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The economics of money, Banking, and financial markeTs B u s i n e s s s c h o o l e d i T i o n
Fourth Edition
Frederic S. Mishkin Columbia University
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Mishkin, Frederic S. The economics of money, banking, and financial markets / Frederic S. Mishkin, Columbia University. – Business School Edition, Fourth Edition. pages cm Includes index. ISBN 978-0-13-385980-5 1. Finance. 2. Money. 3. Banks and banking. I. Title. HG173.M632 2014 332–dc23 2014042183 10 9 8 7 6 5 4 3 2 1
ISBN 10: 0-13-385980-0 ISBN 13: 978-0-13-385980-5
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To Sally
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viivii
ParT 1 INTRODUCTION 1 1 Why Study Money, Banking, and Financial Markets? ............................................................2 2 An Overview of the Financial System ...................................................................................... 22 3 What Is Money? .............................................................................................................................. 49
ParT 2 FINANCIAL MARKETS 63 4 The Meaning of Interest Rates ................................................................................................... 64 5 The Behavior of Interest Rates ................................................................................................... 85 6 The Risk and Term Structure of Interest Rates ....................................................................116 7 The Stock Market, the Theory of Rational Expectations, and the Efficient
Market Hypothesis .......................................................................................................................140
ParT 3 Financial Institutions 161 8 An Economic Analysis of Financial Structure .......................................................................162 9 Banking and the Management of Financial Institutions ....................................................186 10 Economic Analysis of Financial Regulation ...........................................................................215 11 Banking Industry: Structure and Competition ....................................................................234 12 Financial Crises ..............................................................................................................................267 13 Nonbank Finance ..........................................................................................................................291 14 Financial Derivatives ....................................................................................................................315 15 Conflicts of Interest in the Financial Industry ......................................................................341
ParT 4 Central Banking and the Conduct of Monetary Policy 359 16 Central Banks and the Federal Reserve System ..................................................................360 17 The Money Supply Process .......................................................................................................384 18 Tools of Monetary Policy ...........................................................................................................409 19 The Conduct of Monetary Policy: Strategy and Tactics ...................................................434
ParT 5 International Finance and Monetary Policy 467 20 The Foreign Exchange Market ..................................................................................................468 21 The International Financial System .........................................................................................495
ParT 6 Monetary Theory 523 22 Quantity Theory, Inflation, and the Demand for Money ................................................524 23 Aggregate Demand and Supply Analysis .............................................................................543 24 Monetary Policy Theory ............................................................................................................587 25 Transmission Mechanisms of Monetary Policy ....................................................................616
Brief Contents
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viii Brief Contents
Chapters on the Web 1 Financial Crises in Emerging Market Economies 2 The IS Curve 3 The Monetary Policy and Aggregate Demand Curves 4 The Role of Expectations in Monetary Policy 5 The ISLM Model
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ixix
ParT 1 Introduction 1
c h a P Te r 1 Why Study Money, Banking, and Financial Markets? 2 Why Study Financial Markets? ...............................................................................................................2
The Bond Market and Interest Rates ....................................................................................... 3 The Stock Market ................................................................................................................... 3
Why Study Financial Institutions and Banking? ................................................................................5 Structure of the Financial System ........................................................................................... 6 Banks and Other Financial Institutions ................................................................................... 6 Financial Innovation .............................................................................................................. 6 Financial Crises ...................................................................................................................... 7
Why Study Money and Monetary Policy? .........................................................................................7 Money and Business Cycles .................................................................................................... 7 Money and Inflation ............................................................................................................... 8 Money and Interest Rates ..................................................................................................... 10 Conduct of Monetary Policy ................................................................................................. 10 Fiscal Policy and Monetary Policy ........................................................................................ 11
Why Study International Finance? ..................................................................................................... 12 The Foreign Exchange Market .............................................................................................. 12 The International Financial System ...................................................................................... 14
How We Will Study Money, Banking, and Financial Markets .................................................... 14 Exploring the Web ............................................................................................................... 15
Concluding Remarks............................................................................................................................... 15 Summary 15 • Key Terms 16 • Questions 16 • Applied Problems 17 •
Data Analysis Problems 17 • Web Exercises 18 • Web References 18
a P P e n d i X To c h a P Te r 1 Defining Aggregate Output, Income, the Price Level, and the Inflation Rate 19 Aggregate Output and Income .......................................................................................................... 19 Real Versus Nominal Magnitudes ....................................................................................................... 19 Aggregate Price Level ............................................................................................................................ 20 Growth Rates and the Inflation Rate ................................................................................................. 21
c h a P Te r 2 An Overview of the Financial System 22 Function of Financial Markets .............................................................................................................. 22 Structure of Financial Markets ............................................................................................................. 25
Debt and Equity Markets ...................................................................................................... 25 Primary and Secondary Markets ........................................................................................... 25 Exchanges and Over-the-Counter Markets ........................................................................... 26 Money and Capital Markets .................................................................................................. 27
Contents in Detail
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x Contents in Detail
Financial Market Instruments ............................................................................................................... 27 Money Market Instruments .................................................................................................. 27
following the financial news Money Market Rates 28
Capital Market Instruments .................................................................................................. 29
following the financial news Capital Market Interest Rates 30
Internationalization of Financial Markets ......................................................................................... 31
global Are U.S. Capital Markets Losing Their Edge? 32
International Bond Market, Eurobonds, and Eurocurrencies ................................................ 32 World Stock Markets ............................................................................................................ 33
Function of Financial Intermediaries: Indirect Finance ................................................................ 33
following the financial news Foreign Stock Market Indexes 34
Transaction Costs ................................................................................................................. 34
global The Importance of Financial Intermediaries Relative to Securities Markets: An International Comparison 35
Risk Sharing ......................................................................................................................... 36 Asymmetric Information: Adverse Selection and Moral Hazard ............................................ 36 Economies of Scope and Conflicts of Interest ....................................................................... 38
Types of Financial Intermediaries ...................................................................................................... 38 Depository Institutions ......................................................................................................... 38 Contractual Savings Institutions ........................................................................................... 40 Investment Intermediaries .................................................................................................... 41
Regulation of the Financial System ..................................................................................................... 42 Increasing Information Available to Investors ....................................................................... 42 Ensuring the Soundness of Financial Intermediaries ............................................................. 43 Financial Regulation Abroad................................................................................................. 45 Summary 45 • Key Terms 46 • Questions 46 • Applied Problems 47 •
Data Analysis Problems 48 • Web Exercises 48 • Web References 48
c h a P Te r 3 What Is Money? 49 Meaning of Money ................................................................................................................................. 49 Functions of Money ................................................................................................................................ 50
Medium of Exchange ............................................................................................................ 50 Unit of Account .................................................................................................................... 51 Store of Value ....................................................................................................................... 52
Evolution of the Payments System ..................................................................................................... 53 Commodity Money .............................................................................................................. 53 Fiat Money ........................................................................................................................... 53 Checks ................................................................................................................................. 53 Electronic Payment ............................................................................................................... 54 E-Money .............................................................................................................................. 54
fyi Are We Headed for a Cashless Society? 55
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Contents in Detail xi
APPLICATION Will Bitcoin Become the Money of the Future? ................................55
Measuring Money ................................................................................................................................... 56 The Federal Reserve’s Monetary Aggregates .......................................................................... 56
following the financial news The Monetary Aggregates 57
fyi Where Are All the U.S. Dollars? 58
Summary 59 • Key Terms 60 • Questions 60 • Applied Problems 61 • Data Analysis Problems 62 • Web Exercises 62 • Web References 62
ParT 2 Financial Markets 63
c h a P Te r 4 The Meaning of Interest Rates 64 Measuring Interest Rates ....................................................................................................................... 64
Present Value ........................................................................................................................ 64
APPLICATION Simple Present Value .........................................................................66
APPLICATION How Much Is That Jackpot Worth? ...................................................66 Four Types of Credit Market Instruments ............................................................................. 67 Yield to Maturity .................................................................................................................. 68
APPLICATION Yield to Maturity on a Simple Loan ...................................................68
APPLICATION Yield to Maturity and the Yearly Payment on a Fixed-Payment Loan ..................................................................................70
APPLICATION Yield to Maturity and Bond Price for a Coupon Bond ......................71
APPLICATION Yield to Maturity on a Perpetuity ......................................................73
APPLICATION Yield to Maturity on a Discount Bond ...............................................74
The Distinction Between Interest Rates and Returns................................................................... 75 Maturity and the Volatility of Bond Returns: Interest-Rate Risk ............................................. 78 Summary .............................................................................................................................. 79
The Distinction Between Real and Nominal Interest Rates ........................................................ 79
APPLICATION Calculating Real Interest Rates ..........................................................80 Summary 82 • Key Terms 82 • Questions 82 • Applied Problems 83 •
Data Analysis Problems 84 • Web Exercises 84 • Web References 84
c h a P Te r 4 W e B a P P e n d i X Measuring Interest-Rate Risk: Duration Go to the Companion Website, http://www.pearsonhighered.com/mishkin
c h a P Te r 5 The Behavior of Interest Rates 85 Determinants of Asset Demand .......................................................................................................... 85
Wealth .................................................................................................................................. 86
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xii Contents in Detail
Expected Returns ................................................................................................................. 86 Risk ...................................................................................................................................... 86 Liquidity .............................................................................................................................. 87 Theory of Portfolio Choice ................................................................................................... 87
Supply and Demand in the Bond Market ........................................................................................ 88 Demand Curve ..................................................................................................................... 88 Supply Curve ....................................................................................................................... 89 Market Equilibrium .............................................................................................................. 90 Supply and Demand Analysis ............................................................................................... 91
Changes in Equilibrium Interest Rates .............................................................................................. 91 Shifts in the Demand for Bonds ............................................................................................ 92 Shifts in the Supply of Bonds................................................................................................ 95
APPLICATION Changes in the Interest Rate Due to Expected Inflation: The Fisher Effect ................................................................................................97
APPLICATION Changes in the Interest Rate Due to a Business Cycle Expansion .................................................................................................99
APPLICATION Explaining Low Japanese Interest Rates ..........................................100
Supply and Demand in the Market for Money: The Liquidity Preference Framework ....................................................................................101
Changes in Equilibrium Interest Rates in the Liquidity Preference Framework.................104 Shifts in the Demand for Money ......................................................................................... 104 Shifts in the Supply of Money............................................................................................. 104
APPLICATION Changes in the Equilibrium Interest Rate Due to Changes in Income, the Price Level, or the Money Supply .............................105
Changes in Income ............................................................................................................. 106 Changes in the Price Level .................................................................................................. 106 Changes in the Money Supply ............................................................................................ 106
Money and Interest Rates ...................................................................................................................107
APPLICATION Does a Higher Rate of Growth of the Money Supply Lower Interest Rates? .......................................................................................109
Summary 112 • Key Terms 112 • Questions 112 • Applied Problems 113 • Data Analysis Problems 114 • Web Exercises 115 • Web References 115
c h a P Te r 5 W e B a P P e n d i X 1 Models of Asset Pricing Go to the Companion Website, http://www.pearsonhighered.com/mishkin
c h a P Te r 5 W e B a P P e n d i X 2 Applying the Asset Market Approach to a Commodity Market: The Case of Gold Go to the Companion Website, http://www.pearsonhighered.com/mishkin
c h a P Te r 5 W e B a P P e n d i X 3 Loanable Funds Framework Go to the Companion Website, http://www.pearsonhighered.com/mishkin
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Contents in Detail xiii
c h a P Te r 6 The Risk and Term Structure of Interest Rates 116 Risk Structure of Interest Rates .........................................................................................................116
Default Risk ........................................................................................................................ 116
fyi Conflicts of Interest at Credit-Rating Agencies and the Global Financial Crisis 120
APPLICATION The Global Financial Crisis and the Baa-Treasury Spread ..............121 Liquidity ............................................................................................................................ 121 Income Tax Considerations ................................................................................................ 122 Summary ............................................................................................................................ 123
APPLICATION Effects of the Obama Tax Increase on Bond Interest Rates .............123
Term Structure of Interest Rates .......................................................................................................124
following the financial news Yield Curves 124
Expectations Theory ........................................................................................................... 126 Segmented Markets Theory ................................................................................................ 129 Liquidity Premium and Preferred Habitat Theories ............................................................. 130 Evidence on the Term Structure ......................................................................................... 133
fyi The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle 134
Summary ............................................................................................................................ 134
APPLICATION Interpreting Yield Curves, 1980–2014 ............................................134 Summary 136 • Key Terms 136 • Questions 136 • Applied Problems 138 •
Data Analysis Problems 138 • Web Exercises 139 • Web References 139
c h a P Te r 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 140 Computing the Price of Common Stock ........................................................................................140
The One-Period Valuation Model ....................................................................................... 141 The Generalized Dividend Valuation Model ........................................................................ 142 The Gordon Growth Model ................................................................................................ 142
How the Market Sets Stock Prices ....................................................................................................143
APPLICATION Monetary Policy and Stock Prices ...................................................145
APPLICATION The Global Financial Crisis and the Stock Market .........................145
The Theory of Rational Expectations .............................................................................................145 Formal Statement of the Theory ......................................................................................... 147 Rationale Behind the Theory .............................................................................................. 147 Implications of the Theory ................................................................................................. 148
The Efficient Market Hypothesis: Rational Expectations in Financial Markets ...................149 Rationale Behind the Hypothesis ........................................................................................ 150 Random-Walk Behavior of Stock Prices .............................................................................. 151
global Should Foreign Exchange Rates Follow a Random Walk? 152
APPLICATION Practical Guide to Investing in the Stock Market ...........................152
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xiv Contents in Detail
How Valuable Are Reports Published by Investment Advisers? ........................................... 152 Should You Be Skeptical of Hot Tips? ................................................................................. 153
fyi Should You Hire an Ape as Your Investment Adviser? 154
Do Stock Prices Always Rise When There Is Good News? .................................................. 154 Efficient Market Prescription for the Investor ..................................................................... 154
Why the Efficient Market Hypothesis Does Not Imply That Financial Markets are Efficient ........................................................................................155
APPLICATION What Do Stock Market Crashes Tell Us About the Efficient Market Hypothesis and the Efficiency of Financial Markets? ..........................156
Behavioral Finance ................................................................................................................................156 Summary 157 • Key Terms 158 • Questions 158 • Applied Problems 159 •
Data Analysis Problems 160 • Web Exercises 160 • Web References 160
c h a P Te r 7 W e B a P P e n d i X Evidence on the Efficient Market Hypothesis Go to the Companion Website, http://www.pearsonhighered.com/mishkin
ParT 3 Financial Institutions 161
c h a P Te r 8 An Economic Analysis of Financial Structure 162 Basic Facts About Financial Structure Throughout the World ................................................162 Transaction Costs ..................................................................................................................................165
How Transaction Costs Influence Financial Structure ......................................................... 165 How Financial Intermediaries Reduce Transaction Costs .................................................... 166
Asymmetric Information: Adverse Selection and Moral Hazard ...........................................167 The Lemons Problem: How Adverse Selection Influences Financial Structure .................167
Lemons in the Stock and Bond Markets.............................................................................. 168 Tools to Help Solve Adverse Selection Problems ................................................................. 168
fyi The Enron Implosion 170
How Moral Hazard Affects the Choice Between Debt and Equity Contracts ...................................................................................................................173
Moral Hazard in Equity Contracts: The Principal–Agent Problem ....................................... 173 Tools to Help Solve the Principal–Agent Problem ............................................................... 174
How Moral Hazard Influences Financial Structure in Debt Markets .....................................176 Tools to Help Solve Moral Hazard in Debt Contracts .......................................................... 176 Summary ............................................................................................................................ 178
APPLICATION Financial Development and Economic Growth ..............................179
fyi The Tyranny of Collateral 180
APPLICATION Is China a Counterexample to the Importance of Financial Development? ...............................................................................181
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Contents in Detail xv
Summary 182 • Key Terms 183 • Questions 183 • Applied Problems 184 • Data Analysis Problems 185 • Web Exercises 185 • Web References 185
C H A P TE R 9 Banking and the Management of Financial Institutions 186 The Bank Balance Sheet ......................................................................................................................186
Liabilities ............................................................................................................................ 186 Assets ................................................................................................................................. 189
Basic Banking ...........................................................................................................................................190 General Principles of Bank Management .......................................................................................193
Liquidity Management and the Role of Reserves .................................................................193 Asset Management .............................................................................................................. 196 Liability Management ......................................................................................................... 197 Capital Adequacy Management .......................................................................................... 198
APPLICATION Strategies for Managing Bank Capital .............................................200
APPLICATION How a Capital Crunch Caused a Credit Crunch During the Global Financial Crisis ...............................................................................201
Managing Credit Risk ...........................................................................................................................201 Screening and Monitoring .................................................................................................. 202 Long-Term Customer Relationships ....................................................................................203 Loan Commitments ............................................................................................................204 Collateral and Compensating Balances ...............................................................................204 Credit Rationing .................................................................................................................205
Managing Interest-Rate Risk...............................................................................................................205 Gap and Duration Analysis ................................................................................................. 206
APPLICATION Strategies for Managing Interest-Rate Risk ......................................207
Off-Balance-Sheet Activities ..............................................................................................................208 Loan Sales .......................................................................................................................... 208 Generation of Fee Income .................................................................................................. 208 Trading Activities and Risk Management Techniques .......................................................... 209
Global Barings, Daiwa, Sumitomo, Société Générale, and JP Morgan Chase: Rogue Traders and the Principal–Agent Problem 210
Summary 211 • Key Terms 212 • Questions 212 • Applied Problems 213 • Data Analysis Problems 213 • Web Exercises 214 • Web References 214
C H A P TE R 9 W E b A P P E n d i x 1 Duration Gap Analysis Go to the Companion Website, http://www.pearsonhighered.com/mishkin
C H A P TE R 9 W E b A P P E n d i x 2 Measuring Bank Performance Go to the Companion Website, http://www.pearsonhighered.com/mishkin
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xvi Contents in Detail
c h a P Te r 1 0 Economic Analysis of Financial Regulation 215 Asymmetric Information as a Rationale for Financial Regulation ...........................................215
Government Safety Net ...................................................................................................... 215
global The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing? 217
Drawbacks of the Government Safety Net .......................................................................... 218
Types of Financial Regulation ............................................................................................................220 Restrictions on Asset Holdings ........................................................................................... 220 Capital Requirements ......................................................................................................... 220 Prompt Corrective Action ................................................................................................... 221
global Where Is the Basel Accord Heading After the Global Financial Crisis? 222
Financial Supervision: Chartering and Examination ........................................................... 223 Assessment of Risk Management ........................................................................................ 224 Disclosure Requirements .................................................................................................... 225
fyi Mark-to-Market Accounting and the Global Financial Crisis 226
Consumer Protection .......................................................................................................... 226 Restrictions on Competition ............................................................................................... 227 Summary ............................................................................................................................ 227
global International Financial Regulation 228
Summary 231 • Key Terms 231 • Questions 231 • Applied Problems 232 • Data Analysis Problems 232 • Web Exercises 233 • Web References 233
c h a P Te r 1 0 W e B a P P e n d i X 1 The 1980s Banking and Savings and Loan Crisis Go to the Companion Website, http://www.pearsonhighered.com/mishkin
c h a P Te r 1 0 W e B a P P e n d i X 2 Banking Crises Throughout the World Go to the Companion Website, http://www.pearsonhighered.com/mishkin
c h a P Te r 1 1 Banking Industry: Structure and Competition 234 Historical Development of the Banking System...........................................................................234
Multiple Regulatory Agencies ............................................................................................. 236
Financial Innovation and the Growth of the “Shadow Banking System” ..............................237 Responses to Changes in Demand Conditions: Interest-Rate Volatility ................................ 238 Responses to Changes in Supply Conditions: Information Technology ............................... 239
fyi Will “Clicks” Dominate “Bricks” in the Banking Industry? 241
Securitization and the Shadow Banking System .................................................................. 242 Avoidance of Existing Regulations ...................................................................................... 243
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Contents in Detail xvii
fyi Bruce Bent and the Money Market Mutual Fund Panic of 2008 245
Financial Innovation and the Decline of Traditional Banking .............................................. 246
Structure of the U.S. Commercial Banking Industry ...................................................................249 Restrictions on Branching ................................................................................................... 250 Response to Branching Restrictions .................................................................................... 251
Bank Consolidation and Nationwide Banking ..............................................................................252 The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 .......................... 253 What Will the Structure of the U.S. Banking Industry Look Like in the Future? ................. 254 Are Bank Consolidation and Nationwide Banking Good Things? ........................................ 254
global Comparison of Banking Structure in the United States and Abroad 255
Separation of Banking and Other Financial Service Industries ...............................................256 Erosion of Glass-Steagall ..................................................................................................... 256 The Gramm-Leach-Bliley Financial Services Modernization
Act of 1999: Repeal of Glass-Steagall ............................................................................. 256 Implications for Financial Consolidation ............................................................................ 257
fyi The Global Financial Crisis and the Demise of Large, Free-Standing Investment Banks 257
Separation of Banking and Other Financial Services Industries Throughout the World....... 258
Thrift Industry: Regulation and Structure......................................................................................258 Savings and Loan Associations ........................................................................................... 258 Mutual Savings Banks ......................................................................................................... 259 Credit Unions ..................................................................................................................... 259
International Banking ...........................................................................................................................260 Eurodollar Market .............................................................................................................. 260
global Ironic Birth of the Eurodollar Market 261
Structure of U.S. Banking Overseas .................................................................................... 261 Foreign Banks in the United States ..................................................................................... 262 Summary 263 • Key Terms 264 • Questions 264 • Data Analysis
Problems 265 • Web Exercises 266 • Web References 266
c h a P Te r 1 2 Financial Crises 267 What Is a Financial Crisis? ...................................................................................................................267 Dynamics of Financial Crises ..............................................................................................................268
Stage One: Initial Phase ...................................................................................................... 268 Stage Two: Banking Crisis ................................................................................................... 269 Stage Three: Debt Deflation ................................................................................................ 271
APPLICATION The Mother of All Financial Crises: The Great Depression ............272 Stock Market Crash ............................................................................................................ 272 Bank Panics ........................................................................................................................ 272 Continuing Decline in Stock Prices .................................................................................... 273 Debt Deflation .................................................................................................................... 273 International Dimensions ................................................................................................... 274
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The Global Financial Crisis of 2007–2009 ....................................................................................274 Causes of the 2007–2009 Financial Crisis .......................................................................... 274
fyi Collateralized Debt Obligations (CDOs) 275
Effects of the 2007–2009 Financial Crisis ........................................................................... 276
inside the fed Was the Fed to Blame for the Housing Price Bubble? 277
global The European Sovereign Debt Crisis 280
Height of the 2007–2009 Financial Crisis .......................................................................... 281 Government Intervention and the Recovery ....................................................................... 282
global Worldwide Government Bailouts During the 2007–2009 Financial Crisis 283
Response of Financial Regulation .....................................................................................................283 Macroprudential Versus Microprudential Supervision ........................................................ 283 Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ............................. 284
Too-Big-to-Fail and Future Regulation ...........................................................................................285 What Can Be Done About the Too-Big-to-Fail Problem? ..................................................... 285 Other Issues for Future Regulation ..................................................................................... 286 Summary 287 • Key Terms 288 • Questions 288 • Data Analysis
Problems 289 • Web Exercises 290 • Web References 290
c h a P Te r 1 3 Nonbank Finance 291 Insurance ..................................................................................................................................................291
Life Insurance ..................................................................................................................... 291 Property and Casualty Insurance ........................................................................................ 292 The Competitive Threat from the Banking Industry............................................................ 294 Credit Insurance ................................................................................................................. 294
fyi The AIG Blowup 295
fyi The Global Financial Crisis and the Monoline Insurers 296
APPLICATION Insurance Management ...................................................................296 Screening ........................................................................................................................... 297 Risk-Based Premiums ......................................................................................................... 297 Restrictive Provisions .......................................................................................................... 297 Prevention of Fraud ............................................................................................................ 298 Cancellation of Insurance ................................................................................................... 298 Deductibles ........................................................................................................................ 298 Coinsurance ....................................................................................................................... 298 Limits on the Amount of Insurance .................................................................................... 298 Summary ............................................................................................................................ 299
Pension Funds .........................................................................................................................................299 Private Pension Plans .......................................................................................................... 300 Public Pension Plans .......................................................................................................... 301
fyi Should Social Security Be Privatized? 301 Finance Companies ...............................................................................................................................302
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Securities Market Operations ...........................................................................................................303 Investment Banking ............................................................................................................ 303 Securities Brokers and Dealers ............................................................................................ 304 Organized Exchanges ......................................................................................................... 304
Mutual Funds ..........................................................................................................................................305
fyi Sovereign Wealth Funds: Are They a Danger? 306
Money Market Mutual Funds ............................................................................................. 307
Hedge Funds ...........................................................................................................................................307 Private Equity and Venture Capital Funds .....................................................................................308 Government Financial Intermediation ............................................................................................309
Federal Credit Agencies ...................................................................................................... 309
fyi The Global Financial Crisis and the Bailout of Fannie Mae and Freddie Mac 310
Summary 311 • Key Terms 312 • Questions 312 • Applied Problems 313 • Data Analysis Problems 313 • Web Exercises 314 • Web References 314
c h a P Te r 1 4 Financial Derivatives 315 Hedging ....................................................................................................................................................315 Interest-Rate Forward Contracts ......................................................................................................316
APPLICATION Hedging with Interest-Rate Forward Contracts ..............................316 Pros and Cons of Forward Contracts .................................................................................. 317
Financial Futures Contracts and Markets .......................................................................................318
APPLICATION Hedging with Financial Futures ......................................................319 Organization of Trading in Financial Futures Markets ........................................................ 321 The Globalization of Financial Futures Markets .................................................................. 322 Explaining the Success of Futures Markets ......................................................................... 322
APPLICATION Hedging Foreign Exchange Risk .....................................................324 Hedging Foreign Exchange Risk with Forward Contracts ................................................... 324 Hedging Foreign Exchange Risk with Futures Contracts .................................................... 324
Options ....................................................................................................................................................325 Option Contracts ................................................................................................................ 326 Profits and Losses on Option and Futures Contracts .......................................................... 326
APPLICATION Hedging with Future Options .........................................................329 Factors Affecting Option Premiums .................................................................................... 330 Summary ............................................................................................................................ 331
Swaps.........................................................................................................................................................332 Interest-Rate Swap Contracts .............................................................................................. 332
APPLICATION Hedging with Interest-Rate Swaps ..................................................333 Advantages of Interest-Rate Swaps ...................................................................................... 333 Disadvantages of Interest-Rate Swaps ................................................................................. 334 Financial Intermediaries in Interest-Rate Swaps .................................................................. 334
Credit Derivatives .................................................................................................................................334
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Credit Options ................................................................................................................... 335 Credit Swaps ...................................................................................................................... 335 Credit-Linked Notes ........................................................................................................... 336
APPLICATION Lessons from the Global Financial Crisis: When Are Financial Derivatives Likely to Be a Worldwide Ticking Time Bomb? ............336
Summary 338 • Key Terms 338 • Questions 339 • Applied Problems 339 • Data Analysis Problems 340 • Web Exercises 340 • Web References 340
c h a P Te r 1 5 Conflicts of Interest in the Financial Industry 341 What Are Conflicts of Interest, and Why Are They Important? ...........................................342
Why Do We Care About Conflicts of Interest? .................................................................... 342
Ethics and Conflicts of Interest ..........................................................................................................342 Types of Conflicts of Interest ............................................................................................................343
Underwriting and Research in Investment Banking ............................................................ 343 Auditing and Consulting in Accounting Firms ................................................................... 344 Credit Assessment and Consulting in Credit-Rating Agencies ............................................. 344
fyi The Collapse of Arthur Andersen 345
Universal Banking .............................................................................................................. 345
fyi Why Do Issuers of Securities Pay to Have Their Securities Rated? 346
fyi Banksters 347
Can the Market Limit Exploitations of Conflicts of Interest? ...................................................347 What Has Been Done to Remedy Conflicts of Interest? ...........................................................349
Sarbanes-Oxley Act of 2002 ............................................................................................... 349 Legal Settlement of 2002 .................................................................................................... 350 Dodd-Frank Bill of 2010 .................................................................................................... 351
A Framework for Evaluating Policies to Remedy Conflicts of Interest ..................................351 Approaches to Remedying Conflicts of Interest ................................................................... 352
APPLICATION Evaluating Sarbanes-Oxley, the Global Legal Settlement, and the Dodd-Frank Bill ...................................................................................354
Summary 356 • Key Terms 357 • Questions 357 • Web Exercises 358 • Web References 358
ParT 4 Central Banking and the Conduct of Monetary Policy 359
c h a P Te r 1 6 Central Banks and the Federal Reserve System 360 Origins of the Federal Reserve System ...........................................................................................360
inside the fed The Political Genius of the Founders of the Federal Reserve System 361
Structure of the Federal Reserve System .......................................................................................361 Federal Reserve Banks ........................................................................................................ 362
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inside the fed The Special Role of the Federal Reserve Bank of New York 364
Member Banks ................................................................................................................... 365 Board of Governors of the Federal Reserve System ............................................................. 366 Federal Open Market Committee (FOMC) ......................................................................... 366
inside the fed The Role of the Research Staff 367
inside the fed The FOMC Meeting 368
inside the fed Green, Blue, Teal, and Beige: What Do These Colors Mean at the Fed? 369
Why the Chair of the Board of Governors Really Runs the Show ........................................ 369
inside the fed Styles of Federal Reserve Chairs: Bernanke and Yellen Versus Greenspan 370
How Independent Is the Fed? ..........................................................................................................371 Should the Fed Be Independent? ....................................................................................................373
The Case for Independence ................................................................................................ 373 The Case Against Independence ......................................................................................... 374 Central Bank Independence and Macroeconomic Performance Throughout the World....... 375
Explaining Central Bank Behavior .....................................................................................................375
inside the fed The Evolution of the Fed’s Communication Strategy 376
Structure and Independence of the European Central Bank ..................................................377 Differences Between the European System of Central Banks
and the Federal Reserve System ..................................................................................... 377 Governing Council ............................................................................................................. 378 How Independent Is the ECB? ............................................................................................ 379
Structure and Independence of Other Foreign Central Banks ...............................................379 Bank of Canada .................................................................................................................. 379 Bank of England ................................................................................................................. 379 Bank of Japan ..................................................................................................................... 380 The Trend Toward Greater Independence ........................................................................... 381 Summary 381 • Key Terms 382 • Questions 382 • Data Analysis
Problems 383 • Web Exercises 383 • Web References 383
c h a P Te r 1 7 The Money Supply Process 384 Three Players in the Money Supply Process .................................................................................384 The Fed’s Balance Sheet ......................................................................................................................384
Liabilities ............................................................................................................................ 385 Assets ................................................................................................................................. 386
Control of the Monetary Base ...........................................................................................................386 Federal Reserve Open Market Operations........................................................................... 387 Shifts from Deposits into Currency ..................................................................................... 388 Loans to Financial Institutions............................................................................................ 389 Other Factors That Affect the Monetary Base ...................................................................... 389 Overview of the Fed’s Ability to Control the Monetary Base ................................................ 390
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Multiple Deposit Creation: A Simple Model ................................................................................391 Deposit Creation: The Single Bank ..................................................................................... 391 Deposit Creation: The Banking System ............................................................................... 392 Deriving the Formula for Multiple Deposit Creation ........................................................... 395 Critique of the Simple Model ............................................................................................. 396
Factors That Determine the Money Supply .................................................................................397 Changes in the Nonborrowed Monetary Base, MBn ............................................................. 397 Changes in Borrowed Reserves, BR, from the Fed ............................................................... 397 Changes in the Required Reserve Ratio, rr .......................................................................... 398 Changes in Excess Reserves ................................................................................................ 398 Changes in Currency Holdings ........................................................................................... 398
Overview of the Money Supply Process .......................................................................................398 The Money Multiplier..........................................................................................................................399
Deriving the Money Multiplier ........................................................................................... 399 Intuition Behind the Money Multiplier ............................................................................... 401 Money Supply Response to Changes in the Factors ............................................................ 402
APPLICATION Quantitative Easing and the Money Supply, 2007–2014. ................403 Summary 405 • Key Terms 405 • Questions 405 • Applied Problems 406 •
Data Analysis Problems 407 • Web Exercises 407 • Web References 408
c h a P Te r 1 7 W e B a P P e n d i X 1 The Fed’s Balance Sheet and the Monetary Base Go to the Companion Website, http://www.pearsonhighered.com/mishkin
c h a P Te r 1 7 W e B a P P e n d i X 2 The M2 Money Multiplier Go to the Companion Website, http://www.pearsonhighered.com/mishkin
c h a P Te r 1 7 W e B a P P e n d i X 3 Explaining the Behavior of the Currency Ratio Go to the Companion Website, http://www.pearsonhighered.com/mishkin
c h a P Te r 1 7 W e B a P P e n d i X 4 The Great Depression Bank Panics, 1930–1933, and the Money Supply Go to the Companion Website, http://www.pearsonhighered.com/mishkin
c h a P Te r 1 8 Tools of Monetary Policy 409 The Market for Reserves and the Federal Funds Rate...............................................................409
Demand and Supply in the Market for Reserves ................................................................. 410 How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate ..................... 411
APPLICATION How the Federal Reserve’s Operating Procedures Limit Fluctuations in the Federal Funds Rate ...........................................................415
Conventional Monetary Policy Tools ..............................................................................................416 Open Market Operations .................................................................................................... 416
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Discount Policy and the Lender of Last Resort .................................................................... 417
inside the fed A Day at the Trading Desk 418
Reserve Requirements ........................................................................................................ 420
inside the fed Using Discount Policy to Prevent a Financial Panic 421
Interest on Reserves ............................................................................................................ 422 Relative Advantages of the Different Tools .......................................................................... 422
Nonconventional Monetary Policy Tools and Quantitative Easing .......................................423 Liquidity Provision ............................................................................................................. 423 Large-Scale Asset Purchases ................................................................................................ 424
inside the fed Fed Lending Facilities During the Global Financial Crisis 425
Quantitative Easing Versus Credit Easing............................................................................ 426 Forward Guidance and the Commitment to Future Policy Actions ..................................... 428
Monetary Policy Tools of the European Central Bank ...............................................................429 Open Market Operations .................................................................................................... 429 Lending to Banks................................................................................................................ 430 Reserve Requirements ........................................................................................................ 430 Summary 430 • Key Terms 431 • Questions 431 • Applied Problems 432 •
Data Analysis Problems 433 • Web Exercises 433 • Web References 433
c h a P Te r 1 9 The Conduct of Monetary Policy: Strategy and Tactics 434 The Price Stability Goal and the Nominal Anchor ......................................................................434
The Role of a Nominal Anchor ........................................................................................... 435 The Time-Inconsistency Problem ....................................................................................... 435
Other Goals of Monetary Policy .......................................................................................................436 High Employment and Output Stability ............................................................................. 436 Economic Growth .............................................................................................................. 437 Stability of Financial Markets ............................................................................................. 437 Interest-Rate Stability ......................................................................................................... 437 Stability in Foreign Exchange Markets ................................................................................ 438
Should Price Stability Be the Primary Goal of Monetary Policy? ...........................................438 Hierarchical Versus Dual Mandates ..................................................................................... 438 Price Stability as the Primary, Long-Run Goal of Monetary Policy ....................................... 439
Inflation Targeting .................................................................................................................................439 Inflation Targeting in New Zealand, Canada, and the United Kingdom .............................. 440 Advantages of Inflation Targeting ....................................................................................... 442 Disadvantages of Inflation Targeting ................................................................................... 444
The Evolution of the Federal Reserve’s Monetary Policy Strategy ........................................445 The Fed’s “Just Do It” Monetary Policy Strategy .................................................................. 445 The Long Road to Inflation Targeting ................................................................................. 447
inside the fed Ben Bernanke’s Advocacy of Inflation Targeting 447
global The European Central Bank’s Monetary Policy Strategy 448
Lessons for Monetary Policy Strategy from the Global Financial Crisis ...............................449
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Implications for Inflation Targeting .................................................................................... 450
Should Central Banks Try to Stop Asset-Price Bubbles? ..........................................................451 Two Types of Asset-Price Bubbles ....................................................................................... 451 The Debate Over Whether Central Banks Should Try to Pop Bubbles ................................. 452
Tactics: Choosing the Policy Instrument .........................................................................................455 Criteria for Choosing the Policy Instrument ....................................................................... 457
Tactics: The Taylor Rule .......................................................................................................................458
inside the fed The Fed’s Use of the Taylor Rule 461
inside the fed Fed Watchers 461
Summary 462 • Key Terms 462 • Questions 463 • Applied Problems 464 • Data Analysis Problems 464 • Web Exercises 465 • Web References 466
c h a P Te r 1 9 W e B a P P e n d i X 1 Monetary Targeting Go to the Companion Website, http://www.pearsonhighered.com/mishkin
c h a P Te r 1 9 W e B a P P e n d i X 2 A Brief History of Federal Reserve Policymaking Go to the Companion Website, http://www.pearsonhighered.com/mishkin
ParT 5 International Finance and Monetary Policy 467
c h a P Te r 2 0 The Foreign Exchange Market 468 Foreign Exchange Market ....................................................................................................................468
What Are Foreign Exchange Rates? .................................................................................... 469
following the financial news Foreign Exchange Rates 470
Why Are Exchange Rates Important? .................................................................................. 470 How Is Foreign Exchange Traded? ...................................................................................... 471
Exchange Rates in the Long Run .......................................................................................................471 Law of One Price ................................................................................................................ 471 Theory of Purchasing Power Parity ..................................................................................... 472 Why the Theory of Purchasing Power Parity Cannot Fully Explain Exchange Rates ........... 473 Factors That Affect Exchange Rates in the Long Run .......................................................... 474
Exchange Rates in the Short Run: A Supply and Demand Analysis .......................................476 Supply Curve for Domestic Assets ...................................................................................... 476 Demand Curve for Domestic Assets .................................................................................... 476 Equilibrium in the Foreign Exchange Market ..................................................................... 477
Explaining Changes in Exchange Rates ...........................................................................................478 Shifts in the Demand for Domestic Assets........................................................................... 478 Recap: Factors That Change the Exchange Rate .................................................................. 481
APPLICATION Effects of Changes in Interest Rates on the Equilibrium Exchange Rate ..............................................................................483
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APPLICATION Why Are Exchange Rates So Volatile?.............................................484
APPLICATION The Dollar and Interest Rates ..........................................................485
APPLICATION The Global Financial Crisis and the Dollar ....................................486 Summary 487 • Key Terms 487 • Questions 487 • Applied Problems 488 •
Data Analysis Problems 489 • Web Exercises 489 • Web References 490
a P P e n d i X To c h a P Te r 2 0 The Interest Parity Condition 491 Comparing Expected Returns on Domestic and Foreign Assets ............................................491 Interest Parity Condition .....................................................................................................................493
c h a P Te r 2 1 The International Financial System 495 Intervention in the Foreign Exchange Market ..............................................................................495
Foreign Exchange Intervention and the Money Supply ....................................................... 495
inside the fed A Day at the Federal Reserve Bank of New York’s Foreign Exchange Desk 496
Unsterilized Intervention .................................................................................................... 498 Sterilized Intervention ........................................................................................................ 499
Balance of Payments .............................................................................................................................499
global Why the Large U.S. Current Account Deficit Worries Economists 501
Exchange Rate Regimes in the International Financial System.................................................501 Gold Standard .................................................................................................................... 501 The Bretton Woods System ................................................................................................. 502 How a Fixed Exchange Rate Regime Works ........................................................................ 503 Speculative Attacks ............................................................................................................. 504
APPLICATION The Foreign Exchange Crisis of September 1992 ...........................505 The Policy Trilemma ........................................................................................................... 506
APPLICATION How Did China Accumulate $4 Trillion of International Reserves? ................................................................................507
Monetary Unions ................................................................................................................ 508
global Will the Euro Survive? 509
Managed Float .................................................................................................................... 509
Capital Controls .....................................................................................................................................510 Controls on Capital Outflows ............................................................................................. 510 Controls on Capital Inflows ................................................................................................ 510
The Role of the IMF ..............................................................................................................................511 Should the IMF Act as an International Lender of Last Resort? ........................................... 511
International Considerations and Monetary Policy ....................................................................512 Direct Effects of the Foreign Exchange Market on Monetary Policy .................................... 512 Balance-of-Payments Considerations .................................................................................. 512 Exchange Rate Considerations ............................................................................................ 513
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To Peg or Not to Peg: Exchange-Rate Targeting as an Alternative Monetary Policy Strategy .............................................................................................513
Advantages of Exchange-Rate Targeting .............................................................................. 513 Disadvantages of Exchange-Rate Targeting ......................................................................... 514 When Is Exchange-Rate Targeting Desirable for Industrialized Countries? .......................... 516 When Is Exchange-Rate Targeting Desirable for Emerging Market Countries? .................... 517 Currency Boards ................................................................................................................. 517
global Argentina’s Currency Board 518
Dollarization ...................................................................................................................... 519 Summary 519 • Key Terms 520 • Questions 520 • Applied Problems 521 •
Data Analysis Problems 522 • Web Exercises 522 • Web References 522
ParT 6 Monetary Theory 523
c h a P Te r 2 2 Quantity Theory, Inflation, and the Demand for Money 524 Quantity Theory of Money ...............................................................................................................524
Velocity of Money and Equation of Exchange ..................................................................... 524 From the Equation of Exchange to the Quantity Theory of Money ..................................... 526 Quantity Theory and the Price Level .................................................................................. 527 Quantity Theory and Inflation ............................................................................................ 527
APPLICATION Testing the Quantity Theory of Money ...........................................528
Budget Deficits and Inflation .............................................................................................................530 Government Budget Constraint .......................................................................................... 530 Hyperinflation .................................................................................................................... 532
APPLICATION The Zimbabwean Hyperinflation ....................................................532
Keynesian Theories of Money Demand ........................................................................................533 Transactions Motive ............................................................................................................ 533 Precautionary Motive.......................................................................................................... 533 Speculative Motive ............................................................................................................. 533 Putting the Three Motives Together .................................................................................... 533
Portfolio Theories of Money Demand ...........................................................................................534 Theory of Portfolio Choice and Keynesian Liquidity Preference .......................................... 535 Other Factors That Affect the Demand for Money .............................................................. 535 Summary ............................................................................................................................ 536
Empirical Evidence for the Demand for Money ..........................................................................536 Interest Rates and Money Demand ..................................................................................... 536 Stability of Money Demand ................................................................................................ 537 Summary 538 • Key Terms 538 • Questions 538 • Applied Problems 540 •
Data Analysis Problems 540 • Web Exercises 541 • Web References 541
c h a P Te r 2 2 W e B a P P e n d i X 1 The Baumol-Tobin and Tobin Mean-Variance Model Go to the Companion Website, http://www.pearsonhighered.com/mishkin
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c h a P Te r 2 2 W e B a P P e n d i X 2 Empirical Evidence for the Demand for Money Go to the Companion Website, http://www.pearsonhighered.com/mishkin
c h a P Te r 2 3 Aggregate Demand and Supply Analysis 543 Aggregate Demand ..............................................................................................................................543
following the financial news Aggregate Output, Unemployment, and Inflation 544
Deriving the Aggregate Demand Curve ............................................................................... 544 Factors That Shift the Aggregate Demand Curve................................................................. 545
fyi What Does Autonomous Mean? 546
Aggregate Supply .................................................................................................................................549 Long-Run Aggregate Supply Curve ..................................................................................... 549 Short-Run Aggregate Supply Curve .................................................................................... 549 Price Stickiness and the Short-Run Aggregate Supply Curve ............................................... 551
Shifts in the Aggregate Supply Curves ...........................................................................................551 Shifts in the Long-Run Aggregate Supply Curve ................................................................. 551 Shifts in the Short-Run Aggregate Supply Curve ................................................................. 552
Equilibrium in Aggregate Demand and Supply Analysis ..........................................................555 Short-Run Equilibrium ....................................................................................................... 556 How the Short-Run Equilibrium Moves to the Long-Run Equilibrium over Time ............... 556 Self-Correcting Mechanism ................................................................................................ 559
Changes in Equilibrium: Aggregate Demand Shocks .................................................................559
APPLICATION The Volcker Disinflation, 1980–1986 .............................................560
APPLICATION Negative Demand Shocks, 2001–2004 ............................................562
Changes in Equilibrium: Aggregate Supply (Inflation) Shocks ................................................562 Temporary Supply Shocks .................................................................................................. 562
APPLICATION Negative Supply Shocks, 1973–1975 and 1978–1980 ....................565 Permanent Supply Shocks and Real Business Cycle Theory ................................................ 565
APPLICATION Positive Supply Shocks, 1995–1999 ................................................568 Conclusions ....................................................................................................................... 569
APPLICATION Negative Supply and Demand Shocks and the 2007–2009 Financial Crisis ..............................................................................570
AD/AS Analysis of Foreign Business Cycle Episodes ...................................................................570
APPLICATION The United Kingdom and the 2007–2009 Financial Crisis ............572
APPLICATION China and the 2007–2009 Financial Crisis .....................................573 Summary 574 • Key Terms 575 • Questions 575 • Applied Problems 576 •
Data Analysis Problems 576 • Web Exercises 577 • Web References 577
a P P e n d i X To c h a P Te r 2 3 The Phillips Curve and the Short-Run Aggregate Supply Curve 578 The Phillips Curve .................................................................................................................................578
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Phillips Curve Analysis in the 1960s .................................................................................. 578
fyi The Phillips Curve Tradeoff and Macroeconomic Policy in the 1960s 580
The Friedman-Phelps Phillips Curve Analysis .................................................................... 580 The Phillips Curve After the 1960s ..................................................................................... 582 The Modern Phillips Curve ................................................................................................ 582 The Modern Phillips Curve with Adaptive (Backward-Looking) Expectations .................... 583
The Short-Run Aggregate Supply Curve ......................................................................................584
c h a P Te r 2 3 W e B a P P e n d i X 1 The Effects of Macroeconomic Shocks on Asset Prices Go to the Companion Website, http://www.pearsonhighered.com/mishkin
c h a P Te r 2 3 W e B a P P e n d i X 2 Aggregate Demand and Supply: A Numerical Example Go to the Companion Website, http://www.pearsonhighered.com/mishkin
c h a P Te r 2 3 W e B a P P e n d i X 3 The Algebra of the Aggregate Demand and Supply Model Go to the Companion Website, http://www.pearsonhighered.com/mishkin
c h a P Te r 2 3 W e B a P P e n d i X 4 The Taylor Principle and Inflation Stability Go to the Companion Website, http://www.pearsonhighered.com/mishkin
c h a P Te r 2 4 Monetary Policy Theory 587 Response of Monetary Policy to Shocks ........................................................................................587
Response to an Aggregate Demand Shock .......................................................................... 588 Response to a Permanent Supply Shock ............................................................................. 590 Response to a Temporary Supply Shock ............................................................................. 592 The Bottom Line: The Relationship Between Stabilizing Inflation and
Stabilizing Economic Activity ........................................................................................ 595
How Actively Should Policymakers Try to Stabilize Economic Activity? .............................595 Lags and Policy Implementation ......................................................................................... 595
Inflation: Always and Everywhere a Monetary Phenomenon .................................................596
fyi The Activist/Nonactivist Debate Over the Obama Fiscal Stimulus Package 597
Causes of Inflationary Monetary Policy ..........................................................................................597 High Employment Targets and Inflation ............................................................................. 597
APPLICATION The Great Inflation ..........................................................................601
Monetary Policy at the Zero Lower Bound ...................................................................................603 Deriving the Aggregate Demand Curve with the Zero Lower Bound ................................... 603 The Disappearance of the Self-Correcting Mechanism at the Zero Lower Bound ................. 605
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APPLICATION Nonconventional Monetary Policy and Quantitative Easing ..........606 Liquidity Provision ............................................................................................................. 607 Asset Purchases and Quantitative Easing ............................................................................ 608 Management of Expectations .............................................................................................. 609
APPLICATION Abenomics and the Shift in Japanese Monetary Policy in 2013 .........610 Summary 612 • Key Terms 612 • Questions 613 • Applied Problems 614 •
Data Analysis Problems 614 • Web Exercises 615 • Web References 615
c h a P Te r 2 5 Transmission Mechanisms of Monetary Policy 616 Transmission Mechanisms of Monetary Policy .............................................................................616
Traditional Interest-Rate Channels ...................................................................................... 617 Other Asset Price Channels ................................................................................................ 618 Credit View ........................................................................................................................ 621
fyi Consumers’ Balance Sheets and the Great Depression 623
Why Are Credit Channels Likely to Be Important? ............................................................. 624
APPLICATION The Great Recession ........................................................................625
Lessons for Monetary Policy ..............................................................................................................625
APPLICATION Applying the Monetary Policy Lessons to Japan’s Two Lost Decades .............................................................................627
Summary 628 • Key Terms 628 • Questions 628 • Applied Problems 629 Data Analysis Problems 630 • Web Exercises 630 • Web References 631
c h a P Te r 2 5 W e B a P P e n d i X Evaluating Empirical Evidence: The Debate Over the Importance of Money in Economic Fluctuations Go to the Companion Website, http://www.pearsonhighered.com/mishkin
Glossary ..........................................................................................................................G-1
Index ..................................................................................................................................I-1
Contents on the Web The following chapters are available on our Companion Website at http://www.pearsonhighered.com/mishkin.
W e B c h a P Te r 1 Financial Crises in Emerging Market Economies W-1 Dynamics of Financial Crises in Emerging Market Economies ................................................W-1
Stage One: Initial Phase ..................................................................................................... W-1 Stage Two: Currency Crisis ................................................................................................ W-5 Stage Three: Full-Fledged Financial Crisis ......................................................................... W-6
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APPLICATION Crisis in South Korea, 1997–1998.................................................. W-7 Financial Liberalization and Globalization Mismanaged .................................................... W-8 Perversion of the Financial Liberalization and Globalization Process: Chaebols
and the South Korean Crisis ......................................................................................... W-9 Stock Market Decline and Failure of Firms Increase Uncertainty ..................................... W-10 Adverse Selection and Moral Hazard Problems Worsen, and the Economy Contracts ...... W-11 Currency Crisis Ensues .................................................................................................... W-11 Final Stage: Currency Crisis Triggers Full-Fledged Financial Crisis .................................. W-11 Recovery Commences ..................................................................................................... W-13
APPLICATION The Argentine Financial Crisis, 2001–2002................................. W-13 Severe Fiscal Imbalances ................................................................................................. W-13 Adverse Selection and Moral Hazard Problems Worsen ................................................... W-13 Bank Panic Begins ........................................................................................................... W-14 Currency Crisis Ensues .................................................................................................... W-14 Currency Crisis Triggers Full-Fledged Financial Crisis ..................................................... W-15 Recovery Begins .............................................................................................................. W-17
global When an Advanced Economy Is Like an Emerging Market Economy: The Icelandic Financial Crisis of 2008 W-18
Preventing Emerging Market Financial Crises ........................................................................... W-18 Beef Up Prudential Regulation and Supervision of Banks................................................. W-18 Encourage Disclosure and Market-Based Discipline ......................................................... W-19 Limit Currency Mismatch ................................................................................................ W-19 Sequence Financial Liberalization .................................................................................... W-20 Summary W-20 • Key Terms W-20 • Questions W-21
W e B c h a P Te r 2 The IS Curve W-1 Planned Expenditure and Aggregate Demand ...........................................................................W-1 The Components of Aggregate Demand.....................................................................................W-2
Consumption Expenditure ................................................................................................ W-2
fyi Meaning of the Word Investment W-3
Planned Investment Spending ........................................................................................... W-3 Net Exports ....................................................................................................................... W-5 Government Purchases and Taxes ...................................................................................... W-6
Goods Market Equilibrium ................................................................................................................W-7 Solving for Goods Market Equilibrium .............................................................................. W-7 Deriving the IS Curve ........................................................................................................ W-8
Understanding the IS Curve .............................................................................................................W-8 What the IS Curve Tells Us: Intuition ................................................................................ W-8 What the IS Curve Tells Us: Numerical Example ............................................................... W-8 Why the Economy Heads Toward Equilibrium ................................................................ W-10
Factors That Shift the IS Curve ...................................................................................................... W-10 Changes in Government Purchases .................................................................................. W-10
APPLICATION The Vietnam War Buildup, 1964–1969 ........................................ W-11 Changes in Taxes ............................................................................................................. W-12
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Contents in Detail xxxi
APPLICATION The Fiscal Stimulus Package of 2009 ........................................... W-13 Changes in Autonomous Spending .................................................................................. W-14 Changes in Financial Frictions ........................................................................................ W-16 Summary of Factors That Shift the IS Curve .................................................................... W-16 Summary W-16 • Key Terms W-16 • Questions W-17 • Applied Problems W-18 •
Data Analysis Problems W-19 • Web Exercises W-20 • Web References W-20
W e B c h a P Te r 3 The Monetary Policy and Aggregate Demand Curves W-1 The Federal Reserve and Monetary Policy ..................................................................................W-1 The Monetary Policy Curve ..............................................................................................................W-2
The Taylor Principle: Why the Monetary Policy Curve Has an Upward Slope .......................................................................................................... W-2
Shifts in the MP Curve....................................................................................................... W-4 Movements Along Versus Shifts In the MP Curve .............................................................. W-5
APPLICATION Movement Along the MP Curve: The Rise in the Federal Funds Rate Target, 2004–2006 ................................................................................... W-5
APPLICATION Shift in the MP Curve: Autonomous Monetary Easing at the Onset of the Global Financial Crisis ..................................................... W-5
The Aggregate Demand Curve .......................................................................................................W-6 Deriving the Aggregate Demand Curve Graphically ........................................................... W-6 Factors That Shift the Aggregate Demand Curve................................................................ W-8
fyi Deriving the Aggregate Demand Curve Algebraically W-8
Summary W-12 • Key Terms W-12 • Questions W-12 • Applied Problems W-13 • Data Analysis Problems W-14 • Web Exercises W-15 • Web References W-15
W e B c h a P Te r 4 The Role of Expectations in Monetary Policy W-1 Lucas Critique of Policy Evaluation .................................................................................................W-1
Econometric Policy Evaluation .......................................................................................... W-2
APPLICATION The Term Structure of Interest Rates .............................................. W-2
Policy Conduct: Rules or Discretion? .............................................................................................W-3 Discretion and the Time-Inconsistency Problem ................................................................ W-3 Types of Rules .................................................................................................................... W-4 The Case for Rules ............................................................................................................. W-4
fyi The Political Business Cycle and Richard Nixon W-5
The Case for Discretion ..................................................................................................... W-5 Constrained Discretion ...................................................................................................... W-6
global The Demise of Monetary Targeting in Switzerland W-6
The Role of Credibility and a Nominal Anchor ..........................................................................W-7 Benefits of a Credible Nominal Anchor .............................................................................. W-7 Credibility and Aggregate Demand Shocks ........................................................................ W-8 Credibility and Aggregate Supply Shocks ........................................................................ W-10
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xxxii Contents in Detail
APPLICATION A Tale of Three Oil Price Shocks .................................................. W-11 Credibility and Anti-Inflation Policy ................................................................................ W-13
global Ending the Bolivian Hyperinflation: A Successful Anti-Inflation Program W-14
APPLICATION Credibility and the Reagan Budget Deficits .................................. W-15
Approaches to Establishing Central Bank Credibility ............................................................ W-16 Nominal GDP Targeting .................................................................................................. W-16
inside the fed The Appointment of Paul Volcker, Anti-Inflation Hawk W-17
Appoint “Conservative” Central Bankers .......................................................................... W-17 Summary W-18 • Key Terms W-18 • Questions W-18 • Applied
Problems W-19 • Data Analysis Problems W-20 • Web Exercises W-20
W e B c h a P Te r 5 The ISLM Model W-1 Keynes’s Fixed Price Level Assumption and the IS Curve ........................................................W-1
The LM Curve ................................................................................................................... W-1 Equilibrium in the Market for Money: The LM Curve ........................................................ W-2
ISLM Approach to Aggregate Output and Interest Rates .......................................................W-4 Factors That Cause the LM Curve to Shift ....................................................................................W-5 Changes in Equilibrium Level of the Interest Rate and Aggregate Output .......................W-7
Response to a Change in Monetary Policy ......................................................................... W-7 Response to a Change in Fiscal Policy ............................................................................... W-8
APPLICATION The Economic Stimulus Act of 2008 .............................................. W-9
Effectiveness of Monetary Versus Fiscal Policy ......................................................................... W-11 Monetary Policy Versus Fiscal Policy: The Case of Complete Crowding Out .................... W-11
APPLICATION Targeting Money Supply Versus Interest Rates ............................ W-13
ISLM Model in the Long Run.......................................................................................................... W-16 Summary W-18 • Key Terms W-19 • Questions and Applied Problems W-19 •
Web Exercises W-19 • Web References W-20
a P P e n d i X To W e B c h a P Te r 5 Algebra of the ISLM Model W-24 Basic Closed-Economy ISLM Model ............................................................................................ W-21
IS and LM Curves ............................................................................................................ W-22 Solution of the Model ...................................................................................................... W-22 Implications .................................................................................................................... W-22
Open-Economy ISLM Model ......................................................................................................... W-23 Implications ......................................................................................................................................... W-24
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HALLMARkS Although this text has undergone a major revision, it retains the basic hallmarks that have made it the best-selling textbook on money and banking since its inception over thirty-years ago:
• A unifying, analytic framework that uses a few basic economic principles to or- ganize students’ thinking about the structure of financial markets, the foreign ex- change markets, financial institution management, and the role of monetary policy in the economy
• A careful, step-by-step development of economic models (the approach used in the best principles of economics textbooks), which makes it easier for students to learn
• The complete integration of an international perspective throughout the text • A thoroughly up-to-date treatment of the latest developments in monetary theory • A special feature called “Following the Financial News,” included to encourage
reading of a financial newspaper • An applications-oriented perspective with numerous applications and special-topic
boxes that increase students’ interest by showing them how to apply theory to real- world examples
WHAT’S NEW IN THE FOuRTH EDITION In addition to the expected updating of all data through 2014 whenever possible, there is major new material in every part of the text.
Enhanced Pearson e-text with Mini-Lecture Videos: A New Way of Learning
Preface
xxxiii
MyEconLab
The Enhanced Pearson e-text in MyEconLab for the fourth edition is available online from MyEconLab textbook resources. Instructors and students can highlight the text, bookmark, search the glossary, and take notes. More importantly, the enhanced Pearson e-text provides a new way of learning that is particularly geared to today’s students. Not only will students be able to read the material in the textbook, but by a simple click on an icon they will be able to watch over 120 mini-lecture videos presented by the author, one for every figure in the text. For analytic figures, these mini-lectures build each graph step-by-step and explain the intuition necessary to fully understand the theory behind the graph. For data figures, the mini-lectures highlight the key data points that are of greatest interest. The mini-lectures are an invaluable study tool for students who typically learn better when they see and hear economic analysis rather than read it.
Real-Time Data A high percentage of the in-text data figures are labeled MyEconLab Real-Time Data. For these figures, students can see the latest data in the enhanced Pearson e-text, using the Federal Reserve Bank of St. Louis’s FRED database. In addition, the new edition of
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xxxiv Preface
the text has a whole new class of problems that involve real-time data analysis. These problems, marked with , ask the students to download data from the Federal Reserve Bank of St. Louis FRED website and then use the data to answer questions about current issues in macroeconomics.
In MyEconLab, these easy-to-assign and automatically-graded Real-Time Data Analysis Problems communicate directly with the FRED site, so that students see updated data every time new data is posted by FRED. Thus the Real-Time Data Analysis Problems offer a no-fuss solution for instructors who wish to make the most current data a central part of their macroeconomics course. These exercises will not only help students understand mac- roeconomics better, but will also enable them to see the real-world relevance of their studies.
The Business School Edition: A More Finance-Oriented Approach I am pleased to continue providing two versions of The Economics of Money, Banking, and Financial Markets. While both versions contain the core chapters that all professors want to cover, The Economics of Money, Banking, and Financial Markets, Business School Edition, presents a more finance-oriented approach—an approach more commonly taught in business schools, but also one that some professors in economics departments prefer when teaching their money and banking courses. The Business School Edition includes chapters on nonbank finance, financial derivatives, and conflicts of interest in the financial industry. The Business School Edition omits the chapters on the IS curve and the monetary policy and aggregate demand curves, as well as the chapter on the role of expectations in monetary policy. The Economics of Money, Banking, and Financial Markets, Business School Edition, more closely fits the needs of those professors whose courses have less of an emphasis on monetary theory.
For professors who desire a comprehensive discussion of monetary theory and monetary policy, The Economics of Money, Banking, and Financial Markets, Eleventh Edition, contains all of the chapters on monetary theory. Professors who do want this coverage are often hard-pressed to cover all of the finance and institutions chapters. To that end, the Eleventh Edition omits the chapters on nonbank finance, financial derivatives, and conflicts of interest. The Companion Website at http://www.pearsonhighered .com/mishkin provides the omitted chapters, making them readily available for those who wish to utilize them in their courses.
Reorganization of Part 3, Financial Institutions The global financial crisis of 2007–2009 has become a central topic in the teaching of money and banking. When I teach this material, I find that students understand the dynamics of the crisis more deeply if they are taught about bank management, financial regulation, and the shadow banking system before they delve into the details of the global financial crisis. For this reason, I have moved the chapter titled “Financial Crises” so that it follows the three chapters titled “Banking and the Management of Financial Institutions,” “Economic Analysis of Financial Regulation,” and “Banking Industry: Structure and Competition.”
In addition, I have added the following new material to Part 3 of the text:
• A new FYI box on the tyranny of collateral (Chapter 8) • A new section that provides more detail on securitization and the shadow banking
system (Chapter 11)
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Preface xxxv
• A new section on the response of financial regulation to the global financial crisis (Chapter 12)
• A new section exploring what can be done about the too-big-to-fail problem (Chapter 12)
Nonconventional Monetary Policy and the Zero Lower Bound Monetary policy en
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