funds from banks, read more..

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    Repurchase Agreements. Repurchase agreements, or repos, are effectively short-term loans (usually with a maturity of less than two weeks) in which Treasury bills serve as collateral, an asset that the lender receives if the borrower does not pay back the loan. Repos are made as follows: A large corporation, such as General Motors, may have some idle funds in its bank account, read more..

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    to repurchase them the next week at a price slightly above GM’s purchase price. The effect of this agreement is that GM makes a loan of $1 million to the bank and holds $1 million of the bank’s Treasury bills until the bank repurchases the bills to pay off the loan. Repurchase agreements are a fairly recent innovation in financial markets, having been introduced in read more..

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    Stocks. Stocks are equity claims on the net income and assets of a corporation. Their value of $11 trillion at the end of 2002 exceeds that of any other type of security in the capital market. The amount of new stock issues in any given year is typically quite small—less than 1% of the total value of shares outstanding. Individuals hold around half of the value of read more..

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    Corporate Bonds. These are long-term bonds issued by corporations with very strong credit ratings. The typical corporate bond sends the holder an interest payment twice a year and pays off the face value when the bond matures. Some corporate bonds, called convertible bonds, have the additional feature of allowing the holder to convert them into a specified number of shares of read more..

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    44 PREVIEW If you had lived in America before the Revolutionary War, your money might have consisted primarily of Spanish doubloons (silver coins that were also called pieces of eight). Before the Civil War, the principal forms of money in the United States were not only gold and silver coins but also paper notes, called banknotes, issued by private banks. Today, you use read more..

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    To complicate matters further, the word money is frequently used synonymously with wealth. When people say, “Joe is rich—he has an awful lot of money,” they prob- ably mean that Joe has not only a lot of currency and a high balance in his checking account but has also stocks, bonds, four cars, three houses, and a yacht. Thus while “currency” is too narrow a read more..

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    Let’s see what happens if we introduce money into Ellen the Economics Professor’s world. Ellen can teach anyone who is willing to pay money to hear her lec- ture. She can then go to any farmer (or his representative at the supermarket) and buy the food she needs with the money she has been paid. The problem of the double coincidence of wants is avoided, and Ellen read more..

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    prices, the tag on each item would have to list up to 999 different prices, and the time spent reading them would result in very high transaction costs. The solution to the problem is to introduce money into the economy and have all prices quoted in terms of units of that money, enabling us to quote the price of eco- nomics lectures, peaches, and movies in terms of, read more..

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    on to money, and so the use of money to carry out transactions declined and barter became more and more dominant. Transaction costs skyrocketed, and as we would expect, output in the economy fell sharply. Evolution of the Payments System We can obtain a better picture of the functions of money and the forms it has taken over time by looking at the evolution of the read more..

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    take place without the need to carry around large amounts of currency. The introduc- tion of checks was a major innovation that improved the efficiency of the payments system. Frequently, payments made back and forth cancel each other; without checks, this would involve the movement of a lot of currency. With checks, payments that can- cel each other can be settled by read more..

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    frustrating. Second, all the paper shuffling required to process checks is costly; it is estimated that it currently costs over $10 billion per year to process all the checks written in the United States. The development of inexpensive computers and the spread of the Internet now make it cheap to pay bills electronically. In the past, you had to pay your bills by mailing a read more..

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    Electronic payments technology can not only substitute for checks, but can substitute for cash, as well, in the form of electronic money (or e-money), money that exists only in electronic form. The first form of e-money was the debit card. Debit cards, which look like credit cards, enable consumers to purchase goods and services by electronically transferring funds directly from read more..

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    supply, which are also referred to as monetary aggregates (see Table 1 and the Following the Financial News box). The narrowest measure of money that the Fed reports is M1, which includes cur- rency, checking account deposits, and traveler’s checks. These assets are clearly money, because they can be used directly as a medium of exchange. Until the mid- 1970s, only commercial read more..

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    The M3 monetary aggregate adds to M2 somewhat less liquid assets such as large- denomination time deposits and repurchase agreements, Eurodollars, and institu- tional money market mutual fund shares. Because we cannot be sure which of the monetary aggregates is the true measure of money, it is logical to wonder if their movements closely parallel one another. If they do, then read more..

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    54 PA R T I Introduction Source: Wall Street Journal, Friday, January 3, 2003, p. C10. FEDERAL RESER VE D A T A MONETARY AGGREGATES (daily average in billions) 1 Week Ended: Dec. 23 Dec. 16 Money supply (M1) sa . . . 1227.1 1210.1 Money supply (M1) nsa . . . 1256.0 1214.9 Money supply (M2) sa . . . 5822.7 5811.3 Money supply (M2) nsa . . . 5834.5 5853.9 Money read more..

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    was in the 6–7% range, and 1971, when it was at a similar level. In the same period, the M2 and M3 measures tell a different story; they show a marked acceleration from the 8–10% range to the 12–15% range. Similarly, while the growth rate of M1 actu- ally increased from 1989 to 1992, the growth rates of M2 and M3 in this same period instead showed a downward read more..

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    56 PA R T I Introduction Initial Revised Difference Period Rate Rate (Revised Rate – Initial Rate) January 2.2 5.4 3.2 February 6.8 8.7 1.9 March –1.4 0.2 1.6 April –4.0 –2.6 1.4 May 14.8 15.4 0.6 June 7.6 7.1 –0.5 July 13.6 11.0 –2.6 August 9.9 8.6 –1.3 September 5.1 5.7 0.6 October 10.9 8.3 –2.6 November 10.2 8.0 –2.2 December 2.8 2.8 0.0 Average 6.5 6.5 0.0 Source: Federal Reserve read more..

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    CHAPTER 3 What Is Money? 57 Substantial revisions in the data do occur; they indicate that initially released money data are not a reliable guide to short-run (say, month-to-month) movements in the money supply, although they are more reliable over longer periods of time, such as a year. Key Terms commodity money, p. 48 currency, p. 44 e-cash, p. 51 electronic money (e-money), p. read more..

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    *11. Suppose that a researcher discovers that a measure of the total amount of debt in the U.S. economy over the past 20 years was a better predictor of inflation and the business cycle than M1, M2, or M3. Does this dis- covery mean that we should define money as equal to the total amount of debt in the economy? 12. Look up the M1, M2, and M3 numbers in the read more..

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    Pa r t I I Financial Markets read more..

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    read more..

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    PREVIEW Interest rates are among the most closely watched variables in the economy. Their movements are reported almost daily by the news media, because they directly affect our everyday lives and have important consequences for the health of the economy. They affect personal decisions such as whether to consume or save, whether to buy a house, and whether to purchase bonds or read more..

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    savings account that earns interest and have more than a dollar in one year. Economists use a more formal definition, as explained in this section. Let’s look at the simplest kind of debt instrument, which we will call a simple loan. In this loan, the lender provides the borrower with an amount of funds (called the principal) that must be repaid to the lender at the read more..

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    today’s (present) value of $100 as PV, the future value of $133 as FV, and replacing 0.10 (the 10% interest rate) by i. This leads to the following formula: (1) Intuitively, what Equation 1 tells us is that if you are promised $1 for certain ten years from now, this dollar would not be as valuable to you as $1 is today because if you had the $1 today, you read more..

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    bond. Third is the bond’s coupon rate, the dollar amount of the yearly coupon pay- ment expressed as a percentage of the face value of the bond. In our example, the coupon bond has a yearly coupon payment of $100 and a face value of $1,000. The coupon rate is then $100/$1,000 0.10, or 10%. Capital market instruments such as U.S. Treasury bonds and notes and read more..

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    Study Guide The key to understanding the calculation of the yield to maturity is equating today’s value of the debt instrument with the present value of all of its future payments. The best way to learn this principle is to apply it to other specific examples of the four types of credit market instruments in addition to those we discuss here. See if you can develop read more..

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    value of the bond is calculated as the sum of the present values of all the coupon pay- ments plus the present value of the final payment of the face value of the bond. The present value of a $1,000-face-value bond with ten years to maturity and yearly coupon payments of $100 (a 10% coupon rate) can be calculated as follows: At the end of one year, there is a read more..

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    Three interesting facts are illustrated by Table 1: 1. When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate. 2. The price of a coupon bond and the yield to maturity are negatively related; that is, as the yield to maturity rises, the price of the bond falls. As the yield to matu- rity falls, the price of the bond rises. 3. read more..

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    where P = price of the consol C = yearly payment One nice feature of consols is that you can immediately see that as i goes up, the price of the bond falls. For example, if a consol pays $100 per year forever and the interest rate is 10%, its price will be $1,000 $100/0.10. If the interest rate rises to 20%, its price will fall to $500 $100/0.20. We can also read more..

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    increase in its price at maturity, and the yield to maturity falls from 11.1 to 5.3%. Similarly, a fall in the yield to maturity means that the price of the discount bond has risen. Summary. The concept of present value tells you that a dollar in the future is not as valuable to you as a dollar today because you can earn interest on this dollar. Specifically, a read more..

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    measures of interest rates have come into common use in bond markets. You will fre- quently encounter two of these measures—the current yield and the yield on a discount basis—when reading the newspaper, and it is important for you to understand what they mean and how they differ from the more accurate measure of interest rates, the yield to maturity. The current yield is read more..

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    Before the advent of calculators and computers, dealers in U.S. Treasury bills found it difficult to calculate interest rates as a yield to maturity. Instead, they quoted the inter- est rate on bills as a yield on a discount basis (or discount yield), and they still do so today. Formally, the yield on a discount basis is defined by the following formula: (8) where idb yield read more..

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    this understatement becomes. Even though the discount yield is a somewhat mis- leading measure of the interest rates, a change in the discount yield always indicates a change in the same direction for the yield to maturity. 72 PA R T I I Financial Markets Reading the Wall Street Journal: The Bond Page Application Now that we understand the different interest-rate definitions, read more..

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    CHAPTER 4 Understanding Interest Rates 73 Following the Financial News Bond prices and interest rates are published daily. In the Wall Street Journal, they can be found in the “NYSE/AMEX Bonds” and “Treasury/Agency Issues” section of the paper. Three basic formats for quoting bond prices and yields are illustrated here. Bond Prices and Interest Rates TREASURY BILLS GOVT. BONDS read more..

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    74 PA R T I I Financial Markets the yield to maturity. Our previous discussion provided us with some rules for deciding when the current yield is likely to be a good approximation and when it is not. T-bonds 3 and 4 mature in around 30 years, meaning that their char- acteristics are like those of a consol. The current yields should then be a good approximation of the read more..

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    The Distinction Between Interest Rates and Returns Many people think that the interest rate on a bond tells them all they need to know about how well off they are as a result of owning it. If Irving the Investor thinks he is better off when he owns a long-term bond yielding a 10% interest rate and the inter- est rate rises to 20%, he will have a rude awakening: read more..

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    Study Guide The concept of return discussed here is extremely important because it is used con- tinually throughout the book. Make sure that you understand how a return is calcu- lated and why it can differ from the interest rate. This understanding will make the material presented later in the book easier to follow. More generally, the return on a bond held from time t read more..

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    all these bonds rise from 10 to 20%. Several key findings in this table are generally true of all bonds: • The only bond whose return equals the initial yield to maturity is one whose time to maturity is the same as the holding period (see the last bond in Table 2). • A rise in interest rates is associated with a fall in bond prices, resulting in capital read more..

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    The finding that the prices of longer-maturity bonds respond more dramatically to changes in interest rates helps explain an important fact about the behavior of bond mar- kets: Prices and returns for long-term bonds are more volatile than those for shorter- term bonds. Price changes of 20% and 20% within a year, with corresponding variations in returns, are common for bonds read more..

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    The return on a bond, which tells you how good an investment it has been over the holding period, is equal to the yield to maturity in only one special case: when the holding period and the maturity of the bond are identical. Bonds whose term to maturity is longer than the holding period are subject to interest-rate risk: Changes in interest rates lead to capital gains read more..

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    twentieth century. The Fisher equation states that the nominal interest rate i equals the real interest rate ir plus the expected rate of inflation e:10 (11) Rearranging terms, we find that the real interest rate equals the nominal interest rate minus the expected inflation rate: (12) To see why this definition makes sense, let us first consider a situation in which you have read more..

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    ple will be affected by what is happening in credit markets. Figure 1, which presents estimates from 1953 to 2002 of the real and nominal interest rates on three-month U.S. Treasury bills, shows us that nominal and real rates often do not move together. (This is also true for nominal and real interest rates in the rest of the world.) In par- ticular, when nominal rates read more..

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    Until recently, real interest rates in the United States were not observable; only nominal rates were reported. This all changed when, in January 1997, the U.S. Treasury began to issue indexed bonds, whose interest and principal payments are adjusted for changes in the price level (see Box 3). 82 PA R T I I Financial Markets Box 3 With TIPS, Real Interest Rates Have Become read more..

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    CHAPTER 4 Understanding Interest Rates 83 measures are misleading guides to the size of the interest rate, a change in them always signals a change in the same direction for the yield to maturity. 3. The return on a security, which tells you how well you have done by holding this security over a stated period of time, can differ substantially from the interest rate as read more..

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    84 PA R T I I Financial Markets 10. Pick five U.S. Treasury bonds from the bond page of the newspaper, and calculate the current yield. Note when the current yield is a good approximation of the yield to maturity. *11. You are offered two bonds, a one-year U.S. Treasury bond with a yield to maturity of 9% and a one-year U.S. Treasury bill with a yield on a discount read more..

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    In our discussion of interest-rate risk, we saw that when interest rates change, a bond with a longer term to maturity has a larger change in its price and hence more interest- rate risk than a bond with a shorter term to maturity. Although this is a useful gen- eral fact, in order to measure interest-rate risk, the manager of a financial institution needs more precise read more..

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    Thus: g g 0.497 49.7% But as we have already calculated in Table 2 in Chapter 4, the capital gain on the 10% ten-year coupon bond is 40.3%. We see that interest-rate risk for the ten-year coupon bond is less than for the ten-year zero-coupon bond, so the effective maturity on the coupon bond (which measures interest-rate risk) is, as expected, shorter than the effective read more..

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    To get the effective maturity of the set of zero-coupon bonds, we add up the weighted maturities in column (5) and obtain the figure of 6.76 years. This figure for the effective maturity of the set of zero-coupon bonds is the duration of the 10% ten- year coupon bond because the bond is equivalent to this set of zero-coupon bonds. In short, we see that duration is read more..

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    You might think that knowing the maturity of a coupon bond is enough to tell you what its duration is. However, that is not the case. To see this and to give you more practice in calculating duration, in Table 2 we again calculate the duration for the ten-year 10% coupon bond, but when the current interest rate is 20%, rather than 10% as in Table 1. The read more..

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    Study Guide To make certain that you understand how to calculate duration, practice doing the calculations in Tables 1 and 2. Try to produce the tables for calculating duration in the case of an 11-year 10% coupon bond and also for the 10-year 20% coupon bond mentioned in the text when the current interest rate is 10%. Make sure your calcula- tions produce the same read more..

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    Now that we understand how duration is calculated, we want to see how it can be used by the practicing financial institution manager to measure interest-rate risk. Duration is a particularly useful concept, because it provides a good approximation, particularly when interest-rate changes are small, for how much the security price changes for a given change in interest rates, as read more..

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    where DUR duration 5.98 i change in interest rate 0.11 0.10 0.01 i current interest rate 0.10 Thus: % P 5.98 % P 0.054 5.4% The pension fund manager realizes that the interest-rate risk on the 20% coupon bond is less than on the 10% coupon, so he switches the fund out of the 10% coupon bond and into the 20% coupon bond. Examples 3 and 4 have led the read more..

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    PREVIEW In the early 1950s, nominal interest rates on three-month Treasury bills were about 1% at an annual rate; by 1981, they had reached over 15%, then fell to 3% in 1993, rose to above 5% by the mid-1990s, and fell below 2% in the early 2000s. What explains these substantial fluctuations in interest rates? One reason why we study money, banking, and financial markets read more..

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    whether to buy one asset rather than another, an individual must consider the fol- lowing factors: 1. Wealth, the total resources owned by the individual, including all assets 2. Expected return (the return expected over the next period) on one asset relative to alternative assets 3. Risk (the degree of uncertainty associated with the return) on one asset relative to alternative read more..

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    The degree of risk or uncertainty of an asset’s returns also affects the demand for the asset. Consider two assets, stock in Fly-by-Night Airlines and stock in Feet-on-the- Ground Bus Company. Suppose that Fly-by-Night stock has a return of 15% half the time and 5% the other half of the time, making its expected return 10%, while stock in Feet-on-the-Ground has a fixed read more..

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    assumption that all other economic variables are held constant is called ceteris paribus, which means “other things being equal” in Latin. To clarify our analysis, let us consider the demand for one-year discount bonds, which make no coupon payments but pay the owner the $1,000 face value in a year. If the holding period is one year, then as we have seen in Chapter read more..

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    price and interest rate are always negatively related: As the price of the bond rises, the interest rate on the bond necessarily falls. At a price of $900, the interest rate and expected return equals: Because the expected return on these bonds is higher, with all other economic vari- ables (such as income, expected returns on other assets, risk, and liquidity) held con- read more..

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    An important assumption behind the demand curve for bonds in Figure 1 is that all other economic variables besides the bond’s price and interest rate are held constant. We use the same assumption in deriving a supply curve, which shows the relation- ship between the quantity supplied and the price when all other economic variables are held constant. When the price of the read more..

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    bonds is eliminated by the price rising to the equilibrium level of $850 is there no fur- ther tendency for the price to rise. We can see that the concept of equilibrium price is a useful one because it indicates where the market will settle. Because each price on the left vertical axis of Figure 1 cor- responds to a value of the interest rate on the right read more..

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    supply curves. Because a firm supplying bonds is in fact taking out a loan from a per- son buying a bond, “supplying a bond” is equivalent to “demanding a loan.” Thus the supply curve for bonds can be reinterpreted as indicating the quantity of loans demanded for each value of the interest rate. If we rename the horizontal axis loanable funds, defined as the read more..

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    of bonds, the results are the same: The two ways of analyzing the determination of interest rates are equivalent. An important feature of the analysis here is that supply and demand are always in terms of stocks (amounts at a given point in time) of assets, not in terms of flows. This approach is somewhat different from certain loanable funds analyses, which are conducted read more..

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    94 PA R T I I Financial Markets Table 2 Factors That Shift the Demand Curve for Bonds SUMMARY Change in Change in Quantity Shift in Variable Variable Demanded Demand Curve Wealth ↑↑ Expected interest rate ↑↓ Expected inflation ↑↓ Riskiness of bonds ↑↓ relative to other assets Liquidity of bonds ↑↑ relative to other assets Note: P and i increase in opposite directions: P read more..

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    Wealth. When the economy is growing rapidly in a business cycle expansion and wealth is increasing, the quantity of bonds demanded at each bond price (or interest rate) increases as shown in Figure 3. To see how this works, consider point B on the initial demand curve for bonds Bd1. It tells us that at a bond price of $900 and an inter- est rate of 11.1%, the read more..

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    For bonds with maturities of greater than one year, the expected return may dif- fer from the interest rate. For example, we saw in Chapter 4, Table 2, that a rise in the interest rate on a long-term bond from 10 to 20% would lead to a sharp decline in price and a very negative return. Hence if people begin to think that interest rates will be higher next year read more..

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    abolished in 1975, for example, increased the liquidity of stocks relative to bonds, and the resulting lower demand for bonds shifted the demand curve to the left. Certain factors can cause the supply curve for bonds to shift, among them these: 1. Expected profitability of investment opportunities 2. Expected inflation 3. Government activities We will look at how the supply curve read more..

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    Expected Profitability of Investment Opportunities. The more profitable plant and equipment investments that a firm expects it can make, the more willing it will be to borrow in order to finance these investments. When the economy is growing rapidly, as in a business cycle expansion, investment opportunities that are expected to be profitable abound, and the quantity of bonds read more..

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    government surpluses, as occurred in the late 1990s, decrease the supply of bonds and shift the supply curve to the left. State and local governments and other government agencies also issue bonds to finance their expenditures, and this can also affect the supply of bonds. We will see in later chapters that the conduct of monetary policy involves the purchase and sale of read more..

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    100 PA R T I I Financial Markets FIGURE 5 Response to a Change in Expected Inflation When expected inflation rises, the supply curve shifts from Bs1 to Bs2 , and the demand curve shifts from Bd1 to Bd2. The equi- librium moves from point 1 to point 2, with the result that the equilibrium bond price (left axis) falls from P1 to P2 and the equilibrium interest rate (right read more..

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    CHAPTER 5 The Behavior of Interest Rates 101 FIGURE 6 Expected Inflation and Interest Rates (Three-Month Treasury Bills), 1953–2002 Source: Expected inflation calculated using procedures outlined in Frederic S. Mishkin, “The Real Interest Rate: An Empirical Investigation,” Carnegie-Rochester Conference Series on Public Policy 15 (1981): 151–200. These procedures involve estimating expected read more..

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    102 PA R T I I Financial Markets Expansion in the economy will also affect the demand for bonds. As the business cycle expands, wealth is likely to increase, and then the theory of asset demand tells us that the demand for bonds will rise as well. We see this in Figure 7, where the demand curve has shifted to the right, from Bd1 to Bd2. Given that both the read more..

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    CHAPTER 5 The Behavior of Interest Rates 103 Explaining Low Japanese Interest Rates Application In the 1990s and early 2000s, Japanese interest rates became the lowest in the world. Indeed, in November 1998, an extraordinary event occurred: Interest rates on Japanese six-month Treasury bills turned slightly negative (see Chapter 4). Why did Japanese rates drop to such low levels? In read more..

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    104 PA R T I I Financial Markets The column describes how the coming announcement of the Bush stimu- lus package, which was larger than expected, has led to a decline in the prices of Treasury bonds. This is exactly what our supply and demand analysis pre- dicts would happen. The larger than expected stimulus package has raised concerns about ris- ing future issuance of read more..

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    Supply and Demand in the Market for Money: The Liquidity Preference Framework Whereas the loanable funds framework determines the equilibrium interest rate using the supply of and demand for bonds, an alternative model developed by John Maynard Keynes, known as the liquidity preference framework, determines the equilibrium interest rate in terms of the supply of and demand for money. read more..

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    or no interest), he assumed that money has a zero rate of return. Bonds, the only alter- native asset to money in Keynes’s framework, have an expected return equal to the interest rate i.5 As this interest rate rises (holding everything else unchanged), the expected return on money falls relative to the expected return on bonds, and as the theory of asset demand tells read more..

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    money Ms in the figure is a vertical line at $300 billion. The equilibrium where the quantity of money demanded equals the quantity of money supplied occurs at the intersection of the supply and demand curves at point C, where Md Ms (4) The resulting equilibrium interest rate is at i* 15%. We can again see that there is a tendency to approach this equilibrium by first read more..

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    expands and income rises, people will want to carry out more transactions using money, with the result that they will also want to hold more money. The conclusion is that a higher level of income causes the demand for money to increase and the demand curve to shift to the right. Price-Level Effect. Keynes took the view that people care about the amount of money they hold read more..

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    CHAPTER 5 The Behavior of Interest Rates 109 An increase in the money supply due to expansionary monetary policy by the Federal Reserve implies that the supply curve for money shifts to the right. As is shown in Figure 11 by the movement of the supply curve from Ms1 to Ms2, the equilibrium moves from point 1 down to point 2, where the Ms2 sup- ply curve intersects read more..

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    110 PA R T I I Financial Markets FIGURE 10 Response to a Change in Income or the Price Level In a business cycle expansion, when income is rising, or when the price level rises, the demand curve shifts from Md1 to Md2. The supply curve is fixed at Ms . The equilibrium interest rate rises from i1 to i2. M FIGURE 11 Response to a Change in the Money Supply When the read more..

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    CHAPTER 5 The Behavior of Interest Rates 111 Following the Financial News Forecasting interest rates is a time-honored profes- sion. Economists are hired (sometimes at very high salaries) to forecast interest rates, because businesses need to know what the rates will be in order to plan their future spending, and banks and investors require interest-rate forecasts in order to decide read more..

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    112 PA R T I I Financial Markets Money and Interest Rates Application The liquidity preference analysis in Figure 11 seems to lead to the conclusion that an increase in the money supply will lower interest rates. This conclu- sion has important policy implications because it has frequently caused politicians to call for a more rapid growth of the money supply in order to read more..

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    CHAPTER 5 The Behavior of Interest Rates 113 remaining equal) lowers interest rates—the liquidity effect. However, he views the liquidity effect as merely part of the story: An increase in the money sup- ply might not leave “everything else equal” and will have other effects on the economy that may make interest rates rise. If these effects are substantial, it is entirely read more..

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    114 PA R T I I Financial Markets reversed. We thus see that in contrast to the price-level effect, which reaches its greatest impact next year, the expected-inflation effect will have its small- est impact (zero impact) next year. The basic difference between the two effects, then, is that the price-level effect remains even after prices have stopped rising, whereas the read more..

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    CHAPTER 5 The Behavior of Interest Rates 115 FIGURE 12 Response Over Time to an Increase in Money Supply Growth Liquidity Effect Income, Price-Level, and Expected- Inflation Effects ( a ) Liquidity effect larger than other effects Time i 1 i 2 T Liquidity Effect Income, Price-Level, and Expected- Inflation Effects ( b ) Liquidity effect smaller than other read more..

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    116 PA R T I I Financial Markets FIGURE 13 Money Growth (M2, Annual Rate) and Interest Rates (Three-Month Treasury Bills), 1950–2002 Sources: Federal Reserve: 0 2 4 6 8 10 12 14 16 18 22 20 Money Growth Rate (M2) Interest Rate Interest Rate (%) Money Growth Rate (% annual rate) 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 1950 2 4 6 8 10 read more..

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    CHAPTER 5 The Behavior of Interest Rates 117 Summary 1. The theory of asset demand tells us that the quantity demanded of an asset is (a) positively related to wealth, (b ) positively related to the expected return on the asset relative to alternative assets, (c) negatively related to the riskiness of the asset relative to alternative assets, and (d) positively related to the read more..

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    118 PA R T I I Financial Markets Key Terms asset market approach, p. 93 demand curve, p. 87 expected return, p. 86 excess demand, p. 90 excess supply, p. 90 Fisher effect, p. 100 liquidity, p. 86 liquidity preference framework, p. 105 loanable funds, p. 92 loanable funds framework, p. 92 market equilibrium, p. 90 opportunity cost, p. 106 risk, p. 86 supply curve, p. 90 theory read more..

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    CHAPTER 5 The Behavior of Interest Rates 119 *11. How might a sudden increase in people’s expectations of future real estate prices affect interest rates? 12. Explain what effect a large federal deficit might have on interest rates. *13. Using both the supply and demand for bonds and liq- uidity preference frameworks, show what the effect is on interest rates when the read more..

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    In Chapter 4, we saw that the return on an asset (such as a bond) measures how much we gain from holding that asset. When we make a decision to buy an asset, we are influenced by what we expect the return on that asset to be and its risk. Here we show how to calculate expected return and risk, which is measured by the standard deviation. Expected Return If a read more..

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    p2 probability of occurrence return 2 .33 R2 return in state 2 8% 0.08 Thus: Re (0.67)(0.12) (0.33)(0.08) 0.1068 10.68% The degree of risk or uncertainty of an asset’s returns also affects the demand for the asset. Consider two assets, stock in Fly-by-Night Airlines and stock in Feet-on-the- Ground Bus Company. Suppose that Fly-by-Night stock has a return of 15% half of the read more..

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    Thus: 0.05 5% Feet-on-the-Ground Bus Company has a standard deviation of returns of 0%. Re p1R1 where p1 probability of occurrence of return 1 1.0 R1 return in state 1 10% 0.10 Re expected return (1.0)(0.10) 0.10 Thus: Clearly, Fly-by-Night Airlines is a riskier stock, because its standard deviation of returns of 5% is higher than the zero standard deviation of returns read more..

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    Times Products stock. When the economy is strong, Frivolous Luxuries stock has a return of 15%, while Bad Times Products has a return of 5%. The result is that Irving earns a return of 10% (the average of 5% and 15%) on his holdings of the two stocks. When the economy is weak, Frivolous Luxuries has a return of only 5% and Bad Times Products has a return of 15%, read more..

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    Diversification and Beta In the previous section, we demonstrated the benefits of diversification. Here, we examine diversification and the relationship between risk and returns in more detail. As a result, we obtain an understanding of two basic theories of asset pricing: the cap- ital asset pricing model (CAPM) and arbitrage pricing theory (APT). We start our analysis by read more..

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    value of the portfolio, and the more asset i contributes to portfolio risk. Our algebraic manipulations have thus led to the following important conclusion: The marginal contribution of an asset to the risk of a portfolio depends not on the risk of the asset in isolation, but rather on the sensitivity of that asset’s return to changes in the value of the portfolio. If read more..

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    the beta of an asset is 1.0, it’s return on average increases by 1 percentage point when the market return increases by 1 percentage point; when the beta is 2.0, the asset’s return increases by 2 percentage points when the market return increases by 1 per- centage point; and when the beta is 0.5, the asset’s return only increases by 0.5 per- centage point on read more..

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    where the average of the i’s the average of the i’s If the portfolio is well diversified so that the i’s are uncorrelated with each other, then using this fact and the fact that all the i’s are uncorrelated with the market return, the variance of the portfolio’s return is calculated as: (average varience of i) As n gets large the second term, (1/n)(average read more..

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    return on the risk-free loan, you should also be able to verify, using Equation 5, that the standard deviation of the return on the new portfolio is halfway between zero and m, that is, (1/2) m. The standard deviation-expected return combination for this new portfolio is marked as point B in the figure, and as you can see it lies on the line between point A and point read more..

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    which is just the market portfolio. The assumption that all investors have the same assessment of risk and return for all assets thus means that portfolio M is the market portfolio.Therefore, the Rm and m in Figure 1 are identical to the market return, Rm, and the standard deviation of this return, m, referred to earlier in this appendix. The conclusion that the market read more..

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    To see that securities should be priced so that their expected return-beta combi- nation should lie on the security market line, consider a security like S in Figure 2, which is below the security market line. If an investor makes an investment in which half is put into the market portfolio and half into a risk-free loan, then the beta of this investment will be 0.5, read more..

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    This asset pricing equation indicates that all the securities should have the same mar- ket price for the risk contributed by each factor. If the expected return for a security were above the amount indicated by the APT pricing equation, then it would provide a higher expected return than a portfolio of other securities with the same average sensitivity to each factor. Hence read more..

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    Both models of interest-rate determination in Chapter 4 make use of an asset market approach in which supply and demand are always considered in terms of stocks of assets (amounts at a given point in time). The asset market approach is useful in understand- ing not only why interest rates fluctuate but also how any asset’s price is determined. One asset that has fascinated read more..

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    appreciation in the price of gold over the coming year. The result is that a lower price of gold today implies a higher expected capital gain over the coming year and hence a higher expected return: Re (Pet 1 Pt)/Pt. Thus because the price of gold today (which for simplicity we will denote as P) is lower, the expected return on gold is higher, and the quantity demanded read more..

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    equilibrium, the amount of gold supplied exceeds the amount demanded, and this condition of excess supply leads to a decline in the gold price until it reaches P1, the equilibrium price. Similarly, if the price is below P1, there is excess demand for gold, which drives the price upward until it settles at the equilibrium price P1. Changes in the Equilibrium Price of Gold read more..

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    Applying the Asset Market Approach to a Commodity Market: The Case of Gold Changes in the Equilibrium Price of Gold Due to a Rise in Expected Inflation Application To illustrate how changes in the equilibrium price of gold occur when sup- ply and demand curves shift, let’s look at what happens when there is a change in expected inflation. Suppose that expected inflation is read more..

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    120 PREVIEW In our supply and demand analysis of interest-rate behavior in Chapter 5, we exam- ined the determination of just one interest rate. Yet we saw earlier that there are enor- mous numbers of bonds on which the interest rates can and do differ. In this chapter, we complete the interest-rate picture by examining the relationship of the various interest rates to one read more..

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    to suspend interest payments on its bonds.1 The default risk on its bonds would therefore be quite high. By contrast, U.S. Treasury bonds have usually been consid- ered to have no default risk because the federal government can always increase taxes to pay off its obligations. Bonds like these with no default risk are called default-free bonds. (However, during the budget read more..

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    Study Guide Two exercises will help you gain a better understanding of the risk structure: 1. Put yourself in the shoes of an investor—see how your purchase decision would be affected by changes in risk and liquidity. 2. Practice drawing the appropriate shifts in the supply and demand curves when risk and liquidity change. For example, see if you can draw the appropriate read more..

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    declines. The Treasury bonds thus become more desirable, and demand rises, as shown in panel (b) by the rightward shift in the demand curve for these bonds from D T 1 to D T 2. As we can see in Figure 2, the equilibrium price for corporate bonds (left axis) falls from P c 1 to P c 2, and since the bond price is negatively related to the interest rate, the read more..

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    ratings below Baa (or BBB) have higher default risk and have been aptly dubbed speculative-grade or junk bonds. Because these bonds always have higher interest rates than investment-grade securities, they are also referred to as high-yield bonds. Next let’s look back at Figure 1 and see if we can explain the relationship between interest rates on corporate and U.S. Treasury read more..

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    Another attribute of a bond that influences its interest rate is its liquidity. As we learned in Chapter 4, a liquid asset is one that can be quickly and cheaply converted into cash if the need arises. The more liquid an asset is, the more desirable it is (hold- ing everything else constant). U.S. Treasury bonds are the most liquid of all long-term bonds, because they read more..

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    after taxes, so you are willing to hold the riskier and less liquid municipal bond even though it has a lower interest rate than the U.S. Treasury bond. (This was not true before World War II, when the tax-exempt status of municipal bonds did not convey much of an advantage because income tax rates were extremely low.) Another way of understanding why municipal bonds have read more..

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    The risk structure of interest rates (the relationship among interest rates on bonds with the same maturity) is explained by three factors: default risk, liquidity, and the income tax treatment of the bond’s interest payments. As a bond’s default risk increases, the risk premium on that bond (the spread between its interest rate and the interest rate on a default-free Treasury read more..

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    upward slopes of the yield curve as in the “Following the Financial News” box but sometimes other shapes? Besides explaining why yield curves take on different shapes at different times, a good theory of the term structure of interest rates must explain the following three important empirical facts: 1. As we see in Figure 4, interest rates on bonds of different maturities read more..

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    groundwork for the liquidity premium theory. Second, it is important to see how economists modify theories to improve them when they find that the predicted results are inconsistent with the empirical evidence. The expectations theory of the term structure states the following commonsense proposition: The interest rate on a long-term bond will equal an average of short-term interest read more..

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    To see how the assumption that bonds with different maturities are perfect sub- stitutes leads to the expectations theory, let us consider the following two investment strategies: 1. Purchase a one-year bond, and when it matures in one year, purchase another one-year bond. 2. Purchase a two-year bond and hold it until maturity. Because both strategies must have the same expected read more..

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    Solving for i2t in terms of the one-period rates, we have: (1) which tells us that the two-period rate must equal the average of the two one-period rates. Graphically, this can be shown as: We can conduct the same steps for bonds with a longer maturity so that we can exam- ine the whole term structure of interest rates. Doing so, we will find that the interest rate read more..

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    expected to be below the current short-term rate, implying that short-term interest rates are expected to fall, on average, in the future. Only when the yield curve is flat does the expectations theory suggest that short-term interest rates are not expected to change, on average, in the future. The expectations theory also explains fact 1 that interest rates on bonds with dif- read more..

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    if they match the maturity of the bond to the desired holding period, they can obtain a certain return with no risk at all.5 (We have seen in Chapter 4 that if the term to maturity equals the holding period, the return is known for certain because it equals the yield exactly, and there is no interest-rate risk.) For example, people who have a short holding period read more..

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    where lnt the liquidity (term) premium for the n-period bond at time t, which is always positive and rises with the term to maturity of the bond, n. Closely related to the liquidity premium theory is the preferred habitat theory, which takes a somewhat less direct approach to modifying the expectations hypothe- sis but comes up with a similar conclusion. It assumes that read more..

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    while for the five-year bond it would be: Doing a similar calculation for the one-, three-, and four-year interest rates, you should be able to verify that the one- to five-year interest rates are 5.0, 5.75, 6.5, 7.25, and 8.0%, respectively. Comparing these findings with those for the expectations the- ory, we see that the liquidity premium and preferred habitat theories read more..

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    In the 1980s, researchers examining the term structure of interest rates questioned whether the slope of the yield curve provides information about movements of future short-term interest rates.6 They found that the spread between long- and short-term interest rates does not always help predict future short-term interest rates, a finding that may stem from substantial fluctuations in read more..

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    but is unreliable at predicting movements in interest rates over the intermediate term (the time in between).7 The liquidity premium and preferred habitat theories are the most widely accepted theories of the term structure of interest rates because they explain the major empir- ical facts about the term structure so well. They combine the features of both the expectations theory read more..

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    138 PA R T I I Financial Markets The steep upward-sloping yield curves on March 28, 1985, and January 23, 2003, indicated that short-term interest rates would climb in the future. The long-term interest rate is above the short-term interest rate when short- term interest rates are expected to rise because their average plus the liquid- ity premium will be above the current read more..

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    CHAPTER 6 The Risk and Term Structure of Interest Rates 139 2. Four theories of the term structure provide explanations of how interest rates on bonds with different terms to maturity are related. The expectations theory views long-term interest rates as equaling the average of future short-term interest rates expected to occur over the life of the bond; by contrast, the segmented read more..

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    *8. If a yield curve looks like the one shown in figure (a) in this section, what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the mar- ket’s predictions about the inflation rate in the future? 9. If a yield curve looks like the one shown in (b), what is the market predicting about the read more..

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    PREVIEW Rarely does a day go by that the stock market isn’t a major news item. We have wit- nessed huge swings in the stock market in recent years. The 1990s were an extraor- dinary decade for stocks: the Dow Jones and S&P 500 indexes increased more than 400%, while the tech-laden NASDAQ index rose more than 1,000%. By early 2000, both indexes had reached record read more..

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    claims against the firm’s assets have been satisfied. Stockholders are paid dividends from the net earnings of the corporation. Dividends are payments made periodically, usually every quarter, to stockholders. The board of directors of the firm sets the level of the dividend, usually upon the recommendation of management. In addition, the stockholder has the right to sell the stock. read more..

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    Based on your analysis, you find that the present value of all cash flows from the stock is $53.71. Because the stock is currently priced at $50 per share, you would choose to buy it. However, you should be aware that the stock may be selling for less than $53.71, because other investors place a different risk on the cash flows or esti- mate the cash flows to be read more..

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    Equation 4 has been simplified using algebra to obtain Equation 5.1 (5) This model is useful for finding the value of stock, given a few assumptions: 1. Dividends are assumed to continue growing at a constant rate forever. Actually, as long as they are expected to grow at a constant rate for an extended period of time, the model should yield reasonable results. This is read more..

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    bid your top price of $5,000. He counters with $5,100. The price is now higher than you are willing to pay, so you stop bidding. The car is sold to the more informed buyer for $5,100. This simple example raises a number of points. First, the price is set by the buyer willing to pay the highest price. The price is not necessarily the highest price the asset could read more..

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    146 PA R T I I Financial Markets Monetary Policy and Stock Prices Application Stock market analysts tend to hang on every word that the Chairman of the Federal Reserve utters because they know that an important determinant of stock prices is monetary policy. But how does monetary policy affect stock prices? The Gordon growth model in Equation 5 tells us how. Monetary policy read more..

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    The Theory of Rational Expectations The analysis of stock price evaluation we have outlined in the previous section depends on people’s expectations—especially of cash flows. Indeed, it is difficult to think of any sector in the economy in which expectations are not crucial; this is why it is important to examine how expectations are formed. We do so by outlining the read more..

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    his trip. Sometimes it takes him 35 minutes, other times 25 minutes, but the average non-rush-hour driving time is 30 minutes. If, however, Joe leaves for work during the rush hour, it takes him, on average, an additional 10 minutes to get to work. Given that he leaves for work during the rush hour, the best guess of the driving time—the optimal forecast—is 40 minutes. read more..

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    for the optimal forecast of X using all available information (the best guess possible of his driving time), the theory of rational expectations then simply says: Xe Xof (6) That is, the expectation of X equals the optimal forecast using all available information. Why do people try to make their expectations match their best possible guess of the future using all available read more..

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    2. The forecast errors of expectations will on average be zero and cannot be predicted ahead of time. The forecast error of an expectation is X X e, the difference between the realization of a variable X and the expectation of the variable; that is, if Joe Commuter’s driving time on a particular day is 45 minutes and his expectation of the driving time is 40 read more..

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    period, Pt 1. 5 Denoting the expectation of the security’s price at the end of the hold- ing period as P e t 1, the expected return Re is: The efficient market hypothesis also views expectations of future prices as equal to optimal forecasts using all currently available information. In other words, the mar- ket’s expectations of future securities prices are rational, so read more..

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    Pt is lower than the optimal forecast of tomorrow’s price P t of 1 so that the optimal fore- cast of the return at an annual rate is 50%, which is greater than the equilibrium return of 10%. We are now able to predict that, on average, Exxon’s return would be abnormally high. This situation is called an unexploited profit opportunity because, on average, people read more..

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    Evidence on the Efficient Market Hypothesis Early evidence on the efficient market hypothesis was quite favorable to it, but in recent years, deeper analysis of the evidence suggests that the hypothesis may not always be entirely correct. Let’s first look at the earlier evidence in favor of the hypoth- esis and then examine some of the more recent evidence that casts some read more..

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    Do Stock Prices Reflect Publicly Available Information? The efficient market hypothesis predicts that stock prices will reflect all publicly available information. Thus if infor- mation is already publicly available, a positive announcement about a company will not, on average, raise the price of its stock because this information is already reflected in the stock price. Early empirical read more..

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    generally confirmed the efficient market view that stock prices are not predictable and follow a random walk.9 Technical Analysis. A popular technique used to predict stock prices, called technical analysis, is to study past stock price data and search for patterns such as trends and regular cycles. Rules for when to buy and sell stocks are then established on the basis of the read more..

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    All the early evidence supporting the efficient market hypothesis appeared to be over- whelming, causing Eugene Fama, a prominent financial economist, to state in his famous 1970 survey of the empirical evidence on the efficient market hypothesis, “The evidence in support of the efficient markets model is extensive, and (somewhat uniquely in economics) contradictory evidence is read more..

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    tax issues. Investors have an incentive to sell stocks before the end of the year in December, because they can then take capital losses on their tax return and reduce their tax liability. Then when the new year starts in January, they can repurchase the stocks, driving up their prices and producing abnormally high returns. Although this explanation seems sensible, it does read more..

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    War II and so have raised doubts about whether it is currently an important phenom- enon. The evidence on mean reversion remains controversial.18 New Information Is Not Always Immediately Incorporated into Stock Prices. Although it is generally found that stock prices adjust rapidly to new information, as is suggested by the efficient market hypothesis, recent evidence suggests that, read more..

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    CHAPTER 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 159 The efficient market hypothesis tells us that when purchasing a security, we cannot expect to earn an abnormally high return, a return greater than the equilibrium return. Information in newspapers and in the published reports of investment advisers is readily available to many read more..

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    The following story, reported in the press, illustrates why such anecdotal evi- dence is not reliable. A get-rich-quick artist invented a clever scam. Every week, he wrote two letters. In letter A, he would pick team A to win a particular football game, and in letter B, he would pick the opponent, team B. A mailing list would then be separated into two groups, and he read more..

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    have gotten this information before you, the answer is no. As soon as the information hits the street, the unexploited profit opportunity it creates will be quickly eliminated. The stock’s price will already reflect the information, and you should expect to realize only the equilibrium return. But if you are one of the first to gain the new information, it can do you read more..

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    Evidence on Rational Expectations in Other Markets Evidence in other financial markets also supports the efficient market hypothesis and hence the rationality of expectations. For example, there is little evidence that finan- cial analysts are able to outperform the bond market.21 The returns on bonds appear to conform to the efficient markets condition of Equation 10. Rationality of read more..

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    they watch. They may say they watch ballet on public television, but we know they are actually watching Vanna White light up the letters on Wheel of Fortune instead, because it, not ballet, gets high Nielsen ratings. How many people will admit to being regular watchers of Wheel of Fortune? A second problem with survey evidence is that a market’s behavior may not be read more..

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    164 PA R T I I Financial Markets market fundamentals, this does not mean that rational expectations do not hold. As long as stock market crashes are unpredictable, the basic lessons of the theory of rational expectations hold. Some economists have come up with theories of what they call rational bubbles to explain stock market crashes. A bubble is a situation in which the read more..

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    CHAPTER 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 165 buy-and-hold strategy—purchase stocks and hold them for long periods of time. Empirical evidence generally supports these implications of the efficient market hypothesis in the stock market. 6. The stock market crash of 1987 and the tech crash of 2000 have convinced many financial read more..

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    166 PA R T I I Financial Markets 9. “If stock prices did not follow a random walk, there would be unexploited profit opportunities in the mar- ket.” Is this statement true, false, or uncertain? Explain your answer. *10. Suppose that increases in the money supply lead to a rise in stock prices. Does this mean that when you see that the money supply has had a sharp read more..

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    P a r t III Financial Institutions read more..

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    read more..

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    PREVIEW A healthy and vibrant economy requires a financial system that moves funds from people who save to people who have productive investment opportunities. But how does the financial system make sure that your hard-earned savings get channeled to Paula the Productive Investor rather than to Benny the Bum? This chapter answers that question by providing an economic analysis of read more..

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    Now let us explore the eight puzzles. 1. Stocks are not the most important source of external financing for busi- nesses. Because so much attention in the media is focused on the stock market, many people have the impression that stocks are the most important sources of financing for American corporations. However, as we can see from the pie chart in Figure 1, the stock read more..

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    we see in Figure 2, other countries have a much smaller share of external financing supplied by marketable securities than the United States. Why don’t businesses use marketable securities more extensively to finance their activities? 3. Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses read more..

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    businesses throughout the world are loans (55.3% in the United States). Most of these loans are bank loans, so the data suggest that banks have the most important role in financing business activities. An extraordinary fact that surprises most people is that in an average year in the United States, more than four times more funds are raised with bank loans than with stocks. read more..

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    Transaction Costs Transaction costs are a major problem in financial markets. An example will make this clear. Say you have $5,000 you would like to invest, and you think about investing in the stock market. Because you have only $5,000, you can buy only a small number of shares. The stockbroker tells you that your purchase is so small that the brokerage commission for read more..

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    Economies of scale are also important in lowering the costs of things such as computer technology that financial institutions need to accomplish their tasks. Once a large mutual fund has invested a lot of money in setting up a telecommunications system, for example, the system can be used for a huge number of transactions at a low cost per transaction. Expertise. Financial read more..

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    The analysis of how asymmetric information problems affect economic behavior is called agency theory. We will apply this theory here to explain why financial struc- ture takes the form it does, thereby solving the puzzles described at the beginning of the chapter. The Lemons Problem: How Adverse Selection Influences Financial Structure A particular characterization of the adverse read more..

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    in the used-car market, this securities market will not work very well because few firms will sell securities in it to raise capital. The analysis is similar if Irving considers purchasing a corporate debt instrument in the bond market rather than an equity share. Irving will buy a bond only if its inter- est rate is high enough to compensate him for the average default read more..

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    mation. If many other investors act as Irving does, the increased demand for the undervalued good securities will cause their low price to be bid up immediately to reflect the securities’ true value. Because of all these free riders, you can no longer buy the securities for less than their true value. Now because you will not gain any prof- its from purchasing the read more..

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    An important feature of the used-car market is that most used cars are not sold directly by one individual to another. An individual considering buying a used car might pay for privately produced information by subscribing to a magazine like Consumer Reports to find out if a particular make of car has a good repair record. Nevertheless, reading Consumer Reports does not solve read more..

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    form of a guarantee: either a guarantee that is explicit, such as a warranty, or an implicit guarantee in which they stand by their reputation for honesty. People are more likely to purchase a used car because of a dealer’s guarantee, and the dealer is able to make a profit on the production of information about automobile quality by being able to sell the used car read more..

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    funds, a view that is known as the pecking order hypothesis. This hypothesis is sup- ported in the data, and is described in puzzle 6. Collateral and Net Worth. Adverse selection interferes with the functioning of finan- cial markets only if a lender suffers a loss when a borrower is unable to make loan payments and thereby defaults. Collateral, property promised to the read more..

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    rity. Moral hazard has important consequences for whether a firm finds it easier to raise funds with debt than with equity contracts. Equity contracts, such as common stock, are claims to a share in the profits and assets of a business. Equity contracts are subject to a particular type of moral hazard called the principal–agent problem. When managers own only a small read more..

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    and avoidance of unproductive investments would yield him a profit (and extra income) of $50,000, an amount that would make it worth his while to be a good manager. Production of Information: Monitoring. You have seen that the principal–agent problem arises because managers have more information about their activities and actual profits than stockholders do. One way for stockholders read more..

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    the moral hazard problem. Venture capital firms have been important in the develop- ment of the high-tech sector in the United States, which has resulted in job creation, economic growth, and increased international competitiveness. However, these firms have made mistakes, as Box 2 indicates. Debt Contracts. Moral hazard arises with an equity contract, which is a claim on profits in read more..

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    The advantage of a less frequent need to monitor the firm, and thus a lower cost of state verification, helps explain why debt contracts are used more frequently than equity contracts to raise capital. The concept of moral hazard thus helps explain puz- zle 1, why stocks are not the most important source of financing for businesses.4 How Moral Hazard Influences Financial read more..

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    and is more likely to invest in the ice-cream store, which is more of a sure thing. Hence when Steve has more of his own money (net worth) in the business, you are more likely to make him the loan. One way of describing the solution that high net worth provides to the moral haz- ard problem is to say that it makes the debt contract incentive-compatible; that is, read more..

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    We now see why debt contracts are often complicated legal documents with numerous restrictions on the borrower’s behavior (puzzle 8): Debt contracts require complicated restrictive covenants to lower moral hazard. Financial Intermediation. Although restrictive covenants help reduce the moral haz- ard problem, they do not eliminate it completely. It is almost impossible to write covenants read more..

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    CHAPTER 8 An Economic Analysis of Financial Structure 187 Table 1 Asymmetric Information Problems and Tools to Solve Them SUMMARY Explains Asymmetric Information Problem Tools to Solve It Puzzle No. Adverse Selection Private Production and Sale of Information 1, 2 Government Regulation to Increase Information 5 Financial Intermediation 3, 4, 6 Collateral and Net Worth 7 Moral Hazard in Equity read more..

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    188 P A R T III Financial Institutions effective use of these two tools. In these countries, bankruptcy procedures are often extremely slow and cumbersome. For example, in many countries, cred- itors (holders of debt) must first sue the defaulting debtor for payment, which can take several years, and then, once a favorable judgment has been obtained, the creditor has to sue read more..

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    Financial Crises and Aggregate Economic Activity Agency theory, our economic analysis of the effects of adverse selection and moral hazard, can help us understand financial crises, major disruptions in financial mar- kets that are characterized by sharp declines in asset prices and the failures of many financial and nonfinancial firms. Financial crises have been common in most coun- read more..

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    problems in financial markets and provoke a financial crisis. A decline in the stock market means that the net worth of corporations has fallen, because share prices are the valuation of a corporation’s net worth. The decline in net worth as a result of a stock market decline makes lenders less willing to lend because, as we have seen, the net worth of a firm plays a read more..

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    Problems in the Banking Sector. Banks play a major role in financial markets because they are well positioned to engage in information-producing activities that facilitate productive investment for the economy. The state of banks’ balance sheets has an important effect on bank lending. If banks suffer a deterioration in their balance sheets and so have a substantial contraction in read more..

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    192 P A R T III Financial Institutions Study Guide To understand fully what took place in a U.S. financial crisis, make sure that you can state the reasons why each of the factors—increases in interest rates, increases in uncertainty, asset market effects on balance sheets, and problems in the banking sector—increases adverse selection and moral hazard prob- lems, which in read more..

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    CHAPTER 8 An Economic Analysis of Financial Structure 193 the adverse selection and moral hazard problems continued to increase so that lending, investment spending, and aggregate economic activity remained depressed for a long time. The most significant financial crisis that included debt deflation was the Great Depression, the worst economic contraction in U.S. history (see Box 3). FIGURE read more..

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    194 P A R T III Financial Institutions Box 3 Case Study of a Financial Crisis The Great Depression. Federal Reserve officials viewed the stock market boom of 1928 and 1929, dur- ing which stock prices doubled, as excessive specula- tion. To curb it, they pursued a tight monetary policy to raise interest rates. The Fed got more than it bargained for when the stock market read more..

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    CHAPTER 8 An Economic Analysis of Financial Structure 195 analysis of financial crises to explain this puzzle and to understand the Mexican, East Asian, and Argentine financial situations.7 Because of the different institutional features of emerging-market coun- tries’ debt markets, the sequence of events in the Mexican, East Asian, and Argentine crises is different from that occurring read more..

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    196 P A R T III Financial Institutions Increase in Interest Rates Increase in Uncertainty Deterioration in Banks’ Balance Sheets Fiscal Imbalances Stock Market Decline Banking Crisis Foreign Exchange Crisis Economic Activity Declines Economic Activity Declines Adverse Selection and Moral Hazard Problems Worsen Adverse Selection and Moral Hazard Problems Worsen Adverse Selection and Moral Hazard Problems read more..

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    CHAPTER 8 An Economic Analysis of Financial Structure 197 South Korea, and Argentina. (The stock market declines in Malaysia, Indonesia, and the Philippines, on the other hand, occurred simultaneously with the onset of the crisis.) The Mexican economy was hit by political shocks in 1994 (specifically, the assassination of the ruling party’s presiden- tial candidate and an uprising in read more..

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    198 P A R T III Financial Institutions The collapse of currencies also led to a rise in actual and expected inflation in these countries, and market interest rates rose sky-high (to around 100% in Mexico and Argentina). The resulting increase in interest payments caused reductions in households’ and firms’ cash flow, which led to further deterioration in their balance sheets. read more..

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    CHAPTER 8 An Economic Analysis of Financial Structure 199 Summary 1. There are eight basic puzzles about our financial structure. The first four emphasize the importance of financial intermediaries and the relative unimportance of securities markets for the financing of corporations; the fifth recognizes that financial markets are among the most heavily regulated sectors of the economy; the read more..

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    200 P A R T III Financial Institutions Questions and Problems Questions marked with an asterisk are answered at the end of the book in an appendix, “Answers to Selected Questions and Problems.” 1. How can economies of scale help explain the existence of financial intermediaries? *2. Describe two ways in which financial intermediaries help lower transaction costs in the economy. read more..

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    PREVIEW Because banking plays such a major role in channeling funds to borrowers with pro- ductive investment opportunities, this financial activity is important in ensuring that the financial system and the economy run smoothly and efficiently. In the United States, banks (depository institutions) supply more than $5 trillion in credit annually. They provide loans to businesses, help us read more..

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    on which checks can be drawn: non-interest-bearing checking accounts (demand deposits), interest-bearing NOW (negotiable order of withdrawal) accounts, and money market deposit accounts (MMDAs). Introduced with the Depository Institutions Act in 1982, MMDAs have features similar to those of money market mutual funds and are included in the checkable deposits category. However, MMDAs differ read more..

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    the bank is obligated to pay, checkable deposits are a liability for the bank. They are usually the lowest-cost source of bank funds because depositors are willing to forgo some interest in order to have access to a liquid asset that can be used to make pur- chases. The bank’s costs of maintaining checkable deposits include interest payments and the costs incurred in read more..

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    Bank Capital. The final category on the liabilities side of the balance sheet is bank capital, the bank’s net worth, which equals the difference between total assets and lia- bilities (7% of total bank assets in Table 1). The funds are raised by selling new equity (stock) or from retained earnings. Bank capital is a cushion against a drop in the value of its assets, read more..

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    hold their securities. State and local government and other securities are less mar- ketable (hence less liquid) and are also riskier than U.S. government securities, pri- marily because of default risk: There is some possibility that the issuer of the securities may not be able to make its interest payments or pay back the face value of the secu- rities when they mature. read more..

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    initial balance sheet position. Let’s say that Jane Brown has heard that the First National Bank provides excellent service, so she opens a checking account with a $100 bill. She now has a $100 checkable deposit at the bank, which shows up as a $100 liability on the bank’s balance sheet. The bank now puts her $100 bill into its vault so that the bank’s assets read more..

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    The process initiated by Jane Brown can be summarized as follows: When a check written on an account at one bank is deposited in another, the bank receiving the deposit gains reserves equal to the amount of the check, while the bank on which the check is written sees its reserves fall by the same amount. Therefore, when a bank receives additional deposits, it gains an read more..

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    with higher interest rates. As mentioned earlier, this process of asset transformation is frequently described by saying that banks are in the business of “borrowing short and lending long.” For example, if the loans have an interest rate of 10% per year, the bank earns $9 in income from its loans over the year. If the $100 of checkable deposits is in a NOW account read more..

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    The bank loses $10 million of deposits and $10 million of reserves, but since its required reserves are now 10% of only $90 million ($9 million), its reserves still exceed this amount by $1 million. In short, if a bank has ample reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet. The situation is quite different when a bank holds read more..

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    The cost of this activity is the interest rate on these borrowings, such as the federal funds rate. A second alternative is for the bank to sell some of its securities to help cover the deposit outflow. For example, it might sell $9 million of its securities and deposit the proceeds with the Fed, resulting in the following balance sheet: The bank incurs some brokerage read more..

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    loans outstanding fairly quickly by calling in loans—that is, by not renewing some loans when they come due. Unfortunately for the bank, this is likely to antagonize the customers whose loans are not being renewed because they have not done anything to deserve such treatment. Indeed, they are likely to take their business elsewhere in the future, a very costly consequence for read more..

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    customers. Banks that have not sufficiently sought the benefits of diversification often come to regret it later. For example, banks that had overspecialized in making loans to energy companies, real estate developers, or farmers suffered huge losses in the 1980s with the slump in energy, property, and farm prices. Indeed, many of these banks went broke because they had “put too read more..

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    manage both sides of the balance sheet together in a so-called asset–liability manage- ment (ALM) committee. The emphasis on liability management explains some of the important changes over the past three decades in the composition of banks’ balance sheets. While nego- tiable CDs and bank borrowings have greatly increased in importance as a source of bank funds in recent years read more..

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    The High Capital Bank takes the $5 million loss in stride because its initial cush- ion of $10 million in capital means that it still has a positive net worth (bank capital) of $5 million after the loss. The Low Capital Bank, however, is in big trouble. Now the value of its assets has fallen below its liabilities, and its net worth is now $1 mil- lion. Because the read more..

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    Low Capital Bank, by contrast, has only $4 million of equity, so its equity multiplier is higher, equaling 25 ( $100 million/$4 million). Suppose that these banks have been equally well run so that they both have the same return on assets, 1%. The return on equity for the High Capital Bank equals 1% 10 10%, while the return on equity for the Low Capital Bank equals 1% read more..

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    216 P A R T III Financial Institutions stockholders, you decide to pursue the second alternative and raise the div- idend on the First National Bank stock. Now suppose that the First National Bank is in a similar situation to the Low Capital Bank and has a ratio of bank capital to assets of 4%. You now worry that the bank is short on capital relative to assets read more..

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    Managing Credit Risk As seen in the earlier discussion of general principles of asset management, banks and also other financial institutions must make successful loans that are paid back in full (and so subject the institution to little credit risk) in order to earn high profits. The economic concepts of adverse selection and moral hazard (introduced in Chapters 2 and 8) provide read more..

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    account repayments; the number of years you’ve worked and who your employers have been. You also are asked personal questions such as your age, marital status, and number of children. The lender uses this information to evaluate how good a credit risk you are by calculating your “credit score,” a statistical measure derived from your answers that predicts whether you are read more..

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    savings accounts tell the banker how liquid the potential borrower is and at what time of year the borrower has a strong need for cash. A review of the checks the borrower has written reveals the borrower’s suppliers. If the borrower has borrowed previously from the bank, the bank has a record of the loan payments. Thus long-term customer relationships reduce the costs read more..

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    Besides serving as collateral, compensating balances help increase the likelihood that a loan will be paid off. They do this by helping the bank monitor the borrower and consequently reduce moral hazard. Specifically, by requiring the borrower to use a checking account at the bank, the bank can observe the firm’s check payment prac- tices, which may yield a great deal of read more..

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    interest rates. To see what interest-rate risk is all about, let’s again take a look at the First National Bank, which has the following balance sheet: A total of $20 million of its assets are rate-sensitive, with interest rates that change frequently (at least once a year), and $80 million of its assets are fixed-rate, with inter- est rates that remain unchanged for a read more..

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    concept of duration, which measures the average lifetime of a security’s stream of pay- ments.4 Duration is a useful concept because it provides a good approximation of the sensitivity of a security’s market value to a change in its interest rate: percent change in market value of security percentage-point change in interest rate duration in years where denotes read more..

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    Off-Balance-Sheet Activities Although asset and liability management has traditionally been the major concern of banks, in the more competitive environment of recent years banks have been aggres- sively seeking out profits by engaging in off-balance-sheet activities.5 Off-balance- sheet activities involve trading financial instruments and generating income from fees and loan sales, activities that read more..

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    to make interest and principal payments if the party issuing the security cannot), and providing backup lines of credit. There are several types of backup lines of credit. We have already mentioned the most important, the loan commitment, under which for a fee the bank agrees to provide a loan at the customer’s request, up to a given dollar amount, over a specified read more..

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    CHAPTER 9 Banking and the Management of Financial Institutions 225 Box 1: Global Barings, Daiwa, Sumitomo, and Allied Irish Rogue Traders and the Principal –Agent Problem. The demise of Barings, a venerable British bank over a century old, is a sad morality tale of how the principal– agent problem operating through a rogue trader can take a financial institution that has a read more..

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    maximum loss that its portfolio is likely to sustain over a given time interval, dubbed the value at risk, or VAR. For example, a bank might estimate that the maximum loss it would be likely to sustain over one day with a probability of 1 in 100 is $1 million; the $1 million figure is the bank’s calculated value at risk. Another approach is called “stress read more..

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    CHAPTER 9 Banking and the Management of Financial Institutions 227 Key Terms asset management, p. 208 balance sheet, p. 201 capital adequacy management, p. 208 compensating balance, p. 219 credit rationing, p. 220 credit risk, p. 208 deposit outflows, p. 208 discount loans, p. 203 discount rate, p. 210 duration analysis, p. 221 equity multiplier (EM), p. 214 excess reserves, p. 204 gap read more..

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    228 P A R T III Financial Institutions 11. Why is being nosy a desirable trait for a banker? *12. A bank almost always insists that the firms it lends to keep compensating balances at the bank. Why? 13. “Because diversification is a desirable strategy for avoiding risk, it never makes sense for a bank to spe- cialize in making specific types of loans.” Is this state- read more..

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    An alternative method for measuring interest-rate risk, called duration gap analysis, examines the sensitivity of the market value of the financial institution’s net worth to changes in interest rates. Duration analysis is based on Macaulay’s concept of duration, which measures the average lifetime of a security’s stream of payments (described in the appendix to Chapter 4). Recall read more..

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    assets and adding them up, the bank manager gets a figure for the average duration of the assets of 2.70 years. The manager follows a similar procedure for the liabilities, noting that total lia- bilities excluding capital are $95 million. For example, the weighted duration for checkable deposits is determined by multiplying the 2.0-year duration by $15 million divided by $95 read more..

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    EXAMPLE 1: Duration Gap Analysis The bank manager wants to know what happens when interest rates rise from 10% to 11%. The total asset value is $100 million, and the total liability value is $95 million. Use Equation 1 to calculate the change in the market value of the assets and liabilities. Solution With a total asset value of $100 million, the market value of assets read more..

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    EXAMPLE 2: Duration Gap Analysis Based on the information provided in Example 1, use Equation 2 to determine the dura- tion gap for First National Bank. Solution The duration gap for First National Bank is 1.72 years: DURgap DURa where DURa average duration of assets 2.70 L market value of liabilities 95 A market value of assets 100 DURl average duration of read more..

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    With assets totaling $100 million, Example 3 indicates a fall in the market value of net worth of $1.6 million, which is the same figure that we found in Example 1. As our examples make clear, both income gap analysis and duration gap analysis indicate that the First National Bank will suffer from a rise in interest rates. Indeed, in this example, we have seen that a read more..

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    $50 million of consumer loans with maturities of less than one year, for a total of $55 million of rate-sensitive assets. The manager then calculates the rate-sensitive liabili- ties to be equal to the $40 million of commercial paper, all of which has a maturity of less than one year, plus the $3 million of bank loans maturing in less than a year, for a total of $43 read more..

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    duration gap is calculated assuming that interest rates for all maturities are the same— in other words, the yield curve is assumed to be flat. As our discussion of the term structure of interest rates in Chapter 6 indicated, however, the yield curve is not flat, and the slope of the yield curve fluctuates and has a tendency to change when the level of the interest read more..

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    culating durations of assets and liabilities, because many of the cash payments are uncertain. Thus the estimate of the duration gap might not be accurate either. Do these problems mean that managers of banks and other financial institutions should give up on gap analysis as a tool for measuring interest-rate risk? Financial institutions do use more sophisticated approaches to read more..

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    Appendix 1 to Chapter 9 In this case, as in Equation 3, the market value of net worth would remain unchanged when interest rates change. Alternatively, the bank manager could calculate the value of the duration of the liabilities that would produce a duration gap of zero. To do this would involve setting DURgap equal to zero in Equation 2 and solving for DURl: DURl DURa read more..

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    To understand how well a bank is doing, we need to start by looking at a bank’s income statement, the description of the sources of income and expenses that affect the bank’s profitability. The end-of-year 2002 income statement for all federally insured commercial banks appears in Table 1. Operating Income. Operating income is the income that comes from a bank’s ongoing read more..

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    reserves rise when this is done because by increasing expenses when losses have not yet occurred, earnings are being set aside to deal with the losses in the future. Provisions for loan losses have been a major element in fluctuating bank profits in recent years. The 1980s brought the third-world debt crisis; a sharp decline in energy prices in 1986, which caused substantial read more..

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    1987. Since then, losses on loans have begun to subside, and in 2002, provisions for loan losses dropped to 12% of operating expenses. Income. Subtracting the $401.4 billion in operating expenses from the $529.1 bil- lion of operating income in 2002 yields net operating income of $127.7 billion. Net operating income is closely watched by bank managers, bank shareholders, and bank read more..

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    profits will be high. How well a bank manages its assets and liabilities is affected by the spread between the interest earned on the bank’s assets and the interest costs on its liabilities. This spread is exactly what the net interest margin measures. If the bank is able to raise funds with liabilities that have low interest costs and is able to acquire assets with read more..

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    ures of bank performance move closely together and indicate that from the early to the late 1980s, there was a sharp decline in bank profitability. The rightmost column, net interest margin, indicates that the spread between interest income and interest expenses remained fairly stable throughout the 1980s and even improved in the late 1980s and early 1990s, which should have read more..

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    PREVIEW The operations of individual banks (how they acquire, use, and manage funds to make a profit) are roughly similar throughout the world. In all countries, banks are financial intermediaries in the business of earning profits. When you consider the structure and operation of the banking industry as a whole, however, the United States is in a class by itself. In most read more..

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    chartering of banks. Their efforts led to the creation in 1791 of the Bank of the United States, which had elements of both a private and a central bank, a government insti- tution that has responsibility for the amount of money and credit supplied in the economy as a whole. Agricultural and other interests, however, were quite suspicious of centralized power and hence read more..

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    extremely lax in many states, banks regularly failed due to fraud or lack of sufficient bank capital; their banknotes became worthless. To eliminate the abuses of the state-chartered banks (called state banks), the National Bank Act of 1863 (and subsequent amendments to it) created a new bank- ing system of federally chartered banks (called national banks), supervised by the Office read more..

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    has regulatory responsibility over companies that own one or more banks (called bank holding companies) and secondary responsibility for the national banks. The FDIC and the state banking authorities jointly supervise the 5,800 state banks that have FDIC insurance but are not members of the Federal Reserve System. The state banking authorities have sole jurisdiction over the fewer read more..

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    The most significant change in the economic environment that altered the demand for financial products in recent years has been the dramatic increase in the volatil- ity of interest rates. In the 1950s, the interest rate on three-month Treasury bills fluctuated between 1.0% and 3.5%; in the 1970s, it fluctuated between 4.0% and 11.5%; in the 1980s, it ranged from 5% to over read more..

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    The most important source of the changes in supply conditions that stimulate finan- cial innovation has been the improvement in computer and telecommunications tech- nology. This technology, called information technology, has had two effects. First, it has lowered the cost of processing financial transactions, making it profitable for financial institutions to create new financial products read more..

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    electronic banking (e-banking) facility rather than with a human being. One impor- tant form of an e-banking facility is the automated teller machine (ATM), an elec- tronic machine that allows customers to get cash, make deposits, transfer funds from one account to another, and check balances. The ATM has the advantage that it does not have to be paid overtime and never read more..

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    issued long-term corporate bonds that now had ratings that had fallen below Baa, bonds that were pejoratively dubbed “junk bonds.” With the improvement in information technology in the 1970s, it became easier for investors to screen out bad from good credit risks, thus making it more likely that they would buy long-term debt securities from less well known corporations with read more..

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    Improvements in information technology also help provide an explanation for the rapid rise of the commercial paper market. We have seen that the improvement in information technology made it easier for investors to screen out bad from good credit risks, thus making it easier for corporations to issue debt securities. Not only did this make it easier for corporations to issue read more..

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    the late 1960s to 1980 made the regulatory constraints imposed on this industry even more burdensome, leading to financial innovation. Two sets of regulations have seriously restricted the ability of banks to make prof- its: reserve requirements that force banks to keep a certain fraction of their deposits as reserves (vault cash and deposits in the Federal Reserve System) and read more..

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    well above the 5.5% maximum interest rates payable on savings accounts and time deposits under Regulation Q. In 1977, money market mutual funds had assets under $4 billion; in 1978, their assets climbed to close to $10 billion; in 1979, to over $40 billion; and in 1982, to $230 billion. Currently, their assets are around $2 trillion. To say the least, money market mutual read more..

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    in decline. There is no evidence of a declining trend in bank profitability. However, overall bank profitability is not a good indicator of the profitability of traditional bank- ing, because it includes an increasing amount of income from nontraditional off- balance-sheet activities, discussed in Chapter 9. Noninterest income derived from off-balance-sheet activities, as a share of total read more..

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    banks’ advantage because their major source of funds (over 60%) was checkable deposits, and the zero interest cost on these deposits meant that the banks had a very low cost of funds. Unfortunately, this cost advantage for banks did not last. The rise in inflation from the late 1960s on led to higher interest rates, which made investors more sensitive to yield differentials read more..

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    methods, while computers have lowered transaction costs, making it possible to bun- dle these loans and sell them as securities. When default risk can be easily evaluated with computers, banks no longer have an advantage in making loans. Without their former advantages, banks have lost loan business to other financial institutions even though the banks themselves are involved in the read more..

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    forces in other countries have improved the availability of information in securities markets, making it easier and less costly for firms to finance their activities by issuing securities rather than going to banks. Further, even in countries where securities mar- kets have not grown, banks have still lost loan business because their best corporate customers have had increasing access read more..

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    industry, which is dominated by Microsoft, or the automobile industry, which is dom- inated by General Motors, Ford, Daimler-Chrysler, Toyota, and Honda.) Does the large number of banks in the commercial banking industry and the absence of a few domi- nant firms suggest that commercial banking is more competitive than other industries? The presence of so many commercial banks in read more..

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    tury. (These states usually had large farming populations whose relations with banks periodically became tempestuous when banks would foreclose on farmers who couldn’t pay their debts.) The legacy of nineteenth-century politics was a banking system with restrictive branching regulations and hence an inordinate number of small banks. However, as we will see later in this chapter, read more..

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    The banking industry hit some hard times in the 1980s and early 1990s, with bank failures running at a rate of over 100 per year from 1985 to 1992 (more on this later in the chapter and in Chapter 11). But bank failures are only part of the story. In the years 1985–1992, the number of banks declined by 3,000—more than double the number of failures. And in the read more..

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    pacts were adopted thereafter until by the early 1990s, almost all states allowed some form of interstate banking. With the barriers to interstate banking breaking down in the early 1980s, banks recognized that they could gain the benefits of diversification because they would now be able to make loans in many states rather than just one. This gave them the advantage that if read more..

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    consolidation. Information technology has also been increasing economies of scope, the ability to use one resource to provide many different products and services. For example, details about the quality and creditworthiness of firms not only inform deci- sions about whether to make loans to them, but also can be useful in determining at what price their shares should trade. read more..

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    the consolidation surge will settle down as the U.S. banking industry approaches sev- eral thousand, rather than several hundred, banks.2 Banking consolidation will result not only in a smaller number of banks, but as the mergers between Chase Manhattan Bank and Chemical Bank and between Bank of America and NationsBank suggest, a shift in assets from smaller banks to larger banks read more..

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    It also does not look as though community banks will disappear. When New York State liberalized branching laws in 1962, there were fears that community banks upstate would be driven from the market by the big New York City banks. Not only did this not happen, but some of the big boys found that the small banks were able to run rings around them in the local markets. read more..

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    allow bank holding companies to underwrite previously prohibited classes of securi- ties, banks began to enter this business. The loophole allowed affiliates of approved commercial banks to engage in underwriting activities as long as the revenue didn’t exceed a specified amount, which started at 10% but was raised to 25% of the affili- ates’ total revenue. After the U.S. read more..

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    entity. Banks are allowed to own sizable equity shares in commercial firms, and often they do. The British-style universal banking system, the second framework, is found in the United Kingdom and countries with close ties to it, such as Canada and Australia, and now the United States. The British-style universal bank engages in securities under- writing, but it differs from the read more..

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    loan industry (and implicitly to the housing industry, since most of the S&L loans ar e for residential mortgages). As we will see in the next chapter, the savings and loans experienced serious dif- ficulties in the 1980s. Because savings and loans now engage in many of the same activities as commercial banks, many experts view having a separate charter and reg- ulatory read more..

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    abroad, with assets totaling over $500 billion. The spectacular growth in international banking can be explained by three factors. First is the rapid growth in international trade and multinational (worldwide) corporations that has occurred since 1960. When American firms operate abroad, they need banking services in foreign countries to help finance international trade. For example, they read more..

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    The minimum transaction in the Eurodollar market is typically $1 million, and approximately 75% of Eurodollar deposits are held by banks. Plainly, you and I are unlikely to come into direct contact with Eurodollars. The Eurodollar market is, how- ever, an important source of funds to U.S. banks, whose borrowing of these deposits is over $100 billion. Rather than using an read more..

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    branches of U.S. banks and are not subject to domestic regulations and taxes. The purpose of establishing IBFs is to encourage American and foreign banks to do more banking business in the United States rather than abroad. From this point of view, IBFs were a success: Their assets climbed to nearly $200 billion in the first two years, but have currently fallen to below read more..

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    CHAPTER 10 Banking Industry: Structure and Competition 257 Bank Assets (U.S. $ millions) 1. Mizuho Holdings, Japan 1,281,389 2. Citigroup, U.S. 1,057,657 3. Mitsubishi Tokyo Financial Group, Japan 854,749 4. Deutsche Bank, Germany 815,126 5. Allianz, Germany 805,433 6. UBS, Switzerland 753,833 7. BNP, France 734,833 8. HSBC Holdings, U.K. 694,590 9. J.P. Morgan & Chase Company, U.S. 712,508 10. read more..

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    258 P A R T III Financial Institutions Key Terms automated banking machine (ABM), p. 235 automated teller machine (ATM), p. 235 bank holding companies, p. 232 branches, p. 244 central bank, p. 230 deposit rate ceilings, p. 238 disintermediation, p. 238 dual banking system, p. 231 economies of scope, p. 248 Edge Act corporation, p. 255 financial derivatives, p. 233 financial engineering, read more..

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    7. Unlike commercial banks, savings and loans, and mutual savings banks, credit unions did not have restrictions on locating branches in other states. Why, then, are credit unions typically smaller than the other depository institutions? *8. What incentives have regulatory agencies created to encourage international banking? Why have they done this? 9. How could the approval of read more..

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    260 PREVIEW As we have seen in the previous chapters, the financial system is among the most heavily regulated sectors of the economy, and banks are among the most heavily reg- ulated of financial institutions. In this chapter, we develop an economic analysis of why regulation of banking takes the form it does. Unfortunately, the regulatory process may not always work very well, read more..

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    if bank managers were taking on too much risk or were outright crooks, depositors would be reluctant to put money in the bank, thus making banking institutions less viable. Second is that depositors’ lack of information about the quality of bank assets can lead to bank panics, which, as we saw in Chapter 8, can have serious harmful consequences for the economy. To see read more..

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    $100,000 limit. The purchase and assumption method was the FDIC’s most common procedure for dealing with a failed bank before new banking legislation in 1991. Deposit insurance is not the only way in which governments provide a safety net for depositors. In other countries, governments have often stood ready to provide support to domestic banks when they face runs even in the read more..

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    risks that might result in an insurance payoff. For example, some drivers with auto- mobile collision insurance that has a low deductible might be more likely to drive recklessly, because if they get into an accident, the insurance company pays most of the costs for damage and repairs. Moral hazard is a prominent concern in government arrangements to provide a safety net. read more..

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    monitor the bank and pull out their deposits when it takes on too much risk: No mat- ter what the bank does, large depositors will not suffer any losses. The result of the too-big-to-fail policy is that big banks might take on even greater risks, thereby mak- ing bank failures more likely.1 Financial Consolidation and the Government Safety Net. With financial innovation and read more..

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    bank capital are another way to change the bank’s incentives to take on less risk. When a bank is forced to hold a large amount of equity capital, the bank has more to lose if it fails and is thus more likely to pursue less risky activities. Bank capital requirements take two forms. The first type is based on the so-called leverage ratio, the amount of capital read more..

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    banks can be used by crooks or overambitious entrepreneurs to engage in highly spec- ulative activities, such undesirable people would be eager to run a bank. Chartering banks is one method for preventing this adverse selection problem; through charter- ing, proposals for new banks are screened to prevent undesirable people from con- trolling them. Regular on-site bank examinations, read more..

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    minimum amounts of net worth for borrowing firms, and regular bank examinations are similar to the monitoring of borrowers by lending institutions. A commercial bank obtains a charter either from the Comptroller of the Currency (in the case of a national bank) or from a state banking authority (in the case of a state bank). To obtain a charter, the people planning to read more..

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    was reflected in a new focus on risk management in the Federal Reserve System’s 1993 guidelines to examiners on trading and derivatives activities. The focus was expanded and formalized in the Trading Activities Manual issued early in 1994, which provided bank examiners with tools to evaluate risk management systems. In late 1995, the Federal Reserve and the Comptroller of the read more..

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    ditional accounting conventions by providing information about risk exposure and risk management that is not normally included in conventional balance sheet and income statement reports. The existence of asymmetric information also suggests that consumers may not have enough information to protect themselves fully. Consumer protection regulation has taken several forms. First is “truth in read more..

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    270 P A R T III Financial Institutions Electronic Banking: New Challenges for Bank Regulation The advent of electronic banking has raised new con- cerns for banking regulation, specifically about secu- rity and privacy. Worries about the security of electronic banking and e-money are an important barrier to their increased use. With electronic banking, you might worry that criminals read more..

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    CHAPTER 11 Economic Analysis of Banking Regulation 271 Bank Holding Company Act and Douglas Amendment (1956) Clarified the status of bank holding companies (BHCs) Gave the Federal Reserve regulatory responsibility for BHCs Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980 Gave thrift institutions wider latitude in activities Approved NOW and sweep accounts nationwide read more..

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    International Banking Regulation Because asymmetric information problems in the banking industry are a fact of life throughout the world, bank regulation in other countries is similar to that in the United States. Banks are chartered and supervised by government regulators, just as they are in the United States. Deposit insurance is also a feature of the regulatory sys- tems in read more..

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    ise to keep up with clever people in financial institutions who think up ways to hide what they are doing or to get around the existing regulations. Bank regulation and supervision are difficult for two other reasons. In the regu- lation and supervision game, the devil is in the details. Subtle differences in the details may have unintended consequences; unless regulators get read more..

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    deposit insurance system that seemed to be working well for half a century find itself in so much trouble? The story starts with the burst of financial innovation in the 1960s, 1970s, and early 1980s. As we saw in the previous chapter, financial innovation decreased the prof- itability of certain traditional business for commercial banks. Banks now faced increased competition for read more..

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    the lending boom meant that their activities were expanding in scope and were becoming more complicated, requiring an expansion of regulatory resources to monitor these activities appropriately. Unfortunately, regulators of the S&Ls at the Federal Savings and Loan Insurance Corporation (FSLIC) had neither the expertise nor the resources that would have enabled them to monitor these new read more..

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    play: the throwing of a long pass to try to score a touchdown. Of course, the long bomb is unlikely to be successful, but there is always a small chance that it will work. If it doesn’t, the team has lost nothing, since it would have lost the game anyway. Given the sequence of events we have discussed here, it should be no surprise that savings and loans began read more..

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    discussed in Chapter 8: the principal–agent problem, which occurs when representa- tives (agents) such as managers have incentives that differ from those of their employer (the principal) and so act in their own interest rather than in the interest of the employer. Regulators and politicians are ultimately agents for voter-taxpayers (principals), because in the final analysis, taxpayers read more..

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    campaigns, American politicians must raise substantial contributions. This situation may provide lobbyists and other campaign contributors with the opportunity to influ- ence politicians to act against the public interest. Savings and Loan Bailout: The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 Immediately after taking office, the first Bush administration proposed new read more..

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    Federal Deposit Insurance Corporation Improvement Act of 1991 FDICIA’s provisions were designed to serve two purposes: to recapitalize the Bank Insurance Fund of the FDIC and to reform the deposit insurance and regulatory sys- tem so that taxpayer losses would be minimized. FDICIA recapitalized the Bank Insurance Fund by increasing the FDIC’s ability to borrow from the Treasury and read more..

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    Banking Crises Throughout the World Because misery loves company, it may make you feel better to know that the United States has by no means been alone in suffering a banking crisis. Indeed, as Table 2 and Figure 2 illustrate, banking crises have struck a large number of countries throughout the world, and many of them have been substantially worse than ours. We will read more..

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    engaged in risky lending. When real estate prices collapsed in the late 1980s, massive loan losses resulted. The outcome of this process was similar to what happened in the savings and loan industry in the United States. The government was forced to bail out almost the entire banking industry in these countries in the late 1980s and early 1990s on a scale that was even read more..

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    the government coerced them into purchasing large amounts of Argentine govern- ment debt in order to help solve the government’s fiscal problem. However, when market confidence in the government plummeted, spreads between Argentine gov- ernment debt and U.S. Treasuries soared to more than 2,500 basis points (25 per- centage points), leading to a sharp fall in the price of these read more..

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    pace with the new financial environment. The result was that banks could and did take on excessive risks. When property values collapsed in the early 1990s, the banks were left holding massive amounts of bad loans. For example, Japanese banks decided to get into the mortgage lending market by setting up the so-called jusen, home mort- gage lending companies that raised funds read more..

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    down by the government. Since then, the clean-up process has stalled and the econ- omy has remained weak, with a growth rate from 1991–2002 averaging an anemic 1%. A new, reform-oriented prime minister, Junichiro Koizumi, who pledged to clean up the banking system, came into office in 2001; yet he has been unable to come to grips with the Japanese banking problem. This read more..

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    3. Because of financial innovation, deregulation, and a set of historical accidents, adverse selection and moral hazard problems increased in the 1980s and resulted in huge losses for the U.S. savings and loan industry and for taxpayers. 4. Regulators and politicians are subject to the principal–agent problem, meaning that they may not have sufficient incentives to minimize the costs read more..

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    9. What steps were taken in the FDICIA legislation of 1991 to improve the functioning of federal deposit insurance? *10. Some advocates of campaign reform believe that gov- ernment funding of political campaigns and restric- tions on campaign spending might reduce the principal–agent problem in our political system. Do you agree? Explain your answer. 11. How can the S&L crisis be read more..

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    FDICIA is a major step in reforming the banking regulatory system. How well will it work to solve the adverse selection and moral hazard problems of the bank regulatory system? Let’s use the analysis in the chapter to evaluate the most important provisions of this legislation to answer this question. Study Guide Before looking at the evaluation for each set of provisions and read more..

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    However, other experts do not believe that depositors are capable of monitoring banks and imposing discipline on them. The basic problem with reducing the scope of deposit insurance even further as proposed is that banks would be subject to runs, sudden withdrawals by nervous depositors. Such runs could by themselves lead to bank failures. In addition to protecting individual read more..

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    them, thereby reducing the principal–agent problem. It will also reduce the incentives of politicians to lean on regulators to relax their regulatory supervision of banks. Under FDICIA, banks deemed to be taking on greater risk, in the form of lower cap- ital or riskier assets, will be subjected to higher insurance premiums. Risk-based insurance premiums will consequently reduce the read more..

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    Market-Value Accounting for Capital Requirements. We have seen that the requirement that a bank have substantial equity capital makes the bank less likely to fail. The requirement is also advantageous, because a bank with high equity capital has more to lose if it takes on risky investments and so will have less incentive to hold risky assets. Unfortunately, capital requirements, read more..

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    PREVIEW Banking is not the only type of financial intermediation you are likely to experience. You might decide to purchase insurance, take out an installment loan from a finance company, or buy a share of stock. In each of these transactions you will be engaged in nonbank finance and will deal with nonbank financial institutions. In our economy, nonbank finance also plays an read more..

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    adequate liquid assets to cover losses, and restrictions on the amount of risky assets (such as common stock) that the companies can hold. The regulatory authority is typ- ically a state insurance commissioner. Because death rates for the population as a whole are predictable with a high degree of certainty, life insurance companies can accurately predict what their payouts to read more..

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    investment income that enabled them to keep insurance rates low. Since then, how- ever, investment income has fallen with the decline in interest rates, while the growth in lawsuits involving property and casualty insurance and the explosion in amounts awarded in such cases have produced substantial losses for companies. To return to profitability, insurance companies have raised read more..

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    unnatural disasters such as the Los Angeles earthquake in 1994 and Hurricane Floyd in 1999, which devastated parts of the East Coast, and the September 11, 2001 destruction of the World Trade Center, exposed the property and casualty insurance companies to billions of dollars of losses. Therefore, property and casualty insurance companies hold more liquid assets than life insurance read more..

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    CHAPTER 12 Nonbank Finance 291 bonds, stocks, and loans into insurance policies that provide a set of serv- ices (for example, claim adjustments, savings plans, friendly insurance agents). If the insurer’s production process of asset transformation efficiently provides its customers with adequate insurance services at low cost and if it can earn high returns on its investments, it will read more..

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    292 P A R T III Financial Institutions To understand why an insurance provider finds it necessary to have risk- based premiums, let’s examine an example of risk-based insurance premiums that at first glance seems unfair. Harry and Sally, both college students with no accidents or speeding tickets, apply for auto insurance. Normally, Harry will be charged a much higher premium read more..

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    CHAPTER 12 Nonbank Finance 293 means that if you suffer a loss of $1,000 because of an accident, the insurer will pay you only $750. Deductibles are an additional management tool that helps insurance providers reduce moral hazard. With a deductible, you expe- rience a loss along with the insurer when you make a claim. Because you also stand to lose when you have an read more..

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    Pension Funds In performing the financial intermediation function of asset transformation, pension funds provide the public with another kind of protection: income payments on retirement. Employers, unions, or private individuals can set up pension plans, which acquire funds through contributions paid in by the plan’s participants. As we can see in Table 1, pension plans both public read more..

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    pension plan pays her $1,753 or less after ten years, the plan is fully funded because her contributions and earnings will fully pay for this payment. But if the defined benefit is $2,000, the plan is underfunded, because her contributions and earnings do not cover this amount. A second characteristic of pension plans is their vesting, the length of time that a person must read more..

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    population. Congress has been grappling with the problems of the Social Security sys- tem for years, but the prospect of a huge bulge in new retirees when the 77 billion baby boomers born between 1946 and 1964 start to retire in 2011 has resulted in calls for radical surgery on Social Security (see Box 1). State and local governments and the federal government, like read more..

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    cial intermediation process of finance companies can be described by saying that they borrow in large amounts but often lend in small amounts—a process quite different from that of banking institutions, which collect deposits in small amounts and then often make large loans. A key feature of finance companies is that although they lend to many of the same customers that borrow read more..

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    Mutual funds have seen a large increase in their market share since 1980 (see Table 1), due primarily to the then-booming stock market. Another source of growth has been mutual funds that specialize in debt instruments, which first appeared in the 1970s. Before 1970, mutual funds invested almost solely in common stocks. Funds that purchase common stocks may specialize even further read more..

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    to the asset value of the fund. Mutual funds also can be structured as a closed-end fund, in which a fixed number of nonredeemable shares are sold at an initial offering and are then traded like a common stock. The market price of these shares fluctuates with the value of the assets held by the fund. In contrast to the open-end fund, how- ever, the price of the read more..

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    between $100,000 and $20 million, with the typical minimum investment being $1 million. Long-Term Capital Management required a $10 million minimum invest- ment. Federal law limits hedge funds to have no more than 99 investors (limited part- ners) who must have steady annual incomes of $200,000 or more or a net worth of $1 million, excluding their homes. These restrictions are read more..

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    strategies. Hedge funds also typically charge large fees to investors. The typical fund charges a 1% annual fee on the assets it manages plus 20% of profits, and some charge significantly more. Long-Term Capital, for example, charged investors a 2% asset management fee and took 25% of the profits. The term hedge fund is highly misleading, because the word “hedge” typically read more..

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    In recent years, government financial intermediaries experienced financial diffi- culties. The Farm Credit System is one example. The rising tide of farm bankrupt- cies meant losses in the billions of dollars for the Farm Credit System, and as a result it required a bailout from the federal government in 1987. The agency was author- ized to borrow up to $4 billion to be read more..

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    ket (and so are secondhand). Investment banks assist in the initial sale of securities in the primary market; securities brokers and dealers assist in the trading of securities in the secondary markets, some of which are organized into exchanges. When a corporation wishes to borrow (raise) funds, it normally hires the services of an investment banker to help sell its securities. read more..

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    Securities brokers and dealers conduct trading in secondary markets. Brokers act as agents for investors in the purchase or sale of securities. Their function is to match buyers with sellers, a function for which they are paid brokerage commissions. In contrast to brokers, dealers link buyers and sellers by standing ready to buy and sell securities at given prices. Therefore, read more..

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    trading on insider information, nonpublic information known only to the management of a corporation. The forces of competition led to an important development: Brokerage firms started to engage in activities traditionally conducted by commercial banks. In 1977, Merrill Lynch developed the cash management account (CMA), which provides a package of financial services that includes credit read more..

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    market (in which dealers make the market by buying and selling securities at given prices). Securities are traded on the floor of the exchange with the help of a special kind of dealer-broker called a specialist. A specialist matches buy and sell orders submitted at the same price and so performs a brokerage function. However, if buy and sell orders do not match up, the read more..

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    CHAPTER 12 Nonbank Finance 307 tools, such as information collection and screening of potential policyholders, risk-based premiums, restrictive provisions, prevention of fraud, cancellation of insurance, deductibles, coinsurance, and limits on the amount of insurance. 2. Pension plans provide income payments to people when they retire after contributing to the plans for many years. Pension funds read more..

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    *5. “In contrast to private pension plans, government pension plans are rarely underfunded.” Is this state- ment true, false, or uncertain? Explain your answer. 6. What explains the widespread use of deductibles in insurance policies? *7. Why might insurance companies restrict the amount of insurance a policyholder can buy? 8. Why are restrictive provisions a necessary part of read more..

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    PREVIEW Starting in the 1970s and increasingly in the 1980s and 1990s, the world became a riskier place for the financial institutions described in this part of the book. Swings in interest rates widened, and the bond and stock markets went through some episodes of increased volatility. As a result of these developments, managers of financial insti- tutions became more concerned read more..

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    that security (take a long position) at a future date. We look at how this principle can be applied using forward and futures contracts. Interest-Rate Forward Contracts Forward contracts are agreements by two parties to engage in a financial transaction at a future (forward) point in time. Here we focus on forward contracts that are linked to debt instruments, called read more..

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    The advantage of forward contracts is that they can be as flexible as the parties involved want them to be. This means that an institution like the First National Bank may be able to hedge completely the interest-rate risk for the exact security it is hold- ing in its portfolio, just as it has in our example. However, forward contracts suffer from two problems that read more..

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    A financial futures contract is similar to an interest-rate forward contract, in that it specifies that a financial instrument must be delivered by one party to another on a stated future date. However, it differs from an interest-rate forward contract in several ways that overcome some of the liquidity and default problems of forward markets. To understand what financial futures read more..

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    and thereby agreed to buy (take delivery of ) the bonds are said to have taken a long position, and parties who have sold a futures contract and thereby agreed to sell (deliver) the bonds have taken a short position. To make our understanding of this contract more concrete, let’s consider what happens when you buy or sell a Treasury bond futures contract. Let’s say read more..

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    314 P A R T III Financial Institutions Hedging with Financial Futures Application First National Bank can also use financial futures contracts to hedge the inter- est rate risk on its holdings of $5 million of the 8s of 2023. To see how, sup- pose that in March 2004, the 8s of 2023 are the long-term bonds that would be delivered in the Chicago Board of Trade’s read more..

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    Financial futures contracts are traded in the United States on organized exchanges such as the Chicago Board of Trade, the Chicago Mercantile Exchange, the New York Futures Exchange, the MidAmerica Commodity Exchange, and the Kansas City Board of Trade. These exchanges are highly competitive with one another, and each organi- zation tries to design contracts and set rules that will read more..

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    316 P A R T III Financial Institutions Open Interest January 30, 2003 Type of Contract Contract Size Exchange* Reflects March 2003 Futures Treasury Rate Contracts Treasury bonds $100,000 CBT 393,546 Treasury notes $100,000 CBT 746,015 Five-year Treasury notes $100,000 CBT 683,499 Two-year Treasury notes $200,000 CBT 106,184 Thirty-day Fed levels $5 million CBT 49,069 Treasury bills $1 million CME 292 read more..

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    Because American futures exchanges were the first to develop financial futures, they dominated the trading of financial futures in the early 1980s. For example, in 1985, all of the top ten futures contracts were traded on exchanges in the United States. With the rapid growth of financial futures markets and the resulting high profits made by the American exchanges, foreign read more..

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    a result, the person who has cornered the market can set exorbitant prices for the securities that investors with a short position must buy to fulfill their obligations under the futures contract. The person who has cornered the market makes a fortune, but investors with a short position take a terrific loss. Clearly, the possibility that cor- ners might occur in the market read more..

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    CHAPTER 13 Financial Derivatives 319 Hedging Foreign Exchange Risk Application As we discussed in Chapter 1, foreign exchange rates have been highly volatile in recent years. The large fluctuations in exchange rates subject financial institutions and other businesses to significant foreign exchange risk because they generate substantial gains and losses. Luckily for financial institution managers, read more..

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    Options Another vehicle for hedging interest-rate and stock market risk involves the use of options on financial instruments. Options are contracts that give the purchaser the option, or right, to buy or sell the underlying financial instrument at a specified price, called the exercise price or strike price, within a specific period of time (the term to expiration) . The seller read more..

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    ual stocks are called stock options, and such options have existed for a long time. Option contracts on financial futures called financial futures options or, more com- monly, futures options, were developed in 1982 and have become the most widely traded option contracts. You might wonder why option contracts are more likely to be written on finan- cial futures than on underlying read more..

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    A call option is a contract that gives the owner the right to buy a financial instrument at the exercise price within a specific period of time. A put option is a contract that gives the owner the right to sell a financial instrument at the exercise price within a specific period of time. Study Guide Remembering which is a call option and which is a put option is read more..

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    loss on the option contract of the $2,000 premium he paid. This loss is plotted as point A in panel (a) of Figure 1. On the expiration date, if the price of the futures contract is 115, the call option is “at the money,” and Irving is indifferent whether he exercises his option to buy the futures contract or not, since exercising the option at 115 when the read more..

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    $3,000 ($5,000 $2,000). The $3,000 profit at a price of 120 is plotted as point C. Similarly, if the price of the futures contract rose to 125, the option contract would yield a net profit of $8,000 ($10,000 from exercising the option minus the $2,000 premium), plotted as point D. Plotting these points, we get the kinked profit curve for the call option that we see in read more..

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    Study Guide To make sure you understand how profits and losses on option and futures contracts are generated, calculate the net profits on the put option and the short position in the futures contract at prices on the expiration day of 110, 115, 120, and 125. Then ver- ify that your calculations correspond to the points plotted in panel (b) of Figure 1. Two other read more..

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    326 P A R T III Financial Institutions Similar reasoning indicates that the bank manager might prefer to use options to conduct the macro hedge to immunize the entire bank portfolio from interest-rate risk. Again, the strategy of using options rather than futures has the disadvantage that the First National Bank has to pay the premiums on these contracts up front. By contrast, read more..

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    premium that investors like Irving are willing to pay. Similarly, we saw in panel (b) that a higher price for the underlying financial instrument relative to the exercise price lowers profits on the put (sell) option, so that a higher strike price increases profits and thus causes the premium to increase. The second thing you may have noticed in the Wall Street Journal entry read more..

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    The results we have derived here appear in more formal models, such as the Black-Scholes model, which analyze how the premiums on options are priced. You might study such models in finance courses. Interest-Rate Swaps In addition to forwards, futures, and options, financial institutions use one other important financial derivative to manage risk. Swaps are financial contracts that read more..

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    To eliminate interest-rate risk, both the Midwest Savings Bank and the Friendly Finance Company could have rearranged their balance sheets by converting fixed-rate assets into rate-sensitive assets, and vice versa, instead of engaging in an interest-rate swap. However, this strategy would have been costly for both financial institutions for several reasons. The first is that financial read more..

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    into rate-sensitive assets without affecting the balance sheet. Large transaction costs are avoided, and the financial institutions can continue to make loans where they have an informational advantage. We have seen that financial institutions can also hedge interest-rate risk with other financial derivatives such as futures contracts and futures options. Interest-rate swaps have one big read more..

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    CHAPTER 13 Financial Derivatives 331 be used by financial institutions to hedge (protect) against interest-rate risk. 3. An option contract gives the purchaser the right to buy (call option) or sell (put option) a security at the exercise (strike) price within a specific period of time. The profit function for options is nonlinear—profits do not always grow by the same amount for read more..

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    interest rate of 8% when you invest the incoming funds in long-term bonds. How would you use the futures market to do this? *6. How would you use the options market to accomplish the same thing as in Problem 5? What are the advan- tages and disadvantages of using an options contract rather than a futures contract? 7. If you buy a put option on a $100,000 Treasury bond read more..

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    Pa r t I V Central Banking and the Conduct of Monetary Policy read more..

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    read more..

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    PREVIEW Among the most important players in financial markets throughout the world are cen- tral banks, the government authorities in charge of monetary policy. Central banks’ actions affect interest rates, the amount of credit, and the money supply, all of which have direct impacts not only on financial markets, but also on aggregate output and inflation. To understand the role read more..

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    Bank of the United States expired in 1836 after its renewal was vetoed in 1832 by President Andrew Jackson. The termination of the Second Bank’s national charter in 1836 created a severe prob- lem for American financial markets, because there was no lender of last resort who could provide reserves to the banking system to avert a bank panic. Hence in the nineteenth and read more..

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    include the following entities: the Federal Reserve banks, the Board of Governors of the Federal Reserve System, the Federal Open Market Committee (FOMC), the Federal Advisory Council, and around 4,800 member commercial banks. Figure 1 outlines the relationships of these entities to one another and to the three policy tools of the Fed (open market operations, the discount rate, and read more..

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    Federal Reserve banks in terms of assets are those of New York, Chicago, and San Francisco—combined they hold over 50% of the assets (discount loans, securities, and other holdings) of the Federal Reserve System. The New York bank, with around one- quarter of the assets, is the most important of the Federal Reserve banks (see Box 2). Each of the Federal Reserve banks is read more..

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    The 12 Federal Reserve banks perform the following functions: • Clear checks • Issue new currency • Withdraw damaged currency from circulation • Administer and make discount loans to banks in their districts • Evaluate proposed mergers and applications for banks to expand their activities • Act as liaisons between the business community and the Federal Reserve System • read more..

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    The 12 Federal Reserve banks are involved in monetary policy in several ways: 1. Their directors “establish” the discount rate (although the discount rate in each district is reviewed and determined by the Board of Governors). 2. They decide which banks, member and nonmember alike, can obtain discount loans from the Federal Reserve bank. 3. Their directors select one commercial read more..

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    nonrenewable 14-year term, with one governor’s term expiring every other January.1 The governors (many are professional economists) are required to come from differ- ent Federal Reserve districts to prevent the interests of one region of the country from being overrepresented. The chairman of the Board of Governors is chosen from among the seven governors and serves a four-year read more..

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    banks are voting members of the FOMC, the other seven presidents of the district banks attend FOMC meetings and participate in discussions. Hence they have some input into the committee’s decisions. Because open market operations are the most important policy tool that the Fed has for controlling the money supply, the FOMC is necessarily the focal point for pol- icymaking in read more..

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    are effectively made there. The FOMC does not actually carry out securities purchases or sales. Rather it issues directives to the trading desk at the Federal Reserve Bank of New York, where the manager for domestic open market operations supervises a roomful of people who execute the purchases and sales of the government or agency securities. The manager communicates daily with read more..

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    Then there is an informal buffet lunch, and while eating, the participants hear a presentation on the latest developments in Congress on banking legislation and other legislation relevant to the Federal Reserve. Around 2:15 P .M., the meeting breaks up and a public announcement is made about the outcome of the meeting: whether the target federal funds rate and discount rate have read more..

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    acquired the responsibility for promoting a stable economy, and this responsibility has caused the Federal Reserve System to evolve slowly into a more unified central bank. The framers of the Federal Reserve Act of 1913 intended the Fed to have only one basic tool of monetary policy: the control of discount loans to member banks. The use of open market operations as a tool read more..

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    Congress and the president of the United States. He also exercises control by setting the agenda of Board and FOMC meetings. For example, the fact that the agenda at the FOMC has the chairman speak first about monetary policy enables him to have greater influence over what the policy action will be. The chairman also influences the Board through the force of stature and read more..

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    Stanley Fischer, who was a professor at MIT and then the Deputy Managing Director of the International Monetary Fund, has defined two different types of inde- pendence of central banks: instrument independence, the ability of the central bank to set monetary policy instruments, and goal independence, the ability of the central bank to set the goals of monetary policy. The Federal read more..

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    and, to a lesser extent, from its loans to banks. In recent years, for example, the Fed has had net earnings after expenses of around $28 billion per year—not a bad living if you can find it! Because it returns the bulk of these earnings to the Treasury, it does not get rich from its activities, but this income gives the Fed an important advantage over other read more..

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    You can see that the Federal Reserve has extraordinary independence for a gov- ernment agency and is one of the most independent central banks in the world. Nonetheless, the Fed is not free from political pressures. Indeed, to understand the Fed’s behavior, we must recognize that public support for the actions of the Federal Reserve plays a very important role.5 Structure and read more..

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    set rates “in extreme economic circumstances” and “for a limited period.” Nonethe- less, as in Canada, because overruling the Bank would be so public and is supposed to occur only in highly unusual circumstances and for a limited time, it likely to be a rare occurrence. The decision to set interest rates resides in the Monetary Policy Committee, made up of the governor, read more..

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    pursuit of price stability. The ECB is far more independent than any other central bank in the world because its charter cannot be changed by legislation: It can be changed only by revision of the Maastricht Treaty, a difficult process, because all sig- natories to the treaty would have to agree. As our survey of the structure and independence of the major central banks read more..

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    with its own self-interest is too extreme. Maximizing one’s welfare does not rule out altruism. (You might give generously to a charity because it makes you feel good about yourself, but in the process you are helping a worthy cause.) The Fed is surely concerned that it conduct monetary policy in the public interest. However, much uncertainty and disagreement exist over what read more..

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    shortsighted because they are driven by the need to win their next election. With this as the primary goal, they are unlikely to focus on long-run objectives, such as pro- moting a stable price level. Instead, they will seek short-run solutions to problems, like high unemployment and high interest rates, even if the short-run solutions have undesirable long-run consequences. For read more..

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    Proponents of a Fed under the control of the president or Congress argue that it is undemocratic to have monetary policy (which affects almost everyone in the econ- omy) controlled by an elite group responsible to no one. The current lack of account- ability of the Federal Reserve has serious consequences: If the Fed performs badly, there is no provision for replacing members read more..

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    CHAPTER 14 Structure of Central Banks and the Federal Reserve System 355 Summary 1. The Federal Reserve System was created in 1913 to lessen the frequency of bank panics. Because of public hostility to central banks and the centralization of power, the Federal Reserve System was created with many checks and balances to diffuse power. 2. The formal structure of the Federal Reserve read more..

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    356 PA R T I V Central Banking and the Conduct of Monetary Policy Web Exercises 1. Go to and click on the link to general information. Choose “Structure of the Federal Reserve.” According to the Federal Reserve, what is the most important responsibility of the Board of Governors? 2. Go to the above site and click on “Monetary Policy” to read more..

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    PREVIEW As we saw in Chapter 5 and will see in later chapters on monetary theory, movements in the money supply affect interest rates and the overall health of the economy and thus affect us all. Because of its far-reaching effects on economic activity, it is impor- tant to understand how the money supply is determined. Who controls it? What causes it to change? How read more..

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    The Fed’s Balance Sheet The operation of the Fed and its monetary policy involve actions that affect its bal- ance sheet, its holdings of assets and liabilities. Here we discuss a simplified balance sheet that includes just four items that are essential to our understanding of the money supply process.1 The two liabilities on the balance sheet, currency in circulation and read more..

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    2. Reserves. All banks have an account at the Fed in which they hold deposits. Reserves consist of deposits at the Fed plus currency that is physically held by banks (called vault cash because it is stored in bank vaults). Reserves are assets for the banks but liabilities for the Fed, because the banks can demand payment on them at any time and the Fed is required to read more..

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    Open Market Purchase from a Bank. Suppose that the Fed purchases $100 of bonds from a bank and pays for them with a $100 check. The bank will either deposit the check in its account with the Fed or cash it in for currency, which will be counted as vault cash. To understand what occurs as a result of this transaction, we look at T-accounts, which list only the read more..

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    The effect on the Fed’s balance sheet is that it has gained $100 of securities in its assets column, while it has an increase of $100 of reserves in its liabilities column: As you can see in the above T-account, when the Fed’s check is deposited in a bank, the net result of the Fed’s open market purchase from the nonbank public is identical to the effect of read more..

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    The net effect of the open market purchase in this case is that reserves are unchanged, while currency in circulation increases by the $100 of the open market purchase. Thus the monetary base increases by the $100 amount of the open market purchase, while reserves do not. This contrasts with the case in which the seller of the bonds deposits the Fed’s check in a bank; read more..

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    Study Guide The best way to learn how open market operations affect the monetary base is to use T-accounts. Using T-accounts, try to verify that an open market sale of $100 of bonds to a bank or to a person who pays with a check written on a bank account leads to a $100 reduction in the monetary base. The following conclusion can now be drawn from our analysis of read more..

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    The banking system loses $100 of deposits and hence $100 of reserves: For the Fed, Jane Brown’s action means that there is $100 of additional currency circulating in the hands of the public, while reserves in the banking system have fallen by $100. The Fed’s T-account is: The net effect on the monetary liabilities of the Fed is a wash; the monetary base is unaffected read more..

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    The net effect on the monetary liabilities of the Fed, and hence on the monetary base, is then a reduction of $100. We see that the monetary base changes one-for-one with the change in the borrowings from the Fed. So far in this chapter, it seems as though the Fed has complete control of the mone- tary base through its open market operations and discount loans. read more..

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    reserves, deposits increase by a multiple of this amount—a process called multiple deposit creation. Suppose that the $100 open market purchase described earlier was conducted with the First National Bank. After the Fed has bought the $100 bond from the First National Bank, the bank finds that it has an increase in reserves of $100. To analyze what the bank will do with read more..

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    The final T-account of the First National Bank is: The increase in reserves of $100 has been converted into additional loans of $100 at the First National Bank, plus an additional $100 of deposits that have made their way to other banks. (All the checks written on accounts at the First National Bank are deposited in banks rather than converted into cash, because we are read more..

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    If the money spent by the borrower to whom Bank A lent the $90 is deposited in another bank, such as Bank B, the T-account for Bank B will be: The checkable deposits in the banking system have increased by another $90, for a total increase of $190 ($100 at Bank A plus $90 at Bank B). In fact, the distinction between Bank A and Bank B is not necessary to read more..

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    When the bank buys $90 of securities, it writes a $90 check to the seller of the securities, who in turn deposits the $90 at a bank such as Bank B. Bank B’s checkable deposits rise by $90, and the deposit expansion process is the same as before. Whether a bank chooses to use its excess reserves to make loans or to purchase securities, the effect on deposit read more..

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    where D change in total checkable deposits in the banking system r required reserve ratio (0.10 in the example) R change in reserves for the banking system ($100 in the example)7 The formula for the multiple creation of deposits can also be derived directly using algebra. We obtain the same answer for the relationship between a change in deposits and a change in reserves, but read more..

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    In our example, the required reserve ratio is 10%. If reserves increase by $100, checkable deposits must rise to $1,000 in order for total required reserves also to increase by $100. If the increase in checkable deposits is less than this, say $900, then the increase in required reserves of $90 remains below the $100 increase in reserves, so there are still excess reserves read more..

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    372 PA R T I V Central Banking and the Conduct of Monetary Policy Summary 1. There are four players in the money supply process: the central bank, banks (depository institutions), depositors, and borrowers from banks. 2. Four items in the Fed’s balance sheet are essential to our understanding of the money supply process: the two liability items, currency in circulation and read more..

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    CHAPTER 15 Multiple Deposit Creation and the Money Supply Process 373 out. How much deposit creation takes place for the entire banking system? Unless otherwise noted, the following assumptions are made in all the remaining problems: The required reserve ratio on checkable deposits is 10%, banks do not hold any excess reserves, and the public’s holdings of currency do not change. read more..

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    Just as any other bank has a balance sheet that lists its assets and liabilities, so does the Fed. We examine each of its categories of assets and liabilities because changes in them are an important way the Fed manipulates the money supply. 1. Securities. These are the Fed’s holdings of securities, which consist primarily of Treasury securities but in the past have also read more..

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    3. Gold and SDR certificate accounts. Special drawing rights (SDRs) are issued to governments by the International Monetary Fund (IMF) to settle international debts and have replaced gold in international financial transactions. When the Treasury acquires gold or SDRs, it issues certificates to the Fed that are claims on the gold or SDRs and is in turn credited with deposit read more..

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    Total reserves can be divided into two categories: reserves that the Fed requires banks to hold (required reserves) and any additional reserves the banks choose to hold (excess reserves). For example, the Fed might require that for every dollar of deposits at a depository institution, a certain fraction (say, 10 cents) must be held as reserves. This fraction (10%) is called the read more..

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    items that are included in the sources of the base: Specifically, Federal Reserve notes and reserves equal the sum of all the Fed assets minus all the other Fed liabilities: Federal Reserve notes reserves Securities discount loans gold and SDRs coin cash items in process of collection other Federal Reserve assets Treasury deposits foreign and other deposits deferred-availability cash read more..

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    374 PREVIEW In Chapter 15, we developed a simple model of multiple deposit creation that showed how the Fed can control the level of checkable deposits by setting the required reserve ratio and the level of reserves. Unfortunately for the Fed, life isn’t that simple; control of the money supply is far more complicated. Our critique of this model indicated that decisions by read more..

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    The Money Supply Model and the Money Multiplier Because, as we saw in Chapter 15, the Fed can control the monetary base better than it can control reserves, it makes sense to link the money supply M to the monetary base MB through a relationship such as the following: M m MB (1) The variable m is the money multiplier, which tells us how much the money supply changes read more..

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    Substituting r D for RR in the first equation yields an equation that links reserves in the banking system to the amount of checkable deposits and excess reserves they can support: R (r D) ER A key point here is that the Fed sets the required reserve ratio r to less than 1. Thus $1 of reserves can support more than $1 of deposits, and the multiple expansion of read more..

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    Using the definition of the money supply as currency plus checkable deposits (M D C ) and again specifying C as c D, M D (c D) (1 c) D Substituting in this equation the expression for D from Equation 2, we have: (3) Finally, we have achieved our objective of deriving an expression in the form of our ear- lier Equation 1. As you can see, the ratio that multiplies MB read more..

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    of our money supply model is to realize that although there is multiple expansion of deposits, there is no such expansion for currency. Thus if some portion of the increase in high-powered money finds its way into currency, this portion does not undergo multiple deposit expansion. In our analysis in Chapter 15, we did not allow for this possibility, and so the increase in read more..

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    The analysis just conducted can also be applied to the case in which the required reserve ratio falls. In this case, there will be more multiple expansion for checkable deposits because the same level of reserves can now support more checkable deposits, and the money multiplier will rise. For example, if r falls from 10% to 5%, plugging this value into our money multiplier read more..

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    has been extremely small, so changes in it have only a small impact on the money multiplier. However, there have been times, particularly during the Great Depression, when this ratio was far higher, and its movements had a substantial effect on the money supply and the money multiplier. Thus our final result is still an important one: The money multiplier and the money read more..

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    of excess reserves, and their level should fall. We have the following result: The excess reserves ratio e is positively related to expected deposit outflows. Additional Factors That Determine the Money Supply So far we have been assuming that the Fed has accurate control over the monetary base. However, whereas the amount of open market purchases or sales is completely read more..

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    base) is under the Fed’s control, because it results primarily from open market oper- ations.5 The nonborrowed monetary base is formally defined as the monetary base minus discount loans from the Fed: MBn MB DL where MBn nonborrowed monetary base MB monetary base DL discount loans from the Fed The reason for distinguishing the nonborrowed monetary base MBn from the monetary base MB read more..

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    The result is this: The money supply is positively related to the level of discount loans DL from the Fed. However, because the Federal Reserve now (since January 2003) keeps the interest rate on discount loans (the discount rate) above market inter- est rates at which banks can borrow from each other, banks usually have little incen- tive to take out discount loans. read more..

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    The variables are grouped by the player or players who either influence the vari- able or are most influenced by it. The Federal Reserve, for example, influences the money supply by controlling the first three variables—r, MBn, and DL, also known as the tools of the Fed. (How these tools are used is discussed in subsequent chapters.) Depositors influence the money supply read more..

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    CHAPTER 16 Determinants of the Money Supply 385 that have a major impact on the growth rate of the money supply. The cur- rency ratio c, which is also plotted in Figure 3, explains most of these move- ments in the money multiplier. From January 1980 until October 1984, c is relatively constant. Unsurprisingly, there is almost no trend in the money multiplier m, so the read more..

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    386 PA R T I V Central Banking and the Conduct of Monetary Policy FIGURE 3 Determinants of the Money Supply, 1980–2002 Percentage for each bracket indicates the annual growth rate of the series over the bracketed period. Source: Federal Reserve: m 500 600 700 400 300 200 100 3.0 2.6 0.30 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 2.0% read more..

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    CHAPTER 16 Determinants of the Money Supply 387 with more. Finally, the sharp rise in c from December 1993 to December 2002 should have led to a decline in the money multiplier, because the shift into currency produces less multiple deposit expansion. As our money sup- ply model predicts, the money multiplier did indeed fall sharply in this period, and there was a dramatic read more..

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    388 PA R T I V Central Banking and the Conduct of Monetary Policy $200 million of deposits. That failure was especially important. The Bank of United States was the largest commercial bank, as measured by volume of deposits, ever to have failed up to that time in U.S. history. Moreover, though it was just an ordinary commercial bank, the Bank of United States’s name read more..

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    CHAPTER 16 Determinants of the Money Supply 389 accounts, and c would rise. Our earlier analysis of the excess reserves ratio suggests that the resulting surge in deposit outflows would cause the banks to protect themselves by substantially increasing their excess reserves ratio e. Both of these predictions are borne out by the data in Figure 5. During the first bank panic read more..

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    end of the crises in March 1933, the money supply (M1) had declined by over 25%—by far the largest decline in all of American history—and it coin- cided with the nation’s worst economic contraction (see Chapter 8). Even more remarkable is that this decline occurred despite a 20% rise in the level of the monetary base—which illustrates how important the changes in c read more..

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    CHAPTER 16 Determinants of the Money Supply 391 operations. The money supply model therefore allows for the behavior of all four players in the money supply process: the Fed through its setting of the required reserve ratio, the discount rate, and open market operations; depositors through their decisions about the currency ratio; the banks through their decisions about the excess read more..

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    392 PA R T I V Central Banking and the Conduct of Monetary Policy Web Exercises 1. An important aspect of the supply of money is reserve balances. Go to and locate the most recent release. This site reports changes in factors that affect depository reserve balances. a. What is the current reserve balance? b. What is the change in reserve read more..

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    The derivation of a money multiplier for the M2 definition of money requires only slight modifications to the analysis in the chapter. The definition of M2 is: M2 C D T MMF where C currency in circulation D checkable deposits T time and savings deposits MMF primarily money market mutual fund shares and money market deposit accounts, plus overnight repurchase agreements and overnight read more..

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    An important feature of the M2 multiplier is that it is substantially above the M1 multiplier of 2.5 that we found in the chapter. The crucial concept in understanding this difference is that a lower required reserve ratio for time deposits or money mar- ket mutual fund shares means that they undergo more multiple expansion because fewer reserves are needed to support the read more..

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    Appendix 1 to Chapter 16 Table 1 Response of the M2 Money Supply to Changes in MBn, DL, r, e, c, t, and mm SUMMARY Change inM2 Money Variable Variable Supply Response Reason MBn ↑↑ More MB to support C and D DL ↑↑ More MB to support C and D r ↑↓ Less multiple deposit expansion e ↑↓ Fewer reserves to support C and D c ↑↓ Less overall deposit expansion t read more..

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    The general outline of the movements of the currency ratio c since 1892 is shown in Figure 1. As you can see, several episodes stand out: 1. The declining trend in the ratio from 1892 until 1917, when the United States entered World War I 2. The sharp increase in the ratio during World War I and the decline thereafter 3. The steepest increase in the ratio that we read more..

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    To be worthwhile, our analysis of c must be able to explain these movements. These movements, however, will help us develop the analysis because they provide clues to the factors that influence c. A natural way to approach the analysis of the relative amount of assets (currency and checkable deposits) people want to hold, hence the currency-checkable deposits ratio, is to use read more..

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    undergo substantial fluctuations. However, since 1980, banks have been allowed to pay any interest rate they choose on checkable deposits, suggesting that fluctuations in these rates can now be an important factor influencing c movements. Cost of Acquiring Currency. If currency is made easier to acquire, thereby lowering the cost of using it, then in effect its expected return rises read more..

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    is an increase in the use of currency relative to checkable deposits, and c rises. There is a positive association between illegal activity and the currency ratio.3 Looking at Figure 1, what types of increases in illegal activity would lead to an increase in c? Beginning in the 1960s, c began to climb—just when the illegal drug trade began to experience phenomenal read more..

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    This unreported economic activity has been labeled the underground economy. Evidence of its scope is the fact that the amount of currency for every man, woman, and child in the United States (as measured by currency in circulation in 2002 divided by the population) is around $1,000. Very few people hold this amount of currency; the likelihood is that much is used to read more..

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    Appendix 2 to Chapter 16 meant that they declined more than currency, raising the currency ratio. The increased number of bank failures also made checkable deposits less desirable because it lowered their expected return, also leading to a rise in c. 1921–1929. During the prosperous period of the Roaring Twenties, we would expect to see the downward trend in c reasserting read more..

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    Expanding Behavior of The Currency Ratio able deposits. This raised the expected return on checkable deposits relative to currency, and the resulting reduced demand for currency helped lower c. 1994–2002. The upward trend in c can be explained by the explosion in the number of ATMs starting in the 1990s, which has been discussed in Chapter 10. The increase in the number of read more..

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    PREVIEW In the chapters describing the structure of the Federal Reserve System and the money supply process, we mentioned three policy tools that the Fed can use to manipulate the money supply and interest rates: open market operations, which affect the quan- tity of reserves and the monetary base; changes in discount lending, which affect the monetary base; and changes in read more..

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    The analysis of the market for reserves proceeds in a similar fashion to the analysis of the bond market we conducted in Chapter 5. We derive a demand and supply curve for reserves. Then the market equilibrium in which the quantity of reserves demanded equals the quantity of reserves supplied determines the federal funds rate, the interest rate charged on the loans of read more..

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    the interest rate the Fed charges on these loans, the discount rate (id). Because bor- rowing federal funds is a substitute for taking out discount loans from the Fed, if the federal funds rate iff is below the discount rate id, then banks will not borrow from the Fed and discount loans will be zero because borrowing in the federal funds market is cheaper. Thus, as read more..

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    396 PA R T I V Central Banking and the Conduct of Monetary Policy FIGURE 2 Response to an Open Market Operation An open market purchase increases nonborrowed reserves and hence the reserves supplied, and shifts the supply curve from Rs1 to R s 2 . The equilibrium moves from point 1 to point 2, lowering the federal funds rate from i1ff to i 2 ff . Quantity of Reserves, read more..

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    is lowered by the Fed from i1d to i2d, the vertical section of the supply curve where there is no discount lending just shortens, as in Rs2, while the intersection of the sup- ply and demand curve remains at the same point. Thus, in this case there is no change in the equilibrium federal funds rate, which remains at i1ff. Because this is the typical situation—since read more..

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    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, it leads to a fall in the federal funds rate. Now that we understand how the three tools of monetary policy—open market operations, discount lending, and reserve read more..

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    in the banking system the day before. Later in the morning, her staff issues updated reports that contain detailed forecasts of what will be happening to some of the short- term factors affecting the supply and demand of reserves (discussed in Chapter 15). For example, if float is predicted to decrease because good weather throughout the country is speeding up check delivery, read more..

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    are given several minutes to respond via TRAPS with their propositions to buy or sell government securities. The propositions are then assembled and displayed on a com- puter screen for evaluation. The desk will select all propositions, beginning with the most attractively priced, up to the point where the desired amount is purchased or sold, and it will then notify each dealer read more..

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    The Fed’s discount loans to banks are of three types: primary credit, secondary credit, and seasonal credit.4 Primary credit is the discount lending that plays the most impor- tant role in monetary policy. Healthy banks are allowed to borrow all they want from the primary credit facility, and it is therefore referred to as a standing lending facility. The interest rate on read more..

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    Secondary credit is given to banks that are in financial trouble and are experienc- ing severe liquidity problems. The interest rate on secondary credit is set at 50 basis points (0.5 percentage points) above the discount rate. This interest rate on these loans is set at a higher, penalty rate to reflect the less-sound condition of these bor- rowers. Seasonal credit is given read more..

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    guaranteed by the FDIC, because they exceed the $100,000 limit. A loss of confidence in the banking system could still lead to runs on banks from the large-denomination depositors, and bank panics could still occur despite the existence of the FDIC. The importance of the Federal Reserve’s role as lender of last resort is, if anything, more important today because of the high read more..

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    404 PA R T I V Central Banking and the Conduct of Monetary Policy The Black Monday Stock Market Crash of 1987 and the Terrorist Destruction of the World Trade Center in September 2001. Although October 19, 1987, dubbed “Black Monday,” will go down in the history books as the largest one-day percentage decline in stock prices to date (the Dow Jones Industrial Average read more..

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    the amount of deposits that can be supported by a given level of the monetary base and will lead to a contraction of the money supply. A rise in reserve requirements also increases the demand for reserves and raises the federal funds rate. Conversely, a decline in reserve requirements leads to an expansion of the money supply and a fall in the federal funds rate. The read more..

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    406 PA R T I V Central Banking and the Conduct of Monetary Policy Why Have Reserve Requirements Been Declining Worldwide? Application In recent years, central banks in many countries in the world have been reduc- ing or eliminating their reserve requirements. In the United States, the Federal Reserve eliminated reserve requirements on time deposits in December 1990 and lowered read more..

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    CHAPTER 17 Tools of Monetary Policy 407 Australia, and New Zealand, all of which have eliminated reserve require- ments—shows that central banks can continue to effectively set overnight, interbank interest rates like the federal funds rate. How the channel/corridor system works is illustrated by Figure 6, which describes the market for reserves along the lines discussed at the read more..

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    408 PA R T I V Central Banking and the Conduct of Monetary Policy FIGURE 6 The Channel/ Corridor System for Setting Interest Rates In the channel/corridor system standing facilities result in a step function supply curve, Rs. Then if the demand curve shifts between Rd1 and Rd2, the overnight interest rate iff always remains between ir and il. Quantity of Reserves, R Rn i l i r read more..

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    CHAPTER 17 Tools of Monetary Policy 409 Key Terms defensive open market operations, p. 398 discount window, p. 400 dynamic open market operations, p. 398 federal funds rate, p. 393 lender of last resort, p. 402 matched sale–purchase transaction (reverse repo), p. 400 primary dealers, p. 399 repurchase agreement (repo), p. 400 Questions and Problems Questions marked with an asterisk are read more..

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    410 PA R T I V Central Banking and the Conduct of Monetary Policy Web Exercises 1. Go to This site reports activity by the open market committee. Scroll down to Calendar and click on the statement released after the last meeting. Summarize this statement in one para- graph. Be sure to note whether the committee has decided to increase or decrease read more..

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    PREVIEW Now that we understand the tools that central banks like the Federal Reserve use to conduct monetary policy, we can proceed to how monetary policy is actually con- ducted. Understanding the conduct of monetary policy is important, because it not only affects the money supply and interest rates but also has a major influence on the level of economic activity and hence read more..

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    to look for a better job might be unemployed for a while during the job search. Workers often decide to leave work temporarily to pursue other activities (raising a family, travel, returning to school), and when they decide to reenter the job market, it may take some time for them to find the right job. The benefit of having some unemployment is similar to the benefit read more..

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    decision making for consumers, businesses, and government. Not only do public opinion surveys indicate that the public is very hostile to inflation, but a growing body of evidence suggests that inflation leads to lower economic growth.1 The most extreme example of unstable prices is hyperinflation, such as Argentina, Brazil, and Russia have experienced in the recent past. Many read more..

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    The stability of financial markets is also fostered by interest-rate stability, because fluctuations in interest rates create great uncertainty for financial institutions. An increase in interest rates produces large capital losses on long-term bonds and mort- gages, losses that can cause the failure of the financial institutions holding them. In recent years, more pronounced interest-rate read more..

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    long-term), which have a direct effect on employment and the price level. However, even these intermediate targets are not directly affected by the central bank’s policy tools. Therefore, it chooses another set of variables to aim for, called operating tar- gets, or alternatively instrument targets, such as reserve aggregates (reserves, non- borrowed reserves, monetary base, or read more..

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    sees what is happening to its intermediate target, thus directing monetary policy so that it will achieve its goals of high employment and price stability (the space shuttle launches the satellite in the appropriate orbit). Choosing the Targets As we see in Figure 1, there are two different types of target variables: interest rates and aggregates (monetary aggregates and reserve read more..

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    price level, or the public’s preferences toward holding money. If the demand curve falls to Md , the interest rate will begin to fall below i*, and the price of bonds will rise. With an interest-rate target, the central bank will prevent the interest rate from falling by selling bonds to drive their price back down and the interest rate back up CHAPTER 18 Conduct of read more..

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    to its former level. The central bank will make open market sales until the money sup- ply declines to Ms , at which point the equilibrium interest rate is again i*. Conversely, if the demand curve rises to Md and drives up the interest rate, the central bank would keep interest rates from rising by buying bonds to keep their prices from falling. The central bank will read more..

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    Our discussion of the money supply process and the central bank’s policy tools indicates that a central bank does have the ability to exercise a powerful effect on the money supply, although its control is not perfect. We have also seen that open mar- ket operations can be used to set interest rates by directly affecting the price of bonds. Because a central bank can read more..

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    will also help us interpret the Fed’s activities and see where U.S. monetary policy may be heading in the future. Once we are done studying the Fed, we will then examine central banks’ experiences in other countries. Study Guide The following discussion of the Fed’s policy procedures and their effect on the money supply provides a review of the money supply process read more..

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    the Fed was pressed for income. It solved this problem by purchasing income-earning securities. In doing so, the Fed noticed that reserves in the banking system grew and there was a multiple expansion of bank loans and deposits. This result is obvious to us now (we studied the multiple deposit creation process in Chapter 15), but to the Fed at that time it was a read more..

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    The spate of bank panics from 1930 to 1933 were the most severe in U.S. history, and Roosevelt aptly summed up the problem in his statement “The only thing we have to fear is fear itself.” By the time the panics were over in March 1933, more than one- third of the commercial banks in the United States had failed. In Chapter 16, we examined how the bank panics read more..

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    growth in the monetary base and the money supply. The Fed had thus in effect relin- quished its control of monetary policy to meet the financing needs of the government. When the war ended, the Fed continued to peg interest rates, and because there was little pressure on them to rise, this policy did not result in an explosive growth in the money supply. When the read more..

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    Allan Meltzer and concerns about inflation finally led the Fed to abandon its focus on money market conditions. In 1970, Arthur Burns was appointed chairman of the Board of Governors, and soon thereafter the Fed stated that it was committing itself to the use of monetary aggre- gates as intermediate targets. Did monetary policy cease to be procyclical? A glance at Figure 4 in read more..

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    that it was still very concerned with achieving interest-rate stability and was reluctant to relinquish control over interest-rate movements. The incompatibility of the Fed’s policy procedure with its stated intent of targeting on the monetary aggregates had become very clear by October 1979, when the Fed’s policy procedures underwent drastic revision. In October 1979, two months read more..

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    Interest-rate movements during this period support this interpretation of Fed strategy. After the October 1979 announcement, short-term interest rates were driven up by nearly 5%, until in March 1980 they exceeded 15%. With the imposition of credit controls in March 1980 and the rapid decline in real GDP in the second quar- ter of 1980, the Fed eased up on its policy and read more..

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    Finally, legislation in 2000 amending the Federal Reserve Act dropped the requirement that the Fed report target ranges for monetary aggregates to Congress. Having abandoned monetary aggregates as a guide for monetary policy, the Federal Reserve returned to using a federal funds target in the early 1990s. Indeed, from late 1992 until February 1994, a period of a year and a half, read more..

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    one way to lower the value of the dollar, it is no surprise that the Fed engineered an acceleration in the growth rates of the monetary aggregates in 1985 and 1986 and that the value of the dollar declined. By 1987, policymakers at the Fed agreed that the dol- lar had fallen sufficiently, and sure enough, monetary growth in the United States slowed. These monetary policy read more..

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    rate that is consistent with full employment in the long run) plus a weighted average of two gaps: (1) an inflation gap, current inflation minus a target rate, and (2) an out- put gap, the percentage deviation of real GDP from an estimate of its potential full employment level.8 This rule can be written as follows: Federal funds rate target inflation rate equilibrium real read more..

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    lower than that indicated by the Taylor rule. This fact helps explain why inflation rose during this period. During the Volcker period, when the Fed was trying to bring infla- tion down quickly, the funds rate was generally higher than that recommended by the Taylor rule. The closer correspondence between the actual funds rate and the Taylor rule recommendation during the read more..

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    CHAPTER 18 Conduct of Monetary Policy: Goals and Targets 431 Summary 1. The six basic goals of monetary policy are high employment, economic growth, price stability, interest- rate stability, stability of financial markets, and stability in foreign exchange markets. 2. By using intermediate and operating targets, a central bank like the Fed can more quickly judge whether its policies are read more..

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    6. Compare the monetary base to M2 on the grounds of controllability and measurability. Which do you prefer as an intermediate target? Why? *7. “Interest rates can be measured more accurately and more quickly than the money supply. Hence an inter- est rate is preferred over the money supply as an inter- mediate target.” Do you agree or disagree? Explain your answer. 8. read more..

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    Pa r t V International Finance and Monetary Policy read more..

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    read more..

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    PREVIEW In the mid-1980s, American businesses became less competitive with their foreign counterparts; subsequently, in the 1990s and 2000s, their competitiveness increased. Did this swing in competitiveness occur primarily because American management fell down on the job in the 1980s and then got its act together afterwards? Not really. American business became less competitive in the read more..

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    exchange market determine the rates at which currencies are exchanged, which in turn determine the cost of purchasing foreign goods and financial assets. There are two kinds of exchange rate transactions. The predominant ones, called spot transactions, involve the immediate (two-day) exchange of bank deposits. Forward transactions involve the exchange of bank deposits at some specified read more..

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    CHAPTER 19 The Foreign Exchange Market 437 Following the Financial News Foreign exchange rates are published daily and appear in the “Currency Trading” column of the Wall Street Journal. The entries from one such column, shown here, are explained in the text. The first entry for the euro lists the exchange rate for the spot transaction (the spot exchange rate) on February 5, read more..

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    beginning of 1999 to a value of 0.93 euros per dollar on February 5, 2003, appreci- ated by 9%: (0.93 0.85)/0.85 0.09 9%. Exchange rates are important because they affect the relative price of domestic and foreign goods. The dollar price of French goods to an American is determined by the interaction of two factors: the price of French goods in euros and the euro/dollar read more..

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    we say that a bank is buying dollars in the foreign exchange market, what we actually mean is that the bank is buying deposits denominated in dollars. The volume in this market is colossal, exceeding $1 trillion per day. Trades in the foreign exchange market consist of transactions in excess of $1 million. The market that determines the exchange rates in the “Following the read more..

  • Page - 539

    As our U.S./Japanese example demonstrates, the theory of PPP suggests that if one country’s price level rises relative to another’s, its currency should depreciate (the other country’s currency should appreciate). As you can see in Figure 2, this predic- tion is borne out in the long run. From 1973 to the end of 2002, the British price level rose 99% relative to the read more..

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    that the yen must depreciate by the amount of the relative price increase of Toyotas over Chevys. PPP theory furthermore does not take into account that many goods and services (whose prices are included in a measure of a country’s price level) are not traded across borders. Housing, land, and services such as restaurant meals, haircuts, and golf lessons are not traded goods. read more..

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    Productivity. If one country becomes more productive than other countries, busi- nesses in that country can lower the prices of domestic goods relative to foreign goods and still earn a profit. As a result, the demand for domestic goods rises, and the domestic currency tends to appreciate. If, however, its productivity lags behind that of other countries, its goods become read more..

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    Exchange Rates in the Short Run We have developed a theory of the long-run behavior of exchange rates. However, if we are to understand why exchange rates exhibit such large changes (sometimes sev- eral percent) from day to day, we must develop a theory of how current exchange rates (spot exchange rates) are determined in the short run. The key to understanding the read more..

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    7% higher because the dollar has become worth 7% more in terms of euros. Thus if the interest rate on dollar deposits is 10%, with an expected appreciation of the dol- lar of 7%, the expected return on dollar deposits in terms of euros is 17%: the 10% interest rate plus the 7% expected appreciation of the dollar. Conversely, if the dollar were expected to depreciate by read more..

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    If the interest rate on euro deposits is 5%, for example, and the dollar is expected to appreciate by 4%, then the expected return on euro deposits in terms of dollars is 1%. Al earns the 5% interest rate, but he expects to lose 4% because he expects the euro to be worth 4% less in terms of dollars as a result of the dollar’s appreciation. Al’s expected read more..

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    the right side is the expected return on foreign deposits, both calculated in terms of a single currency, the U.S. dollar. Given our assumption that domestic and foreign bank deposits are perfect substitutes (equally desirable), the interest parity condition is an equilibrium condition for the foreign exchange market. Only when the exchange rate is such that expected returns on read more..

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    dollar, the expected change in the value of the dollar is now 4.8% [ (1.00 – 1.05)/1.05 0.048], so the expected dollar return on foreign deposits RF has now risen to 14.8% [ 10% ( 4.8%)]. This combination of exchange rate and expected return on euro deposits is plotted as point C. The curve connecting these points is the schedule for the expected return on euro deposits read more..

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    rate rises, there is a higher expected depreciation of the dollar and so a higher expected appreciation of the euro, thereby increasing the expected return on euro deposits. Finally, when the exchange rate has risen to E* 1 euro per dollar, the expected return on euro deposits has risen enough so that it again equals the expected return on dollar deposits. Explaining Changes read more..

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    on euro deposits, which shifts the schedule for the expected return on euro deposits to the right and leads to a decline in the exchange rate as in Figure 4. Conversely, a rise in Eet 1 raises the expected appreciation of the dollar, lowers the expected return on foreign deposits, shifts the RF schedule to the left, and raises the exchange rate. To summarize, a rise in read more..

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    Since the expected return on domestic (dollar) deposits is just the interest rate on these deposits i D, this interest rate is the only factor that shifts the schedule for the expected return on dollar deposits. Changes in the Domestic Interest Rate. A rise in i D raises the expected return on dol- lar deposits, shifts the RD schedule to the right, and leads to a rise read more..

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    CHAPTER 19 The Foreign Exchange Market 451 Table 2 Factors That Shift the RF and RD Schedules and Affect the Exchange Rate SUMMARY Change Response of Factor in Factor Exchange Rate Et Domestic interest rate i D ↑↑ Foreign interest rate i F ↑↓ Expected domestic price level* ↑↓ Expected trade barriers* ↑↑ Expected import demand ↑↓ Expected export demand ↑↑ Expected read more..

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    452 PA R T V International Finance and Monetary Policy Changes in the Equilibrium Exchange Rate: Two Examples Application Our analysis has revealed the factors that affect the value of the equilibrium exchange rate. Now we use this analysis to take a close look at the response of the exchange rate to changes in interest rates and money growth. Changes in domestic interest read more..

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    CHAPTER 19 The Foreign Exchange Market 453 interest rate, we must always distinguish between real and nominal measures when analyzing the effects of interest rates on exchange rates. Suppose that the Federal Reserve decides to increase the level of the money supply in order to reduce unemployment, which it believes to be excessive. The higher money supply will lead to a higher read more..

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    454 PA R T V International Finance and Monetary Policy FIGURE 7 Effect of a Rise in the Money Supply A rise in the money supply leads to a higher domestic price level in the long run, which in turn leads to a lower expected future exchange rate. The resulting decline in the expected apprecia- tion of the dollar raises the expected return on foreign deposits, shifting the read more..

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    CHAPTER 19 The Foreign Exchange Market 455 Why Are Exchange Rates So Volatile? Application The high volatility of foreign exchange rates surprises many people. Thirty or so years ago, economists generally believed that allowing exchange rates to be determined in the free market would not lead to large fluctuations in their val- ues. Recent experience has proved them wrong. If we read more..

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    456 PA R T V International Finance and Monetary Policy to climb sharply, and at the same time so did the dollar. After 1984, the real interest rate declined substantially, as did the dollar. Our model of exchange rate determination helps explain the rise and fall in the dollar in the 1980s. As Figure 5 indicates, a rise in the U.S. real inter- est rate raises the read more..

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    CHAPTER 19 The Foreign Exchange Market 457 Figure 8 explains why the rise in nominal rates in the late 1970s did not pro- duce a rise in the dollar. As a comparison of the real and nominal interest rates in the late 1970s indicates, the rise in nominal interest rates reflected an increase in expected inflation and not an increase in real interest rates. As our analysis read more..

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    458 PA R T V International Finance and Monetary Policy Trading” column, an example of which is presented in the “Following the Financial News” box. The column indicates that concerns about a possible war against Iraq and weak economic data have put downward pressure on the U.S. dollar. Our analysis of the foreign exchange market explains why these develop- ments have led read more..

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    The column starts by pointing out that surprisingly weak U.S. employ- ment data has led to a falling dollar. The weakness in the U.S. economy sug- gests that real interest rates in the United States are likely to fall in the future. As a result, in the future we have the opposite scenario to Figure 5 occurring, the RD curve shifts to the left, lowering the value of read more..

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    460 PA R T V International Finance and Monetary Policy Questions and Problems Questions marked with an asterisk are answered at the end of the book in an appendix, “Answers to Selected Questions and Problems.” 1. When the euro appreciates, are you more likely to drink California or French wine? *2. “A country is always worse off when its currency is weak (falls in read more..

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    CHAPTER 19 The Foreign Exchange Market 461 Web Exercises 1. The Federal Reserve maintains a web site that lists the exchange rate between the U.S. dollar and many other currencies. Go to /H10/hist/. Go to the historical data from 1999 and later and find the Euro. a. What has the percentage change in the Euro-dollar exchange rate been between introduction read more..

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    462 PREVIEW Thanks to the growing interdependence between the U.S. economy and the econo- mies of the rest of the world, a country’s monetary policy can no longer be conducted without taking international considerations into account. In this chapter, we examine how international financial transactions and the structure of the international finan- cial system affect monetary policy. We read more..

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    circulation falls by $1 billion. We can see this in the following T-account for the Federal Reserve: Because the monetary base is made up of currency in circulation plus reserves, this decline in currency implies that the monetary base has fallen by $1 billion. If instead of paying for the foreign assets sold by the Fed with currency, the persons buying the foreign assets read more..

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    then the Fed deducts the $1 billion from the deposit accounts these banks have with the Fed. The result is that deposits with the Fed (reserves) decline by $1 billion, as shown in the following T-account: In this case, the outcome of the Fed sale of foreign assets and the purchase of dollar deposits is a $1 billion decline in reserves and a $1 billion decline in the read more..

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    A foreign exchange intervention with an offsetting open market operation that leaves the monetary base unchanged is called a sterilized foreign exchange intervention. Now that we understand that there are two types of foreign exchange interventions— unsterilized and sterilized—let’s look at how each affects the exchange rate. Your intuition might lead you to suspect that if a read more..

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    RF to shift leftward, because it leads to a lower U.S. price level in the long run and thus to a higher expected appreciation of the dollar, and hence a lower expected return on foreign deposits. The increase in the expected return on dollar deposits rel- ative to foreign deposits will mean that people will want to buy more dollar deposits, and the exchange rate will read more..

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    expected returns on dollar and foreign deposits are unaffected, the expected return schedules remain at RD1 and RF1 in Figure 1, and the exchange rate remains unchanged at E1. At first it might seem puzzling that a central bank purchase or sale of domestic currency that is sterilized does not lead to a change in the exchange rate. A central bank purchase of domestic read more..

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    indicating that $416 billion more capital came into the United States than went out. Another way of saying this is that the United States had a net capital inflow of $416 bil- lion.3 The sum of the current account and the capital account equals the official reserve transactions balance, which was negative $1 billion in 2001 ( $417 $416 $1 billion). When economists refer read more..

  • Page - 568

    Before World War I, the world economy operated under the gold standard, meaning that the currency of most countries was convertible directly into gold. American dol- lar bills, for example, could be turned in to the U.S. Treasury and exchanged for approximately ounce of gold. Likewise, the British Treasury would exchange ounce of gold for £1 sterling. Because an American could convert $20 read more..

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    demise. As the Allied victory in World War II was becoming certain in 1944, the Allies met in Bretton Woods, New Hampshire, to develop a new international monetary sys- tem to promote world trade and prosperity after the war. In the agreement worked out among the Allies, central banks bought and sold their own currencies to keep their exchange rates fixed at a certain read more..

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    the money supply decline. Because the exchange rate will continue to be fixed at Epar, the expected future exchange rate remains unchanged, and so the schedule for the expected return on foreign deposits remains at RF1. However, the purchase of domestic CHAPTER 20 The International Financial System 471 FIGURE 2 Intervention in the Foreign Exchange Market Under a Fixed Exchange Rate read more..

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    currency, which leads to a fall in the money supply, also causes the interest rate on domestic deposits i D to rise. This increase in turn shifts the expected return on domestic deposits RD to the right. The central bank will continue purchasing domes- tic currency and selling foreign assets until the RD curve reaches RD2 and the equilib- rium exchange rate is at Epar at read more..

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    just lead to a continuing loss of international reserves until the smaller country was forced to devalue. The smaller country no longer controls its monetary policy, because movements in its money supply are completely determined by movements in the larger country’s money supply. Another way to see that when a country fixes its exchange rate to a larger coun- try’s currency read more..

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    might hurt sales for domestic businesses and increase unemployment, surplus coun- tries have often sold their currency in the foreign exchange market and acquired inter- national reserves. Countries with balance-of-payments deficits do not want to see their currency lose value, because it makes foreign goods more expensive for domestic consumers and can stimulate inflation. To keep the read more..

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    when a currency fell outside the limits, with the central bank with the weak currency giving up international reserves and the one with the strong currency gaining them. Central bank intervention was also very common even when the exchange rate was within the limits, but in this case, if one central bank intervened, no others were required to intervene as well. A serious read more..

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    476 PA R T V International Finance and Monetary Policy hence that the value of foreign (mark) deposits would rise in value relative to the pound. As a result, the expected return on mark deposits increased sharply, shifting the RF schedule to RF3 in Figure 3. The huge potential losses on pound deposits and potential gains on mark deposits caused a massive sell-off of pounds read more..

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    CHAPTER 20 The International Financial System 477 exchange rate intervention during the crisis. What the central banks lost, the speculators gained. A speculative fund run by George Soros ran up $1 billion of profits during the crisis, and Citibank traders are reported to have made $200 million. When an exchange rate crisis comes, life can certainly be sweet for exchange rate read more..

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    Capital Controls Because capital flows have been an important element in the currency crises in Mexico and East Asia, politicians and some economists have advocated that capital mobility in emerging market countries should be restricted with capital controls in order to avoid financial instability. Are capital controls a good idea? Capital outflows can promote financial instability in read more..

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    suggests that capital flight may even increase after controls are put into place, because confidence in the government is weakened. Third, controls on capital outflows often lead to corruption, as government officials get paid off to look the other way when domestic residents are trying to move funds abroad. Fourth, controls on capital out- flows may lull governments into thinking read more..

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    As we saw in Chapter 17, in industrialized countries when a financial crisis occurs and the financial system threatens to seize up, domestic central banks can address matters with a lender-of-last-resort operation to limit the degree of instability in the banking system. In emerging market countries, however, where the credibility of the central bank as an inflation-fighter may be read more..

  • Page - 580

    proper measures in place to prevent excessive risk taking. In addition, it can reduce the incentives for risk taking by restricting the ability of governments to bail out stockholders and large uninsured creditors of domestic financial institutions. Some critics of the IMF believe that the IMF has not put enough pressure on the govern- ments to which it lends to contain the read more..

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    funds available. By this time, the crises had gotten much worse—and much larger sums of funds were needed to cope with the crisis, often stretching the resources of the IMF. One reason central banks can lend so much more quickly than the IMF is that they have set up procedures in advance to provide loans, with the terms and con- ditions for this lending agreed upon read more..

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    Under the Bretton Woods system, balance-of-payments considerations were more important than they are under the current managed float regime. When a non- reserve currency country is running balance-of-payments deficits, it necessarily gives up international reserves. To keep from running out of these reserves, under the Bretton Woods system it had to implement contractionary monetary policy read more..

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    484 PA R T V International Finance and Monetary Policy Summary 1. An unsterilized central bank intervention in which the domestic currency is sold to purchase foreign assets leads to a gain in international reserves, an increase in the money supply, and a depreciation of the domestic currency. Available evidence suggests, however, that sterilized central bank interventions have little read more..

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    CHAPTER 20 The International Financial System 485 special drawing rights (SDRs), p. 474 sterilized foreign exchange intervention, p. 465 trade balance, p. 467 unsterilized foreign exchange inter- vention, p. 464 World Bank, p. 470 Questions and Problems Questions marked with an asterisk are answered at the end of the book in an appendix, “Answers to Selected Questions and Problems.” 1. read more..

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    486 PA R T V International Finance and Monetary Policy Web Exercises 1. The Federal Reserve publishes information online that explains the workings of the foreign exchange market. One such publication can be found at www.ny.frb .org/pihome/addpub/usfxm/. Review the table of con- tents and open Chapter 10, the evolution of the inter- national monetary system. Read this chapter and write read more..

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    PREVIEW Getting monetary policy right is crucial to the health of the economy. Overly expan- sionary monetary policy leads to high inflation, which decreases the efficiency of the economy and hampers economic growth. The United States has not been exempt from inflationary episodes, but more extreme cases of inflation, in which the inflation rate climbs to over 100% per year, have read more..

  • Page - 587

    money. Thus, a nominal anchor of some sort is a necessary element in successful mon- etary policy strategies. One reason a nominal anchor is necessary for monetary policy is that it can help promote price stability, which most countries now view as the most important goal for monetary policy. A nominal anchor promotes price stability by tying inflation expectations to low levels read more..

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    consistency problem in monetary policy by providing an expected constraint on discre- tionary policy. In the following sections, we examine three monetary policy strategies— exchange-rate targeting, monetary targeting, and inflation targeting—that use a nominal anchor. Exchange-Rate Targeting Targeting the exchange rate is a monetary policy strategy with a long history. It can take the read more..

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    Exchange-rate targeting has also been an effective means of reducing inflation quickly in emerging market countries. For example, before the devaluation in Mexico in 1994, its exchange-rate target enabled it to bring inflation down from levels above 100% in 1988 to below 10% in 1994. Despite the inherent advantages of exchange-rate targeting, there are several serious criticisms of read more..

  • Page - 590

    which dropped out of the ERM exchange-rate peg and adopted inflation targeting (discussed later in this chapter), had much better economic performance: economic growth was higher, the unemployment rate fell, and yet its inflation was not much worse than France’s. In contrast to industrialized countries, emerging market countries (including the so-called transition countries of Eastern read more..

  • Page - 591

    Given the above disadvantages with exchange-rate targeting, when might it make sense? In industrialized countries, the biggest cost to exchange-rate targeting is the loss of an independent monetary policy to deal with domestic considerations. If an inde- pendent, domestic monetary policy can be conducted responsibly, this can be a seri- ous cost indeed, as the comparison between the read more..

  • Page - 592

    rate is especially strong because the conduct of monetary policy is in effect put on autopilot, taken completely out of the hands of the central bank and the government. In contrast, the typical fixed or pegged exchange-rate regime does allow the monetary authorities some discretion in their conduct of monetary policy because they can still adjust interest rates or print money. A read more..

  • Page - 593

    (or their central banks) do not have to pay interest on their currency, they earn rev- enue (seignorage) by using this currency to purchase income-earning assets such as bonds. In the case of the Federal Reserve in the United States, this revenue is on the order of $30 billion per year. If an emerging market country dollarizes and gives up its currency, it needs to make read more..

  • Page - 594

    CHAPTER 21 Monetary Policy Strategy: The International Experience 495 Table 1 Advantages and Disadvantages of Different Monetary Policy Strategies SUMMARY Exchange-Rate Monetary Inflation Implicit Nominal Targeting Targeting Targeting Anchor Advantages Directly ties down inflation of internationally traded goods Automatic rule for conduct of monetary policy Simplicity and clarity Simplicity and clarity of read more..

  • Page - 595

    Monetary Targeting In many countries, exchange-rate targeting is not an option, because either the coun- try (or bloc of countries) is too large or because there is no country whose currency is an obvious choice to serve as the nominal anchor. Exchange-rate targeting is there- fore clearly not an option for the United States, Japan, or the European Monetary Union. These countries read more..

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    Japan. The increase in oil prices in late 1973 was a major shock for Japan, which experienced a huge jump in the inflation rate, to greater than 20% in 1974—a surge facilitated by money growth in 1973 in excess of 20%. The Bank of Japan, like the other central banks discussed here, began to pay more attention to money growth rates. In 1978, the Bank of Japan began read more..

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    The key fact about monetary targeting regimes in Germany and Switzerland is that the targeting regimes were very far from a Friedman-type monetary targeting rule in which a monetary aggregate is kept on a constant-growth-rate path and is the pri- mary focus of monetary policy. As Otmar Issing, at the time the chief economist of the Bundesbank has noted, “One of the secrets read more..

  • Page - 598

    When the Bundesbank first set its monetary targets at the end of 1974, it announced a medium-term inflation goal of 4%, well above what it considered to be an appropriate long-run goal. It clarified that this medium-term inflation goal differed from the long-run goal by labeling it the “unavoidable rate of price increase.” Its grad- ualist approach to reducing inflation led read more..

  • Page - 599

    of the shocks to the exchange rate and the shift in the demand for monetary base aris- ing from the above institutional changes created a serious problem for its targeted aggregate. As the 1988 year unfolded, it became clear that the Swiss National Bank had guessed wrong in predicting the effects of these shocks, so that monetary policy was too easy, even though the read more..

  • Page - 600

    All of the above advantages of monetary aggregate targeting depend on a big if: There must be a strong and reliable relationship between the goal variable (inflation or nom- inal income) and the targeted aggregate. If the relationship between the monetary aggregate and the goal variable is weak, monetary aggregate targeting will not work; this seems to have been a serious read more..

  • Page - 601

    which became effective on February 1, 1990. Besides increasing the independence of the central bank, moving it from being one of the least independent to one of the most independent among the developed countries, the act also committed the Reserve Bank to a sole objective of price stability. The act stipulated that the minister of finance and the governor of the Reserve Bank read more..

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    CHAPTER 21 Monetary Policy Strategy: The International Experience 503 FIGURE 1 Inflation Rates and Inflation Targets for New Zealand, Canada, and the United Kingdom, 1980–2002 (a) New Zealand; (b) Canada; (c) United Kingdom Source: Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin, and Adam S. Poson, Inflation Targeting: Lessons from the International Experience (Princeton: Princeton read more..

  • Page - 603

    Before the adoption of inflation targets, inflation had already been falling in the U.K. from a peak of 9% at the beginning of 1991 to 4% at the time of adoption (see Figure 1, panel c). After a small upward movement in early 1993, inflation continued to fall until by the third quarter of 1994, it was at 2.2%, within the intended range articulated by the chancellor. read more..

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    market participants, and the politicians: (1) the goals and limitations of monetary pol- icy, including the rationale for inflation targets; (2) the numerical values of the infla- tion targets and how they were determined, (3) how the inflation targets are to be achieved, given current economic conditions; and (4) reasons for any deviations from targets. These communications have read more..

  • Page - 605

    to the Bank of England occurred because it would operate under a monetary policy regime to ensure that monetary policy goals cannot diverge from the interests of soci- ety for extended periods of time. Nonetheless, monetary policy was to be insulated from short-run political considerations. An inflation-targeting regime makes it more palatable to have an independent central bank that read more..

  • Page - 606

    tion. With rigid adherence to a monetary rule, the breakdown in their relationship could have been disastrous. However, the traditional distinction between rules and discretion can be highly misleading. Useful policy strategies exist that are “rule-like,” in that they involve forward-looking behavior that limits policymakers from system- atically engaging in policies with undesirable read more..

  • Page - 607

    In addition, many inflation targeters, particularly the Bank of Canada, have emphasized that the floor of the target range should be emphasized every bit as much as the ceiling, thus helping to stabilize the real economy when there are negative shocks to demand. Inflation targets can increase the central bank’s flexibility in responding to declines in aggregate spending. Declines read more..

  • Page - 608

    mote a healthy economy with high growth. In addition, if the estimate for potential GDP growth is higher than the true potential for long-term growth and becomes embedded in the public mind as a target, it can lead to a positive inflation bias. Second, information on prices is more timely and more frequently reported than data on nominal GDP (and could be made even more read more..

  • Page - 609

    be embedded in the wage- and price-setting process, creating an inflation momentum that would be hard to halt. Inflation becomes much harder to control once it has been allowed to gather momentum, because higher inflation expectations become ingrained in various types of long-term contracts and pricing agreements. To prevent inflation from getting started, therefore, monetary policy read more..

  • Page - 610

    financial markets and creates doubt among producers and the general public about the future course of inflation and output. Furthermore, the opacity of its policymak- ing makes it hard to hold the Federal Reserve accountable to Congress and the gen- eral public: The Fed can’t be held accountable if there are no predetermined criteria for judging its performance. Low accountability read more..

  • Page - 611

    monetary policy. Also, a move to inflation targeting is consistent with recent steps by the Fed to increase the transparency of monetary policy, such as shortening the time before the minutes of the FOMC meeting are released, the practice of announcing the FOMC’s decision about whether to change the target for the federal funds rates immediately after the conclusion of the read more..

  • Page - 612

    CHAPTER 21 Monetary Policy Strategy: The International Experience 513 Key Terms currency board, p. 492 dollarization, p. 493 nominal anchor, p. 487 seignorage, p. 493 time-consistency problem, p. 488 Questions and Problems Questions marked with an asterisk are answered at the end of the book in an appendix, “Answers to Selected Questions and Problems.” 1. What are the benefits of using read more..

  • Page - 613

    514 PA R T V International Finance and Monetary Policy Web Exercises 1. Many countries have central banks that are responsible for their nation’s monetary policy. Go to and select one of the central banks (for example, Norway). Review that bank’s web site to determine its policies regarding application of monetary policy. How does this bank’s read more..

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    Pa r t V I Monetary Theory read more..

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    read more..

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    PREVIEW In earlier chapters, we spent a lot of time and effort learning what the money supply is, how it is determined, and what role the Federal Reserve System plays in it. Now we are ready to explore the role of the money supply in determining the price level and total production of goods and services (aggregate output) in the economy. The study of the effect of read more..

  • Page - 617

    The clearest exposition of the classical quantity theory approach is found in the work of the American economist Irving Fisher, in his influential book The Purchasing Power of Money, published in 1911. Fisher wanted to examine the link between the total quantity of money M (the money supply) and the total amount of spending on final goods and services produced in the economy read more..

  • Page - 618

    the institutional and technological features of the economy would affect velocity only slowly over time, so velocity would normally be reasonably constant in the short run. Fisher’s view that velocity is fairly constant in the short run transforms the equation of exchange into the quantity theory of money, which states that nominal income is determined solely by movements in the read more..

  • Page - 619

    by the level of nominal income PY and (2) by the institutions in the economy that affect the way people conduct transactions and thus determine velocity and hence k. Is Velocity a Constant? The classical economists’ conclusion that nominal income is determined by movements in the money supply rested on their belief that velocity PY/M could be treated as reason- ably constant.4 read more..

  • Page - 620

    the growth rate of velocity from year to year. The percentage change in M1 velocity (GDP/M1) from 1981 to 1982, for example, was 2.5%, whereas from 1980 to 1981 velocity grew at a rate of 4.2%. This difference of 6.7% means that nominal GDP was 6.7% lower than it would have been if velocity had kept growing at the same rate as in 1980–1981.5 The drop is enough to read more..

  • Page - 621

    Keynes went beyond the classical analysis by recognizing that in addition to holding money to carry out current transactions, people hold money as a cushion against an unexpected need. Suppose that you’ve been thinking about buying a fancy stereo; you walk by a store that is having a 50%-off sale on the one you want. If you are holding money as a precaution for just read more..

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    In putting the three motives for holding money balances together into a demand for money equation, Keynes was careful to distinguish between nominal quantities and real quantities. Money is valued in terms of what it can buy. If, for example, all prices in the economy double (the price level doubles), the same nominal quantity of money will be able to buy only half as many read more..

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    interest rates are procyclical, rising in expansions and falling in recessions. The liq- uidity preference theory indicates that a rise in interest rates will cause velocity to rise also. The procyclical movements of interest rates should induce procyclical move- ments in velocity, and that is exactly what we see in Figure 1. Keynes’s model of the speculative demand for money read more..

  • Page - 624

    purposes are sensitive to the level of interest rates.7 In developing their models, they considered a hypothetical individual who receives a payment once a period and spends it over the course of this period. In their model, money, which earns zero interest, is held only because it can be used to carry out transactions. To refine this analysis, let’s say that Grant Smith read more..

  • Page - 625

    month with $500 of cash, and by the middle of the month, his cash balance has run down to zero. Because bonds cannot be used directly to carry out transactions, Grant must sell them and turn them into cash so that he can carry out the rest of the month’s transactions. At the middle of the month, then, Grant’s cash balance rises back up to $500. By the end read more..

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    simple models, Baumol and Tobin revealed something that we might not otherwise have seen: that the transactions demand for money, and not just the speculative demand, will be sensitive to interest rates. The Baumol-Tobin analysis presents a nice demonstration of the value of economic modeling.9 Study Guide The idea that as interest rates increase, the opportunity cost of holding read more..

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    care about the expected return on one asset versus another when they decide what to hold in their portfolio, but they also care about the riskiness of the returns from each asset. Specifically, Tobin assumed that most people are risk-averse—that they would be willing to hold an asset with a lower expected return if it is less risky. An impor- tant characteristic of money read more..

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    Like his predecessors, Friedman pursued the question of why people choose to hold money. Instead of analyzing the specific motives for holding money, as Keynes did, Friedman simply stated that the demand for money must be influenced by the same factors that influence the demand for any asset. Friedman then applied the the- ory of asset demand to money. The theory of asset read more..

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    An individual can hold wealth in several forms besides money; Friedman catego- rized them into three types of assets: bonds, equity (common stocks), and goods. The incentives for holding these assets rather than money are represented by the expected return on each of these assets relative to the expected return on money, the last three terms in the money demand function. The read more..

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    excess profits, and in doing so they close the gap between interest earned on loans and interest paid on deposits. The net result of this competition in the banking indus- try is that rb rm stays relatively constant when the interest rate i rises.14 What if there are restrictions on the amount of interest that banks can pay on their deposits? Will the expected return on read more..

  • Page - 631

    demand for money accurately) implies that velocity is predictable as well. If we can predict what velocity will be in the next period, a change in the quantity of money will produce a predictable change in aggregate spending. Even though velocity is no longer assumed to be constant, the money supply continues to be the primary deter- minant of nominal income as in the read more..

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    Earlier in the chapter, we saw that if interest rates do not affect the demand for money, velocity is more likely to be a constant—or at least predictable—so that the quantity theory view that aggregate spending is determined by the quantity of money is more likely to be true. However, the more sensitive the demand for money is to interest rates, the more unpredictable read more..

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    534 PA R T V I Monetary Theory economics profession after the sharp drop in velocity during the years of the Great Depression. 3. John Maynard Keynes suggested three motives for holding money: the transactions motive, the precautionary motive, and the speculative motive. His resulting liquidity preference theory views the transactions and precautionary components of money demand as read more..

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    CHAPTER 22 The Demand for Money 535 gest about how velocity moves with the business cycle? Given the data in Figure 1, is it reasonable to assume, as the classical economists did, that declines in aggregate spending are caused by declines in the quantity of money? 8. Using data from the Economic Report of the President, calculate velocity for the M2 definition of the money read more..

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    Baumol-Tobin Model of Transactions Demand for Money The basic idea behind the Baumol-Tobin model was laid out in the chapter. Here we explore the mathematics that underlie the model. The assumptions of the model are as follows: 1. An individual receives income of T0 at the beginning of every period. 2. An individual spends this income at a constant rate, so at the end of read more..

  • Page - 636

    The individual wants to minimize costs by choosing the appropriate level of C. This is accomplished by taking the derivative of costs with respect to C and setting it to zero.1 That is: Solving for C yields the optimal level of C: Because money demand Md is the average desired holding of cash balances C/2, (1) This is the famous square root rule.2 It has these read more..

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    Tobin Mean-Variance Model Tobin’s mean-variance analysis of money demand is just an application of the basic ideas in the theory of portfolio choice. Tobin assumes that the utility that people derive from their assets is positively related to the expected return on their portfolio of assets and is negatively related to the riskiness of this portfolio as represented by the read more..

  • Page - 638

    where E expectation of the variable inside the parentheses Var variance of the variable inside the parentheses If A is the fraction of the portfolio put into bonds (0 ≤ A ≤ 1) and 1 A is the fraction of the portfolio held as money, the return R on the portfolio can be writ- ten as: R ARB (1 A)(0) ARB A(i g) Then the mean and variance of the return on the read more..

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    rate on bonds rises, the demand for money falls; that is, 1 A, the fraction of the portfolio held as money, declines.4 Tobin’s model then yields the same result as Keynes’s analysis of the speculative demand for money: It is negatively related to the level of interest rates. This model, however, makes two important points that Keynes’s model does not: 1. Individuals read more..

  • Page - 640

    A Mathematical Treatment of The Baumol-Tobin and Tobin Mean-Variance Models FIGURE 3 Optimal Choice of the Fraction of the Portfolio in Bonds as the Interest Rate Rises The interest rate on bonds rises from i1 to i2, rotating the opportu- nity locus upward. The highest indifference curve is now at point C, where it is tangent to the new opportunity locus. The optimal level of read more..

  • Page - 641

    Here we examine the empirical evidence on the two primary issues that distinguish the different theories of money demand and affect their conclusions about whether the quantity of money is the primary determinant of aggregate spending: Is the demand for money sensitive to changes in interest rates, and is the demand for money function stable over time? James Tobin conducted one read more..

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    very low.4 Laidler and Meltzer looked at this question by seeing whether the interest sensitivity of money demand differed across periods, especially in periods such as the 1930s when interest rates were particularly low.5 They found that there was no ten- dency for interest sensitivity to increase as interest rates fell—in fact, interest sensi- tivity did not change from period read more..

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    result of this evidence, the M1 money demand function became the conventional money demand function used by economists. The Case of the Missing Money. The stability of the demand for money, then, was a well-established fact when, starting in 1974, the conventional M1 money demand function began to severely overpredict the demand for money. Stephen Goldfeld labeled this phenomenon of read more..

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    Michael Hamburger, for example, found that including the average dividend–price ratio on common stocks (average dividends divided by average price) as a measure of their interest rate resulted in a money demand function that is stable.10 Other researchers, such as Heller and Khan, added the entire term structure of interest rates to their money demand function and found that this read more..

  • Page - 645

    traditional money demand functions.16 In the late 1990s, M2 velocity seemed to set- tle down, suggesting a more normal relationship between M2 demand and macro- economic variables. However, doubts continue to arise about the stability of money demand.17 Conclusion. The main conclusion from the research on the money demand function seems to be that the most likely cause of its read more..

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    536 PREVIEW In the media, you often see forecasts of GDP and interest rates by economists and gov- ernment agencies. At times, these forecasts seem to come from a crystal ball, but econ- omists actually make their predictions using a variety of economic models. One model widely used by economic forecasters is the ISLM model, which was developed by Sir John Hicks in 1937 and read more..

  • Page - 647

    the total planned spending by businesses on new physical capital (machines, com- puters, factories, raw materials, and the like) plus planned spending on new homes; (3) government spending (G ) , the spending by all levels of government on goods and services (aircraft carriers, government workers, red tape, and so forth); and (4) net exports ( NX ) , the net foreign read more..

  • Page - 648

    Ask yourself what determines how much you spend on consumer goods and services. Your likely response is that your income is the most important factor, because if your income rises, you will be willing to spend more. Keynes reasoned similarly that con- sumer expenditure is related to disposable income, the total income available for spending, equal to aggregate income (which is read more..

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    It is important to understand that there are two types of investment. The first type, fixed investment, is the spending by firms on equipment (machines, computers, air- planes) and structures (factories, office buildings, shopping centers) and planned spending on residential housing. The second type, inventory investment, is spend- ing by firms on additional holdings of raw materials, read more..

  • Page - 650

    dealers. If each computer has a wholesale price of $1,000, Compaq has an inventory worth $100 million. If by December 31, 2004, its inventory of personal computers has risen to $150 million, its inventory investment in 2004 is $50 million, the change in the level of its inventory over the course of the year ($150 million minus $100 mil- lion). Now suppose that there is a read more..

  • Page - 651

    at which aggregate output Y equals aggregate demand Y ad; that is, it shows all the points at which the equilibrium condition Y Y ad is satisfied. Since government spending and net exports are zero (G 0 and NX 0), aggregate demand is: Y ad C I Because there is no government sector to collect taxes, there are none in our simpli- fied economy; disposable income read more..

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    amount of output produced in the economy is $1,200 billion and is therefore above the equilibrium level. At this level of output, aggregate demand is $1,100 billion (point K), $100 billion less than the $1,200 billion of output (point L on the 45° line). Since output exceeds aggregate demand by $100 billion, firms are saddled with $100 billion of unsold inventory. To keep read more..

  • Page - 653

    spending adds directly to aggregate demand and shifts the aggregate demand function upward to Y 2 ad. Aggregate demand now equals output at the intersection of Y 2 ad with the 45° line Y Y ad (point 2). As a result of the $100 billion increase in planned investment spending, equilibrium output rises by $200 billion to $1,200 billion (Y2). For every dollar increase in read more..

  • Page - 654

    Because I is multiplied by the term 1/(1 mpc) , this equation tells us that a $1 change in I leads to a $1/(1 mpc) change in aggregate output; thus 1/(1 mpc)is the expenditure multiplier. When mpc 0.5, the change in output for a $1 change in I is $2 [ 1/(1 0.5)]; if mpc 0.8, the change in output for a $1 change in I is $5. The larger the marginal read more..

  • Page - 655

    After witnessing the events in the Great Depression, Keynes took the view that an economy would continually suffer major output fluctuations because of the volatility of autonomous spending, particularly planned investment spending. He was espe- cially worried about sharp declines in autonomous spending, which would inevitably Government’s Role CHAPTER 23 The Keynesian Framework and the ISLM read more..

  • Page - 656

    lead to large declines in output and an equilibrium with high unemployment. If autonomous spending fell sharply, as it did during the Great Depression, how could an economy be restored to higher levels of output and more reasonable levels of unemployment? Not by an increase in autonomous investment and consumer spend- ing, since the business outlook was so grim. Keynes’s answer read more..

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    Although you can see that aggregate output is negatively related to the level of taxes, it is important to recognize that the change in aggregate output from the $400 billion increase in taxes ( Y $400 billion) is smaller than the change in aggregate output from the $400 billion increase in government spending ( Y $800 billion). If both taxes and government spending read more..

  • Page - 658

    International trade also plays a role in determining aggregate output because net exports (exports minus imports) are a component of aggregate demand. To analyze the effect of net exports in the Keynesian cross diagram of Figure 6, suppose that ini- tially net exports are equal to zero (NX1 0) so that the economy is at point 1, where the aggregate demand function Y 1 ad read more..

  • Page - 659

    The effects of changes in each of these variables on aggregate output are summa- rized in Table 2 and discussed next in the text. Changes in Autonomous Consumer Spending (a). A rise in autonomous consumer expenditure a (say, because consumers become more optimistic about the economy when the stock market booms) directly raises consumer expenditure and shifts the aggregate demand read more..

  • Page - 660

    aggregate output. Therefore, aggregate output is positively related to autonomous consumer expenditure a. Changes in Planned Investment Spending (l ). A rise in planned investment spending adds directly to aggregate demand, thus raising the aggregate demand function and aggregate output. A fall in planned investment spending lowers aggregate demand and causes aggregate output to fall. read more..

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    Study Guide To test your understanding of the Keynesian analysis of how aggregate output changes in response to changes in the factors described, see if you can use Keynesian cross dia- grams to illustrate what happens to aggregate output when each variable decreases rather than increases. Also, be sure to do the problems at the end of the chapter that ask you to predict read more..

  • Page - 662

    When the IS and LM curves are combined in the same diagram, the intersection of the two determines the equilibrium level of aggregate output as well as the interest rate. Finally, we will have obtained a more complete analysis of the determination of aggregate output in which monetary policy plays an important role. In Keynesian analysis, the primary way that interest rates read more..

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    CHAPTER 23 The Keynesian Framework and the ISLM Model 553 FIGURE 7 Deriving the IS Curve The investment schedule in panel (a) shows that as the interest rate rises from i1 to i2 to i3, planned investment spending falls from I1 to I2 to I3, and panel (b) shows that net exports also fall from NX1 to NX2 to NX3 as the interest rate rises. Panel (c) then indicates the read more..

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    interest rate i1, the exchange rate is low and net exports NX1 are high; at a high inter- est rate i3, the exchange rate is high and net exports NX3 are low. Deriving the IS Curve. We can now use what we have learned about the relationship of interest rates to planned investment spending and net exports in panels (a) and (b) to examine the relationship between read more..

  • Page - 665

    because we do not know what the interest rate is. To complete our analysis of aggre- gate output determination, we need to introduce another market that produces an additional relationship that links aggregate output and interest rates. The market for money fulfills this function with the LM curve. When the LM curve is combined with the IS curve, a unique equilibrium that read more..

  • Page - 666

    Panel (b) plots the equilibrium interest rates that correspond to the different out- put levels, with points 1, 2, and 3 corresponding to the equilibrium points 1, 2, and 3 in panel (a). The line connecting these points is the LM curve, which shows the combinations of interest rates and output for which the market for money is in equi- librium.9 The positive slope arises read more..

  • Page - 667

    Chapter 4.) As long as an excess supply of money exists, the interest rate will fall until it comes to rest on the LM curve. If the economy is located in the area to the right of the LM curve, there is an excess demand for money. At point B, for example, the interest rate i1 is below the equilibrium level, and people want to hold more money than they currently read more..

  • Page - 668

    which in turn causes both planned investment spending and net exports to rise, and thus aggregate output rises. The economy then moves down along the IS curve, and the process continues until the interest rate falls to i* and aggregate output rises to Y *—that is, until the economy is at equilibrium point E. If the economy is on the LM curve but off the IS curve at read more..

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    CHAPTER 23 The Keynesian Framework and the ISLM Model 559 Key Terms aggregate demand, p. 537 aggregate demand function, p. 541 “animal spirits,” p. 544 autonomous consumer expenditure, p. 538 consumer expenditure, p. 536 consumption function, p. 538 disposable income, p. 538 expenditure multiplier, p. 543 fixed investment, p. 539 government spending, p. 537 inventory investment, p. 539 IS read more..

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    *14. Using a supply and demand diagram for the market for money, show what happens to the equilibrium level of the interest rate as aggregate output falls. What does this imply about the slope of the LM curve? 15. “If the point describing the combination of the interest rate and aggregate output is not on either the IS or the LM curve, the economy will have no read more..

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    PREVIEW Since World War II, government policymakers have tried to promote high employment without causing inflation. If the economy experiences a recession such as the one that began in March 2001, policymakers have two principal sets of tools that they can use to affect aggregate economic activity: monetary policy, the control of interest rates or the money supply, and fiscal read more..

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    causes a movement only along the IS curve.) We have already identified five candi- dates as autonomous factors that can shift aggregate demand and hence affect the level of equilibrium output. We can now ask how changes in each of these factors affect the IS curve. 1. Changes in Autonomous Consumer Expenditure. A rise in autonomous consumer expenditure shifts aggregate demand read more..

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    equilibrium level of aggregate output as a result of this rise in autonomous consumer expenditure when the interest rate is held constant at iA? The IS1 curve tells us that equilibrium aggregate output is at YA when the interest rate is at iA (point A). Panel (b) shows that this point is an equilibrium in the goods market because the aggregate demand function Y 1 ad at read more..

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    fall in net exports shifts the aggregate demand function downward, and the equilib- rium level of output falls, shifting the IS curve to the left. Factors That Cause the LM Curve to Shift The LM curve describes the equilibrium points in the market for money—the com- binations of aggregate output and interest rate for which the quantity of money demanded equals the quantity read more..

  • Page - 675

    CHAPTER 24 Monetary and Fiscal Policy in the ISLM Model 565 FIGURE 2 Shift in the LM Curve from an Increase in the Money Supply The LM curve shifts to the right from LM1 to LM2 when the money supply increases because, as indicated in panel (b), at any given level of aggregate output (say, YA) , the equilibrium interest rate falls (point A to A ). A Interest read more..

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    Conversely, an autonomous decline in money demand would lead to a rightward shift in the LM curve. The fall in money demand would create an excess supply of money, which is eliminated by a rise in the quantity of money demanded from a decline in the interest rate. Changes in Equilibrium Level of the Interest Rate and Aggregate Output You can now use your knowledge of read more..

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    When the economy is at point 1, the increase in the money supply (rightward shift of the LM curve) creates an excess supply of money, resulting in a decline in the inter- est rate. The decline causes investment spending and net exports to rise, which in turn raises aggregate demand and causes aggregate output to rise. The excess supply of money is eliminated when the read more..

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    Why does an increase in government spending or a decrease in taxes move the economy from point 1 to point 2, causing a rise in both aggregate output and the interest rate? An increase in government spending raises aggregate demand directly; a decrease in taxes makes more income available for spending and raises aggregate demand by raising consumer expenditure. The resulting read more..

  • Page - 679

    CHAPTER 24 Monetary and Fiscal Policy in the ISLM Model 569 Table 1 Effects from Factors That Shift the IS and LM Curves SUMMARY Autonomous Change Factor in Factor Response Reason Consumer ↑ Y ↑, i ↑ C ↑ ⇒ Y ad ↑ ⇒ expenditure C IS shifts right Investment I ↑ Y ↑, i ↑ I ↑ ⇒ Y ad ↑ ⇒ IS shifts right Government ↑ Y ↑, i ↑ G ↑ ⇒ Y ad ↑ ⇒ read more..

  • Page - 680

    aggregate output remains unchanged at Y1 (point 2). Equilibrium in the market for money will occur at the same level of aggregate output regardless of the interest rate, and the LM curve will be vertical, as shown in both panels of Figure 6. Suppose that the economy is suffering from a high rate of unemployment, which policymakers try to eliminate with either expansionary read more..

  • Page - 681

    CHAPTER 24 Monetary and Fiscal Policy in the ISLM Model 571 answer is that because the LM curve is vertical, the rightward shift of the IS curve raises the interest rate to i2, which causes investment spending and net exports to fall enough to offset completely the increased spending of the expansionary fiscal policy. Put another way, increased spending that results from read more..

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    572 PA R T V I Monetary Theory to explain why central banks have abandoned monetary targeting for interest- rate targeting.3 As we saw in Chapter 18, when the Federal Reserve attempts to hit a money supply target, it cannot at the same time pursue an interest-rate tar- get; it can hit one target or the other but not both. Consequently, it needs to know which of these read more..

  • Page - 683

    CHAPTER 24 Monetary and Fiscal Policy in the ISLM Model 573 labeled “Money Supply Target.” Because it is not changing the money supply and so keeps the LM curve at LM *, aggregate output will fluctuate between Y M and Y M for the money supply target policy. As you can see in the figure, the money supply target leads to smaller out- put fluctuations around the read more..

  • Page - 684

    574 PA R T V I Monetary Theory money supply. The only effect of the fluctuating LM curve, then, is that the money supply fluctuates more as a result of the interest-rate target policy. The outcome of the interest-rate target is that output will be exactly at the desired level with no fluctuations. Since smaller output fluctuations are desirable, the conclusion from Figure 8 read more..

  • Page - 685

    ISLM Model in the Long Run So far in our ISLM analysis, we have been assuming that the price level is fixed so that nominal values and real values are the same. This is a reasonable assumption for the short run, but in the long run the price level does change. To see what happens in the ISLM model in the long run, we make use of the concept of the natural read more..

  • Page - 686

    happens to output and interest rates when there is a rise in the money supply. As we saw in Figure 2, the rise in the money supply causes the LM curve to shift to LM2, and the equilibrium moves to point 2 (the intersection of IS1 and LM2) , where the interest rate falls to i2 and output rises to Y2. However, as we can see in panel (a), the level of output read more..

  • Page - 687

    ISLM Model and the Aggregate Demand Curve We now examine further what happens in the ISLM model when the price level changes. When we conduct the ISLM analysis with a changing price level, we find that as the price level falls, the level of aggregate output rises. Thus we obtain a rela- tionship between the price level and quantity of aggregate output for which the read more..

  • Page - 688

    in panel (b) plots this level of output for price level P2. A further increase in the price level to P3 causes a further decline in the real money supply, leading to a further increase in the interest rate and a further decline in planned investment and net exports, and out- put declines to Y3. Point 3 in panel (b) plots this level of output for price level P3. read more..

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    Suppose that initially the aggregate demand curve is at AD1 and there is a rise in, for example, government spending. The ISLM diagram in panel (b) shows what then happens to equilibrium output, holding the price level constant at PA. Initially, equi- librium output is at YA at the intersection of IS1 and LM1. The rise in government spending (holding the price level constant read more..

  • Page - 690

    constant at PA. A rise in the money supply shifts the LM curve to the right and raises equilibrium output to YA . This rise in equilibrium output is shown as a movement from point A to point A in panel (a), and the aggregate demand curve shifts to the right. Our conclusion from Figure 12 is similar to that of Figure 11: Holding the price level constant, any read more..

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    CHAPTER 24 Monetary and Fiscal Policy in the ISLM Model 581 Web Exercises 1. We can continue our study of the ISLM framework by reviewing a dynamic interactive site. Go to http://nova Assume that the change in government spending is $25, the tax rate is 30%, the velocity of money is 12, and the money sup- ply is increased by $2. What is the read more..

  • Page - 692

    The use of algebra to analyze the ISLM model allows us to extend the multiplier analy- sis in Chapter 23 and to obtain many of the results of Chapters 23 and 24 very quickly. Basic Closed-Economy ISLM Model The goods market can be described by the following equations: Consumption function: C mpc (Y T) (1) Investment function: I di (2) Taxes: T (3) Government spending: read more..

  • Page - 693

    d interest sensitivity of investment spending autonomous investment spending related to business confidence d autonomous money demand e income sensitivity of money demand f interest sensitivity of money demand mpc marginal propensity to consume Substituting for C, I, and G in the goods market equilibrium condition and then solv- ing for Y, we obtain the IS curve: (9) Solving for i from read more..

  • Page - 694

    Open-Economy ISLM Model To make the basic ISLM model into an open-economy model, we need to include net exports in the goods market equilibrium condition so that Equation 5 becomes Equation 5': Y Yad C I G NX (5') As the discussion in Chapter 24 suggests, the net exports and exchange rate relations can be written: (13) (14) where NX net exports autonomous net exports h read more..

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    2. Equations 16 and 17 indicate that all the results we found for the basic model still hold. 3. Equation 16 indicates that a rise in leads to a rise in Y, and an autonomous rise in the value of the domestic currency leads to a decline in Y. 4. Equation 17 indicates that a rise in leads to a rise in i, and a rise in leads to a decline in i. E NX E NX read more..

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    582 PREVIEW In earlier chapters, we focused considerable attention on monetary policy, because it touches our everyday lives by affecting the prices of the goods we buy and the quan- tity of available jobs. In this chapter, we develop a basic tool, aggregate demand and supply analysis, that will enable us to study the effects of money on output and prices. Aggregate demand is read more..

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    final goods and services. More formally, velocity V is calculated by dividing nominal spending P Y by the money supply M: Suppose that the total nominal spending in a year was $2 trillion and the money sup- ply was $1 trillion; velocity would then be $2 trillion/$1 trillion 2. On average, the money supply supports a level of transactions associated with 2 times its value read more..

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    exchange is transformed into a theory of how aggregate spending is determined and is called the modern quantity theory of money. To see how the theory works, let’s look at an example. If velocity is predicted to be 2 and the money supply is $1 trillion, the equation of exchange tells us that aggre- gate spending will be $2 trillion (2 $1 trillion). If the money read more..

  • Page - 699

    and at a price level of 2.0, the quantity of aggregate output demanded will rise to $2 trillion so that 2.0 2 trillion $4 trillion. Therefore, at a price level of 2.0, the aggregate demand curve moves from point A to A . At a price level of 1.0, the quan- tity of output demanded rises from $2 to $4 trillion (from point B to B ), and at a price level of read more..

  • Page - 700

    (a decline in the exchange rate, denoted by E ↓). The lower value of the dollar, which makes domestic goods cheaper relative to foreign goods, then causes net exports to rise, which in turn increases aggregate demand: P ↓⇒ M/P ↑⇒ i ↓⇒ E ↓⇒ NX ↑⇒ Y ad ↑ Shifts in the Aggregate Demand Curve. The mechanisms described also indicate why Keynesian analysis read more..

  • Page - 701

    billion in net exports. This phenomenon of an exactly offsetting movement of private spending to an expansionary fiscal policy, such as a rise in government spending, is called complete crowding out. How might complete crowding out occur? When government spending increases (G ↑), the government has to finance this spending by competing with private borrow- ers for funds in the read more..

  • Page - 702

    of output supplied at a price level of 1.0 is $4 trillion, represented by point A. A rise in the price level to 2.0 leads, in the short run, to an increase to $6 trillion in the quantity of output supplied (point B). The line AS1 connecting points A and B describes the relationship between the quantity of output supplied in the short run and the price level and read more..

  • Page - 703

    Figure 3 illustrates an equilibrium in the short run in which the quantity of aggregate output demanded equals the quantity of output supplied; that is, where the aggregate demand curve AD and the aggregate supply curve AS intersect at point E. The equi- librium level of aggregate output equals Y *, and the equilibrium price level equals P *. As in our earlier supply and read more..

  • Page - 704

    market is tight, because the demand for labor exceeds the supply; employers will raise wages to attract needed workers, and this raises the costs of production. The higher costs of production lower the profits per unit of output at each price level, and the aggregate supply curve shifts to the left (see Figure 2). By contrast, if the economy enters a recession and the read more..

  • Page - 705

    In panel (b), the initial equilibrium at point 1 is one at which output Y1 is below the natural rate level. Because unemployment is higher than the natural rate, wages begin to fall, shifting the aggregate supply curve rightward until it comes to rest at AS3. The economy slides downward along the aggregate demand curve until it reaches the long-run equilibrium point 3, the read more..

  • Page - 706

    view is reflected in Keynes’s often quoted remark, “In the long run, we are all dead.” These economists view the self-correcting mechanism as slow, because wages are inflexible, particularly in the downward direction when unemployment is high. The resulting slow wage and price adjustments mean that the aggregate supply curve does not move quickly to restore the economy to the read more..

  • Page - 707

    CHAPTER 25 Aggregate Demand and Supply Analysis 593 Table 1 Factors That Shift the Aggregate Demand Curve SUMMARY Shift in the Aggregate Factor Change Demand Curve Money supply M ↑ Government spending G ↑ Taxes T ↑ Net exports NX ↑ Consumer optimism C ↑ Business optimism I ↑ Note: Only increases (↑) in the factors are shown. The effect of decreases in the factors would be read more..

  • Page - 708

    optimistic (C ↑, I ↑). The figure has been drawn so that initially the economy is in long-run equilibrium at point 1, where the initial aggregate demand curve AD1 inter- sects the aggregate supply AS1 curve at Yn. When the aggregate demand curve shifts rightward to AD2, the economy moves to point 1 , and both output and the price level rise. However, the economy will read more..

  • Page - 709

    oil), which raises their price, increases production costs and shifts the aggregate supply curve leftward. A positive supply shock, such as unusually good weather that leads to a bountiful harvest and lowers the cost of food, will reduce production costs and shift the aggregate supply curve rightward. Similarly, the development of a new technology that lowers production costs, perhaps read more..

  • Page - 710

    Now that we know what factors can affect the aggregate supply curve, we can examine what occurs when they cause the aggregate supply curve to shift leftward, as in Figure 6. Suppose that the economy is initially at the natural rate level of output at point 1 when the aggregate supply curve shifts from AS1 to AS2 because of a negative supply shock (a sharp rise in read more..

  • Page - 711

    One group, led by Edward Prescott of the University of Minnesota, has developed a theory of aggregate economic fluctuations called real business cycle theory, in which aggregate supply (real) shocks do affect the natural rate level of output Yn. This theory views shocks to tastes (workers’ willingness to work, for example) and tech- nology (productivity) as the major driving read more..

  • Page - 712

    international trade (net exports), or “animal spirits” (business and consumer optimism)— affects output only in the short run and has no effect in the long run. Furthermore, the initial change in the price level is less than is achieved in the long run, when the aggregate supply curve has fully adjusted. 2. A shift in the aggregate supply curve—which can be caused by read more..

  • Page - 713

    CHAPTER 25 Aggregate Demand and Supply Analysis 599 supply diagram in Figure 6 predicts, both the price level and unemployment began to rise dramatically (see Table 4). The 1978–1980 period was almost an exact replay of the 1973–1975 period. By 1978, the economy had just about fully recovered from the 1973–1974 supply shocks, when poor harvests and a doubling of oil prices read more..

  • Page - 714

    600 PA R T V I Monetary Theory Year Unemployment Rate (%) Inflation (Year to Year) (%) 1995 5.6 2.8 1996 5.4 3.0 1997 4.9 2.3 1998 4.5 1.6 1999 4.2 2.2 Source: Economic Report of the President; Table 5 Unemployment and Inflation During the Favorable Supply Shock Period, 1995–2000 ployment falling to below 5%, well below what many economists read more..

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    CHAPTER 25 Aggregate Demand and Supply Analysis 601 Key Terms activists, p. 592 aggregate demand, p. 582 aggregate demand curve, p. 582 aggregate supply, p. 582 aggregate supply curve, p. 588 “animal spirits,” p. 586 complete crowding out, p. 587 consumer expenditure, p. 585 equation of exchange, p. 583 government spending, p. 585 hysteresis, p. 597 Keynesians, p. 582 long-run aggregate read more..

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    602 PA R T V I Monetary Theory happen to aggregate output and the price level in the short run? *14. Proposals have come before Congress that advocate the implementation of a national sales tax. Predict the effect of such a tax on both the aggregate supply and demand curves and on aggregate output and the price level. 15. When there is a decline in the value of the read more..

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    In this appendix, we examine how economists’ view of aggregate supply has evolved over time and how the concept called the Phillips curve, which described the relation- ship between unemployment and inflation, fits into the analysis of aggregate supply. The classical economists, who predated Keynes, believed that wages and prices were extremely flexible, so the economy would always read more..

  • Page - 718

    and wages decline over time. Hence the Phillips curve supports the view of aggregate supply in Chapter 24 that when the labor market is slack, production costs will fall and the aggregate supply curve will shift to the right.2 Figure 1 shows what the Phillips curve relationship looks like for the United States. As we can see from panel (a), the relationship works well read more..

  • Page - 719

    real wages, not nominal wages; they are concerned with the wage adjusted for any expected increase in the price level—that is, they look at the rate of change of wages minus expected inflation. When unemployment is high relative to the natural rate, real (not nominal) wages should fall ( w/w e 0); when unemployment is low relative to the natural state, real wages should read more..

  • Page - 720

    This expression, often referred to as Lucas supply function, indicates that deviations of unemployment and aggregate output from the natural rate levels respond to unantic- ipated inflation (actual inflation minus expected inflation, e). When inflation is greater than anticipated, unemployment will be below the natural rate (and aggregate output above the natural rate). When inflation is read more..

  • Page - 721

    PREVIEW Since 1980, the U.S. economy has been on a roller coaster, with output, unemploy- ment, and inflation undergoing drastic fluctuations. At the start of the 1980s, infla- tion was running at double-digit levels, and the recession of 1980 was followed by one of the shortest economic expansions on record. After a year, the economy plunged into the 1981–1982 recession, the read more..

  • Page - 722

    variable affects another by using data to build a model that explains the channels through which this variable affects the other; reduced-form evidence examines whether one variable has an effect on another simply by looking directly at the rela- tionship between the two variables. Suppose that you were interested in whether drinking coffee leads to heart dis- ease. Structural model read more..

  • Page - 723

    Now that we have seen how monetarists and Keynesians look at the empirical evidence on the link between money and economic activity, we can consider the advantages and disadvantages of their approaches. The structural model approach, used primarily by Keynesians, has the advantage of giving us an understanding of how the economy works. If the structure is correct—if it contains read more..

  • Page - 724

    The main advantage of reduced-form evidence over structural model evidence is that no restrictions are imposed on the way monetary policy affects the economy. If we are not sure that we know what all the monetary transmission mechanisms are, we may be more likely to spot the full effect of M on Y by looking at whether movements in Y correlate highly with movements in M. read more..

  • Page - 725

    No clear-cut case can be made that reduced-form evidence is preferable to structural model evidence or vice versa. The structural model approach, used primarily by Keynesians, offers an understanding of how the economy works. If the structure is correct, it predicts the effect of monetary policy more accurately, allows predictions of the effect of monetary policy when institutions read more..

  • Page - 726

    view that monetary policy does not matter at all to movements in aggregate output and hence to the business cycle. Their belief in the ineffectiveness of monetary policy stemmed from three pieces of structural model evidence: 1. During the Great Depression, interest rates on U.S. Treasury securities fell to extremely low levels; the three-month Treasury bill rate, for example, read more..

  • Page - 727

    period and the resulting decline in the money supply—the largest ever experienced in the United States (see Chapter 16). Hence monetary policy could explain the worst economic contraction in U.S. history, and the Great Depression could not be singled out as a period that demonstrates the ineffectiveness of monetary policy. A Keynesian could still counter Friedman and Schwartz’s read more..

  • Page - 728

    interest rates and investment spending does not rule out a strong link between real interest rates and investment spending. As depicted in Figure 1, nominal interest rates are often a very misleading indicator of real interest rates—not only during the Great Depression, but in later periods as well. Because real interest rates more accurately reflect the true cost of borrowing, read more..

  • Page - 729

    Early Monetarist Evidence on the Importance of Money In the early 1960s, Milton Friedman and his followers published a series of studies based on reduced-form evidence that promoted the case for a strong effect of money on economic activity. In general, reduced-form evidence can be broken down into three categories: timing evidence, which looks at whether the movements in one read more..

  • Page - 730

    reverse causation occur while money growth still leads output? There are several ways in which this can happen, but we will deal with just one example.4 Suppose that you are in a hypothetical economy with a very regular business cycle movement, plotted in panel (a) of Figure 2, that is four years long (four years from peak to peak). Let’s assume that in our hypothetical read more..

  • Page - 731

    find what we seek when looking for timing evidence. Perhaps the best way of describ- ing this danger is to say that “timing evidence may be in the eyes of the beholder.” Monetarist statistical evidence examines the correlations between money and aggre- gate output or aggregate spending by performing formal statistical tests. Again in Statistical Evidence CHAPTER 26 Transmission read more..

  • Page - 732

    1963 (obviously a vintage year for the monetarists), Milton Friedman and David Meiselman published a paper that proposed the following test of a monetarist model against a Keynesian model.5 In the Keynesian framework, investment and govern- ment spending are sources of fluctuations in aggregate demand, so Friedman and Meiselman constructed a “Keynesian” autonomous expenditure variable A equal read more..

  • Page - 733

    The monetarist historical evidence found in Friedman and Schwartz’s A Monetary History, has been very influential in gaining support for the monetarist position. We have already seen that the book was extremely important as a criticism of early Keynesian thinking, showing as it did that the Great Depression was not a period of easy monetary policy and that the depression could read more..

  • Page - 734

    money growth are followed by business cycle contractions does provide stronger sup- port for the monetarist position. When historical evidence is combined with timing and statistical evidence, the conclusion that money does matter seems warranted. As you can imagine, the economics profession was quite shaken by the appearance of the monetarist evidence, as up to that time most read more..

  • Page - 735

    The second direction was to pursue a structural model approach and to develop a bet- ter understanding of channels (other than interest-rate effects on investment) through which monetary policy affects aggregate demand. In this section we examine some of these channels, or transmission mechanisms, beginning with interest-rate channels, because they are the key monetary transmission read more..

  • Page - 736

    might be unable to lower interest rates, discussed in Chapter 22) during the Great Depression and why expansionary monetary policy could have prevented the sharp decline in output during that period. Some economists, such as John Taylor of Stanford University, take the position that there is strong empirical evidence for substantial interest-rate effects on consumer and investment read more..

  • Page - 737

    619 MONETARY POLICY GROSS DOMESTIC PRODUCT Monetary policy Real interest rates Monetary policy Real interest rates Exchange rate Monetary policy Stock prices Tobin’s q Monetary policy Stock prices Financial wealth Monetary policy Bank deposits Bank loans Monetary policy Stock prices Moral hazard, adverse selection Lending activity Monetary policy Unanticipated price level Moral hazard, adverse selection Lending activity read more..

  • Page - 738

    Tobin’s q Theory. James Tobin developed a theory, referred to as Tobin’s q Theory, that explains how monetary policy can affect the economy through its effects on the valu- ation of equities (stock). Tobin defines q as the market value of firms divided by the replacement cost of capital. If q is high, the market price of firms is high relative to the replacement cost read more..

  • Page - 739

    An important component of consumers’ lifetime resources is their financial wealth, a major component of which is common stocks. When stock prices rise, the value of financial wealth increases, thereby increasing the lifetime resources of con- sumers, and consumption should rise. Considering that, as we have seen, expansion- ary monetary policy can lead to a rise in stock prices, read more..

  • Page - 740

    An important implication of the credit view is that monetary policy will have a greater effect on expenditure by smaller firms, which are more dependent on bank loans, than it will on large firms, which can access the credit markets directly through stock and bond markets (and not only through banks). Though this result has been confirmed by researchers, doubts about the bank read more..

  • Page - 741

    monetary policy, which lowers nominal interest rates, also causes an improvement in firms’ balance sheets because it raises cash flow. The rise in cash flow causes an improvement in the balance sheet because it increases the liquidity of the firm (or household) and thus makes it easier for lenders to know whether the firm (or house- hold) will be able to pay its bills. read more..

  • Page - 742

    lending induced by a monetary contraction should cause a decline in durables and housing purchases by consumers who do not have access to other sources of credit. Similarly, increases in interest rates cause a deterioration in household balance sheets, because consumers’ cash flow is adversely affected. Another way of looking at how the balance sheet channel may operate through read more..

  • Page - 743

    The illiquidity of consumer durable and housing assets provides another reason why a monetary expansion, which lowers interest rates and thereby raises cash flow to consumers, leads to a rise in spending on consumer durables and housing. A rise in consumer cash flow decreases the likelihood of financial distress, which increases the desire of consumers to hold durable goods or read more..

  • Page - 744

    Lessons for Monetary Policy What useful implications for central banks’ conduct of monetary policy can we draw from the analysis in this chapter? There are four basic lessons to be learned. 1. It is dangerous always to associate the easing or tightening of monetary pol- icy with a fall or a rise in short-term nominal interest rates. Because most central banks use short-term read more..

  • Page - 745

    wealth effects provides additional reasons why other asset prices play such an impor- tant role in the monetary transmission mechanisms. Although there are strong dis- agreements among economists about which channels of monetary transmission are the most important—not surprising, given that economists, particularly those in aca- demia, always like to disagree—they do agree that other read more..

  • Page - 746

    628 PA R T V I Monetary Theory Applying the Monetary Policy Lessons to Japan Application Until 1990, it looked as if Japan might overtake the United States in per capita income. Since then, the Japanese economy has been stagnating, with deflation and low growth. As a result, Japanese living standards have been falling farther and farther behind those in the United States. Many read more..

  • Page - 747

    CHAPTER 26 Transmission Mechanisms of Monetary Policy: The Evidence 629 Summary 1. There are two basic types of empirical evidence: reduced- form evidence and structural model evidence. Both have advantages and disadvantages. The main advantage of structural model evidence is that it provides us with an understanding of how the economy works and gives us more confidence in the direction read more..

  • Page - 748

    630 PA R T V I Monetary Theory Questions and Problems Questions marked with an asterisk are answered at the end of the book in an appendix, “Answers to Selected Questions and Problems.” 1. Suppose that a researcher is trying to determine whether jogging is good for a person’s health. She examines this question in two ways. In method A, she looks to see whether joggers read more..

  • Page - 749

    CHAPTER 26 Transmission Mechanisms of Monetary Policy: The Evidence 631 Web Exercises 1. Figure 1 shows the relationship between estimated real interest rates and nominal interest rates. Go to and click on “charts and data” then on “nominal versus real market rates” to find data showing the spread between real interest and nominal interest rates. Discuss how read more..

  • Page - 750

    632 PREVIEW Since the early 1960s, when the inflation rate hovered between 1 and 2%, the econ- omy has suffered from higher and more variable rates of inflation. By the late 1960s, the inflation rate had climbed beyond 5%, and by 1974, it reached the double-digit level. After moderating somewhat during the 1975–1978 period, it shot above 10% in 1979 and 1980, slowed to read more..

  • Page - 751

    Evidence of this type seems to support the proposition that extremely high infla- tion is the result of a high rate of money growth. Keep in mind, however, that you are looking at reduced-form evidence, which focuses solely on the correlation of two variables: money growth and the inflation rate. As with all reduced-form evidence, reverse causation (inflation causing money supply read more..

  • Page - 752

    inflation rates. However, in the last couple of years, inflation in these countries has been brought down considerably. The explanation for the high rates of money growth in these countries is similar to the explanation for Germany during its hyperinflation: The unwillingness of Argentina, Brazil, and Peru to finance government expenditures by raising taxes led to large budget deficits read more..

  • Page - 753

    means when reporting the monthly inflation rate on the nightly news. The newscaster is only telling you how much, in percentage terms, the price level has changed from the previous month. For example, when you hear that the monthly inflation rate is 1% (12% annual rate), this merely indicates that the price level has risen by 1% in that month. This could be a one-shot read more..

  • Page - 754

    there is nothing else that can move the economy from point 1 to 2 to 3 and beyond. Monetarist analysis indicates that rapid inflation must be driven by high money supply growth. Keynesian analysis indicates that the continually increasing money supply will have the same effect on the aggregate demand and supply curves that we see in Figure 2: The aggregate demand curve will read more..

  • Page - 755

    ment expenditure (say, from $500 billion to $600 billion) on aggregate output and the price level. Initially, we are at point 1, where output is at the natural rate level and the price level is P1. The increase in government expenditure shifts the aggregate demand curve to AD2, and we move to point 1 , where output is above the natural rate level at Y1 . The read more..

  • Page - 756

    What about the other side of fiscal policy—taxes? Could continual tax cuts gen- erate an inflation? Again the answer is no. The analysis in Figure 3 also describes the price and output response to a one-shot decrease in taxes. There will be a one-shot increase in the price level, but the increase in the inflation rate will be only tempo- rary. We can increase the read more..

  • Page - 757

    do governments pursue inflationary monetary policies? Since there is nothing intrin- sically desirable about inflation and since we know that a high rate of money growth doesn’t happen of its own accord, it must follow that in trying to achieve other goals, governments end up with a high money growth rate and high inflation. In this sec- tion, we will examine the government read more..

  • Page - 758

    (similar to a negative supply shock) is to shift the aggregate supply curve leftward to AS2. 5 If government fiscal and monetary policy remains unchanged, the economy would move to point 1 at the intersection of the new aggregate supply curve AS2 and the aggregate demand curve AD1. Output would decline to below its natural rate level Yn, and the price level would rise to read more..

  • Page - 759

    to point 2 , and the activist policies will once more be used to shift the aggregate demand curve rightward to AD3 and return the economy to full employment at a price level of P3. If this process continues, the result will be a continuing increase in the price level—a cost-push inflation. What role does monetary policy play in a cost-push inflation? A cost-push infla- read more..

  • Page - 760

    resort to expansionary monetary policy: a continuing increase in the money supply and hence a high money growth rate. Pursuing too high an output target or, equivalently, too low an unemployment rate is the source of inflationary monetary policy in this situation, but it seems senseless for policymakers to do this. They have not gained the benefit of a permanently higher level read more..

  • Page - 761

    expected inflation will eventually rise and cause workers to demand higher wages so that their real wages do not fall. In this way, demand-pull inflation can eventually trig- ger cost-push inflation. Our discussion of the evidence on money and inflation suggested that budget deficits are another possible source of inflationary monetary policy. To see if this could be the case, we read more..

  • Page - 762

    In the United States, however, and in many other countries, the government does not have the right to issue currency to pay for its bills. In this case, the government must finance its deficit by first issuing bonds to the public to acquire the extra funds to pay its bills. Yet if these bonds do not end up in the hands of the public, the only alternative is that read more..

  • Page - 763

    developing countries. If developing countries run budget deficits, they cannot finance them by issuing bonds and must resort to their only other alternative, printing money. As a result, when they run large deficits relative to GDP, the money supply grows at substantial rates, and inflation results. Earlier we cited Latin American countries with high inflation rates and high money read more..

  • Page - 764

    future taxes, with the net result that the public demand for bonds increases to match the increased supply. The demand curve for bonds shifts rightward to BdR in Figure 7, leaving the interest rate unchanged at i1. There is now no need for the Fed to pur- chase bonds to keep the interest rate from rising. To sum up, although high inflation is “always and everywhere read more..

  • Page - 765

    CHAPTER 27 Money and Inflation 647 that a change in money growth takes that long to affect the inflation rate.) The rise in inflation from 1960 to 1980 can be attributed to the rise in the money growth rate over this period. But you have probably noticed that in 1974–1975 and 1979–1980, the inflation rate is well above the money growth rate from two years earlier. You read more..

  • Page - 766

    648 PA R T V I Monetary Theory in interest rates and by rapid financial innovation that made the correct measurement of money far more difficult (see Chapter 3). In their view, this period was an aberration, and the close correspondence of money and infla- tion is sure to reassert itself. However, this has not yet occurred. What is the underlying cause of the increased read more..

  • Page - 767

    CHAPTER 27 Money and Inflation 649 FIGURE 9 Government Debt-to-GDP Ratio, 1960–2002 Source: Economic Report of the President. 1960 1965 1970 1975 1980 1985 1990 1995 2005 2000 0 20 30 40 50 60 Debt (% of GDP) FIGURE 10 Unemployment and the Natural Rate of Unemployment, 1960–2002 Sources: Economic Report of the President and Congressional Budget Office. 3 4 5 6 7 8 9 10 1960 1965 1970 1975 read more..

  • Page - 768

    Activist/Nonactivist Policy Debate All economists have similar policy goals—they want to promote high employment and price stability—and yet they often have very different views on how policy should be conducted. Activists regard the self-correcting mechanism through wage and price adjustment (see Chapter 25) as very slow and hence see the need for the government to pursue active, read more..

  • Page - 769

    dates business cycles) will not declare the economy to be in recession until at least six months after it has determined that one has begun. 3. The legislative lag represents the time it takes to pass legislation to implement a particular policy. The legislative lag does not exist for most monetary policy actions such as open market operations. It can, however, be quite read more..

  • Page - 770

    Case for an Activist Policy. Activists, such as the Keynesians, view the wage and price adjustment process as extremely slow. They consider a nonactivist policy costly, because the slow movement of the economy back to full employment results in a large loss of output. However, even though the five lags described result in delay of a year or two before the aggregate demand read more..

  • Page - 771

    the aggregate supply curve will keep on shifting leftward. As a result, policymakers are forced to accommodate the cost push by continuing to shift the aggregate demand curve to the right to eliminate the unemployment that develops. The accommodating, activist policy with its high employment target has the hidden cost or disadvantage that it may well lead to inflation.7 The main read more..

  • Page - 772

    The following conclusions can be generated from our analysis: Activists believe in the use of discretionary policy to eliminate excessive unemployment whenever it devel- ops, because they view the wage and price adjustment process as sluggish and unre- sponsive to expectations about policy. Nonactivists, by contrast, believe that a discretionary policy that reacts to excessive unemployment read more..

  • Page - 773

    CHAPTER 27 Money and Inflation 655 Importance of Credibility to Volcker’s Victory over Inflation Application In the period from 1965 through the 1970s, policymakers had little credibil- ity as inflation-fighters—a well-deserved reputation, as they pursued an accommodating policy to achieve high employment. As we have seen, the outcome was not a happy one. Inflation soared to double-digit read more..

  • Page - 774

    656 PA R T V I Monetary Theory Key Terms accommodating policy, p. 640 constant-money-growth-rate rule, p. 654 cost-push inflation, p. 639 demand-pull inflation, p. 639 government budget constraint, p. 643 monetizing the debt, p. 644 printing money, p. 644 Ricardian equivalence, p. 645 Questions and Problems Questions marked with an asterisk are answered at the end of the book in an read more..

  • Page - 775

    CHAPTER 27 Money and Inflation 657 Web Exercises 1. Figure 8 reports the inflation rate from 1960 to 2002. As this chapter states, inflation continues to be a major a factor in economic policy. Go to ftp://ftp.bls .gov/pub/special.requests/cpi/cpiai.txt. Move data into Excel using the method described at the end of Chapter 1. Delete all but the first and last column (date and read more..

  • Page - 776

    658 PREVIEW After World War II, economists, armed with Keynesian models (such as the ISL M model) that described how government policies could be used to manipulate employ- ment and output, felt that activist policies could reduce the severity of business cycle fluctuations without creating inflation. In the 1960s and 1970s, these economists got their chance to put their policies read more..

  • Page - 777

    The Lucas Critique of Policy Evaluation In his famous paper “Econometric Policy Evaluation: A Critique,” Robert Lucas pre- sented an argument that had devastating implications for the usefulness of conven- tional econometric models (models whose equations are estimated with statistical procedures) for evaluating policy.3 Economists developed these models for two pur- poses: to forecast read more..

  • Page - 778

    average of expected future short-term rates. It will cause the long-term interest rate to rise by a negligible amount. The term structure relationship estimated using past data will then show only a weak effect on the long-term interest rate of changes in the short-term rate. Suppose the Fed wants to evaluate what will happen to the economy if it pursues a policy that is read more..

  • Page - 779

    leaves real wages unchanged and aggregate output at the natural rate (full-employment) level if expectations are realized. This model then suggests that anticipated policy has no effect on aggregate output and unemployment; only unanticipated policy has an effect. First, let us look at the short-run response to an unanticipated (unexpected) policy such as an unexpected increase in the read more..

  • Page - 780

    to the right and will expect the aggregate price level to rise to P2. Workers will demand higher wages so that their real earnings will remain the same when the price level rises. The aggregate supply curve then shifts leftward to AS2 and intersects AD2 at point 2, an equilibrium point where aggregate output is at the natural rate level Yn and the price level has risen read more..

  • Page - 781

    This conclusion has been called the policy ineffectiveness proposition, because it implies that one anticipated policy is just like any other; it has no effect on output fluctuations. You should recognize that this proposition does not rule out output effects from policy changes. If the policy is a surprise (unanticipated), it will have an effect on output.5 Another important feature read more..

  • Page - 782

    Study Guide Mastering the new classical macroeconomic model, as well as the new Keynesian model in the next section, requires practice. Make sure that you can draw the aggre- gate demand and supply curves that explain what happens in each model when there is a contractionary policy that is (1) unanticipated, (2) anticipated, and (3) less con- tractionary than anticipated. The new read more..

  • Page - 783

    Where does this lead us? Should the Fed and other policymaking agencies pack up, lock the doors, and go home? In a sense, the answer is yes. The new classical model implies that discretionary stabilization policy cannot be effective and might have undesirable effects on the economy. Policymakers’ attempts to use discretionary policy may create a fluctuating policy stance that read more..

  • Page - 784

    formed. The model they have developed, the new Keynesian model, assumes that expectations are rational but does not assume complete wage and price flexibility; instead, it assumes that wages and prices are sticky. Its basic conclusion is that unan- ticipated policy has a larger effect on aggregate output than anticipated policy (as in the new classical model). However, in contrast read more..

  • Page - 785

    els (the new classical macroeconomic model and the new Keynesian model) to a model that we call, for lack of a better name, the traditional model. In the traditional model, expectations are not rational. That model uses adaptive expectations (mentioned in Chapter 7), expectations based solely on past experience. The traditional model views expected inflation as an average of past read more..

  • Page - 786

    the public’s predictions of future policy; hence predictions of future policy do not affect the aggregate supply curve. First we will examine the short-run output and price responses in the three mod- els. Then we will examine the implications of these models for both stabilization and anti-inflation policies. Study Guide As a study aid, the comparison of the three models is read more..

  • Page - 787

    CHAPTER 28 Rational Expectations: Implications for Policy 669 FIGURE 5 Comparison of the Short-Run Response to Expansionary Policy in the Three Models Initially, the economy is at point 1. The expansionary policy shifts the aggregate demand curve from AD1 to AD2. In the traditional model, the expansionary policy moves the economy to point 1 whether the policy is anticipated or not. In read more..

  • Page - 788

    expansionary policy is unanticipated, all three models show the same short-run out- put response. The traditional model views the aggregate supply curve as given in the short run, while the other two view it as remaining at AS1 because there is no change in the expected price level when the policy is a surprise. Hence when policy is unan- ticipated, all three models indicate read more..

  • Page - 789

    In the new classical model, the conduct of policy can be viewed as a game in which the public and the policymakers are always trying to outfox each other by guessing the other’s intentions and expectations. The sole possible outcome of this process is that an activist stabilization policy will have no predictable effect on output and cannot be relied on to stabilize read more..

  • Page - 790

    672 PA R T V I Monetary Theory FIGURE 6 Anti-inflation Policy in the Three Models With an ongoing inflation in which the economy is moving from point 1 to point 2, the aggre- gate demand curve is shifting from AD1 to AD2 and the short-run aggregate supply curve from AS1 to AS2. The anti-inflation policy, when implemented, prevents the aggre- gate demand curve from rising, read more..

  • Page - 791

    intersection of the AD1 and AS2 curves), and the inflation rate slows down because the price level increases only to P2 rather than P2. The reduction in inflation has not been without cost: Output has declined to Y2 , which is well below the natural rate level. In the traditional model, estimates of the cost in terms of lost output for each 1% reduction in the read more..

  • Page - 792

    John Taylor, a proponent of the new Keynesian model, has demonstrated that a more gradual approach to reducing inflation may be able to eliminate inflation with- out producing a substantial output loss.7 An important catch here is that this gradual policy must somehow be made credible, which may be harder to achieve than a cold- turkey anti-inflation policy, which demonstrates read more..

  • Page - 793

    ever, had quite a different outcome: The rate of growth of the money supply increased rapidly during the period, and inflation soared. Such episodes have reduced the cred- ibility of the Federal Reserve in the eyes of the public and, as predicted by the new classical and new Keynesian models, have had serious consequences. The reduction of inflation that occurred from 1981 to read more..

  • Page - 794

    Impact of the Rational Expectations Revolution The theory of rational expectations has caused a revolution in the way most econo- mists now think about the conduct of monetary and fiscal policies and their effects on economic activity. One result of this revolution is that economists are now far more aware of the importance of expectations to economic decision making and to the read more..

  • Page - 795

    economists question whether the degree of wage and price flexibility required in the new classical model actually exists. The result is that many economists take an intermediate position that recognizes the distinction between the effects of anticipated versus unanticipated policy but believe that anticipated policy can affect output. They are still open to the possibility that activist read more..

  • Page - 796

    678 PA R T V I Monetary Theory Key Terms econometric models, p. 659 policy ineffectiveness proposition, p. 663 Questions and Problems Questions marked with an asterisk are answered at the end of the book in an appendix, “Answers to Selected Questions and Problems.” 1. If the public expects the Fed to pursue a policy that is likely to raise short-term interest rates read more..

  • Page - 797

    CHAPTER 28 Rational Expectations: Implications for Policy 679 *13. The chairman of the Federal Reserve Board announces that over the next year, the rate of money growth will be reduced from its current rate of 10% to a rate of 2%. If the chairman is believed by the public but the Fed actually reduces the rate of money growth to 5%, predict what will happen to the read more..

  • Page - 798

    read more..

  • Page - 799

    Applications Reading the Wall Street Journal: The Bond Page, p. 72 Changes in the Equilibrium Interest Rate Due to Expected Inflation or Business Cycle Expansions, p. 99 Explaining Low Japanese Interest Rates, p. 103 Reading the Wall Street Journal “Credit Markets” Column, p. 103 Changes in the Equilibrium Interest Rate Due to Changes in Income, the Price Level, or the Money read more..

  • Page - 800

    Global Boxes The Importance of Financial Intermediaries to Securities Markets: An International Comparison, p. 31 Birth of the Euro: Will It Benefit Europe?, p. 49 Negative T-Bill Rates? Japan Shows the Way, p. 69 Barings, Daiwa, Sumitomo, and Allied Irish: Rogue Traders and the Principal–Agent Problem, p. 225 Comparison of Banking Structure in the United States and Abroad, p. 249 read more..

  • Page - 801

    Page where Symbol Introduced Term Δ 369 change in a variable πe 80 expected inflation a 538 autonomous consumer expenditure AD 578 aggregate demand curve AS 588 aggregate supply curve Bd 89 demand for bonds Bs 90 supply of bonds c 375 currency ratio C 66 yearly coupon payment C 375 currency C 536 consumer expenditure D 122 demand curve D 375 checkable deposits DL 382 discount loans e 375 excess read more..

  • Page - 802

    M 375 money supply Md 105 demand for money Ms 105 supply of money M1 52 M1 monetary aggregate M2 52 M2 monetary aggregate M3 53 M3 monetary aggregate MB 359 monetary base (high-powered money) MBn 382 nonborrowed monetary base mpc 538 marginal propensity to consume NX 537 net exports P 577 price level Pe 617 expected price level Ps 620 stock prices Pt 76 price of a security at time t r 238 read more..

  • Page - 803

    accommodating policy An activist policy in pursuit of a high employment target. 640 activist An economist who views the self-correcting mecha- nism through wage and price adjustment to be very slow and hence sees the need for the government to pursue active, discretionary policy to eliminate high unemploy- ment whenever it develops. 592 adaptive expectations Expectations of a variable read more..

  • Page - 804

    basis point One one-hundredth of a percentage point. 74 Board of Governors of the Federal Reserve System A board with seven governors (including the chairman) that plays an essential role in decision making within the Federal Reserve System. 337 bond A debt security that promises to make payments peri- odically for a specified period of time. 3 branches Additional offices of banks read more..

  • Page - 805

    currency board A monetary regime in which the domestic currency is backed 100% by a foreign currency (say dol- lars) and in which the note-issuing authority, whether the central bank or the government, establishes a fixed exchange rate to this foreign currency and stands ready to exchange domestic currency at this rate whenever the public requests it. 492 currency swap The exchange read more..

  • Page - 806

    e-finance A new means of delivering financial services elec- tronically. 8 electronic money (or e-money) Money that exists only in electronic form and substitutes for cash as well. 51 equation of exchange The equation MV PY, which relates nominal income to the quantity of money. 518, 583 equities Claims to share in the net income and assets of a corporation (such as common stock). read more..

  • Page - 807

    fixed-payment loan A credit market instrument that pro- vides a borrower with an amount of money that is repaid by making a fixed payment periodically (usually monthly) for a set number of years. 63 float Cash items in process of collection at the Fed minus deferred-availability cash items. 365 foreign bonds Bonds sold in a foreign country and denomi- nated in that country’s read more..

  • Page - 808

    international policy coordination Agreements among coun- tries to enact policies cooperatively. 428 international reserves Central bank holdings of assets denominated in foreign currencies. 462 inventory investment Spending by firms on additional hold- ings of raw materials, parts, and finished goods. 539 inverted yield curve A yield curve that is downward- sloping. 127 investment banks Firms that read more..

  • Page - 809

    margin requirement A sum of money that must be kept in an account (the margin account) at a brokerage firm. 318 marked to market Repriced and settled in the margin account at the end of every trading day to reflect any change in the value of the futures contract. 318 market equilibrium A situation occurring when the quantity that people are willing to buy (demand) equals read more..

  • Page - 810

    off-balance-sheet activities Bank activities that involve trad- ing financial instruments and the generation of income from fees and loan sales, all of which affect bank profits but are not visible on bank balance sheets. 223, 265 official reserve transactions balance The current account balance plus items in the capital account. 468 open-end fund A mutual fund in which shares can be read more..

  • Page - 811

    real money balances The quantity of money in real terms. 523 real terms Terms reflecting actual goods and services one can buy. 80 recession A period when aggregate output is declining. 9 reduced-form evidence Evidence that examines whether one variable has an effect on another by simply looking directly at the relationship between the two variables. 604 regulatory arbitrage A process in read more..

  • Page - 812

    smart card A stored-value card that contains a computer chip that lets it be loaded with digital cash from the owner’s bank account whenever needed. 51 special drawing rights (SDRs) An IMF-issued paper substi- tute for gold that functions as international reserves. 474 specialist A dealer-broker operating in an exchange who maintains orderly trading of the securities for which he or read more..

  • Page - 813

    velocity See velocity of money. 518, 582 velocity of money The rate of turnover of money; the aver- age number of times per year that a dollar is spent in buy- ing the total amount of final goods and services produced in the economy. 518, 582 venture capital firm A financial intermediary that pools the resources of its partners and uses the funds to help entre- preneurs read more..

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  • Page - 815

    Chapter 1 Why Study Money, Banking, and Financial Markets? 2. The data in Figures 1, 2, 3, and 4 suggest that real output, the inflation rate, and interest rates would all fall. 4. You might be more likely to buy a house or a car because the cost of financing them would fall, or you might be less likely to save because you earn less on your savings. 6. No. It read more..

  • Page - 816

    then a better store of value, and you would have been will- ing to hold more of it. 9. Money loses its value at an extremely rapid rate in hyper- inflation, so you want to hold it for as short a time as possi- ble. Thus money is like a hot potato that is quickly passed from one person to another. 11. Not necessarily. Although the total amount of debt has pre- read more..

  • Page - 817

    The demand curve Bd will shift to the left, the price falls, and the equilibrium interest rate will rise. Chapter 6 The Risk and Term Structure of Interest Rates 2. U.S. Treasury bills have lower default risk and more liquid- ity than negotiable CDs. Consequently, the demand for Treasury bills is higher, and they have a lower interest rate. 4. True. When bonds of different read more..

  • Page - 818

    also take advantage of economies of scale and engage in large transactions that have a lower cost per dollar per transaction. 4. Standard accounting principles make profit verification easier, thereby reducing adverse selection and moral hazard problems in financial markets and hence making them operate better. Standard accounting principles make it easier for investors to screen out good read more..

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    banks have greater protection from competition and are more likely to survive than small savings and loans. 8. International banking has been encouraged by giving special tax treatment and relaxed branching regulations to Edge Act corporations and to international banking facilities (IBFs); this was done to make American banks more competitive with foreign banks. The hope is that it read more..

  • Page - 820

    Chapter 13 Financial Derivatives 2. You would enter into a contract that specifies that you will sell the $25 million of 8s of 2015 at a price of 110 one year from now. 4. You have a loss of 6 points, or $6,000, per contract. 6. You would buy $100 million worth (1,000 contracts) of the call long-term bond option with a delivery date of one year in the future and read more..

  • Page - 821

    3. Reserves increase by $50 million, but the monetary base increases by $100 million, as the T-accounts for the five banks and the Fed indicate: 5. The T-accounts are identical to those in the sections “Deposit Creation: The Single Bank” and “Deposit Creation: The Banking System” except that all the entries are multiplied by 10,000 (that is, $100 becomes $1 million). The read more..

  • Page - 822

    the volume of discount loans, which would also cause the monetary base and the money supply to fall. Chapter 17 Tools of Monetary Policy 1. The snowstorm would cause float to increase, which would increase the monetary base. To counteract this effect, the manager will undertake a defensive open market sale. 3. As we saw in Chapter 15, when the Treasury’s deposits at the read more..

  • Page - 823

    higher sales of domestic products may lead to higher employment, a beneficial effect on the economy. 4. It predicts that the value of the yen will fall 5% in terms of dollars. 6. Even though the Japanese price level rose relative to the American, the yen appreciated because the increase in Japanese productivity relative to American productivity made it possible for the Japanese read more..

  • Page - 824

    monetary policy will result in a sharp fall in the value of the currency. Avoiding these outcomes constrains policymakers and politicians so time-consistent monetary policy is less likely to occur. 10. A currency board has the advantage that the central bank no longer can print money to create inflation, and so it is a stronger commitment to a fixed exchange rate. The disad- read more..

  • Page - 825

    itive association between aggregate output and the equilib- rium interest rate, and the LM curve slopes up. Chapter 24 Monetary and Fiscal Policy in the ISLM Model 2. When investment spending collapsed, the aggregate demand function in the Keynesian cross diagram fell, leading to a lower level of equilibrium output for any given interest rate. The fall in equilibrium output for any read more..

  • Page - 826

    the money supply. In addition, a rise in output and interest rates would cause free reserves to fall (because excess reserves would fall and the volume of discount loans would rise). If the Fed has a free reserves target, the increase in aggregate output will then cause the Fed to increase the money supply because it believes that money is tight. 10. Monetarists went on to read more..

  • Page - 827

    to the left because expected inflation would be higher. The result is that the increase in the price level (the inflation rate) would be higher. 13. The aggregate supply curve would shift to the left less than the aggregate demand curve shifts to the right; hence at their intersection, aggregate output would rise and the price level would be higher than it would have been read more..

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  • Page - 829

    Page 30. Following the Financial News: Foreign Stock Market Indexes. “International Stock Market Indexes” from The Wall Street Journal, January 21, 2003, p. C6. Republished by permis- sion of Dow Jones, Inc. via Copyright Clearance Center, Inc. © 2003 Dow Jones & Co., Inc. All Rights Reserved Worldwide. Page 54. Following the Financial News: The Monetary Aggregates. “Monetary read more..

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  • Page - 831

    Aaa rated bonds, 124–127 ABM (automated banking machine), 235 Accommodating policy, 640 Activist/nonactivist policy debate, 650–655 Activists, 592 Activities, restrictions on, 39–40 Adaptive expectations, 147 Adjustable-rate mortgages (ARMs), 233 Adverse selection, 32–34, 174–175 property and casualty companies, 291 regulations, 263 Advice, investment, 160 Afghanistan, 146–147 Agency theory, 175 Agent read more..

  • Page - 832

    Banks, 8. See also banking proce- dures asymmetric information and reg- ulation, 260–271 balance sheets, 201–205 capital, 204 central bank, 12 charters, 230 commercial banks, 34 competition, restrictions on, 269 consolidation, 245–250, 246 consolidation regulations, 264–271 credit cards, 234 debit cards, 234 decline in traditional banking, 242–243 deposits at other banks, 204 electronic banking, read more..

  • Page - 833

    Bretton Woods system, 469, 470 balance-of-payments considera- tions, 483 fixed exchange rates, 473–478 British-style universal banking sys- tem, 252 Brokerage firms, 304 Brokers, 26, 303. See also securities audits, 315 Brown, Henry, 238 Brown, Phillip, 154 Bryant, Ralph, 618 Bubbles, 164 Budget deficits inflation, 643 surpluses, 12 Bull markets, 5 Burns, Arthur, 424 Bush, George H. W., 348 Bush read more..

  • Page - 834

    Collateral, 172 compensating balances, 219 net worth, 180 Collection, items in process of, 204 Commercial banks, 34. See also financial intermediaries checking accounts, 52 separation from securities indus- try, 39–40 Commercial paper, 236–237 Commissions, brokerage firms, 304 Commodities Futures Trading Commission (CFTC), 38, 315, 321 Commodity money, 48 Common stock, 5. See also stock read more..

  • Page - 835

    Debt. See also interest rates budget deficits and surpluses, 12 collateral, 172 contracts, 172, 183 coupon bonds, 63, 65–68 deflation, 192 discount bonds, 64, 68–69 evolution of the euro, 49 fixed-payment loans, 63, 65 Great Depression, 193 influences on financial structures, 184–188 maturity of, 26 monetizing the, 644 moral hazards, 180–184 secured debt, 172 simple loans, 52, 63, 64–65 read more..

  • Page - 836

    Duration analysis, 221 Dynamic open market operations, 398 East Asia, 480 banking crises, 284 financial crises, 194–198 Eastern Europe, banking crises, 282 E-cash, 51. See also payments sys- tems ECB (European Central Bank), 49, 350, 498 Econometric policy evaluation, 659 Economic expansions, 9 Economic growth, 22 financial development and, 187–188 inflation targeting, 508–509 monetary policy, 412 read more..

  • Page - 837

    theory, 129 theory of rational, 147–150 Expected deposit outflows, 380 Expected price levels, 594 Expected returns. See also returns discount bonds, 88 equilibrium in interest rates, 95–96 foreign exchange markets, 448–459 interest rate, 86 segmented markets theory, 132 Expenditure multiplier, 542 Expertise, financial intermediaries, 174 Exports, 537. See also net exports changes in, 563–564 read more..

  • Page - 838

    Financial intermediaries (continued) function of, 29–34 importance of, 31 indirect finance, 171 insurance companies, 287–293 interest-rate swaps, 330 limits on competition, 40 restrictions on assets and activi- ties, 39–40 restrictions on entry, 39 restrictions on interest rates, 40–41 Financial markets, 3 foreign stock market indexes, 30 function of, 23–25 internationalization of, 28–29 read more..

  • Page - 839

    General Electric (GE), 149 Generalized dividend valuation model, 143 General Motors Acceptance Corporation (GMAC), 297 General Theory of Employment, Interest, and Money, The, 536. See also Keynes, John Maynard Generation X, 298 Germany EMS, 474 euro, 49 financial regulation, 40–41 hyperinflation, 633 hyperinflation after World War I, 47 monetary targeting, 497–501 reunification of, 490 Gertler, Mark, read more..

  • Page - 840

    Income (continued) shifts in demand for money, 107–108 Income taxes bonds, 125–126 Bush tax cut of 2001, 127 changes in, 563 Independence of the Federal Reserve System, 352–354 Indexes bonds, 82 effective exchange rate, 455 foreign stock markets, 30 TIPS, 82 Indirect finance, 171 Individual retirement accounts (IRAs), 294 Indonesia, financial crises, 194–198 Industrial production, 583 Inflation, read more..

  • Page - 841

    International monetary policy, 427 exchange-rate targeting, 489–495 inflation targeting, 501–509 monetary targeting, 496–501 nominal anchor, 487–489 International policy coordination, 428 International reserves, 462 International trade, aggregate out- put, 548 Internet banking, 234–235 mutual funds, 298 securities market operations, 306 Inventory investment, 539 Inverted yield curve, 127 Investment banks, read more..

  • Page - 842

    Liquidity (continued) interest rates, 86, 104–117 management, 208 preference analysis, 112–117, 555 services, 31 Liquidity preference framework interest rates, 107–117 money markets, 105–107 Liquidity preference theory, 521–524 Liquidity premium theory, 133 Lloyd’s of London, 290. See also insurance companies LM curve, 551, 556, 564–566 shifts in, 579–580 Load mutual funds, 299 Loanable read more..

  • Page - 843

    liquidity premium theory, 133 preferred habitat theory, 134 Maturity bucket approach, 221 Mayer, Colin, 31 McFadden Act of 1927, 244 Mean reversion, 157 Measurability of targets, 418 Medium of exchange, 45 Medium-Term Financial Strategy, 496 Meetings, FOMC, 343 Meiselman, David, 614 Meltzer, Alan, 480, 622 Member banks, Federal Reserve System, 340, 346 Membership in the Federal Reserve System, read more..

  • Page - 844

    Moral hazards, 32–33, 174–175 debt, 180–184 influences in debt markets, 184–188 regulations, 262–263 Morgan, J. P., 231, 251 Morris, Charles S., 158 Mortgages. See also federal credit agencies; loans ARMs (adjustable-rate mort- gages), 233 fixed-rate, 233 structure of financial markets, 25–28 Multiple deposit creation, 357, 365–371 Multipliers, 542 Muncie, Indiana, 607 Municipal bond income read more..

  • Page - 845

    Organization for Electronic Cooperation and Development (OECD), 265 OTC (over-the-counter) markets, 27 OTS (Office of Thrift Supervision), 38, 252, 278 Outflows controls on capital, 478–479 deposits, 208 money multiplier, 380 Output aggregate, 583 inflation targeting, 507–508 international trade, 548 Keynesian framework, 536–551 natural rate level of, 575 short-run, 668 Overreaction, markets, 157 read more..

  • Page - 846

    Productivity, foreign exchange mar- kets, 442 Profitability arbitrage, 313 banks, 242 equilibrium in interest rates, 98 loans, 205 options, 322 unexploited profit opportunity, 152 Property and casualty insurance, 288–293 Prudential supervision, 265 Public pension funds, 295 Purchase and assumption methods, 261 Put (sell) options, 327 Quantity of assets, 85–87 Quantity of loans demanded, 92 Quantity read more..

  • Page - 847

    management of interest rates, 220–223 moral hazards, 33, 186. See also moral hazards premiums, 121, 123 Risk-based premiums, 291–292 Risk structure of interest rates, 120–127 ROA (return on assets), 214 ROE (return on equity), 214 Roll, Richard, 154, 157 Romania, inflation rates, 11 Romer, Christina, 615 Romer, David, 615 Royal Bank of Canada, 235 RTC (Resolution Trust Corporation), 278 read more..

  • Page - 848

    Spot exchange rate, 436 Spot transactions, 436 Spreads, Baa-Aaa bonds, 124–127 Stabilization policy, 670 Standard and Poor’s bond ratings, 123 Standardized gap analysis, 221 State banking and insurance com- missions, 38 State banks, 231. See also banks State Farm, 288 Statistical evidence, 613 Sterilized foreign exchange interven- tion, 465 Stockholders, 141 Stock market crash of 1929, 39 Stock read more..

  • Page - 849

    Transactions adverse selection and moral haz- ards, 174–175 costs, 173–174 evolution of payments system, 48–51 forward, 436 highly leveraged transaction loans, 274 Keynesian approach, develop- ments in, 524–528 matched sale-purchase, 400 movement of, 521 nontransaction deposits, 203 official reserve transaction bal- ance, 468 spot, 436 Transmission mechanisms, 604, 616–626 TRAPS (Trading Room read more..

  • Page - 850

    I-20 Index Yield curves (continued) short-term interest rates, 136 U.S. Government bonds, 138 Yield to maturity, 64 Zero-coupon bonds. See discount bonds Zero impact, expanded-inflation effect, 113–114 Zombie S&Ls, 275–276. See also S&Ls read more..

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