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The Economics of

Money,
Banking,
and Financial
Markets
Te n t h E d i t i o n

Frederic S. Mishkin

Columbia University

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Library of Congress Cataloging-in-Publication Data
Mishkin, Frederic S.

The economics of money, banking & financial markets / Frederic S. Mishkin. –
10th ed.(and the 3rd ed. of the business ed.)
p. cm.
Includes bibliographical references and index.
ISBN 13: 978-0-13-277024-8 (main ed : alk. paper)
ISBN 10: 0-13-277024-5 (main ed : alk. paper)
ISBN 13: 978-0-13-274137-8 (business ed : alk. paper)
ISBN 10: 0-13-274137-7 (business ed : alk. paper)
1. Finance. 2. Money. 3. Banks and banking. I. Title. II. Title: The economics of money, banking, and financial markets.
HG173.M632 2013
332–dc23
2011045340
10 9 8 7 6 5 4 3 2 1

www.pearsonhighered.com

ISBN 10: 0-13-277024-5
ISBN 13: 978-0-13-277024-8

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Brief Contents
PART 1


Introduction  1
1 Why Study Money, Banking, and Financial Markets?.......................................... 2
2 An Overview of the Financial System................................................................ 25
3 What Is Money?................................................................................................. 52

PART 2

Financial Markets  65





PART 3

4
5
6
7

Financial Institutions  161
8
9
10
11
12

PART 4


An Economic Analysis of Financial Structure.................................................. 162
Financial Crises ................................................................................................ 185
Banking and the Management of Financial Institutions .................................. 213
Economic Analysis of Financial Regulation . ................................................... 242
Banking Industry: Structure and Competition................................................. 269

Central Banking and the Conduct of Monetary Policy  301
13
14
15
16

PART 5

Understanding Interest Rates............................................................................. 66
The Behavior of Interest Rates............................................................................ 88
The Risk and Term Structure of Interest Rates................................................. 118
The Stock Market, the Theory of Rational Expectations,
and the Efficient Market Hypothesis................................................................. 141

Central Banks and the Federal Reserve System ............................................... 302
The Money Supply Process .............................................................................. 325
The Tools of Monetary Policy........................................................................... 355
The Conduct of Monetary Policy: Strategy and Tactics .................................. 380

International Finance and Monetary Policy  421
17 The Foreign Exchange Market ......................................................................... 422
18 The International Financial System................................................................. 446

PART 6


Monetary Theory  479
19
20
21
22
23
24
25

Quantity Theory, Inflation, and the Demand for Money................................... 480
The IS Curve..................................................................................................... 497
The Monetary Policy and Aggregate Demand Curves....................................... 515
Aggregate Demand and Supply Analysis........................................................... 528
Monetary Policy Theory.................................................................................... 570
The Role of Expectations in Monetary Policy................................................... 589
Transmission Mechanisms of Monetary Policy................................................. 608
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Contents
PART 1

Introduction  1
C hapter 1

Why Study Money, Banking, and Financial Markets?  2
Why Study Financial Markets?...................................................................................... 2
The Bond Market and Interest Rates........................................................................................ 2
The Stock Market.................................................................................................................... 4

Why Study Financial Institutions and Banking?............................................................ 4
Structure of the Financial System............................................................................................ 5
Financial Crises....................................................................................................................... 6
Banks and Other Financial Institutions.................................................................................... 6
Financial Innovation............................................................................................................... 6

Why Study Money and Monetary Policy?...................................................................... 7
Money and Business Cycles..................................................................................................... 7
Money and Inflation................................................................................................................ 7
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
Collecting and Graphing Data............................................................................................... 15

Web Exercises.............................................................................................................. 15
Concluding Remarks................................................................................................... 16
Summary  17  •   Key Terms  18  •   Questions  19  •   Applied Problems  20  •  
Web Exercises  20  •   Web References  21


App endix to C h apt e r 1
Defining Aggregate Output, Income, the Price Level,
and the Inflation Rate  22
Aggregate Output and Income..................................................................................... 22
Real Versus Nominal Magnitudes................................................................................. 22
Aggregate Price Level................................................................................................... 23
Growth Rates and the Inflation Rate............................................................................ 24

C hapter 2
An Overview of the Financial System  25
Function of Financial Markets..................................................................................... 25
Structure of Financial Markets..................................................................................... 27
Debt and Equity Markets....................................................................................................... 27
Primary and Secondary Markets............................................................................................ 28

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Contents
Exchanges and Over-the-Counter Markets............................................................................ 29
Money and Capital Markets................................................................................................... 29

Financial Market Instruments...................................................................................... 30
Money Market Instruments................................................................................................... 30

Following the Financial News  Money Market Rates  31
Capital Market Instruments................................................................................................... 32


Following the Financial News  Capital Market Interest Rates  33
Internationalization of Financial Markets..................................................................... 34
Global  Are U.S. Capital Markets Losing Their Edge?  35
International Bond Market, Eurobonds, and Eurocurrencies................................................. 35
World Stock Markets............................................................................................................. 36

Function of Financial Intermediaries: Indirect Finance................................................ 36
Following the Financial News  Foreign Stock Market Indexes  37
Transaction Costs.................................................................................................................. 37

Global The Importance of Financial Intermediaries Relative to Securities Markets:
An International Comparison  38
Risk Sharing.......................................................................................................................... 38
Asymmetric Information: Adverse Selection and Moral Hazard............................................. 39
Economies of Scope and Conflicts of Interest........................................................................ 41

Types of Financial Intermediaries................................................................................. 41
Depository Institutions.......................................................................................................... 41
Contractual Savings Institutions............................................................................................ 43
Investment Intermediaries..................................................................................................... 44

Regulation of the Financial System.............................................................................. 45
Increasing Information Available to Investors........................................................................ 45
Ensuring the Soundness of Financial Intermediaries.............................................................. 45
Financial Regulation Abroad................................................................................................. 48

Summary 48   •   Key Terms   •   49   •   Questions  49   •   Applied Problems 50   •  
 Web Exercises 51   •    Web References 51


Chapter 3
What Is Money?  52
Meaning of Money....................................................................................................... 52
Functions of Money..................................................................................................... 53
Medium of Exchange............................................................................................................. 53
Unit of Account..................................................................................................................... 54
Store of Value........................................................................................................................ 55

Evolution of the Payments System............................................................................... 56
Commodity Money............................................................................................................... 56
Fiat Money............................................................................................................................ 56
Checks.................................................................................................................................. 56
Electronic Payment................................................................................................................ 57
E-Money............................................................................................................................... 57

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Contents

FYI   Are We Headed for a Cashless Society?  58
Measuring Money........................................................................................................ 58
The Federal Reserve’s Monetary Aggregates........................................................................... 59

Following the Financial News: The Monetary Aggregates..................................... 60
FYI  Where Are All the U.S. Dollars?  60
Summary  62  •   Key Terms 62  •  Questions 62  •  Applied Problems 64  • 
Web Exercises 64  •   Web References 64


PART 2

Financial Markets  65
C hapter 4
Understanding Interest Rates  66
Measuring Interest Rates.............................................................................................. 66
Present Value......................................................................................................................... 66
Application  Simple Present Value......................................................................... 68
Application  How Much Is That Jackpot Worth?................................................... 68
Four Types of Credit Market Instruments.............................................................................. 69
Yield to Maturity................................................................................................................... 70
Application  Yield to Maturity on a Simple Loan................................................... 70
Application  Yield to Maturity and the Yearly Payment

on a Fixed-Payment Loan.......................................................................................... 72
Application  Yield to Maturity and the Bond Price for a Coupon Bond................ 73
Application  Perpetuity.......................................................................................... 75

Global  Negative T-Bill Rates? It Can Happen  77
The Distinction Between Interest Rates and Returns.................................................... 77
Maturity and the Volatility of Bond Returns: Interest-Rate Risk.............................................. 80
Summary............................................................................................................................... 81

The Distinction Between Real and Nominal Interest Rates........................................... 81
Application  Calculating Real Interest Rates.......................................................... 82

FYI  With TIPS, Real Interest Rates Have Become Observable in the United States  84
Summary 84  •   Key Terms 84  •   Questions 85  •   Applied Problems 85  •  
Web Exercises 86  •   Web References 87  •   Web Appendices 87


C hapter 5
The Behavior of Interest Rates  88
Determinants of Asset Demand.................................................................................... 88
Wealth................................................................................................................................... 89
Expected Returns.................................................................................................................. 89
Risk....................................................................................................................................... 89
Liquidity............................................................................................................................... 90
Theory of Portfolio Choice.................................................................................................... 90

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Contents

Supply and Demand in the Bond Market..................................................................... 91
Demand Curve...................................................................................................................... 91
Supply Curve........................................................................................................................ 92
Market Equilibrium............................................................................................................... 93
Supply and Demand Analysis................................................................................................ 94

Changes in Equilibrium Interest Rates......................................................................... 94
Shifts in the Demand for Bonds............................................................................................. 94
Shifts in the Supply of Bonds................................................................................................ 98
Application  Changes in the Interest Rate Due to Expected

Inflation: The Fisher Effect............................................................................... 100
Application  Changes in the Interest Rate Due to a Business


Cycle Expansion................................................................................................ 101
Application  Explaining Low Japanese Interest Rates.......................................... 103

Supply and Demand in the Market for Money: The Liquidity
Preference Framework........................................................................................ 104
Changes in Equilibrium Interest Rates in the Liquidity Preference Framework.......... 107
Shifts in the Demand for Money.......................................................................................... 107
Shifts in the Supply of Money............................................................................................. 107
Application  Changes in the Equilibrium Interest Rate Due to Changes

in Income, the Price Level, or the Money Supply............................................. 107
Changes in Income.............................................................................................................. 108
Changes in the Price Level................................................................................................... 109
Changes in the Money Supply............................................................................................. 109
Application  Money and Interest Rates................................................................ 110

Does a Higher Rate of Growth of the Money Supply Lower Interest Rates?................ 111
Summary 114   •   Key Terms 115   •   Questions 115   •   Applied Problems 116   •  
Web Exercises 117   •   Web References 117   •   Web Appendices 1, 2, 3 117

Chapter 6
The Risk and Term Structure of Interest Rates  118
Risk Structure of Interest Rates.................................................................................. 118
Default Risk......................................................................................................................... 118

FYI Conflicts of Interest at Credit-Rating Agencies and the Global
Financial Crisis  122
Application  The Global Financial Crisis and the Baa-Treasury Spread.............. 122
Liquidity............................................................................................................................. 123

Income Tax Considerations................................................................................................. 123
Summary............................................................................................................................. 125
Application  Effects of the Bush Tax Cut and Its Possible Repeal

on Bond Interest Rates...................................................................................... 125
Term Structure of Interest Rates................................................................................. 126
Following the Financial News  Yield Curves  126
Expectations Theory............................................................................................................ 128
Segmented Markets Theory................................................................................................. 131

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Contents
Liquidity Premium and Preferred Habitat Theories.............................................................. 132
Evidence on the Term Structure.......................................................................................... 134
Summary............................................................................................................................. 134

FYI  The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle  136
Application Interpreting Yield Curves, 1980–2011............................................. 136

Summary 137   •   Key Terms 138   •   Questions 138   •   Applied Problems 139   •  
Web Exercises 140   •   Web References 140

C hapter 7
The Stock Market, the Theory of Rational Expectations,
and the Efficient Market Hypothesis  141
Computing the Price of Common Stock.................................................................... 141

The One-Period Valuation Model........................................................................................ 142
The Generalized Dividend Valuation Model......................................................................... 143
The Gordon Growth Model................................................................................................. 143

How the Market Sets Stock Prices.............................................................................. 144
Application Monetary Policy and Stock Prices.................................................... 145
Application The Global Financial Crisis and the Stock Market.......................... 146

The Theory of Rational Expectations......................................................................... 146
Formal Statement of the Theory.......................................................................................... 148
Rationale Behind the Theory............................................................................................... 148
Implications of the Theory.................................................................................................. 149

The Efficient Market Hypothesis: Rational Expectations in Financial Markets............ 149
Rationale Behind the Hypothesis......................................................................................... 151
Application Practical Guide to Investing in the Stock Market............................ 152
How Valuable Are Published Reports by Investment Advisers?............................................ 152
Should You Be Skeptical of Hot Tips?.................................................................................. 153
Do Stock Prices Always Rise When There Is Good News?................................................... 153

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

Web Exercises 160   •  Web References 160   •  Web Appendix 160

PART 3

Financial Institutions  161
C hapter 8
An Economic Analysis of Financial Structure  162
Basic Facts About Financial Structure Throughout the World.................................... 162

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Contents

Transaction Costs...................................................................................................... 165
How Transaction Costs Influence Financial Structure.......................................................... 165
How Financial Intermediaries Reduce Transaction Costs..................................................... 165

Asymmetric Information: Adverse Selection and Moral Hazard................................. 166
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............... 172
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........................... 175
Tools to Help Solve Moral Hazard in Debt Contracts........................................................... 176
Summary............................................................................................................................. 178
Application  Financial Development and Economic Growth.............................. 179

FYI  Should We Kill All the Lawyers?  180
Application  Is China a Counterexample to the Importance

of Financial Development?...........................................................................................180
Summary 181   •  Key Terms 182   •  Questions 182   •  Applied Problems 183   • 
Web Exercises 184   •  Web References 184

Chapter 9
Financial Crises  185
What Is a Financial Crisis?........................................................................................ 185
Dynamics of Financial Crises in Advanced Economies............................................... 186
Stage One: Initiation of Financial Crisis............................................................................... 186
Stage Two: Banking Crisis.................................................................................................... 188
Stage Three: Debt Deflation................................................................................................. 189
Application  The Mother of All Financial Crises: The Great Depression............ 189
Stock Market Crash............................................................................................................. 189
Bank Panics......................................................................................................................... 190
Continuing Decline in Stock Prices..................................................................................... 190
Debt Deflation..................................................................................................................... 191
International Dimensions.................................................................................................... 191
Application  The Global Financial Crisis of 2007–2009...................................... 192
Causes of the 2007–2009 Financial Crisis........................................................................... 192

FYI  Collateralized Debt Obligations (CDOs)  193
Effects of the 2007–2009 Financial Crisis............................................................................ 194


Inside the Fed  Was the Fed to Blame for the Housing Price Bubble?  195
Global  Ireland and the 2007–2009 Financial Crisis  198
Height of the 2007–2009 Financial Crisis........................................................................... 198
Government Intervention and the Recovery........................................................................ 199

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Contents

Global  Worldwide Government Bailouts During the 2007–2009 Financial Crisis  200
Dynamics of Financial Crises in Emerging Market Economies................................... 200
Stage One: Initiation of Financial Crisis............................................................................... 202
Stage Two: Currency Crisis.................................................................................................. 204
Stage Three: Full-Fledged Financial Crisis........................................................................... 205
Application  Financial Crises in Mexico, 1994–1995; East Asia, 1997–1998;

and Argentina, 2001–2002................................................................................ 206

Global The Perversion of the Financial Liberalization/Globalization Process:
Chaebols and the South Korean Crisis  207
Summary 210   •  Key Terms 211   •  Questions 211   •  Web Exercises 212   • 
Web References 212

C hapter 1 0
Banking and the Management of Financial Institutions  213
The Bank Balance Sheet............................................................................................. 213

Liabilities............................................................................................................................. 213
Assets.................................................................................................................................. 216

Basic Banking............................................................................................................ 217
General Principles of Bank Management.................................................................... 220
Liquidity Management and the Role of Reserves.................................................................. 220
Asset Management............................................................................................................... 223
Liability Management.......................................................................................................... 224
Capital Adequacy Management........................................................................................... 225
Application  Strategies for Managing Bank Capital............................................. 227
Application  How a Capital Crunch Caused a Credit Crunch

During the Global Financial Crisis................................................................... 228
Managing Credit Risk................................................................................................ 229
Screening and Monitoring................................................................................................... 229
Long-Term Customer Relationships..................................................................................... 231
Loan Commitments............................................................................................................. 231
Collateral and Compensating Balances................................................................................ 231
Credit Rationing.................................................................................................................. 232

Managing Interest-Rate Risk...................................................................................... 233
Gap and Duration Analysis.................................................................................................. 233
Application  Strategies for Managing Interest-Rate Risk...................................... 235

Off-Balance-Sheet Activities....................................................................................... 235
Loan Sales........................................................................................................................... 235
Generation of Fee Income................................................................................................... 236
Trading Activities and Risk Management Techniques........................................................... 236

Global Barings, Daiwa, Sumitomo, and Société Générale: Rogue Traders

and the Principal–Agent Problem  237
Summary 238   •  Key Terms 239   •  Questions 239   •  Applied Problems 240   • 
Web Exercises 241   •  Web References 241   •  Web Appendices 1, 2 241

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Contents

Chapter 1 1
Economic Analysis of Financial Regulation  242
Asymmetric Information and Financial Regulation.................................................... 242
Government Safety Net....................................................................................................... 242

Global The Spread of Government Deposit Insurance Throughout the World:
Is This a Good Thing?  244
Restrictions on Asset Holdings............................................................................................ 247
Capital Requirements.......................................................................................................... 247
Prompt Corrective Action.................................................................................................... 248

Global  Where Is the Basel Accord Heading After the Global Financial Crisis?  249
Financial Supervision: Chartering and Examination............................................................ 250
Assessment of Risk Management......................................................................................... 251
Disclosure Requirements..................................................................................................... 252
Consumer Protection........................................................................................................... 252

FYI  Mark-to-Market Accounting and the Global Financial Crisis  253
FYI  The Subprime Mortgage Crisis and Consumer Protection Regulation  254

Restrictions on Competition................................................................................................ 255
Macroprudential Versus Microprudential Supervision......................................................... 255

Global  International Financial Regulation  256
Summary............................................................................................................................. 257

The 1980s Savings and Loan and Banking Crisis....................................................... 259
Banking Crises Throughout the World...................................................................... 261
“Déjà vu All Over Again”..................................................................................................... 261

The Dodd-Frank Bill and Future Regulation.............................................................. 262
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.............................. 264
Future Regulation................................................................................................................ 265

Summary  266  •   Key Terms  266  •   Questions  267  •   Applied Problems  267  •  
Web Exercises  268  •   Web References  268  •   Web Appendices  1, 2  268

Chapter 1 2
Banking Industry: Structure and Competition  269
Historical Development of the Banking System.......................................................... 269
Multiple Regulatory Agencies.............................................................................................. 271

Financial Innovation and the Growth of the “Shadow Banking System”..................... 272
Responses to Changes in Demand Conditions: Interest-Rate Volatility................................. 273
Responses to Changes in Supply Conditions: Information Technology................................ 274

FYI  Will “Clicks” Dominate “Bricks” in the Banking Industry?  276
Avoidance of Existing Regulations....................................................................................... 277

FYI  Bruce Bent and the Money Market Mutual Fund Panic of 2008  279

Financial Innovation and the Decline of Traditional Banking............................................... 280

Structure of the U.S. Commercial Banking Industry.................................................. 283

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Contents

xvii

Restrictions on Branching.................................................................................................... 284
Response to Branching Restrictions..................................................................................... 285

Bank Consolidation and Nationwide Banking............................................................ 286
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994........................... 288
What Will the Structure of the U.S. Banking Industry Look Like in the Future?.................. 288

Global  Comparison of Banking Structure in the United States and Abroad  289
Are Bank Consolidation and Nationwide Banking Good Things?......................................... 289

Separation of the Banking and Other Financial Service Industries............................. 290
Erosion of Glass-Steagall...................................................................................................... 290
The Gramm-Leach-Bliley Financial Services Modernization Act of 1999:
Repeal of Glass-Steagall.................................................................................................. 290
Implications for Financial Consolidation............................................................................. 291
Separation of Banking and Other Financial Services Industries Throughout the World....... 291


FYI The Global Financial Crisis and the Demise of Large, Free-Standing
Investment Banks  292
Thrift Industry: Regulation and Structure.................................................................. 292
Savings and Loan Associations............................................................................................ 292
Mutual Savings Banks.......................................................................................................... 293
Credit Unions...................................................................................................................... 293

International Banking................................................................................................ 294
Eurodollar Market............................................................................................................... 294

Global  Ironic Birth of the Eurodollar Market  295
Structure of U.S. Banking Overseas..................................................................................... 295
Foreign Banks in the United States...................................................................................... 296

Summary  297  •   Key Terms  298  •   Questions  298  •   Web Exercises  299  •  
Web References  300

PART 4

Central Banking and the Conduct of Monetary Policy  301
C hapter 1 3
Central Banks and the Federal Reserve System  302
Origins of the Federal Reserve System....................................................................... 302

Inside the Fed The Political Genius of the Founders of the Federal
Reserve System  303
Structure of the Federal Reserve System.................................................................... 303
Federal Reserve Banks......................................................................................................... 304
Member Banks.................................................................................................................... 306


Inside the Fed  The Special Role of the Federal Reserve Bank of New York  307
Board of Governors of the Federal Reserve System.............................................................. 308
Federal Open Market Committee (FOMC).......................................................................... 308

Inside the Fed  The Role of the Research Staff  309


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Contents

Inside the Fed  The FOMC Meeting  310
Why the Chairman of the Board of Governors Really Runs the Show.................................. 311

Inside the Fed Green, Blue, Teal, and Beige: What Do These Colors
Mean at the Fed?  311
How Independent Is the Fed?.................................................................................... 312
Should the Fed Be Independent?............................................................................... 313

Inside the Fed  How Bernanke’s Style Differs from Greenspan’s  314
The Case for Independence................................................................................................. 315
The Case Against Independence.......................................................................................... 316
Central Bank Independence and Macroeconomic Performance Throughout the World....... 316

Explaining Central Bank Behavior............................................................................. 317

Inside the Fed  The Evolution of the Fed’s Communication Strategy  318
Structure and Independence of the European Central Bank....................................... 318
Differences Between the European System of Central Banks and the
Federal Reserve System.................................................................................................. 319

Governing Council.............................................................................................................. 319
How Independent Is the ECB?............................................................................................. 320

Structure and Independence of Other Foreign Central Banks.................................... 321
Bank of Canada................................................................................................................... 321
Bank of England.................................................................................................................. 321
Bank of Japan...................................................................................................................... 322
The Trend Toward Greater Independence............................................................................ 322

Summary  322  •   Key Terms  323  •   Questions  323  •   Web Exercises  324  •  
Web References  324

Chapter 1 4
The Money Supply Process  325
Three Players in the Money Supply Process............................................................... 325
The Fed’s Balance Sheet............................................................................................. 325
Liabilities............................................................................................................................. 326
Assets.................................................................................................................................. 327

Control of the Monetary Base.................................................................................... 327
Federal Reserve Open Market Operations........................................................................... 328
Shifts from Deposits into Currency...................................................................................... 331
Loans to Financial Institutions............................................................................................ 332
Other Factors That Affect the Monetary Base....................................................................... 332
Overview of the Fed’s Ability to Control the Monetary Base................................................. 333

Multiple Deposit Creation: A Simple Model............................................................... 334
Deposit Creation: The Single Bank...................................................................................... 334
Deposit Creation: The Banking System................................................................................ 335
Deriving the Formula for Multiple Deposit Creation............................................................ 338

Critique of the Simple Model.............................................................................................. 339

Factors That Determine the Money Supply................................................................ 340
Changes in the Nonborrowed Monetary Base, MBn. ............................................................ 340

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Contents
Changes in Borrowed Reserves, BR, from the Fed................................................................ 340
Changes in the Required Reserve Ratio, rr........................................................................... 340
Changes in Currency Holdings............................................................................................ 340
Changes in Excess Reserves................................................................................................. 341

Overview of the Money Supply Process..................................................................... 341
The Money Multiplier................................................................................................ 342
Deriving the Money Multiplier............................................................................................ 342
Intuition Behind the Money Multiplier................................................................................ 344
Money Supply Response to Changes in the Factors............................................................. 345
Application  The Great Depression Bank Panics, 1930–1933,

and the Money Supply.......................................................................................................346
Application  The 2007–2009 Financial Crisis and the Money Supply.................. 348

Summary  351   •  Key Terms  351   •  Questions  352   •  Applied Problems  352   • 
Web Exercises  353   •  Web References  354   •  Web Appendices 1, 2,3  354

C hapter 1 5

Tools of Monetary Policy  355
The Market for Reserves and the Federal Funds Rate................................................. 355
Demand and Supply in the Market for Reserves.................................................................. 355

Inside the Fed  Why Does the Fed Need to Pay Interest on Reserves?  357
How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate...................... 358
Application  How the Federal Reserve’s Operating Procedures

Limit Fluctuations in the Federal Funds Rate.................................................. 362
Conventional Monetary Policy Tools.......................................................................... 364
Open Market Operations..................................................................................................... 364

Inside the Fed  A Day at the Trading Desk  365
Discount Policy and the Lender of Last Resort..................................................................... 366

Inside the Fed  Using Discount Policy to Prevent a Financial Panic  368
Reserve Requirements......................................................................................................... 369
Interest on Reserves............................................................................................................. 370
Relative Advantages of the Different Tools........................................................................... 370

Nonconventional Monetary Policy Tools During the Global Financial Crisis.............. 371
Liquidity Provision.............................................................................................................. 371
Asset Purchases................................................................................................................... 372

Inside the Fed  Fed Lending Facilities During the Global Financial Crisis  373
Quantitative Easing Versus Credit Easing............................................................................ 372
Commitment to Future Policy Actions................................................................................ 374

Monetary Policy Tools of the European Central Bank................................................ 375
Open Market Operations..................................................................................................... 376

Lending to Banks................................................................................................................ 376
Reserve Requirements......................................................................................................... 376

Summary  377   •  Key Terms  377   •  Questions  378   •  Applied Problems  379   • 
Web Exercises  379   •  Web References  379

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Contents

Chapter 1 6
The Conduct of Monetary Policy: Strategy and Tactics  380
The Price Stability Goal and the Nominal Anchor...................................................... 380
The Role of a Nominal Anchor............................................................................................ 381
The Time-Inconsistency Problem........................................................................................ 381

Other Goals of Monetary Policy................................................................................. 382
High Employment and Output Stability.............................................................................. 382
Economic Growth............................................................................................................... 383
Stability of Financial Markets.............................................................................................. 383
Interest-Rate Stability.......................................................................................................... 383
Stability in Foreign Exchange Markets................................................................................. 383

Should Price Stability be the Primary Goal of Monetary Policy?................................. 384
Hierarchical Versus Dual Mandates...................................................................................... 384
Price Stability as the Primary, Long-Run Goal of Monetary Policy........................................ 385


Inflation Targeting..................................................................................................... 385
Inflation Targeting in New Zealand, Canada, and the United Kingdom............................... 386
Advantages of Inflation Targeting........................................................................................ 388
Disadvantages of Inflation Targeting.................................................................................... 389

The Federal Reserve’s Monetary Policy Strategy......................................................... 391
Advantages of the Fed’s “Just Do It” Approach..................................................................... 392
Disadvantages of the Fed’s “Just Do It” Approach................................................................. 392

Lessons for Monetary Policy Strategy from the Global Financial Crisis...................... 393

Inside the Fed  Chairman Bernanke and Inflation Targeting  394
Implications for Inflation Targeting..................................................................................... 395
How Should Central Banks Respond to Asset-Price Bubbles?.............................................. 396

Tactics: Choosing the Policy Instrument.................................................................... 400
Criteria for Choosing the Policy Instrument........................................................................ 402

Tactics: The Taylor Rule............................................................................................. 403

Inside the Fed  The Fed’s Use of the Taylor Rule  406
Inside the Fed  Fed Watchers  406
Summary  407   •  Key Terms  407   •  Questions  408   •  Applied Problems  409   • 
Web Exercises  409   •  Web References  410   •  Web Appendix  410

Appendix to Ch apte r 1 6
Fed Policy Procedures: Historical Perspective  411
The Early Years: Discount Policy as the Primary Tool................................................. 411
Discovery of Open Market Operations....................................................................... 412
The Great Depression................................................................................................ 412


Inside the Fed  Bank Panics of 1930–1933: Why Did the Fed Let
Them Happen?  413
Reserve Requirements as a Policy Tool....................................................................... 413
War Finance and the Pegging of Interest Rates: 1942–1951....................................... 414
Targeting Money Market Conditions: the 1950s and 1960s....................................... 414
Targeting Monetary Aggregates: the 1970s................................................................. 415

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Contents

New Fed Operating Procedures: October 1979–October 1982.................................. 416
De-Emphasis of Monetary Aggregates: October 1982–Early 1990s............................ 417
Federal Funds Targeting Again: Early 1990s and Beyond........................................... 418
Preemptive Strikes Against Inflation.......................................................................... 418
Preemptive Strikes Against Economic Downturns and Financial Disruptions:
LTCM, Enron, and the Global Financial Crisis.................................................... 419
International Considerations..................................................................................... 419

PART 5

International Finance and Monetary Policy  421
C hapter 1 7
The Foreign Exchange Market  422
Foreign Exchange Market.......................................................................................... 422
What Are Foreign Exchange Rates?..................................................................................... 423


Following the Financial News  Foreign Exchange Rates  424
Why Are Exchange Rates Important?................................................................................... 424
How Is Foreign Exchange Traded?....................................................................................... 425

Exchange Rates in the Long Run................................................................................ 425
Law of One Price................................................................................................................. 425
Theory of Purchasing Power Parity...................................................................................... 426
Why the Theory of Purchasing Power Parity Cannot Fully Explain
Exchange Rates.............................................................................................................. 427
Factors That Affect Exchange Rates in the Long Run........................................................... 428

Exchange Rates in the Short Run: A Supply and Demand Analysis............................ 429
Supply Curve for Domestic Assets....................................................................................... 430
Demand Curve for Domestic Assets..................................................................................... 431
Equilibrium in the Foreign Exchange Market...................................................................... 431

Explaining Changes in Exchange Rates...................................................................... 431
Shifts in the Demand for Domestic Assets........................................................................... 432
Recap: Factors That Change the Exchange Rate................................................................... 434
Application  Effects of Changes in Interest Rates on the Equilibrium

Exchange Rate................................................................................................... 436
Application  Why Are Exchange Rates So Volatile?............................................. 437
Application  The Dollar and Interest Rates.......................................................... 438
Application  The Global Financial Crisis and the Dollar..................................... 439

Summary  440   •  Key Terms  440   •  Questions  441   •  Applied Problems  441   • 
Web Exercises  442   •  Web References  442


App endix to Ch apte r 1 7
The Interest Parity Condition  443
Comparing Expected Returns on Domestic and Foreign Assets................................. 443
Interest Parity Condition........................................................................................... 445

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Contents

Chapter 1 8
The International Financial System  446
Intervention in the Foreign Exchange Market............................................................ 446
Foreign Exchange Intervention and the Money Supply........................................................ 446

Inside the Fed  A Day at the Federal Reserve Bank of New York’s
Foreign Exchange Desk  447
Unsterilized Intervention..................................................................................................... 449
Sterilized Intervention......................................................................................................... 450

Balance of Payments.................................................................................................. 450

Global  Why the Large U.S. Current Account Deficit Worries Economists  451
Exchange Rate Regimes in the International Financial System................................... 452
Gold Standard..................................................................................................................... 452
The Bretton Woods System.................................................................................................. 453

Global  The Euro’s Challenge to the Dollar  454

How a Fixed Exchange Rate Regime Works......................................................................... 454
Application  How Did China Accumulate Over $3 Trillion of

International Reserves?..................................................................................... 457
Managed Float..................................................................................................................... 458
European Monetary System (EMS)...................................................................................... 459
Application  The Foreign Exchange Crisis of September 1992........................... 460
Application  Recent Foreign Exchange Crises in Emerging Market

Countries: Mexico 1994, East Asia 1997, Brazil 1999, and
Argentina 2002.................................................................................................. 462
Capital Controls........................................................................................................ 463
Controls on Capital Outflows.............................................................................................. 463
Controls on Capital Inflows................................................................................................. 463

The Role of the IMF................................................................................................... 464
Should the IMF Be an International Lender of Last Resort?.................................................. 464
How Should the IMF Operate?............................................................................................ 465

Global  The Global Financial Crisis and the IMF  467
International Considerations and Monetary Policy.................................................... 467
Direct Effects of the Foreign Exchange Market on Monetary Policy..................................... 467
Balance-of-Payments Considerations................................................................................... 468
Exchange Rate Considerations............................................................................................. 468

To Peg or Not to Peg: Exchange-Rate Targeting as an Alternative
Monetary Policy Strategy.................................................................................... 469
Advantages of Exchange-Rate Targeting............................................................................... 469
Disadvantages of Exchange-Rate Targeting.......................................................................... 470
When Is Exchange-Rate Targeting Desirable for Industrialized Countries?........................... 472

When Is Exchange-Rate Targeting Desirable for Emerging Market Countries?..................... 473
Currency Boards.................................................................................................................. 473

Global  Argentina’s Currency Board  474
Dollarization....................................................................................................................... 474

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Contents

Summary  475   •  Key Terms  476   •  Questions  476   •  Applied Problems  477   • 
Web Exercises  478   •  Web References  478

PART 6

Monetary Theory  479
C hapter 1 9
Quantity Theory, Inflation, and the Demand for Money  480
Quantity Theory of Money........................................................................................ 480
Velocity of Money and Equation of Exchange...................................................................... 480
From the Equation of Exchange to the Quantity Theory of Money...................................... 482
Quantity Theory and the Price Level................................................................................... 483
Quantity Theory and Inflation............................................................................................. 483
Application Testing the Quantity Theory of Money............................................ 484

Budget Deficits and Inflation..................................................................................... 486
Government Budget Constraint........................................................................................... 486

Hyperinflation..................................................................................................................... 488
Application The Zimbabwean Hyperinflation..................................................... 488

Keynesian Theories of Money Demand...................................................................... 488
Transactions Motive............................................................................................................. 489
Precautionary Motive.......................................................................................................... 489
Speculative Motive.............................................................................................................. 489
Putting the Three Motives Together..................................................................................... 489

Portfolio Theories of Money Demand........................................................................ 490
Theory of Portfolio Choice and Keynesian Liquidity Preference........................................... 490
Other Factors That Affect the Demand for Money............................................................... 491
Summary............................................................................................................................. 491

Empirical Evidence for the Demand for Money......................................................... 492
Interest Rates and Money Demand...................................................................................... 492
Stability of Money Demand................................................................................................. 493

Summary  493   •  Key Terms  494   •  Questions  494   •  Applied Problems  495   • 
Web Exercises  496   •  Web References  496   •  Web Appendices 1, 2  496

C hapter 2 0
The IS Curve  497
Planned Expenditure and Aggregate Demand............................................................ 497
The Components of Aggregate Demand..................................................................... 498
Consumption Expenditure.................................................................................................. 498

FYI  Meaning of the Word Investment  499
Planned Investment Spending............................................................................................. 499
Net Exports......................................................................................................................... 501

Government Purchases and Taxes........................................................................................ 502

Goods Market Equilibrium........................................................................................ 503
Solving for Goods Market Equilibrium................................................................................ 503
Deriving the IS Curve.......................................................................................................... 504

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Contents

Understanding the IS Curve...................................................................................... 504
What the IS Curve Tells Us: Intuition.................................................................................. 504
What the IS Curve Tells Us: Numerical Example................................................................. 504
Why the Economy Heads Toward the Equilibrium.............................................................. 505

Factors that Shift the IS Curve................................................................................... 506
Changes in Government Purchases...................................................................................... 506
Application  The Vietnam War Buildup, 1964–1969........................................... 506
Changes in Taxes................................................................................................................. 507
Application  The Fiscal Stimulus Package of 2009.............................................. 508
Changes in Autonomous Spending...................................................................................... 509
Changes in Financial Frictions............................................................................................ 510
Summary of Factors That Shift the IS Curve........................................................................ 510

Summary  511  •   Key Terms  512  •   Questions  512  •   Applied Problems  513  •  
Web Exercises  514  •   Web References  514


Chapter 2 1
The Monetary Policy and Aggregate Demand Curves  515
The Federal Reserve and Monetary Policy.................................................................. 515
The Monetary Policy Curve....................................................................................... 516
The Taylor Principle: Why the Monetary Policy Curve Has an Upward Slope...................... 516
Shifts in the MP Curve........................................................................................................ 517
Application  Autonomous Monetary Easing at the Onset of the

2007–2009 Financial Crisis............................................................................... 518
The Aggregate Demand Curve................................................................................... 519
Deriving the Aggregate Demand Curve Graphically............................................................. 519
Factors That Shift the Aggregate Demand Curve................................................................. 520

FYI  Deriving the Aggregate Demand Curve Algebraically  520
Summary  525  •   Key Terms  525  •   Questions  525  •   Applied Problems  526  •  
Web Exercises  527  •   Web References  527

Chapter 2 2
Aggregate Demand and Supply Analysis  528
Aggregate Demand.................................................................................................... 528

Following the Financial News: Aggregate Output, Unemployment,
and Inflation  529
Deriving the Aggregate Demand Curve................................................................................ 529
Factors That Shift the Aggregate Demand Curve................................................................. 530

Aggregate Supply....................................................................................................... 533
Long-Run Aggregate Supply Curve...................................................................................... 533
Short-Run Aggregate Supply Curve..................................................................................... 534


Shifts in Aggregate Supply Curves............................................................................. 536
Shifts in the Long-Run Aggregate Supply Curve.................................................................. 536
Shifts in the Short-Run Aggregate Supply Curve.................................................................. 537

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