M&B
M&B
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COPYRIGHT 2006 by South-Western, part of the Thomson Corporation. South-Western, Thomson, and the Thomson logo are trademarks used herein under license. Printed in the United States of America 1 2 3 4 5 08 07 06 05 Package ISBN: 0-324-17673-2 Book-only ISBN: 0-324-32282-8 Library of Congress Control Number: 2004114017
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To Sally
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Copyright 2006 Thomson Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
CONTENTS CONTENTS
Chapter 1 PART 1 INTRODUCTION 1 MONEY, BANKING, AND FINANCIAL MARKETS: AN OVERVIEW 2 Introduction 2 Money and Banking: Key Elements 3
Money 4 Banks and Other Financial Intermediaries 6 Interest Rates 7 Federal Budget Decits 10
Summary 16 Key Terms 16 Note to Students and Instructors 16 Chapter 2 MONEY: ITS NATURE, FUNCTIONS, AND EVOLUTION 18 The Nature and Functions of Money 18
Meaning of Money 19 Distinctions Among Money, Wealth, and Income 19 Functions of Money 20
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Summary 38 Key Terms 39 Study Questions 39 Suggestions for Additional Reading 40 PART 2 FINANCIAL MARKETS, INSTITUTIONS, AND INTEREST RATES 41 Chapter 3 FINANCIAL MARKETS AND INSTRUMENTS 42 Financial Markets and the Flow of Funds 42 Attributes of Financial Instruments 45
Liquidity 46 Risk 46 Yield 46 Liquidity, Risk, and Yield: Their Relationship 47
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Summary 66 Key Terms 66 Study Questions 67 Suggestions for Additional Reading 68 Chapter 4 FINANCIAL INTERMEDIATION 69 The Economic Basis for Financial Intermediation 69
Risks and Costs in the Absence of Intermediation 69 Benets of Intermediation 71
Summary 93 Key Terms 93 Study Questions 93 Suggestions for Additional Reading 94 Chapter 5 INTEREST RATE DETERMINATION 95 Present Value: Interest Rates and Security Prices 97
The Concept of Present Value 97 Interest Rates and Security Prices 99
Major Interest Rate Movements, 19602004 113 Real Interest Rates: Ex Ante Versus Ex Post 114
Ex Ante and Ex Post Real Rates in the United States 115 Two Measures of Ex Ante Real Interest Rates 117 The Historical Behavior of Expected Real Interest Rates 117
Summary 120 Key Terms 120 Study Questions 121 Suggestions for Additional Reading 122
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Chapter 6 THE TERM STRUCTURE AND RISK STRUCTURE OF INTEREST RATES 123 The Term Structure of Interest Rates 123 Theories of Term Structure 126
Pure Expectations Theory 126 Liquidity Premium Theory 129 Segmented Markets Theory 131 Preferred Habitat Theory 132
Term Structure Theories: How Well Do They Explain the Facts? 135
Fact 1: Upward-Sloping Yield Curve Predominates 136 Fact 2: Yields of Various Maturities Typically Move in the Same Direction 137 Fact 3: Yield Curve Exhibits a Regular Cyclical Pattern 137
The Risk Structure of Interest Rates 139 Summary 143 Key Terms 144 Study Questions 144 Suggestions for Additional Reading 146 Chapter 7 THE STOCK MARKET 147 Introduction 147
Long-Term Stock Market Behavior 147 Stock Prices as a Barometer of Economic Sentiment 148
The Stock Market: Risk and Returns 157 What Determines the Price of a Share of Stock? 159
Why We Discount the Expected Future Payments from Stocks 160 Impact of Various Events on Stock Prices 162
Should the Federal Reserve React to Perceived Bubbles in Asset Markets? 169
Arguments for Federal Reserve Intervention Against Bubbles 169 Arguments for the Federal Reserves Laissez-Faire Approach 170 The Tendency for Mean Reversion in Returns from Stocks 171
Summary 173 Key Terms 173 Study Questions 174 Suggestions for Additional Reading 175
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Chapter 8 THE FOREIGN EXCHANGE MARKET 176 Foreign Exchange Markets and Rates 176
The Foreign Exchange Market 176 The Foreign Exchange Rate 177 Fixed and Floating Exchange Rates 178 Spot and Forward Exchange Markets 180 The Importance of the Exchange Rate 182
Summary 198 Key Terms 199 Study Questions 199 Suggestions for Additional Reading 201 PART 3 BANKING: STRUCTURE, REGULATION, AND DEPOSIT INSURANCE 203 COMMERCIAL BANKING 204 The Commercial Bank Balance Sheet 204 Commercial Bank Liabilities 205
Transactions Deposits 207 Non-Transactions Deposits 208 Non-Deposit Borrowing 209 Other Bank Liabilities 209 Changing Sources of Bank Funds 209
Chapter 9
Summary 227 Key Terms 228 Study Questions 228 Suggestions for Additional Reading 229 Chapter 10 THE BANKING INDUSTRY: ITS EVOLUTION, STRUCTURE, AND REGULATION 230 Early History and Evolution of U.S. Banking 230
The Bank of the United States 231 The Free Banking Era 232 The National Banking Act of 1863 232
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The Future Shape of Banking 251 Summary 253 Key Terms 253 Study Questions 254 Suggestions for Additional Reading 255 Chapter 11 THE ECONOMICS OF BANKING REGULATION AND DEPOSIT INSURANCE 256 Limiting the Consequences of Asymmetric Information 258
The Government Safety Net for Bank Depositors: FDIC Insurance and Other Measures 258 Challenges Created by the Government Safety Net 259
The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) 268 Summary: The Role of Moral Hazard and Adverse Selection in the S&L Fiasco 269 The Escalation of Commercial Bank Failures in the 1980s 271
The Adverse Effect of Financial Innovations and Regulatory Actions 272 Economic Instability and Commercial Bank Financial Condition 272
Summary 281 Key Terms 282 Study Questions 282 Suggestions for Additional Reading 283
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Chapter 12
PART 4 CENTRAL BANKING, THE FEDERAL RESERVE, AND THE MONEY SUPPLY PROCESS 285 THE FEDERAL RESERVE SYSTEM: ITS STRUCTURE AND FUNCTIONS 286 The Origin of the Federal Reserve System 286 The Balance Sheet and Income Statement of the Federal Reserve System 288
The Balance Sheet of the Federal Reserve System 288 Federal Reserve Earnings and Expenses 292
Summary 307 Key Terms 308 Study Questions 308 Suggestions for Additional Reading 309 Chapter 13 THE EUROPEAN CENTRAL BANK 311 The Movement Toward Economic Unication of Europe 311
The Road to Monetary Union and Establishment of the European Central Bank 311 The Treaty on Monetary Union (the Maastricht Treaty) 312
Summary 323 Key Terms 324 Study Questions 325 Suggestions for Additional Reading 325 Chapter 14 THE DEPOSIT EXPANSION PROCESS: THE SIMPLE ANALYTICS 326 Banks and the Creation of Bank Deposits 326
Multiple Expansion of Bank Deposits 328 Multiple Contraction of Deposits 332
How the Federal Reserve Gets a Grip on the Money Supply 333 Summary 335 Key Terms 335 Study Questions 336 Suggestions for Additional Reading 336
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Chapter 15 MONEY SUPPLY DETERMINATION: THE MONETARY BASE 337 The Monetary BaseMoney Multiplier Framework 337 The Monetary Base: Fundamental Concepts 338
Derivation of the Monetary Base 340 Sources of the Monetary Base 340 Uses for the Monetary Base 342
Federal Reserve Operations and the Monetary Base 354 Summary 354 Key Terms 355 Study Questions 355 Suggestions for Additional Reading 356 Chapter 16 MONEY SUPPLY DETERMINATION: THE MONEY SUPPLY MULTIPLIER 357 The Money Supply Multiplier: Derivation and Applications 359
Comparison of Money Supply Multiplier with the Simple, Naive Deposit Expansion Multiplier 361 Role of the Federal Reserve in Inuencing the Money Supply Multiplier 361 Arithmetic Examples 364
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Analysis of the Variables Underlying the Money Supply Multiplier (k, rr, and re) 367
The Currency Ratio (k) 367 Specic Determinants of the Currency Ratio (k) 369 Importance of k in Money Supply Multiplier 371 Determinants of the Required Reserve Ratio (rr) 371 The Desired Excess Reserve Ratio (re) 372
Summary 375 Key Terms 375 Study Questions 376 Suggestions for Additional Reading 377 Chapter 17 THE ROLE OF THE FEDERAL RESERVE IN THE GREAT DEPRESSION OF 19291933 378 The Debate Over the Causes of the Depression 379 Bank Failures and Monetary Phenomena: The Facts 381
Bank Failures and the Run on Banks 381 Causes of the Contraction of the Money Supply 383
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Summary 393 Key Terms 393 Study Questions 394 Suggestions for Additional Reading 395 PART 5 INSTRUMENTS, TARGETS, AND STRATEGIES OF CENTRAL BANKING POLICY 397 Chapter 18 THE TOOLS OF FEDERAL RESERVE POLICY 398 Open Market Operations: Fundamental Considerations 398
Discovery of Open Market Operations and The Banking Act of 1935 399 Domain of the Feds Open Market Activity 400
Summary 420 Key Terms 420 Study Questions 421 Suggestions for Additional Reading 422 Chapter 19 CONDUCTING MONETARY POLICY: ULTIMATE GOALS AND INTERMEDIATE TARGETS 423 The Ultimate Goals of Monetary Policy 423
Price Level Stability 423 High Employment 426 Long-Term Economic Growth 428 Stable International Exchange Rate 428 Stability of Financial Markets and Interest Rates 429
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Summary 447 Key Terms 447 Study Questions 448 Suggestions for Additional Reading 449 PART 6 THE LINKAGE BETWEEN INTERMEDIATE TARGET VARIABLES AND ECONOMIC ACTIVITY 451 Chapter 20 THE AGGREGATE DEMAND-AGGREGATE SUPPLY MODEL 452 The Aggregate DemandAggregate Supply Framework 452
The Aggregate Demand Curve 453 The Aggregate Supply Curve 454 Equilibrium Output and the Equilibrium Price Level in the Short Run 454 Factors that Shift the Aggregate Demand Curve 455 Factors that Shift the Aggregate Supply Curve 458
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Short-Run Versus Long-Run Equilibrium in the AD/AS Model 459 Challenges Facing Monetary Policymakers 462
Uncertainties about the Positions, Slopes, and Dynamics of the AD and AS Curves 462 Uncertainties about the NAIRU Level and Forces that Cause NAIRU to Change 463
The Phillips Curve, the NAIRU, and Macroeconomic Policy 465 Monetary Policy: Responding to Shocks to the AD and AS Curves 469
Monetary Policy and Aggregate Demand Shocks 469 The Dilemma Posed for Monetary Policy by Adverse Supply Shocks 470
Summary 474 Key Terms 475 Study Questions 475 Suggestions for Additional Reading 476 Chapter 21 THE AD/AS MODEL AND POST-1929 U.S. MACROECONOMIC HISTORY 477 Macroeconomic Developments, 19291950 477
The Great Depression of the 1930s 477 World War II and Its Immediate Aftermath 478
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Summary 494 Key Terms 495 Study Questions 495 Suggestions for Additional Reading 495 Chapter 22 MONEY DEMAND AND VELOCITY 497 The Equation of Exchange and the Velocity of Money 499
Velocity of Money and the Demand for Money 501
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Velocity Behavior and Monetary Policy 521 Summary 524 Key Terms 525 Study Questions 525 Suggestions for Additional Reading 526 Chapter 23 THE MONETARY TRANSMISSION MECHANISM: HOW FEDERAL RESERVE POLICY INFLUENCES ECONOMIC ACTIVITY 527 Early Views of the Transmission Mechanism 528
Early Keynesian Views 529 Early Monetarist Views 530
Can Monetary Stimulus be Effective When Interest Rates Are Zero? 546 Summary 548 Key Terms 549 Study Questions 550 Suggestions for Additional Reading 551
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Chapter 24 DIFFERING VIEWS ON THE APPROPRIATE CONDUCT OF MONETARY POLICY 552 Should Monetary Policy be Active or Passive? 552
The Self-Correcting Mechanism 554 Viability of the Self-Correcting Mechanism 554
Has the Federal Reserve Been a Destabilizing Inuence? 558 Rules Versus Discretion in the Conduct of Monetary Policy 563
The Case for a Monetary Policy Rule 564
A Passive Monetary Policy Rule: The Constant Money Growth Rule 565 Active Monetary Policy Rules (Feedback Rules) 567
The Nominal GDP Targeting Rule 567 The Ination Targeting Rule 568 The Taylor Rule 568
Summary 574 Key Terms 575 Study Questions 575 Suggestions for Additional Reading 577 Chapter 25 INFLATION TARGETING 578 Ination Targeting: Its Meaning and Potential Benets 579
Arguments in Favor of Ination Targeting 580 Arguments Against Ination Targeting 585
Summary 600 Key Terms 601 Study Questions 601 Suggestions for Additional Reading 602 Glossary 603 Index 611
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PREFACE PREFACE
Students come to undergraduate money and banking courses with widely differing backgrounds, majors, and objectives. Money and banking instructors place varying degrees of emphasis on monetary theory, institutions, and policy. This textbook reects my view that the money and banking course should be the most interesting and timely course in an economics or nance curriculum, and that it should be of considerable value to students with diverse backgrounds and interests. In addition, Money, Banking, and Financial Markets should help instructors teach more easily, regardless of academic focus. This textbook will provide students with a solid grasp of the fundamental topics, principles, and issues traditionally covered in the money and banking course that are not thoroughly covered in other courses in the curriculum. This book seeks to minimize any overlap with intermediate macroeconomics courses. Instead, it aims to provide clear and up-to-date coverage of such fundamental topics as the nature and role of money, nancial institutions and markets, and banking structure and regulation. Money, Banking, and Financial Markets provides an unusually thorough treatment of Federal Reserve instruments, strategies, and policy transmission, the determinants of interest rates, stock prices, foreign exchange rates, and the nations money supply. Compared to other leading money and banking texts, this one seeks to cover fewer topics, but to cover those selected topics more clearly and effectively. This is a policy-oriented text. It provides a thorough explanation of the relevant analytical framework, keyed closely to economic policy issues. We pay greater-than-normal attention to the instruments of Federal Reserve policy and the difculties involved in conducting monetary policy in uncertain economic environments. Separate chapters (12 and 13) cover the institutional makeup of the Federal Reserve System and the European Central Bank. The challenges confronting discretionary conduct of monetary policy and the rules versus discretion debate are thoroughly covered. The text features unprecedented coverage and analysis of the Taylor Rule (chapter 24), analyzing its strengths and weaknesses both in formulating monetary policy prospectively and in evaluating policy retrospectively. Modern views of the transmission mechanism of monetary policythe myriad ways in which monetary policy inuences economic activity are thoroughly covered in Chapter 23. Because more than 20 nations have now adopted ination-targeting central bank regimes, an entire chapter (25) provides unprecedented coverage of this topic. In short, this text covers monetary policy in more depth than any existing money and banking text. Money, Banking, and Financial Markets provides a solid theoretical framework. Students sometimes nd economic theory dull or difcult to understand. But an economic theory, after all, is simply a rigorous explanation of an economic phenomenon. The loanable funds model of interest rates and the various theories of the term structure of interest rates are carefully developed in chapters 5 and 6. We invoke the present value framework to explain stock, bond, and other asset pricing in chapters 5 and 7. Chapter 8 presents theories of long-run and short-run exchange rate determination. Following a brief chapter on the principles of deposit expansion and contraction, we set forth the monetary basemoney supply multiplier framework for understanding money supply determination in chapters 15 and 16. Chapter 20 develops the aggregate demand and aggregate supply framework; this chapter also includes a thorough analysis of the Phillips curve hypothesis and the factors that cause the natural rate of unemployment to uctuate over time. Chapter 22 provides a comprehensive discussion of the theory of money demand and velocity. Chapter 23 analyzes the transmission of monetary policy, including an in-depth discussion of the money view and the credit view. The book adopts a mainstream analytical approach in which both monetary and scal policies signicantly inuence economic activity, and leaves debates about the vari-
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ous theoretical paradigms that diametrically contradict one another to intermediate macroeconomics courses. While this text does not skimp on economic theory, it develops the relevant theory only to shed light on important economic events and developments. We surround theory with examples from current events and economic history. For example: As soon as we present the analytical framework for understanding how to price shares of stock in chapter 7, we discuss the 1990s run-up of stock prices, the ensuing crash, and the contentious issue of whether central banks should intervene to head off stock market bubbles. Immediately after developing the Fisher hypothesiswhich links nominal interest rates to expected inationin chapter 5, we test the theory by examining bond yields and ination rates in a cross section of 14 nations. As soon as we examine the purchasing power parity (PPP) theory of exchange rates in chapter 8, we provide a graph illustrating the actual and PPP U.S.Australia exchange rates over a 30-year period. This presentation enables students to observe that purchasing power parity is strictly a long-run theory of exchange rate determination. As soon as chapters 15 and 16 develop the monetary basemoney supply multiplier framework, we use the framework to analyze the fundamental causes of the contraction of the U.S. money supply in the Great Depression and the Federal Reserves role in that catastrophe (chapter 17). Immediately after chapter 20 discusses the aggregate supply-aggregate demand model, we use the framework to analyze the most important macroeconomic developments of the past 75 years (emphasizing those of the past decade).
Given this approach, students develop the attitude that economic theory is interesting and valuable in understanding contemporary economic events.
Reviewers consistently remarked on the clarity of the writing style, the timeliness of the topics discussed, and the thorough coverage of recent developments. Such developments include the post-1995 acceleration of productivity, the unusual nature of the 2001 recession and the jobless recovery of 20022004, the 2003 Federal Reserve change in discount window procedures, the corporate and mutual fund scandals of 20022004, and recent changes in the list of the nations 10 largest banks. Instructors will note several distinguishing features of this textbook vis-a-vis alternative texts.
Empirical Orientation.
More than any other money and banking text, this book provides students with a feel for a multitude of key monetary and nancial variables, via tables and time-series graphs. More than 70 graphs illustrate how such variables as exchange rates, bond yields, the currency ratio, the money-supply multiplier, velocity of money, stock prices, and ination rates have behaved over a period of years. Other gures show the price-earnings ratios of the S&P 500 stock market index; the fed funds rate vs. that indicated by the Taylor Rule both in the U.S. and in Japan; actual and potential GDP; the high correlation between money market yields in the U.S. and Germany, and other economic phenomena. Many of these illustrations are unique they do not appear in other money and banking texts. While the interest rate chapter of a leading money and banking text includes only one time-series graph featuring interest rates or yields, this one includes seven such graphs. Students gain a feel for the magnitude and behavior over time of the variables under discussion.
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Substantive Exhibits. Numerous reviewers commented on the substantive and unique nature of the boxed exhibits. This book includes more than 50 exhibits that cover such topics as the tech wreck of 20002002, the economics of ATMs, the growth of internet banking, an evaluation of the Gramm-Leach-Bliley Act, the 2004 enlargement of the European Union, and salaries of top Federal Reserve ofcials. Other exhibits discuss Irving Fishers genius and versatility; recent trends in U.S. productivity growth; a brief history of money market mutual funds; the demise of the reserve requirement tax; bandwagon phenomena in exchange rate movements, and oil prices as aggregate supply shocks. Both instructors and student readers will nd these exhibits superior to those in other texts. Emphasis on the Worldwide Applicability of Concepts and Economic Phenomena. The more we study economics, the more we become aware of the
sense that we are in this together. In the age of the Internet, information travels around the world instantaneously. This text emphasizes the high degree of correlation between asset prices, business cycle developments, and other economic phenomena in the United States and in other nations. This point is driven home by time-series graphs illustrating the co-variation of interest rates, stock prices, and other phenomena across countries. Students come to appreciate the worldwide nature of macroeconomic and nancial developments, which enhances the value of the analytical tools that help us understand these phenomena.
As the number and percentage of American families owning stocks has increased and knowledge of the superior longterm performance of equities has become widespread, interest in the stock market has increased apace. Students are keenly interested in the stock market. Chapter 7 is devoted entirely to the stock market, providing a framework for understanding the factors determining the prices of stocks. The chapter also looks at various stock market indexes and discusses the various measures of stock valuation. We analyze the risk inherent in stocks relative to government bonds and discuss the equity risk premium anomaly and the phenomenon of mean reversion in stock prices. The economics profession has seen a remarkable resurgence of interest in the Great Depression in the past decade or two. This tragic episode presents an excellent case study of monetary policy gone awry. This text devotes a full chapter (17) to the causes of the contraction of the money supply in the early 1930s, the role of the Federal Reserve in that experience, and the ongoing debate over whether monetary policy is rendered impotent in an environment of deation.
Unique Chapter on Ination Targeting. In recent years, ination rates in industrial nations have declined to the lowest levels in half a century. This reduction is due, in part, to the fact that more than 20 nations have implemented ination targeting monetary policy regimes. We include a full chapter (25) that analyzes the cases for and against ination targeting and looks at the contentious issue of whether the Federal Reserve should implement such a regime.
PEDAGOGICAL FEATURES
This work contains a number of features designed to enhance the effectiveness of this book as a teaching instrument. Part Openers for each of the six sections of the text outline the importance of and relationships among the topics covered in each section.
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Denitions of Key Terms appear in the margins as the terms are introduced, as well in the textual discussion. A glossary of all key terms is compiled in alphabetical order at the end of the book. More than 50 boxed exhibits provide interesting background on various economic and nancial relationships, events, and developments. International Perspectives boxes provide a global perspective on key topics and empirical economic phenomena. These boxes provide discussion of such topics as the worldwide decline in ination since 1990, the synchronization of economic phenomena across countries, and the use of the Taylor Rule to evaluate the Bank of Japans contribution to deation in the past decade. A From the Financial News feature introduces students to nancial tables from daily newspapers, covering such topics as the yield curve, stock prices, foreign exchange rates, and weekly Federal Reserve data. A Your Turn feature gets students into active mode by posing questions that test their understanding of various formulas and concepts as the ideas are introduced. Answers appear at the end each chapter. More than 70 time-series gures introduce students to a multitude of macroeconomic and nancial data. Chapter summaries review key points developed in each chapter. Study Questions at the end of each chapter test students understanding of the most important concepts and principles discussed in the chapter. An Additional Reading feature at the end of each chapter points instructors (as well as highly motivated students) to classic literature as well as recent articles on major topics. URLs are provided with each time-series gure so that students may access original data and check to see how the pertinent variables have changed most recently.
Supplementary Materials
The Study Guide, written by Professor Alan Grant of Eastern Illinois University, provides an overview of each chapter and a variety of measures to increase student learning. Each Study Guide chapter supplies a variety of questions for students, including matching, true-false, ll in the blank, multiple choice, and problems. Answers are provided at the end of each chapter. A Test Bank written by Amanda Freeman, Alan Grant, and Lloyd Thomas provides some 1900 multiple choice examination questions, or an average of about 75 questions per chapter. Lloyd Thomas has contributed about 50 percent of these questions and has reviewed all other questions for quality. An Instructors Manual, written by Professor Robert Guell of Indiana State University includes sample course outlines, answers to end-of-chapter questions, and teaching hints for each chapter. Instructors Manual chapters are keyed directly to PowerPoint Software presentations.
Thomas Textbook Support Web Site (http://thomas.swlearning. com) provides instructional materials for professors, including the Instructors
Manual, Test Bank, and PowerPoint Presentation Software via a password-protected section of the site that is not accessible to students. Approximately 10 online quizzing questions for students are also available at this site.
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ExamView ExamView Computerized Testing Software contains all of the questions in the Test Bank. ExamView is an easy-to-use test creation package compatible with both Microsoft Windows and Macintosh client software. You can select questions by previewing them on the screen, selecting them by number, or selecting them randomly. Questions, instructions, and answers can be edited, and new questions can easily be added. You can also administer quizzes onlineover the Internet, through a local area network (LAN), or through a wide area network (WAN). MarketSim MarketSim, by Tod Porter at Youngstown State University, is an online
simulation designed to help students in microeconomics classes better understand how markets work, by having students take on the roles of consumers and producers in a simulated economy. In the simulations, students make and accept offers to buy and sell labor and goods asynchronously via the Internet.
CNN Economics Video CNN video segments bring the real world right to students desktops by using the CNN Principles of Economics Video Updates. This video provides current stories of economic interest, and the accompanying integration guide provides a summary and discussion questions for each clip. The video is produced in cooperation with Turner Learning Inc.
Contact your local Thomson Learning/South-Western sales representative about obtaining these support materials.
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ACKNOWLEDGEMENTS
The author is indebted to many individuals who have contributed substantially to the development of this project over the past three years. Foremost among those to whom I am indebted is Professor Alan Grant of Eastern Illinois University, whose contribution to this project over the years has been enormous. Al carefully critiqued two versions of every chapter, contributed numerous end-of-chapter Study Questions, pointed me to relevant journal articles, and is responsible for chapter 10 on banking structure and regulation. In addition, he contributed hundreds of questions for the Test Bank, wrote the Study Guide for this text, and has generally been a tremendous colleague in the development of this entire project. Professor Robert Guell of Indiana State University did a meticulous job of putting together the PowerPoint and Instructors Manual ancillaries for this project. Professor Ronnie J. Phillips of Colorado State University reviewed the entire manuscript and provided a multitude of constructive suggestions. Amanda Freeman, a Ph.D. student at Kansas State University and a money and banking instructor, made a major contribution to this project during the nal year of its development. In addition to carefully proofreading and critiquing each chapter, she checked all URLs and references for accuracy, put together the Test Bank, and served as an extremely able and invaluable resource for the author. Professor Mark Wohar of the University of NebraskaOmaha, through numerous phone calls and e-mails, provided important prodding and encouragement to bring this work to fruition. My colleague and a veteran money and banking teacher, Michael Oldfather, critiqued several chapters and also contributed by sharing his extensive knowledge of the business, structure, and regulation of commercial banking. Numerous conversations with colleagues Patrick Gormely, Wayne Nafziger, and Roger Trenary also added value to the nal product. Many graduate and undergraduate students at KSU contributed in a variety of ways. Jared Wirths and Jared Dressman are responsible for developing the multitude of time-series graphs in this book. Boaz Nandwa, Daniel Nibarger, Shane Sanders, Jamie Stamatson, and Danhua Wu also contributed in such ways as checking references, contributing study questions, supplying the author with pertinent literature, and reading the page proofs. Kristi Smith and Susan Koch helped with manuscript preparation and typing of tables. I am greatly indebted to numerous individuals at Thomson Learning/SouthWestern. At the top of the list is my Senior Development Editor, Trish Taylor. Trish expertly handled the myriad challenges of coordinating the development of the text with that of the Study Guide, Instructors Manual, Test Bank, PowerPoint slides, and other ancillary materials. I am also indebted to Trish for being a stickler about efciency in writing style, for prodding me to revise the manuscript conscientiously in response to constructive suggestions from reviewers, and for calmly dealing with an author of rather volatile temperament. I am indebted to production editor Cliff Kallemeyn for coolly dealing with numerous glitches and roadblocks, carefully implementing needed corrections, and delivering the end product in excellent condition. I am grateful to Tippy McIntosh for the outstanding design of this book, including the spectacular cover. Senior Technology Product Editor Peggy Buskey brought her expertise to bear in creating a superior package of electronic supplements. Senior Acquisitions editor Mike Worls and Senior Marketing Manager John Carey supplied important encouragement and counsel during the development of this work. Most of all, I am grateful to my wife (Sally), daughter (Elizabeth Thomas Horn), and mother (Marianne Moon Thomas) for their encouragement, support, and loyalty.
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Numerous reviewers made constructive suggestions and contributed materially to the nal product. These include: Burton Abrams (University of Kathy Kelly (University of Texas-Austin) Delaware) Benjamin Kim (University of Richard Boylan (University of Alabama) NebraskaLincoln) Charles Britton (University of Arkansas) Todd Knoop (Cornell College) Stacy Brook (University of Sioux Falls) Sungkyu Kwak (Washburn University) Jim Butkiewicz (University of Delaware) B. Starr McMullen (Oregon State Miles Cahill (College of Holy Cross) University) Thomas Carroll (University of Ed Merkel (Troy State University) NevadaLas Vegas) Michael Oldfather (Kansas State Catherine Chambers (Central Missouri University) State University) Douglas Pearce (North Carolina State Martin Cherkes (Princeton University) University) Dal Didia (Jackson State University) Mark Perry (University of Chris Erickson (New Mexico State MichiganFlint) University) Ronnie Phillips (Colorado State David Flynn (University of North University) Dakota) Scott Redenius (Bryn Mawr College) James Gale (Michigan Technological Prosper Raynold (Miami University of University) Ohio) Ralph Gamble (Fort Hays State Russell Rhine (St. Marys College of University) Maryland) Ron Gilbert (Texas Tech University) Joseph Santos (South Dakota State Ismail Genc (University of Idaho) University) Dipak Ghosh (Emporia State Edward Sattler (Bradley University) University) Donald Scarry (RutgersThe State Waca Ghoul (Davenport University) University of New Jersey) Rik Hafer (Southern Illinois Elizabeth Schmitt (SUNYOswego) UniversityEdwardsville) Paul Storer (Western Washington Bradley Hobbs (Florida State University) University) Robert Tokle (Idaho State University) Jon Hooks (Albion College) Karen Vorst (University of Thomas Ireland (University of MissouriKansas City) MissouriSt.Louis) John Wassom (Western Kentucky Art Janssen (Emporia State University) University) Nancy Jianakoplos (Colorado State Mark Wohar (University of University) NebraskaOmaha) Bryce Kanago (University of Northern Gil Wolpe (Newbury College) Iowa) Robert Wright (University of Virginia) Shawn Kantor (University of Arizona) Shu Wu (University of Kansas) Elizabeth Sawyer Kelly (University of Bill Yang (Georgia Southern University) WisconsinMadison) David Zalewski (Providence College)
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Copyright 2006 Thomson Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
VP/Editorial Director: Jack W. Calhoun VP/Editor-in-Chief: Dave Shaut Acquisitions Editor: Mike Worls Sr. Developmental Editor: Trish Taylor Sr. Marketing Manager: John Carey
Production Editor: Cliff Kallemeyn Sr. Technology Project Editor: Peggy Buskey Technology Project Editor: Pam Wallace Sr. Manufacturing Coordinator: Sandee Milewski Art Director: Tippy McIntosh
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Glossary Glossary
A
active rule (feedback rule) rule in
which the central bank changes the interest rate level or the money growth rate by strict predetermined formulas in response to ongoing developments
B
balance sheet statement of assets, liabilities, and net worth at a given point in time bank charters ofcial authorizations to open and operate banks bank holding company corporation that owns a controlling interest in one or several banks but is itself not a bank
C
CAMELS system acronym indicating
the six categories evaluated to assess a banks overall nancial condition: C (capital adequacy), A (asset quality), M (management), E (earnings), L (liquidity), and S (sensitivity to risk) capital accounts (capital) net worth of a bank, or value of the bank owners residual claim on the banks assets capital market market in which longterm securities issued by government and private concerns are exchanged
Banking Act of 1933 (GlassSteagall Act) legislation separating commercial banking from investment banking, and separating banking from industry
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D
dealers holders of inventories of securities who stand ready to buy or sell at quoted bid and ask prices debit card card with which an individual pays for an item by transferring funds electronically and immediately from his/her bank account to the merchants bank account debt instrument contractual agreement by the issuer to pay a specic amount of money (principal or face value) at a specied future date; contract may include periodic interest payments as well default risk risk that issuer of debt instrument will not make interest payments or pay back the face value when the instrument matures
Council of Economics and Finance Ministers (ECOFIN) group consisting of the nance ministers of each of the European Union member countries; group initiates the Executive Board appointment process coupon bonds bonds that promise a nite series of constant annual or semi-annual payments for 10, 20, or 30 years and repayment of principal at maturity credit view view that an increase in bank loans has a stronger impact on GDP expenditures and economic activity than does an equal amount of bank security purchases, even though both events have the same impact on M1 and M2
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605
E
Economic and Monetary Union (EMU) group of European nations
that use a common currency (the euro) and have a common monetary policy economies of scale economies formed when the average cost of providing a unit of bank service declines as more units of the service are provided economies of scope economies formed when greater efciency is achieved by one rm providing a group of services rather than separate specialized rms providing those services electronic cash (e-cash) form of money that facilitates payment for items purchased over the Internet electronic checks form of checks that are processed electronically, circumventing the costly procedure of physically processing and transporting checks electronic money system a system in which money is stored and transferred electronically via cards and computer accounts equation of exchange a mathematical identity that sets forth the relationship between the supply of money, velocity, the price level and real output; MV PY equities nancial claims representing ownership in a business entity; gives bearer the right to share in the net income of issuer equity multiplier ratio of nancial institutions total assets to capital; indicates magnitude of leverage applied to the rate of return on assets equity risk premium additional rate of return required to compensate prospective investors for risk and induce investors to buy stocks rather than safer government bonds euro single currency used by 12 western European nations Eurodollars deposits in foreign banks or U.S. bank branches in foreign countries, in denominations of U.S. dollars rather than local currencies
European System of Central Banks (ESCB) organization consisting of the European Central Bank and the individual central banks of the European Monetary Union nations European Union (EU) organization dedicated to achieving economic integration and unication of its member countries excess reserves depository institution reserves (cash and deposits at Fed) above the required amount exchange traded funds (ETFs) instruments designed to track a particular stock market index or sector; can be purchased by individual investors like shares of stock Executive Board six-person board that participates on the Governing Council of the European Central Bank in formulating monetary policy
expected (ex ante) real interest rate (rex ante) difference between
nominal interest rate and expected ination rate
F
Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) legislation that
recapitalized the nearly insolvent FDIC and redesigned the federal deposit insurance system with the intent of minimizing taxpayer exposure to future losses federal funds unsecured loans, in the form of deposits at the Federal Reserve Banks, made between depository institutions federal funds market market in which banks borrow funds overnight from other banks in the form of deposits at the Federal Reserve federal funds rate rate of interest prevailing on overnight loans between banks of deposits at the Federal Reserve
Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) legislation
abolishing both the FHLBB and the FSLIC and creating The Ofce of Thrift Supervision, The Bank Insurance Fund, and The Savings Association Insurance Fund nancial intermediaries institutions that serve as middlemen for the transfer of funds from individuals, businesses, and other entities with surplus funds to those who borrow nancial intermediary institution that obtains funds by issuing secondary claims and uses the proceeds to purchase primary claims, thereby transferring funds from societys savers/lenders to borrowers/spenders nancial intermediation ow of funds from savers to decit spenders by way of nancial intermediaries
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G
Glass-Steagall Act law mandating
the separation of commercial banking and investment banking Governing Council committee that makes European Central Bank monetary policy decisions Governors heads of the central bank of the 12 individual nations making up the Economic and Monetary Union
in income that induced the change in money demand ination persistent or continuing increase in a nations general price level ination neutrality condition in which ination is fully anticipated and compensated for by economic agents, attenuating the potential redistributive effects of ination ination targeting monetary policy strategy in which a specic low ination rate (or band of rates) is proclaimed as its predominant intermediate and long-term objective inationary gap situation in which equilibrium output exceeds fullemployment output and the actual unemployment rate is below the natural unemployment rate
H
hysteresis idea that the NAIRU level is
inuenced by the level and duration of the actual unemployment rate
I
impact lag time that elapses between
the point when policy action is implemented and the point at which the policy begins to inuence the nations GDP implementation lag time that elapses between the point when a need for policy action is recognized and the point at which the appropriate policy is implemented income ow of earnings, measures as dollars per unit of time
J
junk bonds bonds judged to have a
high risk of default, rated Ba or lower by Moodys
L
law of one price principle that a homogeneous goods price will be the
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607
same whether purchased at home or abroad if free trade and zero transactions costs prevail legal reserves (reserves) cash and deposits that a bank places in a larger bank (formerly) or Federal Reserve (today) legal tender money that cannot lawfully be refused as payment for goods and services or for discharge of debts; consists of currency and coins lender of last resort provider of temporary cash reserves to the banking system in times of crisis liabilities indications of what is owed or claims that external entities have on a bank or other entity limited branching restrictions limiting banks to a certain number of ofces liquidity relative ease with which an asset can be converted into money without signicant commissions or other charges, inconvenience, and risk of loss of principal liquidity premium theory theory asserting that the long-term interest rate equals the average of current and expected future short-term interest rates plus a premium to compensate lenders for market risk loanable funds model model in which the supply and demand for funds determine the interest rate Lombard system system in which the discount rate is set signicantly above money market yields and use of the discount window is a right rather than a privilege administered by the central bank
M
M1 narrow or transactions measure of
money, which includes only currency, demand deposits and other checking accounts in depository institutions, and travelers checks M2 broad measure of money, which includes M1 and several highly liquid nancial assets such as savings deposits, money market mutual fund shares owned by individuals, and other instruments M3 very broad measure of money, which includes M2 and several additional liquid instruments managed oat system in which governments intervene to prevent exchange rate movements perceived to be excessive or strongly at odds with the national interest
monetary policy measures implemented by the central bank that inuence the availability of credit, the level of interest rates, and the money supply in the nation monetary policy rule arrangement in which the central bank announces in advance specically how it will respond to ongoing economic developments and commits the central bank to following through on the announcement monetary union adoption of a single currency by a group of countries money anything that is generally acceptable as payment for goods and services or for settlement of debt; most commonly dened to include currency, coins, and checking accounts in depository institutions money market market in which shortterm debt instrumentsthose with maturities less than 1 yearare traded, typically in massive quantities
money market deposit accounts (MMDAs) interest-bearing deposits with limited check writing features that permit banks to compete with money market mutual funds money supply multiplier ratio of the money supply to the monetary base money view view that information about the nations monetary aggregates, obtained from the deposit information on the liability side of the bank balance sheet, is sufcient to predict the impact of monetary policy on aggregate spending and GDP moral hazard risk that one party to a transaction will undertake activities that are undesirable from the other partys viewpoint mortgage long-term loan nancing the purchase of real property, secured by a lien on that property mortgage-backed security nancial instrument that splits the nancing and servicing of mortgages; banks package groups of mortgages, which are sold in security form to large investors municipal bonds long-term debt instrument representing a claim on a city or county
long-run aggregate supply curve (LRAS) relationship between nations price level and real output produced when actual and expected ination are equal and input prices have fully adjusted to output prices loss function equation indicating the cost or loss to society associated with the twin evils of deviations of ination from desired rate and deviations of output from full employment levels
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N
NAIRU (non-accelerating ination rate of unemployment) rate of
unemployment at which demand for labor equals the supply, thus maintaining ination at its existing rate National Banking Act of 1863 legislation allowing the charting of national banks, thereby facilitating issuance of a uniform currency national debt stock of government debt outstanding; cumulative sum of past budget decits less past surpluses natural rate of output specic output level that generates full employment, where the supply of workers equals the demand for workers natural rate of unemployment unemployment rate that exists when the labor market is in equilibrium and there is full employment negotiable CDs large CDs that can be traded through a network of dealers prior to maturity
present value formula formula expressing the value today of the right to receive a payment or stream of payments in the future price/earnings (PE) ratio ratio of the price of a share of stock to the current annual earnings per share achieved by the corporation price-to-book ratio ratio of the price of a share of stock to the book value of the company primary credit discount loans to banks that are in sound nancial condition primary market market in which newly issued securities are exchanged prime loan rate key interest rate posted by large U.S. banks, used as a benchmark for setting bank lending rates principal-agent problem moral hazard problem that occurs when those in control (agents) act in their own interest rather than the interest of the owners or the public (principals) productivity output per hour of work
P
passive rule rule in which the central
bank does not respond to ongoing developments; constant money supply growth rule permanent income long-run average expected future income Phillips curve hypothesis proposition that, other things being equal, a lower unemployment rate is associated with a higher price level ination rate policy activists individuals who believe active use of monetary and scal policies contribute positively to economic stability policy directive written statement indicating the intended posture of Federal Reserve policy until the next FOMC meeting policy non-activists individuals who believe active use of monetary and scal policies do not lead to increased economic stability political business cycle manipulation of the economy for political ends
purchasing power parity (PPP) theory theory postulating that exchange rates adjust completely to offset the effects of different rates of ination in two countries pure expectations theory theory in which market forces dictate that the yield on a long-term security of any particular maturity equals the geometric mean (the average) of the current short-term yield and successive future short-term yields currently expected to prevail over the life of the long-term security
Q
quotas nations restrictions on the
volume of imported goods
O
Ofce of Thrift Supervision (OTS)
organization created as a bureau within the Treasury Department to replace the FHLBB Okuns Law equation describing the relationship between the nations unemployment rate and the nations loss of output
R
rate of time preference extent to
which people prefer present consumption over future consumption real interest rate interest rate after adjusting the nominal interest rate for expected ination
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609
realized (ex post) real interest rate (rex post) difference between
nominal interest rate and realized ination rate recessionary gap situation in which equilibrium output falls short of full-employment output and the actual unemployment rate is above the natural rate of unemployment because output falls short of the natural rate of output recognition lag time that elapses between the point when policy actions ideally would have been implemented (discovered only with hindsight) and the point at which policy-making ofcials become aware of the need for action
self-correcting mechanism mechanism that tends automatically to restore full employment conditions through wage and price exibility shares claims of ownership in individual corporations held by stockholders sources of the base factors determining the monetary base; includes 10 factors, dominated by Federal Reserve security portfolio
Riegle-Neal Interstate Banking and Branching Efciency Act of 1994 act revoking the rights
granted states to determine branching laws for banks operating within individual states risk premium additional yield contained in nancial instruments to compensate lenders for default risk
S
sacrice ratio percentage of 1 years
output (GDP) that a nation must forgo or sacrice in order to reduce its ination rate by one percentage point
Savings Association Insurance Fund (SAIF) insurance fund created by FIRREA for thrift institutions seasonal credit Federal Reserve loans to institutions subject to strong seasonal uctuations in loan demand, such as small banks in farming communities and resort areas secondary credit discount loans to banks experiencing liquidity problems or other nancial problems secondary market market in which securities are traded after they have been issued
Resolution Trust Corporation (RTC) temporary institution created by FIRREA that managed and resolved insolvent thrift institutions and liquidated assets of failed institutions
T
T-accounts a device showing the
change in the balance sheet resulting from a given event tariffs taxes on imported goods tax and loan accounts U.S. Treasury deposits in commercial banks, periodically replenished by federal tax receipts and by the proceeds of new Treasury securities sales to the public
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uses for the base ways in which the transactions costs value of money
and time needed for nancial transactions monetary base is allocated or used; bank reserves and currency held by the public
V
velocity of money ratio of nominal
GDP to the money stock
virtuous cycle cycle in which expanding economic activity and rising stock prices lead to increased investment expenditures, thereby further expanding economic activity
W
wealth the value of assets, including
money stock and other nancial and real assets, minus the value of liabilities wealth effect effect of changes in individuals net worth on their consumption and saving decisions
Y
yield rate of return on an asset, expressed as a percentage per year
yield to maturity average annual return including any capital gain or loss realized at maturity when the face value of the bond is redeemed
Z
zero coupon bond bond that provides no annual payments but agrees to return a specic principal at maturity
U
unit banking system in which a bank
is permitted to have only one ofce, with no branching permitted
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Index Index
A
Active monetary policy rules, 563564, 567572 Adjustable-peg exchange rate system, 179180 Adverse selection, 70, 258 S&L 1980s crisis, 269 Aggregate demand (AD) curve, 453454. See also Aggregate demand/aggregate supply (AD/AS) model factors that shift, 455457 monetary policy and AD shocks, 469470 Aggregate demand/aggregate supply (AD/AS) model, 452453. See also Macroeconomic historical developments disequilibrium, 454455 equilibrium output, 454455, 459462 equilibrium price level, 454455 short-run versus long-run equilibrium output, 459462 Aggregate supply (AS) curve, 454. See also Aggregate demand/aggregate supply (AD/AS) model factors that shift, 458, 459 monetary policy and AS shocks, 470472 oil prices and AS shocks, 482483 Amortized mortgages, 75 Appreciation, 15 Assets, 205 commercial banks, 210215 Feds assets, 289290, 348349 Asymmetric information, 70 limiting the consequences of, 258259 transaction costs, 71 ATMs, 239241 ATS accounts, 207208 Australian interest rates, 134 Automated teller machines, 239241 Automatic transfer service (ATS) accounts, 207208 insurance. See Deposit insurance; FDIC insurance multiple contraction of, 332333 multiple expansion of, 328331 Bankers acceptances, 5354 Bank holding companies, 209, 236, 239 Bank Holding Company Act of 1956, 239 Banking Act of 1933. See Glass-Steagall Act Banking Act of 1935, 400 Banking panic, 86 Bank insolvency, 215 Bank Insurance Fund (BIF), 268 Bank liquidity trap, 386 Bank of the United States, 231323 Banks and banking, 67 branching restrictions, 238245 chartering, 234, 261262 commercial banks. See Commercial banks competition restrictions, 262 Comptroller. See Comptroller of the Currency consolidation of banks, 242245 contemporary structure, 237248 deposits. See Bank deposits disclosure requirements, 261 dual banking system, 233 early U.S. banking history, 230233 economies of scale, 243 electronic banking, 239241 excess reserves, 328 FDIC. See Federal Deposit Insurance Corporation (FDIC) Federal Reserve. See Federal Reserve (Fed) Free Banking Era, 232 future directions, 251252 geographic restrictions, 238245 German banking system, 249250 Internet banking, 241242 investment banks, 48, 246248 Japanese banking system, 249250 modern banking, 246251 mutual savings banks, 76 National Banking Act of 1863, 232233 non-bank banks, 239 regulation of, 233236 reserve requirement. See Reserve requirement(s) risk-limiting regulatory measures, 260262 supervision and examination, 261 unit banking, 232 Barter economy, 20 Bond market, 1314 Bonds, 13 bond prices, monetary policy and, 531532 corporate bonds, 55 coupon bonds, 98, 99 federal agency bonds, 5556 federal bonds, 55 junk bonds, 141 municipal bonds, 55 treasury bonds, 55, 57, 6164, 440441 zero coupon bonds, 9798 Book value, 167 common stocks, 168 Branch banking restrictions, 238245 Bretton Woods exchange rate system, 179180 Broad measures of money, 3536 Brokerage services, 247 Brokered deposits, 267 Brokers, 45 Bubble economy Federal Reserve policy, 169172 20002002, 164165 Budget decit, 10. See also Federal budget decits (or surpluses) Business loans, 212
C
CAMELS system, 235, 261 Capital, 205 commercial banks, 215216, 224226 cost of, 150 Feds capital accounts, 291292 Capital deepening, 458 Capital market, 50 Capital market instruments, 5456 Carryover allowance, 416 Cash assets, 210211 Cash markets, 49 CDs. See Certicates of deposit (CDs) Central bank, 3 accountability, 582 credibility, 582584 of Europe. See European Central Bank (ECB) independence and economic performance, 305306 ination targeting advantages, 581584 ination targeting escape clauses and sanctions, 592
B
Balance sheet, 205 commercial banks, 204205 Federal Reserve (Fed), 288292 Bank charters, 234, 261262 Bank deposits CDs. See Certicates of deposit (CDs) commercial banks, 207209 creation of, 326333
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D
Dealers, 45 Debit cards, 30 Debt instruments, 47 Debt markets, 47 Default risk, 46 Defensive open market operations, 406 Decits budget decit, 10. See also Federal budget decits (or surpluses) trade decit. See Trade decit Deation, 6 ination targeting, impact of, 584585 Delors Report, 312 Demand deposits, 207 Demand for money, 498, 501, 503 equation, 503 income elasticity of, 513 interest rates, role of, 507511 motives for holding money, 503507 precautionary demand, 506507 speculative demand, 507 transactions demand, 503506, 509511 and the velocity of money, 501503 Demand-pull ination, 455 Deposit insurance FDIC. See FDIC insurance in foreign countries, 279 private insurance, 281 savings and loan associations (S&Ls), 266267 Depository Institutions Act of 1982, 257258, 266
E
E-cash, 30, 32 ECB. See European Central Bank (ECB) Economic and Monetary Union (EMU), 311312 Economies of scale, 243 Economies of scope, 248 Electronic banking, 239241 Electronic cash, 30 Electronic checks, 32 Electronic money, 2930, 32 Electronic money system, 29 Equation of exchange, 499503 Equities, 47 Equity markets, 47 Equity risk premium, 160 Euro, 2425 Eurodollars, 53 Europe central bank. See European Central Bank (ECB) economic unication of, 311314 European Central Bank (ECB), 311, 312 accountability, 319321 Council of Economics and Finance Ministers, 316 Executive Board, 316317 Governing Council, 316 Governors, 316, 317 ownership of, 317318 political independence, 318319 prots, distribution of, 318 structure of, 316317 transparency, 321323
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613
F
FDIC insurance, 258259, 275277 FDICIA reform, 277278, 280 proposed reforms, 280281 Federal agency bonds, 5556 Federal bonds, 55 Federal budget decits (or surpluses), 1011 interest rates, 110, 112 securities, issuance of, 58 Federal Deposit Insurance Corporation (FDIC), 86, 87, 233, 259 function of, 259 insurance. See FDIC insurance overlapping authority, 236 supervisory responsibility, 235 Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), 257, 277278, 280 Federal funds, 53 Federal funds market, 209 Federal funds rate, 53, 209 open market operations, 404405 Federal Home Loan Bank Board (FHLBB), 262 Federal notes, 55 Federal Open Market Committee (FOMC), 293, 296 Federal regulation, 8587 Federal Reserve Act, 256, 257, 287 Federal Reserve banks, 288, 296299 Federal Reserve Data, 343 Federal Reserve (Fed), 34, 233 AD/AS challenges, 462465 allocation of power within, 299302 assets, 289290 balance sheet, 288292 bank lending, control over, 545
treasury bonds, 55, 57, 6164, 440441 treasury ination-protected securities, 64, 65 treasury notes, 55, 57, 6164 Federal securities market, 5657 Fed funds rate targeting (1990s to 2004), 446 Fedwire, 30 Feedback monetary policy rules, 563564, 567572 Finance companies, 82 Financial futures, 49 Financial futures contracts, 4950 Financial futures markets, 4950 Financial innovations, ratchet effect of, 518519 Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), 257, 258, 268269 Financial instruments attributes of, 4547 liquidity, 46, 47 risk, 46, 47 yield, 4647 Financial intermediaries, 7, 45, 7277 commercial banks. See Commercial banks contractual savings institutions, 7781 credit unions, 7677 deposit insurance. See Deposit insurance disclosure requirements, 86 nance companies, 82 re and casualty insurance companies, 78, 80 investment-type nancial intermediaries, 8184 life insurance companies, 7778 money market mutual funds (MMMFs), 8284 mutual funds, 81 mutual savings banks, 76 private pension funds, 8081 retirement funds, 8081 S&Ls. See Savings and loan associations (S&Ls) stability controls, 8586 Financial intermediation, 45 benets of, 7172 changing nature of, 8893 costs and risks in absence of, 6971 decit units, benets to, 72 economic basis for, 6972 savers, benets to, 7172 Financial markets, 4245 cash versus derivative markets, 4950 classication of, 4750 debt versus equity markets, 47 money versus capital markets, 50 organized exchanges versus over-thecounter markets, 4849 primary versus secondary markets, 4748
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H
Hard currency, 369 Hysteresis, 465
I
Impact lag, 556 Implementation lag, 556 Income, 20 Friedmans permanent income hypothesis, 520521 long-run average income, 520 permanent income, 520 Income elasticity of demand for money, 513 Income velocity. See Velocity of money Ination, 56 demand-pull ination, 455 forecasting, 587 interest rates and, 103108, 115116, 134 international rate, 425 stock prices, changes in, 163 supply-shock ination, 455 targeting. See Ination targeting treasury ination-protected securities, 64, 65 unemployment. See NAIRU (nonaccelerating ination rate of unemployment) velocity of money, expected ination and, 512 worldwide downward trend, 425 Inationary gap, 460 Ination neutrality, 105 Ination targeting, 6, 578580 arguments against, 585588 arguments in favor of, 580585 Chiles experience with, 596597 experience with, 592594
G
GarnSt. Germain Act, 257258, 266 GDP. See Gross domestic product (GDP) Geographic banking restrictions, 238245 German banking system, 249250 Glass-Steagall Act, 88, 9091, 92, 235, 246247, 257 removal of Glass-Steagall restrictions, 248, 250251 response to, 247248 Government purchases, factors inuencing, 456 Government regulation, 8587
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615
M
Maastricht Treaty, 312315 Macroeconomic historical developments, 479 19291933, 477478 19411945, 478 1960s (early), 480481 19651972, 481 19731982, 481, 483484 19831991, 484485 19932001, 485489 2001 recession, 489492 20022004, 492494 Manager of the System Open Market Account, 296, 409 Marginal productivity of capital, 105 Margin requirements, 294 Market capitalization, 152 Market risk, 46 Matched sale-purchase transactions, 408 McFadden Act, 239 Mean reversion, 166, 171 MMDAs, 208 MMMFs, 8284 Monetary aggregates, 3233, 435 Feds policy in the 1970s, 442443 open market operations, impact of, 402 Monetary base (B), 337340 control by the Fed, 344354 derivation of, 340 factors producing changes in, 344345 Federal Reserve discount loans (A), 345346 Federal Reserve oat (Fl), 342, 346347 Federal Reserve securities portfolio (P), 344345
J
Japan banking system, 249250 ination targeting, 585 Jobless recovery of 2002 to 2004, 492494 Junk bonds, 140
K
Kennedy years, 480481 Keynesian view(s), 385386 of appropriate target variables, 439 transmission mechanism of monetary policy, 529530
L
Labor force participation rate, 458 Lags of monetary policy, 555557 Law of one price, 186187 Legal reserves, 210, 287 Legal tender, 19 Liabilities, 205 commercial banks, 205, 206209, 222224 other liabilities and capital of the Federal Reserve (OLC), 353354 Life insurance companies, 7778 Limited branching, 239 Liquidity, 26 bank insolvency, 215 bank liquidity trap, 386 commercial banks, 216221
Feds gold certicates and special drawings rights accounts (G), 347348 Feds monetary policy, 433434 nonborrowed base (B-A), 434 open market operations, impact of, 402 other Federal Reserve assets (OA), 348349 other liabilities and capital of the Federal Reserve (OLC), 353354 sources of, 340342 Treasury cash holdings (TCa), 353 Treasury currency outstanding (TCu), 349351 Treasury deposits at the Federal Reserve (Ft), 351353 uses for, 342, 344 Monetary policy activism, problems confronting, 555558 activism versus passivism, 552555 and bond prices, 531532 and consumption spending, 532536 discount window policy, 410412 discretionary monetary policy, 563 Fed as a destabilizing inuence, 558563 Fed policy directive, 408410 nancial markets, stability of, 429 exibility, 586 forecasting-related problems, 557558 goals of, 423429 high employment goal, 426428 historical review of Feds policies, 439446 interest rates, stability of, 429 intermediate monetary policy targets, 429432 intermediate target variables, 423, 435437 international exchange rate, stability of, 428 and investment spending, 536540 Keynesian view of appropriate target variables, 439 lag problems, 555557 long-term economic growth, goal of, 428 monetarists view of appropriate target variables, 439 money supply targets versus interest rate targets, 437439 and net exports, 540541 net free reserves, 431432, 434 open market operations. See Open market operations operating target variables, 423, 432435 price level stability, 423424, 426 reserve requirements. See Reserve requirement(s) rule. See Monetary policy rule self-correcting mechanism, 554555 and stock prices, 531532 time inconsistency problem, 565
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O
Ofce of the Comptroller of the Currency (OCC), 87. See also Comptroller of the Currency Ofce of Thrift Supervision (OTS), 87, 268 Oil prices and AS shocks, 482483 Okuns Law, 426 Online trading, 154155 Open market operations, 290, 398399 advantages of, 401402 Banking Act of 1935, 400 defensive operations versus dynamic operations, 406 discovery of, 399 early disadvantages, 403404 effectiveness of, 401405 and the federal funds rate, 404405 impacts of, 401402 outright transactions versus repurchase agreements, 406408 scope of Feds activity, 400401 technical aspects of, 406408 Operating target variables, 423, 432435 Options, 49 Organized exchanges, 48 Output equilibrium output, 454455, 459462 future output, impact of ination targeting on, 588 natural rate of, 460 Output gap, 480 Outright transactions, 406407 Over-the-counter (OTC) markets, 4849
N
NAIRU (non-accelerating ination rate of unemployment), 460 forces that change, 463465 Phillips curve and, 465469, 472473 Narrow measure of money, 3334 Narrow money supply (M1), 359 National Association of Securities Dealers Automated Quotations (NASDAQ), 153154 National Banking Act of 1863, 232233 National Credit Union Administration (NCUA), 87 National debt, 10 managing, 132 National saving rate, 485 Natural rate of output, 460 Natural rate of unemployment, 460 Negotiable CDs, 52, 208209 Negotiable order of withdrawal (NOW) accounts, 207 Net exports (nx) factors inuencing, 456457 and monetary policy, 540541 Net free reserves (NFR), 431432, 434 Fed policy in the 1950s and 1960s, 441442 Net worth, 205 New York Stock Exchange Composite Index (NYSE), 153 Nominal GDP, 497498 multiplier linking money stock to. See Velocity of money targeting rule, 567
P
Passbook savings accounts, 208 Passive monetary policy rule, 563, 565567 Payments system, 2630 Permanent income, 520 Phillips curve hypothesis, 465469, 472473 Policy activists, 552 Policy directive, 408410 Policy nonactivists, 552 Political business cycle, 564 Precautionary demand for money, 506507 Preferred habitat theory, 133, 135 Present value (PV), 9798 Price/earnings (PE) ratio, 166167 Price of inputs, changes in, 458, 459 Price-to-book ratio, 167168 Primary credit facility, 411 Primary versus secondary markets, 4748
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617
Q
Quantity of inputs, changes in, 458 Quotas, 189
R
Rate of time preference, 105 Reaganomics, 484485 Real estate loans, 211212 Real GDP, 497498 Real interest rates, 7, 95 changes in, 194195 expected real interest rate (rex ante), 95, 114119 versus nominal interest rates, 436437 realized real interest rate (rex post), 95, 115117 Recessionary gap, 460 Recessions Carter years, 483 economic activity in, 486487 jobless recovery of 2002 to 2004, 492494 Reagan years, 483 2001 recession, 489492 Recognition lag, 555556 Regulatory controls, 8587 Representative full-bodied money, 2728 Repurchase agreements (RPs), 5253, 407408 Required reserve ratio (rr), 210, 360 changes in, impact of, 365366 determinants of, 371372 Reserve averaging, 416 Reserve requirement(s), 328, 412, 415 demise of the tax, 414415 institutional aspects of, 415416 interest rates, inuence on, 417418 money supply, inuence on, 417418 money supply multiplier (m), 359360, 362 Reserves, 53, 287 carryover allowance, 416 commercial banks, 210, 217, 218 excess reserves. See Excess reserves Feds monetary policy, 433434
S
Savings accounts, 208. See also Bank deposits Savings and loan associations (S&Ls), 7576 brokered deposits, 267 deposit insurance, 266267 deregulation, 265266 forbearance, 266 origins and operations, 262263 risk taking, 268 1980s failures and response, 262271, 273 zombies, 268 Savings Association Insurance Fund (SAIF), 86, 268 Search cost, 71 Seasonal credit, 411 Secondary credit, 411 Secondary markets, 47 versus primary markets, 4748 Securities bond market, 1314. See also Bonds commercial banks, 213215, 247 federal budget decits, issuance to cover, 58 federal securities. See Federal securities Feds securities portfolio, 344345 mortgage-backed securities, 56 prices. See Security prices stock market. See Stock market stock market indexes. See Stock market indexes
stock prices. See Stock prices treasury ination-protected securities, 64, 65 Securities and Exchange Commission (SEC), 85, 87 Securitization, 211 Security prices bond prices, monetary policy and, 531532 interest rates and, 99 open market operations, impact of, 402 stock prices. See Stock prices Segmented markets theory, 131133 Self-correcting mechanism, 462, 554555 Shares, 12 Short-run exchange rate determinants, 189190 bandwagon effects, 195196 changes in, 193196 expected investment returns, 190191, 192193 interest parity condition, 191192 Small certicates of deposit, 208 Sources of the base, 340342 Speculative demand for money, 507 Spot exchange markets, 180, 182 Spot exchange rate, 180 Spot transactions, 180 Stagation, 470, 483 Standard and Poors 500 Index (S&P 500), 153 Standing credit facility, 411 State banking and insurance commissions, 87 Stock market, 1213 discount brokerages, 154155 dividend reinvestment, importance of, 156157 ETFs (exchange traded funds), 154155 international performance, 161 i shares, 154 long-term behavior, 147148 measuring performance of. See Stock market indexes online trading, 154155 risks and returns, 157159 virtuous and vicious cycles, 150151 Stock market indexes Dow Jones Industrial Average (DJIA), 152153 exchange traded funds (ETFs), 154155 good index characteristics, 152 historical performance of, 155156 National Association of Securities Dealers Automated Quotations (NASDAQ), 153154 New York Stock Exchange Composite Index (NYSE), 153 Standard and Poors 500 Index (S&P 500), 153
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618
Index Too-big-to-fail policy, 259 proposal to abolish, 280 Tool of monetary policy, 398 Trade decit, 15, 193 unanticipated changes in, 195 Transaction costs, 71 Transactions demand for money, 503506 interest rates and, 509510 Transactions deposits, 207208 Transactions measure of money, 3334 Transmission mechanism of monetary policy, 527528 and bond prices, 531532 and consumption spending, 532536 credit view, 543545 early Keynesian views, 529530 early monetarist views, 530 and investment spending, 536540 lending view, 543545 modern views, 530541 money view, 542543 and net exports, 540541 and stock prices, 531532 Transparency, 581 Treasury bills, 52, 5961 Treasury bonds, 55, 57, 6164 Fed policy from 1942-1951, 440441 Treasury cash holdings (TCa), 353 Treasury currency outstanding (TCu), 349351 Treasury deposits at the Federal Reserve (Ft), 351353 Treasury ination-protected securities (TIPS), 64, 65 Treasury notes, 55, 57, 6164 Treasury yield curve, 125 Treaty of Rome, 312 Treaty on Monetary Union, 312315 Trickle-down economics, 485
Stock prices, 1213 as a barometer of economic sentiment, 148151 bubble economy, 164165, 169172 and consumption spending, 149 determinants of, 159164 discounting expected future payments, 160, 162 dividend yields, 167 expected ination, changes in, 163 expected payments, revision of, 162163 indicators of, 166168 and investment spending, 150 mean reversion, 166, 171 monetary policy and, 531532 price/earnings (PE) ratio, 166167 price-to-book ratio, 167168 risk premium, changes in, 163164 Stored value cards, 30 Supply-shock ination, 455 Supply-side economics, 484485 Sweep account, 511 SWIFT (Society for Worldwide Intertelecommunications Financial Transfers), 30
V
Velocity of money, 498499 cyclical behavior of, 519521 and the demand for money, 501503 determinants of, 511513 economic uncertainty and, 512 equation of exchange, 499503 expected ination and, 512 nancial innovations, ratchet effect of, 518519 nancial technology and, 511512 Friedman luxury-good explanation, 514515 Friedmans permanent income hypothesis, 520521 income and, 513 induced changes in, 518 institutional factors, 511 interest rates, 512, 519520 international comparisons of long-run behavior, 517 long-run behavior, 513516, 517 monetary policy and, 521, 522 P-star analysis, 522523 short-run behavior, 516, 518521 Tobin institutional explanation, 515516 Vietnam era, 481
T
T-accounts, 216 Tariffs, 189 Tax and loan accounts, 291 Taylor rule, 568573 Technological change, 458 Term premium, 130 Terms of trade, 197198 Term structure of interest rates, 123124 as forecaster of macroeconomic phenomena, 140 yield curve, 123, 125, 134, 136138 Term structure theories liquidity premium theory, 129131 preferred habitat theory, 133, 135 pure expectations theory, 126129 segmented markets theory, 131133 utility/validity of, 135139 Thrift institutions, 72. See also Savings and loan associations (S&Ls) declining role of, 8990 Time inconsistency problem, 565 Tobin institutional explanation, 515516 Tobins q theory, 538
W
Wealth, 20 Wealth effect, 149150, 454 and consumption spending, 535536 Weighted measures of money, 3738 Werner Report, 312 World War II, 478479
Y
Yield, 4647 dividend yield(s), 156157, 167 interest rates. See Interest rates Yield curve, 123, 125, 134, 136138 cyclical pattern of, 137139 maturity of yield and direction, 137 upward-sloping yield curve, predominance of, 136137 Yield to maturity, 4647
U
Underground economy, 369 Unemployment NAIRU. See NAIRU (non-accelerating ination rate of unemployment) natural rate of, 460 Phillips curve hypothesis, 465469, 472473 Unemployment, consequences of, 426428 Unit banking, 232 United States. See Federal Uses for the base, 342, 344
Z
Zero coupon bonds, 9798 Zero interest rates economies, 546 Zombies, 268
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