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M&B

ABOUT the author Lloyd B. Thomas, Jr., is Professor and Head of the Department of Economics at Kansas State University. He has published in numerous economics journals, primarily in the areas of macroeconomic policy, monetary economics, and international finance.

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0% found this document useful (1 vote)
479 views41 pages

M&B

ABOUT the author Lloyd B. Thomas, Jr., is Professor and Head of the Department of Economics at Kansas State University. He has published in numerous economics journals, primarily in the areas of macroeconomic policy, monetary economics, and international finance.

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MONEY, BANKING and FINANCIAL MARKETS


Lloyd B. Thomas
Kansas State University

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Money, Banking, and Financial Markets Lloyd B. Thomas

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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

ALL RIGHTS RESERVED. No part of this work covered by the copyright hereon may be reproduced or used in any form or by any meansgraphic, electronic, or mechanical, including photocopying, recording, taping, Web distribution or information storage and retrieval systemswithout the written permission of the publisher.

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To Sally

ABOUT THE AUTHOR ABOUT THE AUTHOR


Lloyd B. Thomas, Jr., is Professor and Head of the Department of Economics at Kansas State University. He received a B.A. and M.A. in economics from the University of Missouri and a Ph.D. in economics from Northwestern University. Professor Thomas has published in numerous economics journals, primarily in the areas of macroeconomic policy, monetary economics, and international nance. Most recently, his research has focused on the accuracy and rationality of survey measures of ination expectations and other forecasts of ination. He is the author or coauthor of ve previous textbooks, several of which have been published in multiple editions. Recognized as an excellent teacher, Professor Thomas has won numerous teaching awards. His teaching interests lie chiey in the areas of money and banking, monetary theory and policy, and principles of economics. Professor Thomas has gained teaching experience at numerous universities, including Northwestern University, the University of California at Berkeley, Florida State University, the University of Delaware, the University of Idaho, Indiana University at Bloomington, and Adelaide University in Australia. For fun, he enjoys running and playing tennis.

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BRIEF CONTENTS BRIEF CONTENTS


PART 1 INTRODUCTION 1 Chapter 1 Money, Banking, and Financial Markets: an Overview 2 Chapter 2 Money: Its Nature, Functions, and Evolution 18 PART 2 FINANCIAL MARKETS, INSTITUTIONS, AND INTEREST RATES 41 Chapter 3 Financial Markets and Instruments 42 Chapter 4 Financial Intermediation 69 Chapter 5 Interest Rate Determination 95 Chapter 6 The Term Structure and Risk Structure of Interest Rates 123 Chapter 7 The Stock Market 147 Chapter 8 The Foreign Exchange Market 176 PART 3 BANKING: STRUCTURE, REGULATION, AND DEPOSIT INSURANCE 203 Chapter 9 Commercial Banking 204 Chapter 10 The Banking Industry: Its Evolution, Structure, and Regulation 230 Chapter 11 The Economics of Banking Regulation and Deposit Insurance 256 PART 4 CENTRAL BANKING, THE FEDERAL RESERVE, AND THE MONEY SUPPLY PROCESS 285 Chapter 12 The Federal Reserve System: Its Structure and Functions 286 Chapter 13 The European Central Bank 311 Chapter 14 The Deposit Expansion Process: The Simple Analytics 326 Chapter 15 Money Supply Determination: The Monetary Base 337 Chapter 16 Money Supply Determination: The Money Supply Multiplier 357 Chapter 17 The Role of the Federal Reserve in The Great Depression Of 19291933 378 PART 5 INSTRUMENTS, TARGETS, AND STRATEGIES OF CENTRAL BANKING POLICY 397 Chapter 18 The Tools of Federal Reserve Policy 398 Chapter 19 Conducting Monetary Policy: Ultimate Goals and Intermediate Targets 423 PART 6 THE LINKAGE BETWEEN INTERMEDIATE TARGET VARIABLES AND ECONOMIC ACTIVITY 451 Chapter 20 The Aggregate Demand-aggregate Supply Model 452 Chapter 21 The Ad/As Model and Post-1929 U.S. Macroeconomic History 477 Chapter 22 Money Demand and Velocity 497 Chapter 23 The Monetary Transmission Mechanism: How Federal Reserve Policy Inuences Economic Activity 527 Chapter 24 Differing Views on the Appropriate Conduct of Monetary Policy 552 Chapter 25 Ination Targeting 578

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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

Key Financial Markets 12


The Stock Market 12 The Bond Market 13 The Foreign Exchange Market 14

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

I I

The Evolution of Money and the Payments System 26


Full-Bodied or Commodity Money 27 Representative Full-Bodied Money 27 Fiat or Credit Money 28 Checking Accounts 29 Electronic Money 29

Measures of the Money Supply 32


The Narrow Denition of Money (M1) 33 Broader Measures of Money: M2, M3 35 Which Measure Is Most Useful? 36 Weighted Measures of Money 37

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

Classication of Financial Markets 47


Debt Versus Equity Markets 47 Primary Versus Secondary Markets 47 Organized Exchanges Versus Over-the-Counter Markets 48 Cash Versus Derivative Markets 49 Money Versus Capital Markets 50

Instruments of the Money and Capital Markets 51


Instruments of the Money Market 51 Instruments of the Capital Market 54

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Contents

The U.S. Government Securities Market 56


Kinds of U.S. Government Securities 57 Non-Marketable Government Debt 64

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

Classication and Growth of Financial Intermediaries 72


Depository Institutions 72 Contractual Savings Institutions 77 Investment-Type Financial Intermediaries 81

Government Regulation of the Financial System 85


Increasing the Availability and Accuracy of Information 85 Ensuring the Stability of the Financial Intermediaries 85 Improving Monetary Control 86

The Changing Nature of Financial Intermediation 88


The Emergence of Retirement Funds and Mutual Funds 88 The Declining Role of Commercial Banks and Thrift Institutions 89 Benets and Costs of Institutional Change 92

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

The Loanable Funds Model of Interest Rates 99


The Market for Loanable Funds 100 Factors Shifting Supply and Demand for Loanable Funds 103

Fundamental Determinants of Interest Rates 103


Ination Expectations 103 Federal Reserve Policy 109 The Business Cycle 109 Federal Budget Decits (or Surpluses) 110

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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Contents

vii

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 Connection Between Stock Prices and Economic Activity 149


Stock Prices and Consumption Spending 149 Stock Prices and Investment Spending 150 Virtuous and Vicious Cycles 150

Measuring Stock Market Performance 152


Characteristics of a Good Stock Market Index 152 U.S. Stock Market Indexes 152 Historical Performance of Various Stock Market Indexes 155 Importance of Dividend Reinvestment 156

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

Assessing the Appropriate Level of Stock Prices 164


Indicators of Stock Market Valuations 166

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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Contents

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

Exchange Rate Determination 183 Long-Run Exchange Rate Determination 184


Relative Price Level Behavior 185 Other Long-Run Exchange Rate Determinants 188 Long-Run Exchange Rate Determinants: Summary 189

Short-Run Exchange Rate Determinants 189


Expected Returns from Investing at Home and Abroad 190 The Interest Parity Condition 191 Equilibrium in the Foreign Exchange Market 192 Factors Causing Short-Run Exchange Rate Changes 193 Examples of Forces Producing Short-Run Exchange Rate Changes 194

Consequences of Exchange Rate Changes 196


Price Level Effects 197 Income Distribution Effects 197 Terms of Trade Effects 197

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

Commercial Bank Assets 210


Cash Assets 210 Loans 211 Securities 213 Other Assets 215

Commercial Bank Capital Accounts 215 Commercial Bank Management 216


Liquidity Management 216 Liability Management 222 Capital Management 224

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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Contents

ix

The Regulation of the U.S. Banking System 233


Aspects of Bank Chartering and Regulation 233

The Structure of Contemporary American Banking 237


Geographic Restrictions on Bank Activity 238 Banks Response to Geographic Restrictions 239 The Removal of Restrictions 241 Banking Industry Consolidation and the Forces Driving It 242 The Size Distribution of U.S. Commercial Banks 245

The Scope of Modern Banking 246


The Glass-Steagall Act 246 The Response to Glass-Steagall 247 The Removal of Glass-Steagall Restrictions 248

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

Regulatory Measures Intended to Limit Bank Risk Taking 260


Restricting Types of Eligible Bank Assets, Requiring Diversication, and Mandating Bank Capital Requirements 260 Banking Supervision and Examination and Disclosure Requirements 261 Granting of Bank Charters and Restrictions on Competition in Banking 261

Events Leading Up to the S&L Disaster of the 1980s 262


Origins and Operations of the Savings and Loan Industry 262 The Escalation of Ination and Interest Rates in the 1970s 263 The Squeeze on S&Ls Prots: Cyclical and Structural Causes 264

Government Response to the S&L Problems of the Early 1980s 265


Deregulation 265 Forbearance, Deposit Insurance, and Risk-Taking 266 Inadequate Funding for S&L Supervisors and the FSLIC 268

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

Federal Deposit Insurance 275


The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) 277 Evaluation of FDICIA 278 Other Proposed Reforms of Deposit Insurance 280

Summary 281 Key Terms 282 Study Questions 282 Suggestions for Additional Reading 283
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Contents

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

The Structure of the Federal Reserve System 293


Board of Governors 293 Federal Open Market Committee (FOMC) 296 The 12 Federal Reserve Banks 296 The Member Banks 299 Allocation of Power within the Federal Reserve System 299

The Question of Federal Reserve Independence 302


The Case for Federal Reserve Independence 304 The Case Against Federal Reserve Independence 304

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

The European Central Bank 316


The Structure of the European Central Bank 316 Ownership of the European Central Bank and Disposition of Its Prots 317 The Issue of Political Independence 318 Central Bank Accountability 319 Central Bank Transparency 321

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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Contents

xi

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

Analysis of the 10 Factors that Produce Changes in the Base 344


The Federal Reserve Securities Portfolio (P) 344 Federal Reserve Discount Loans Loans to Banks (A) 345 Federal Reserve Float (FL) 346 The Feds Gold Certicates and Special Drawings Rights Accounts (G) 347 Other Federal Reserve Assets (OA) 348 Treasury Currency Outstanding (Tcu) 349 Treasury Deposits at the Federal Reserve (Ft) 351 Other Factors Absorbing Base Money (Ff, TCa, and OLC) 353

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

I I

Impact of Changes in k, rr, and re on the Money Supply Multiplier 364


Impact of a Change in k 365 Impact of a Change in rr 365 Impact of a Change in re 366 Historical Behavior of the Money Supplier Multiplier 366

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

Interpreting the Facts: Keynesians Versus Monetarists 385


The Keynesian View: You Cant Push On a String 385 The Monetarist View: The Fed Didnt Push 387

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Contents

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

The Effectiveness of Open Market Operations 401


Impacts of Open Market Operations 401 Advantages of Open Market Operations 402 Early Disadvantages of Open Market Operations 403 Open Market Operations and the Federal Funds Rate 404

Technical Aspects of Open Market Operations 406


Defensive Operations Versus Dynamic Operations 406 Outright Transactions Versus Repurchase Agreements 406

The Policy Directive 408


Arriving at the Policy Directive 409 Implementation of the Policy Directive 409

Discount Window Policy 410


The 2003 Federal Reserve Change in Discount Window Policy 411

The Reserve Requirement Instrument 412


Institutional Aspects of Reserve Requirements 415 Institutional Aspects of Bank Reserve Management 416

The Economic Effects of Changes in the Reserve Requirement 417


Inuence on the Money Supply and Interest Rates 417 Advantages of the Reserve Requirement Tool 418 Disadvantages of the Reserve Requirement Tool 419

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

Intermediate Monetary Policy Targets 429


Criteria for an Effective Intermediate Target 430 An Example of a Flawed Target Variable: Net Free Reserves 431

Links Between Policy, Targets, and Goals 432


Operating Target Variables 432 Intermediate Target Variables 435 Money Supply Targets Versus Interest Rate Targets 437 Monetarists Versus Non-Monetarists on Appropriate Target Variables 439

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Contents

xiii

Effects of Federal Reserve Policies: A Historical Review 439


Pegging Treasury Bond Yields, 19421951 440 The 1950s and 1960s: Targeting Money Market Conditions and Net Free Reserves 441 The 1970s: The Emergence of Monetary Aggregate Targeting 442 19791982: De-emphasis of Interest Rate Targeting 443 October 1982 to the Early 1990s: De-Emphasis of Money Supply Targets 445 Early 1990s2004: The Return to Fed Funds Rate Targeting 446

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

I I

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

Macroeconomic Developments after 1950 479


Output and Ination in the Post-1960 Era 479 The Early 1960s 480 The Vietnam Era: 19651972 481 The Economic Nightmare of 1973-1982 481 19831991: The Reagan Expansion and the Era of Supply-Side Economics 484 19932001: The Clinton Years, the Economic Boom, and New Economy Debate 485 The 2001 Recession 489 The Jobless Recovery of 20022003 492

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Contents

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

The Demand for Money 503


Motives for Holding Money 503 Demand for Money: Role of Interest Rates 507

Determinants of the Velocity of Money 511


Institutional Factors 511 Financial Technology 511 Interest Rates 512 Economic Uncertainty 512 Expected Ination 512 Income 513

I I

The Long-Run Behavior of Velocity 513


The Friedman Luxury-Good Explanation 514 The Tobin Institutional Explanation 515

The Short-Run Behavior of Velocity 516


Induced Changes in Velocity and the Effectiveness of Money Policy 518 The Ratchet Effect of Financial Innovation 518 The Cyclical Behavior of Velocity 519

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

Modern Views on the Transmission Mechanism 530


Monetary Policy and Stock and Bond Prices 531 The Components of GDP Expenditures 532 Monetary Policy and Consumption Spending 532 Monetary Policy and Investment Spending 536 Monetary Policy and Net Exports (X-M) 540

The Money View Versus the Credit View 542


The Money View 542 The Lending or Credit View 543

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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Contents

xv

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

Problems Confronting Monetary Policy Activism 555


Problems Posed by Lags of Monetary Policy 555 The Problems Posed by Difculties of Forecasting 557

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

Practical Considerations in Implementing Ination Targeting 588


Who Sets the Target and What Price Index Should be Used? 590 What Is the Appropriate Level or Band for the Ination Target? 590 Should There be Escape Clauses and Sanctions for Central Bank Failure to Hit Ination Target? 592

Experience with Ination Targeting 592


Ination Performance Before and After Ination Targeting Implementation 593 Sacrice Ratios and Other Considerations 595

The Evolution of the Federal Reserves Policy Mandate 597


Authority for Implementing Ination Targeting in the United States 598 Should the U.S. Implement Ination Targeting? The Afrmative View 598 Should the U.S. Implement Ination Targeting? The Negative View 599

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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Preface

xvii

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.

DISTINGUISHING FEATURES OF THIS TEXT

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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Preface

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.

Entire Chapter on the Stock Market.

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 the Great Depression.

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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Preface

xix

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.

Power Point Presentation Software, also prepared by Professor Robert Guell


of Indiana State University, illustrate the key concepts and principles presented in each chapter.

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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Preface

Thomas Xtra! Web Site (http://thomasxtra.swlearning.com/)


Thomas Xtra!, available to be packaged with the textbook, provides access to a robust set of online learning tools for students. Please ask your Thomson sales representative for more information. Thomas Xtra! contains these key features:
Interactive E-Lectures. Difcult concepts from each chapter are explained and illustrated via Flash-animated tutorials. Xtra! Quizzing. In addition to the open-access chapter-by-chapter quizzes found at the Thomas Product Support Web site, (http://thomas.swlearning. com), Thomas Xtra! offers students the opportunity to practice for midterms and nals by taking extensive interactive quizzes. Economic Applications. EconNews Online, EconDebate Online, EconData Online, and EconLinks Online help to deepen students understanding of theoretical concepts through hands-on exploration and analysis of the latest economic news stories, policy debates, and data.

TextChoice is a custom format of Thomson Learnings online digital content


that provides the fastest, easiest way for you to create your own learning materials. You may select content from hundreds of best-selling titles, choose material from our numerous databases, and add your own material. http://thomsoncustom.com.

Ecoursepacks Create a customizable, easy-to-use, online companion for any


course with eCourse packs. ECourse packs give educators access to current content from thousands of popular, professional, and academic periodicals, including NACRA and Darden cases, and business and industry information from Gale. You can easily add your own materialeven collecting a royalty if you choose. http://ecoursepacks.swlearning.com.

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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Preface

xxi

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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Preface

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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MONEY, BANKING and FINANCIAL MARKETS


Lloyd B. Thomas
Kansas State University

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Money, Banking, and Financial Markets Lloyd B. Thomas

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

Production House: Graphic World, Inc. Printer: RR Donnelley Willard, OH

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

ALL RIGHTS RESERVED. No part of this work covered by the copyright hereon may be reproduced or used in any form or by any meansgraphic, electronic, or mechanical, including photocopying, recording, taping, Web distribution or information storage and retrieval systemswithout the written permission of the publisher.

For permission to use material from this text or product, submit a request online at http://www.thomsonrights.com. For more information contact South-Western, 5191 Natorp Boulevard, Mason, Ohio 45040. Or you can visit our Internet site at: http://www.swlearning.com

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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

automatic transfer service (ATS) accounts type of account in which


funds are automatically transferred from savings account to checking account as checks are presented for payment

banking panic waves of systemic


bank runs that lead to contraction of bank lending and economic contraction banks institutions that accept various types of deposits and use the funds primarily to grant loans and purchase relatively safe debt instruments barter economy economy in which goods and services are traded directly for one another Board of Governors seven-person board that dominates the conduct of monetary policy; this board sets reserve requirements and the discount rate, and constitutes the voting majority of the Federal Open Market Committee bond long-term debt instrument issued by a corporation, government, or government agency; a contractual agreement to make certain payments at specied future dates brokers individuals acting as customers agents, locating a security buyer or seller and charging a commission for the service budget decit annual amount by which federal government expenditures exceed tax revenues

adjustable-peg (Bretton Woods) exchange rate agreement in


which each countrys central bank intervenes aggressively in foreign exchange markets to x or peg its exchange rate at a predetermined level adverse selection condition in which people who are most undesirable from the other partys viewpoint are the ones most likely to seek to engage in a transaction aggregate demand curve relationship between the nations aggregate price level and the amount of real output (real GDP) demanded, other factors being held constant aggregate supply curve relationship between the nations aggregate price level and the amount of real output rms collectively desire to produce and sell, other factors being held constant amortized mortgage mortgage in which part of each monthly payment reduces the principal so that the home is owned free and clear after a period of 15 or 30 years appreciation an increase in value of one nations currency relative to another currency assets indications of what is owned or claims on external entities asymmetric information condition in which two parties to a transaction have differing information about the intentions of the other party and the likely risks involved

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

Bank Holding Company Act of 1956 legislation prohibiting bank


branching via acquisition of banks by bank holding companies bank insolvency state of nancial condition in which the value of a banks total assets is less than the value of the banks total liabilities Bank Insurance Fund (BIF) insurance fund created by FIRREA for commercial banks bank liquidity trap potential situation in which bank demand for excess reserves is perfectly elastic with respect to the interest rate, rendering the central bank incapable of increasing the money supply Bank of the United States rst national bank chartered in the United States bankers acceptance check, generally written by a business rm, payable at a specic future date and stamped accepted by a major 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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Glossary

cash market transactions in which


the buyer pays the seller for the asset up front central bank a nations monetary authority or agency charged with conducting monetary policy and other duties certicate of deposit (CD) a form of deposit that stipulates that the bearer will receive annual interest payments of a specied amount plus a lump sum equal to the original principal at maturity commercial paper short-term promissory notes issued by major corporations to attract funds for day-to-day business needs common stocks ownership claims against a rms real capital assets; entitles owner to share in prots of the rm Comptroller of the Currency government agency within the Treasury Department charged with chartering, supervising, and examining national banks convergence criteria specic and stringent standards each nation must meet to achieve membership in the monetary union corporate bonds long-term debt claims against a corporations assets, claims that may or may not be secured by mortgages and other assets cost of capital cost of raising funds to nance capital expenditures

currency ratio (k) ratio of currency


held by the public (Cp) to DDO (demand deposits and other checkable deposits) current yield yield computed as the annual payment from the instrument (in dollars) divided by the price or initial principal

depreciation a decrease in value of


one nations currency relative to another currency derivative market trades that are arranged currently with locked-in terms, but settlement and delivery of the instrument are made at a specied future date

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

desired excess reserves ratio (re)


ratio of banks desired excess reserves to DDO (demand deposits and other checkable deposits)

discount loans (discounts and advances) loans made by the Federal


Reserve to depository institutions

discount rate interest rate charged on


loans made by the Federal Reserve to commercial banks discount window facility through which the Federal Reserve district banks lend reserves to depository institutions discretionary monetary policy policy in which the central bank is free to assess economic circumstances as they unfold and implement whatever measures the central bank deems appropriate at the time disintermediation active withdrawal of funds from depository institutions by customers searching for higher yields elsewhere district Federal Reserve banks one Federal Reserve bank exists for each of the 12 Federal Reserve districts in the United States dividend yield annual dividend expressed as a percentage of the stocks price divisia aggregates weighted measures of money used to predict changes in price level and output of goods and services; may eventually replace our current measures of money dual banking system system in which both the federal government and state governments have authority to charter banks dual mandate mandate given to the central bank to maintain both price level stability and maximum sustainable employment

defensive open market operations


Feds open market operations made to defend bank reserves and the monetary base against outside forces over which the Fed has little or no control deation persistent or continuing decline in a nations general price level demand deposits deposits that can be withdrawn in currency or transferred to a third party at the initiative of the owner demand for money amount of wealth individuals and rms desire to maintain in the form of money demand-pull ination ination caused by a persistently rightward shifting AD curve, typically the result of rapid growth of a nations government expenditures and money supply

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

Depository Institutions Act of 1982 (GarnSt. Germain Act)


act accelerating deregulation of the S&Ls by authorizing them to engage in additional activities and compete with money market mutual funds

dynamic open market operations


operations by which the Federal Reserve deliberately changes the

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Glossary

605

course of economic activity in line with the Feds policy objectives

European Central Bank central


bank that conducts monetary policy collectively for Economic and Monetary Union countries

Federal Open Market Committee (FOMC) committee responsible


for formulating the general posture of monetary policy; consists of the seven members of the Board of Governors and the 12 presidents of the district Federal reserve banks Federal Reserve Act legislation establishing the Federal Reserve System Federal Reserve oat difference between cash items in the process of collection and deferred availability cash items Federal Reserve System (Fed) the central bank of the United States, charged with conducting monetary policy and other duties associated with our nancial system

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

Federal Savings and Loan Insurance Corporation (FSLIC)


subsidiary of the FHLBB created to insure savings and loan deposits at money (credit money) form of money that derives its value by at or government decree rather than through its value as a commodity nancial futures purchase of (and payment for) a nancial instrument at a specied future date, at a price determined in advance

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

Federal Home Loan Bank Board (FHLBB) organization established


by Congress to regulate the savings and loan industry

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Glossary

Fisher effect tendency for interest


rates to be positively related to the level of ination expectations Fisher hypothesis strong form of this theory asserts that interest rates move one-for-one with the magnitude of expected ination; the weak form states that expected ination signicantly inuences interest rates xed exchange rates international nancial arrangement in which exchange rates are pegged or held constant by direct government intervention in the foreign exchange market oat difference between cash items in the process of collection and deferred credit items; arises from check collection procedures oating exchange rates international nancial arrangement in which exchange rates are allowed to change continuously in response to the market forces of supply and demand, with occasional government intervention FOMC directive formal statement indicating the intended conduct of monetary policy until the next meeting of the Federal Open Market Committee and voted on by the FOMC foreign exchange market market in which national currencies are exchanged foreign exchange rate price at which one nations currency is exchanged for another nations currency forward exchange rate exchange rate at which forward transactions take place forward interest rate hypothetical future short-term interest rate that equalizes average returns earned on a long-term security and a succession of short-term securities forward transactions purchase and sale of foreign currencies for delivery and payment at a particular future date and a price specied in advance

Free Banking Era period from 1836


to 1863, characterized by minimal supervision of banking activity freely oating exchange rates system in which governments do not intervene in the foreign exchange market, permitting exchange rates to be driven entirely by free market forces

full-bodied money (commodity money) form of money whose


value is approximately the same whether it is used as money or for nonmoney (commodity) purposes

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

instrument or tool of monetary policy variable the Fed controls


completely in order to inuence such key intermediate variables as short-term interest rates, the monetary base, M1, and M2 interest parity condition condition in which, in a world of capital mobility, expected returns on assets are equal across countries interest rate cost of borrowing (or the return from lending), expressed as a percent per year intermediate target variables intermediate-term variables the central bank attempts to control in its effort to achieve policy goals international capital ows acquisition of nancial and real assets across national borders

Gramm-Leach-Bliley Financial Services Modernization Act of 1999 legislation allowing securities


and insurance rms to purchase banks and permitting banks to participate in securities, insurance, and real estate activities

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

International Monetary Fund (IMF) organization created in 1944


for the purpose of creating a stable international monetary order investment banks institutions that underwrite new securities issues and trade existing issues

J
junk bonds bonds judged to have a
high risk of default, rated Ba or lower by Moodys

fractional reserve banking system


system in which each bank maintains only a small percentage of bank deposit liabilities in the form of reserves

income elasticity of demand for money ratio of the percentage


change in quantity of money demanded to the percentage change

L
law of one price principle that a homogeneous goods price will be the

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Glossary

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

manager of the System Open Market Account ofcer of the


Federal Reserve Bank of New York responsible for carrying out, through a network of government security dealers, the open market transactions needed to meet the specications outlined in the Federal Open Market Committee directive margin requirements percentage of the value of securities purchased that the buyer must pay for using his/her own funds, as opposed to borrowed funds

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

marginal productivity of capital


rate of return expected by rms from purchase of an additional unit of capital goods market capitalization market value of the aggregate shares of stock outstanding of a corporation or a universe of corporations market risk risk that the price of a nancial instrument will uctuate McFadden Act legislation prohibiting national banks from operating outside their home state and compelling banks to abide by state regulations on intrastate branching mean reversion tendency to ultimately revert to long-term averages monetary base those nancial assets that can potentially be used as reserves; bank reserves and currency held by the public

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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Glossary

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

open market operations buying and


selling of government securities by the Fed to inuence bank lending, interest rates, and the nations money supply operating target variables nearterm variables the central bank controls as part of its strategy to achieve policy goals options contracts that give the owner the right to buy or sell a nancial asset at a particular price within a specied time period output gap situation in which actual GDP is below potential GDP; thus the unemployment rate exceeds the NAIRU

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

negotiable order of withdrawal (NOW) accounts interest-bearing


savings account, on which limited check writing privileges are permitted net free reserves (NFR) difference between aggregate excess reserves held by depository institutions and borrowed reserves (discount loans) net worth amount by which total assets exceed total liabilities nominal interest rate actual interest rate unadjusted for ination nonborrowed base (B-A) difference between monetary base and borrowed reserves (discount loans) nonborrowed reserves (R-A) difference between total reserves held by depository institutions and borrowed reserves (discount loans)

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

precautionary demand for money


maintenance of money balances to meet unforeseen circumstances preferred habitat theory theory that borrowers and lenders have strong preferences for particular maturities but may be induced to switch if expected benets are large present value value today of payments to be received in the future

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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Glossary

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

Ricardian equivalence proposition


theory that asserts that agents anticipate future tax liabilities associated with larger budget decits and increase their saving rates to compensate

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

speculative demand for money


money balances held so that a speculative opportunity can be undertaken and nanced in the event it should arise spot exchange rate exchange rate at which spot transactions take place spot transactions exchange of currencies for immediate or on the spot delivery and payment stagation combination of stagnant or falling output and sharply rising prices stored value cards cards loaded with a predetermined amount of money; used to make payments supply-shock ination ination caused by sharp increases in input prices, which shift the AS curve leftward. supply-side economics macroeconomic policies designed to increase saving, investment, and work incentives, thereby shifting the aggregate supply curve persistently rightward sweep account device through which the banks computer automatically transfers funds out of customers checking accounts into interestbearing nancial assets at the end of each day

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

representative full-bodied money


paper money that attests to an ownership claim on a commodity such as gold or silver repurchase agreement (RP) money market instrument that government security dealers, banks, and other large nancial market players use to mobilize temporarily idle funds required reserve ratio (rr) ratio of required reserves to DDO (demand deposits and other checkable deposits) reserve requirements percentage gure that depository institutions are required to hold in reserves to support deposit liabilities reserves cash on hand and deposits at the Federal Reserve maintained by depository institutions

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 Funding Corporation (RFC) establishment created by


Congress to issue bonds to cover the expenses of nancial institution reform

Securities and Exchange Commission (SEC) government


organization charged with preventing nancial abuses such as insider trading of stocks, bonds, and other nancial instruments, and failure of corporations to clearly and honestly disclose key nancial information securitization transformation of illiquid nancial assets into highly marketable capital market instruments segmented markets theory theory that borrowers and lenders are committed to particular maturities, unwilling to switch in response to yield considerations

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

reverse repurchase agreement (reverse RPs) or matched salepurchase transaction transaction


in which securities are sold to buyers, who agree to buy back the securities at a specic date and price

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Glossary

Taylor rule monetary policy rule in


which the Federal Reserve moves its federal funds rate target in response to changes in both ination and the output gap term premium additional yield embedded in long-term debt instruments to compensate lenders for market risk term structure of interest rates relationship at a given point in time between the length of time to maturity and the yield on a security terms of trade ratio of the price of the nations exports divided by the price of the nations imports, with both prices measured in units of domestic currency time inconsistency problem tendency of policymakers to announce a particular policy to inuence expectations and then to follow different policies after the expectations have been formed time preference human propensity to exhibit preference for current consumption over future consumption Tobins q theory theory that monetary policy inuences investment spending by altering stock prices and rms market capitalization relative to replacement cost of capital too big to fail policy regulatory policy of systematically bailing out very large, troubled nancial institutions whose failure might touch off major nancial market repercussions trade decit amount by which the total value of a nations imports exceeds the total value of its exports

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

transactions demand for money


demand for money to nance expenditures that are not perfectly synchronized with receipt of funds

V
velocity of money ratio of nominal
GDP to the money stock

transmission mechanism of monetary policy various avenues or


channels through which changes in Federal Reserve policy alter aggregate demand and economic activity Treasury bills short-term IOUs issued by U.S. government, traded at a discount from face value in a welldeveloped secondary market Treasury bonds IOUs issued by the U.S. government that have original maturity of 10 to 40 years Treasury notes IOUs issued by the U.S. government that have an original maturity of 1 to 10 years

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

Treaty on Monetary Union (Maastricht Treaty) agreement


that formed the European Union and set forth the requisite conditions for the creation of the single currency and central bank Treaty of Rome treaty that created the European Economic Community and formed an arrangement in which member countries practice free trade among themselves while maintaining a common tariff or other trade restrictions vis-vis nonmember nations

Y
yield rate of return on an asset, expressed as a percentage per year

yield curve graphical depiction of the


term structure of interest rates

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

transactions (checkable) deposits


deposits on which checks can be written with unlimited checking privileges

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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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Index Constant money growth rule, 565567 Consumer loans, 212213 Consumption spending monetary policy and, 532534, 536 wealth effect and, 535536 Contagion effects, 258 Contractual savings institutions, 7781 Convergence criteria, 313 Corporate bonds, 55 Cost of capital, 150 Counterfeit money, 34 Coupon bonds, 98 and security prices, 99 Credit crunch of the 1990s, 539 Credit money, 2829 Credit unions, 7677 Credit Union Share Insurance Fund, 86 Credit view, 543545 Currency (CP), 369 Currency ratio (k), 360 changes in, impact of, 365 determinants of, 369371 importance in the money supply multiplier, 371 required reserve ratio (rr), 371372 Current interest rates, 96 Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA), 257, 258 Depreciation, 15, 178 Depression. See Great Depression Derivative markets, 4950 Desired excess reserves ratio (re), 360 changes in, impact of, 365366 Discount brokerages, 154155 Discount loans, 290, 399 Discount rate, 209, 410 Discounts and advances, 290 Discount window, 410 Discount window policy, 410412 Discretionary monetary policy, 563 Disintermediation, 207 District Federal Reserve banks, 288, 296299 Dividend reinvestment, importance of, 156157 Dividend yield(s), 156157, 167 Divisia aggregates, 38 Dow Jones Industrial Average (DJIA), 152153 Dual banking system, 233 Dynamic open market operations, 406 Central bankcontd as lender of last resort, 258259 transparency, 581 Certicates of deposit (CDs), 52 brokered deposits, 267 negotiable CDs, 52, 208209 small certicates of deposit, 208 Checkable deposits, 207208 Checking accounts, 29 Chiles ination targeting experience, 596597 CHIPS (Clearing House Interbank Payments and Settlements), 30 Clinton years, 485489 Commercial banks, 73, 75 assets, 210215 ATS accounts, 207208 balance sheet, 204205 brokerage services, 247 business loans, 212 capital accounts, 215216 capital management, 224226 cash assets, 210211 consumer loans, 212213 declining role of, 8990 discount loans, 209 excess reserves, 218 1980s/1990s failures, 271275 legal reserves, 210 liabilities, 205, 206209 liability management, 222224 liquidity management, 216221 loan loss reserves, 217 loans, 211213 management, 216226 money market deposit accounts (MMDAs), 208 mutual funds, 247 negotiable CDs, 208209 nondeposit borrowing, 209 nontransactions deposits, 208209 NOW accounts, 207 passbook savings accounts, 208 real estate loans, 211212 required reserve ratios, 210 reserves, 210, 217, 218 securities, 213215 securities underwriting, 247 size distribution of, 245 small certicates of deposit, 208 transactions deposits, 207208 Commercial paper, 5152 Commodities Futures Trading Commission (CFTC), 87 Commodity money, 27 Common stocks, 5455 Competition in banking, 262 Comptroller of the Currency, 233 overlapping authority, 236 supervisory responsibility, 235 Consolidation of banks, 242245

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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Index European System of Central Banks (ESCB), 316 European Union (EU), 312 Ex ante real interest rate (rex ante), 95, 114119 Excess reserve ratio (re), 372374 Excess reserves, 218, 328 money supply multiplier (m), 359360, 362 Exchange rate(s) Bretton Woods exchange rate system, 179180 xed, 1415, 179 oating. See Floating exchange rates foreign. See Foreign exchange rates forward, 180 international rate, stability of, 428 spot, 180 Exchange traded funds (ETFs), 154155 Expected real interest rate (rex ante), 114119 Exports. See Net exports (nx) Ex post real interest rate (rex post), 115117 Board of Governors, 293296 broad money supply multiplier, 363 bubble economy policy, 169172 capital accounts, 291292 currency ratio changes, impact of, 365 as a destabilizing inuence, 558563 discount loans, 290, 345346 discounts and advances, 290 discount window policy, 410412 district Federal Reserve banks, 288, 296299 earnings and expenses, 292293 excess reserves ratio changes, impact of, 366 Federal Open Market Committee, 293, 296 oat, 291, 342, 346347 foreign exchange market operations, 349 gold certicates accounts, 347348 Great Depression, role in, 385393 independence, 302304, 306307 ination targeting policy mandate, 597600 interest rates policy, 8, 109, 443445 as lender of last resort, 287288 liabilities, 290291 manager of the System Open Market Account, 409 member banks, 299 monetary base control, 354 and the money supply, 333334, 445446 and the money supply multiplier, 361362 open market operations. See Open market operations origin of, 286288 other Federal Reserve assets, 348349 other liabilities and capital, 353354 overlapping authority, 236 policy directive, 408410 required reserve ratio changes, impact of, 365366, 417418 reserve requirement instrument, 412, 415419 salaries of top ofcers, 300301 securities portfolio, 344345 special drawings rights accounts, 347348 structure of, 293302 supervisory responsibility, 234235 Treasury deposits at, 351353 Federal Reserve System (FRS), 87 Federal Savings and Loan Insurance Corporation (FSLIC), 262 Federal securities agency bonds, 55 kinds of, 5765 outstanding debt by security, 57 treasury bills, 52, 5961

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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Index Gramm-Leach-Bliley Financial Services Modernization Act, 9091, 248, 257, 258 Great Depression, 90, 378379 AD/AS model analysis, 477478 bank failures, 381383 causes of, 379 Feds role, 385393 monetarist view, 387393 money supply, causes of contraction in, 383384 worldwide scope of, 380381 Greenspans performance, 571 Gross domestic product (GDP) expenditures, components of, 532 ination targeting rule, 568 nominal GDP, 497498. See also Velocity of money nominal GDP targeting rule, 567 real GDP, 497498 Taylor rule, 568573 Feds policy mandate, 597600 implementation of, 588592 ination performance before and after, 593595 practical considerations, 588592 sacrice ratios, 595 what is the appropriate target level, 590593 what price index should be used, 590 who sets the target, 590 Ination targeting rule, 568 Information accuracy and availability of, 85 asymmetric. See Asymmetric information bank disclosure requirements, 261 Insolvency, 215 Instrument of monetary policy, 398 Insurance bank deposits. See Deposit insurance; FDIC insurance Bank Insurance Fund, 268 Credit Union Share Insurance Fund, 86 Savings Association Insurance Fund, 86, 268 state banking and insurance commissions, 87 Insurance companies re and casualty insurance companies, 78, 80 life insurance companies, 7778 Interest parity condition, 191192 Interest rates, 89, 95, 97 1960 to 2004, 113114 Australian interest rates, 134 business cycles, 109110 current rates, 96 demand for money, role in, 507511 federal budget decits (or surpluses), 110, 112 Federal Reserve policy, 8, 109 Feds policy from 1979 to 1982, 443445 fundamental determinants of, 103110 future value (FV), 97 ination expectations and, 103108, 115116, 134 international synchronization, 111 loanable funds model, 99103 long-term rates, 436 money market yields and, 434435 money supply targets versus interest rate targets, 437439 nominal rates. See Nominal interest rates open market operations, impact of, 402 present value (PV), 9798 real interest rates. See Real interest rates real versus nominal interest rates, 436437 reserve requirements, inuence of, 417418 risk structure of, 139143 and security prices, 99 Fire and casualty insurance companies, 78, 80 Fire walls, 90, 91 Fisher, Irving, 501 Fisher effect, 105 Fisher hypothesis, 105108 Fixed exchange rates, 1415, 179 Float, 342, 346347 Floating exchange rates, 15, 178180 freely oating exchange rates, 183 managed oat, 183 Flow of funds, 4245 moral hazard, 7071 FOMC directive, 296 Forecasting ination, 587 Foreign exchange market(s), 1415, 176177 equilibrium in, 192193 Federal Reserve operations in, 349 forward exchange markets, 180, 182 spot exchange markets, 180, 182 Foreign exchange rates, 14, 177178 changes and effects, 193198 daily quotations, 181 determination of, 183184 oating rates. See Floating exchange rates forward exchange rate, 180 importance of, 182 long-run determinants, 184189 short-run determinants, 189196 spot exchange rate, 180 Forward exchange markets, 180, 182 Forward exchange rate, 180 Forward transactions, 180 Fractional reserve banking system, 287 Free Banking Era, 232 Freely oating exchange rates, 183 Friedman luxury-good explanation, 514515 Friedmans permanent income hypothesis, 520521 Full-bodied money, 27 Future output, impact of ination targeting on, 588 Futures, 49 Futures contracts, 4950 Futures markets, 4950 Future value (FV), 97

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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Index stability, goal of, 429 term structure of. See Term structure of interest rates term structure theories, 126139. See also Term structure theories velocity of money, determinants of, 512, 519520 yield curve, 123, 125, 134, 136138 zero rates economies, 546 Intermediate target variables, 423, 435437 International capital ows, 177 International deposit insurance systems, 279 International ination rate, 425 International Monetary Fund (IMF), 179 International payments instruments, 31 International stock market performance, 161 International synchronization of economic phenomena, 910 of interest rates, 111 Internet banking, 241242 Investment, factors inuencing, 456 Investment banks, 48, 246 banking services by, 247248 Investment spending, 536540 Investment-type nancial intermediaries, 8184 nancial instruments, 46, 47 liquidity-protability trade-off, 220221 liquidity-risk trade-off, 219220 Liquidity premium theory, 129131 Loanable funds model, 99103 Loan loss reserves, 217 Loan production ofces, 239 Loans commercial banks, 211213 discount loans, 290, 399 Lombard system, 412, 413 Long-run aggregate supply curve (LRAS), 462 Long-run average income, 520 Long-run exchange rate determinants, 184185 preferences, 189, 190 price level behavior, 185188, 190 product development, 189, 190 productivity, 189, 190 quotas, 189, 190 tariffs, 189, 190 Long-term interest rates, 436 Loss function, 586

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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Licensed to: iChapters User 616


Index derivation of, 359361 desired excess reserves ratio (re), 360 excess reserve ratio (re), 372374 excess reserves, 359360, 362 Federal Reserves role, 361362 historical behavior of, 366367 naive deposit expansion multiplier, compared, 361 narrow money supply (M1), 359 required reserve ratio (rr), 360 required reserves, 359360, 362 reserves, 359360, 362 Money view, 542543 Moral hazard problem, 70, 258 ow of funds, 4245 principal agent problem, 269, 271 Mortgage-backed securities, 56 Mortgages, 56 amortized mortgages, 75 commercial banks, 211212 Motives for holding money, 503507 Municipal bonds, 55 Mutual funds, 81 commercial banks, 247 emergence of, 8889 Mutual savings banks, 76 Nominal interest rates, 95 changes in, 194 versus real interest rates, 436437 Non-bank banks, 239 Nonborrowed base (B-A), 434 Nonmarketable government debt, 64 NOW accounts, 207 Monetary policycontd transmission mechanism. See Transmission mechanism of monetary policy velocity behavior and, 521, 522 Monetary policy rule, 563, 565567 active rules, 563564, 567572 case for, 564565 passive rule, 563, 565567 Monetary union, 311 Money, 3, 18, 19 broad measures of, 3536 commodity money, 27 counterfeit money, 34 credit money, 2829 demand for. See Demand for money electronic money, 2930, 32 evolution of, 2630 at money, 2829 full-bodied money, 27 functions of, 2026 income, distinguished, 20 meaning of, 19 as means-of-payment function, 21 medium-of-exchange function, 21 motives for holding, 503507 representative full-bodied money, 2728 as standard-of-value function, 2223 store-of-value function, 23 supply. See Money supply as unit-of-account function, 2223 velocity of. See Velocity of money wealth, distinguished, 20 weighted measures of, 3738 Money market deposit accounts (MMDAs), 208 Money market instruments, 5154 Money market mutual funds (MMMFs), 8284 Money market(s), 50 capital markets versus, 50 Fed policy in the 1950s and 1960s, 441442 Money supply, 3. See also Monetary base (B); Money supply multiplier (m) and the Federal Reserve, 333334 Feds policy from late 1982 to the early 1990s, 445446 interest rate targets versus money supply targets, 437439 measures of, 3238 M1 measure of, 3334 M2 measure of, 3536 M3 measure of, 3536 weighted measures of, 3738 what determines, 35 Money supply multiplier (m), 337, 338, 357359, 369 applications, 364 currency ratio (k), 360, 367371

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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Index Prime loan rate, 8 Principal-agent problem, 269, 271 S&L 1980s crisis, 269, 271 Private pension funds, 8081 Problem banks, 235, 261 Productivity, 2 growth trends, 488489 long-run exchange rate determinant, 189, 190 marginal productivity of capital, 105 P-star analysis, 522523 Purchasing power parity (PPP) theory, 186188 Pure expectations theory, 126128 implicit forward rate, 128129 loan loss reserves, 217 money supply multiplier (m), 359360, 362 nonborrowed reserves (R-A), 434 open market operations, impact of, 402 required reserves. See Reserve requirement(s) reserve averaging, 416 Resolution Trust Corporation (RTC), 268269 Retirement funds, 8081 emergence of, 8889 Reverse repurchase agreements (reverse RPs), 408 Ricardian equivalence proposition, 112 Riegle-Neal Interstate Banking and Branching Efciency Act of 1994, 241 Risk default risk, 46 nancial instruments, 46, 47 interest rates, risk structure of, 139143 liquidity-risk trade-off, 219220 market risk, 46 savings and loan associations, 268 stock market, 157159 Risk premium, 141 equity risk premium, 160

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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