The Economics of Money, Banking, and Financial Markets

Seventh Edition

Abel/Bernanke

Macroeconomics

Bade/Parkin

Foundations of Microeconomics

Bade/Parkin

Foundations of Macroeconomics

Bierman/Fernandez

Game Theory with Economic Applications

Binger/Hoffman

Microeconomics with Calculus

Boyer

Principles of Transportation Economics

Branson

Macroeconomic Theory and Policy

Bruce

Public Finance and the American Economy

Byrns/Stone

Economics

Carlton/Perloff

Modern Industrial Organization

Caves/Frankel/Jones

World Trade and Payments:

An Introduction

Chapman

Environmental Economics:

Theory, Application, and Policy

Cooter/Ulen

Law and Economics

Downs

An Economic Theory of Democracy

Eaton/Mishkin

Online Readings to Accompany

The Economics of Money, Banking, and

Financial Markets

Ehrenberg/Smith

Modern Labor Economics

Ekelund/Tollison

Economics: Private Markets

and Public Choice

Fusfeld

The Age of the Economist

Gerber

International Economics

Ghiara

Learning Economics:

A Practical Workbook

Gordon

Macroeconomics

Gregory

Essentials of Economics

Gregory/Stuart

Russian and Soviet Economic Performance

and Structure

Hartwick/Olewiler

The Economics of Natural Resource Use

Hubbard

Money, the Financial System,

and the Economy

Hughes/Cain

American Economic History

Husted/Melvin

International Economics

Jehle/Reny

Advanced Microeconomic Theory

Klein

Mathematical Methods

for Economics

Krugman/Obstfeld

International Economics:

Theory and Policy

Laidler

The Demand for Money:

Theories, Evidence, and Problems

Leeds/von Allmen

The Economics of Sports

Lipsey/Courant/Ragan

Economics

McCarty

Dollars and Sense:

An Introduction to Economics

Melvin

International Money

and Finance

Miller

Economics Today

Miller/Benjamin/North

The Economics of Public Issues

Mills/Hamilton

Urban Economics

Mishkin

The Economics of Money, Banking, and

Financial Markets

Parkin

Economics

Parkin/Bade

Economics in Action Software

Perloff

Microeconomics

Phelps

Health Economics

Riddell/Shackelford/Stamos/

Schneider

Economics: A Tool for Critically

Understanding Society

Ritter/Silber/Udell

Principles of Money, Banking,

and Financial Markets

Rohlf

Introduction to Economic Reasoning

Ruffin/Gregory

Principles of Economics

Sargent

Rational Expectations

and Inflation

Scherer

Industry Structure, Strategy,

and Public Policy

Schotter

Microeconomics:

A Modern Approach

Stock/Watson

Introduction to Econometrics

Studenmund

Using Econometrics:

A Practical Guide

Tietenberg

Environmental and Natural

Resource Economics

Tietenberg

Environmental Economics and Policy

Todaro/Smith

Economic Development

Waldman/Jensen

Industrial Organization:

Theory and Practice

Williamson

Macroeconomics

The Addison-Wesley Series in Economics

Frederic S. Mishkin

Columbia University

Editor in Chief: Denise Clinton

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Library of Congress Cataloguing-in-Publication Data

Mishkin, Frederic S.

The economics of money, banking, and financial markets / Frederic S. Mishkin.—7th ed.

p. cm. — (The Addison-Wesley series in economics)

Supplemented by a subscription to a companion web site.

Includes bibliographical references and index.

ISBN 0-321-12235-6

1. Finance. 2. Money. 3. Banks and banking. I. Title. II. Series.

HG173.M632 2004

332—dc21

2003041912

Copyright © 2004 by Frederic S. Mishkin. All rights reserved. No part of this publication may be repro￾duced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical,

photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in

the United States of America.

1 2 3 4 5 6 7 8 9 10—DOW—06050403

To Sally

Introduction 1

1 Why Study Money, Banking, and Financial Markets? . . . . . . . . . . . . . . . . . . . .3

2 An Overview of the Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23

3 What Is Money? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44

Financial Markets 59

4 Understanding Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61

5 The Behavior of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85

6 The Risk and Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . .120

7 The Stock Market, the Theory of Rational Expectations,

and the Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .141

Financial Institutions 167

8 An Economic Analysis of Financial Structure . . . . . . . . . . . . . . . . . . . . . . . .169

9 Banking and the Management of Financial Institutions . . . . . . . . . . . . . . . . .201

10 Banking Industry: Structure and Competition . . . . . . . . . . . . . . . . . . . . . . . .229

11 Economic Analysis of Banking Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . .260

12 Nonbank Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287

13 Financial Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .309

Central Banking and the Conduct of

Monetary Policy 333

14 Structure of Central Banks and the Federal Reserve System . . . . . . . . . . . . .335

15 Multiple Deposit Creation and the Money Supply Process . . . . . . . . . . . . . .357

16 Determinants of the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .374

17 Tools of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .393

18 Conduct of Monetary Policy: Goals and Targets . . . . . . . . . . . . . . . . . . . . . .411

International Finance and Monetary Policy 433

19 The Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .435

20 The International Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .462

21 Monetary Policy Strategy: The International Experience . . . . . . . . . . . . . . . .487

PART V

PART IV

PART III

PART II

PART I

vii

CONTENTS IN BRIEF

Monetary Theory 515

22 The Demand for Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .517

23 The Keynesian Framework and the ISLM Model . . . . . . . . . . . . . . . . . . . . . .536

24 Monetary and Fiscal Policy in the ISLM Model . . . . . . . . . . . . . . . . . . . . . . .561

25 Aggregate Demand and Supply Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . .582

26 Transmission Mechanisms of Monetary Policy: The Evidence . . . . . . . . . . . .603

27 Money and Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .632

28 Rational Expectations: Implications for Policy . . . . . . . . . . . . . . . . . . . . . . . .658

PART VI

viii Contents in Brief

Introduction 1

CHAPTER 1

WHY STUDY MONEY, BANKING, AND FINANCIAL MARKETS? . . . . . . . . . . . . . . . . .3

Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3

Why Study Financial Markets? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3

The Bond Market and Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3

The Stock Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

The Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

Why Study Banking and Financial Institutions? . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7

Structure of the Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7

Banks and Other Financial Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8

Financial Innovation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8

Why Study Money and Monetary Policy? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8

Money and Business Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9

Money and Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10

Money and Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12

Conduct of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12

Fiscal Policy and Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12

How We Will Study Money, Banking, and Financial Markets . . . . . . . . . . . . . . . . . .13

Exploring the Web . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14

Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . . .17

Appendix to Chapter 1

Defining Aggregate Output, Income, the Price Level,

and the Inflation Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20

Aggregate Output and Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20

Real Versus Nominal Magnitudes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20

Aggregate Price Level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21

Growth Rates and the Inflation Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22

PART I

ix

CONTENTS

CHAPTER 2

AN OVERVIEW OF THE FINANCIAL SYSTEM . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23

Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23

Function of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23

Structure of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25

Debt and Equity Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25

Primary and Secondary Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26

Exchanges and Over-the-Counter Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27

Money and Capital Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27

Internationalization of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28

International Bond Market, Eurobonds, and Eurocurrencies . . . . . . . . . . . . . . . . . . . . . . . .28

World Stock Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29

Function of Financial Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29

Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29

Following the Financial News Foreign Stock Market Indexes . . . . . . . . . . . . . . . .30

Box 1 Global: The Importance of Financial Intermediaries to Securities

Markets: An International Comparison . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31

Risk Sharing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31

Asymmetric Information: Adverse Selection and Moral Hazard . . . . . . . . . . . . . . . . . . . . .32

Financial Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34

Depository Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34

Contractual Savings Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .35

Investment Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37

Regulation of the Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37

Increasing Information Available to Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39

Ensuring the Soundness of Financial Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39

Financial Regulation Abroad . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . . .41

CHAPTER 3

WHAT IS MONEY? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44

Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44

Meaning of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44

Functions of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45

Medium of Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45

Unit of Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .46

Store of Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .47

Evolution of the Payments System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48

Commodity Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48

Fiat Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48

Checks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48

Box 1 Global: Birth of the Euro: Will It Benefit Europe? . . . . . . . . . . . . . . . . . . . . .49

Electronic Payment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .50

x Contents

Box 2 E-Finance: Why Are Scandinavians So Far Ahead of Americans in

Using Electronic Payments? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .50

E-Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .51

Measuring Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .51

The Federal Reserve’s Monetary Aggregates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .51

Box 3 E-Finance: Are We Headed for a Cashless Society? . . . . . . . . . . . . . . . . . . . .52

Following the Financial News The Monetary Aggregates . . . . . . . . . . . . . . . . . . .54

How Reliable Are the Money Data? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . . .56

Financial Markets 59

CHAPTER 4

UNDERSTANDING INTEREST RATES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61

Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61

Measuring Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61

Present Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61

Four Types of Credit Market Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .63

Yield to Maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .64

Box 1 Global: Negative T-Bill Rates? Japan Shows the Way . . . . . . . . . . . . . . . . . . .69

Other Measures of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .69

Current Yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .70

Yield on a Discount Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .71

Application Reading the Wall Street Journal: The Bond Page . . . . . . . . . . . . . . . . .72

Following the Financial News Bond Prices and Interest Rates . . . . . . . . . . . . . . .73

The Distinction Between Interest Rates and Returns . . . . . . . . . . . . . . . . . . . . . . . . .75

Maturity and the Volatility of Bond Returns: Interest-Rate Risk . . . . . . . . . . . . . . . . . . . . . .78

Box 2 Helping Investors to Select Desired Interest-Rate Risk . . . . . . . . . . . . . . . . .79

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .79

The Distinction Between Real and Nominal Interest Rates . . . . . . . . . . . . . . . . . . . .79

Box 3 With TIPS, Real Interest Rates Have Become Observable in the

United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .82

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . . .82

CHAPTER 5

THE BEHAVIOR OF INTEREST RATES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85

Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85

Determinants of Asset Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85

Wealth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .86

PART II

Contents xi

Expected Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .86

Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .87

Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .87

Theory of Asset Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .87

Supply and Demand in the Bond Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .87

Demand Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .88

Supply Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .90

Market Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .90

Supply and Demand Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .91

Loanable Funds Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .91

Changes in Equilibrium Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .93

Shifts in the Demand for Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .93

Shifts in the Supply of Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .97

Application Changes in the Equilibrium Interest Rate Due to Expected

Inflation or Business Cycle Expansions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .99

Changes in Expected Inflation: The Fisher Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .99

Business Cycle Expansion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .100

Application Explaining Low Japanese Interest Rates . . . . . . . . . . . . . . . . . . . . . .103

Application Reading the Wall Street Journal “Credit Markets” Column . . . . . . . .103

Following the Financial News The “Credit Markets” Column . . . . . . . . . . . . . .104

Supply and Demand in the Market for Money: The Liquidity

Preference Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .105

Changes in Equilibrium Interest Rates in the Liquidity Reference Framework . . . . .107

Shifts in the Demand for Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .107

Shifts in the Supply of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .108

Application Changes in the Equilibrium Interest Rate Due to Changes

in Income, the Price Level, or the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . .108

Changes in Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .108

Changes in the Price Level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .108

Changes in the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .109

Following the Financial News Forecasting Interest Rates . . . . . . . . . . . . . . . . . .111

Application Money and Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .112

Does a Higher Rate of Growth of the Money Supply Lower Interest Rates? . . . . . . . . . . . .114

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .117

CHAPTER 6

THE RISK AND TERM STRUCTURE OF INTEREST RATES . . . . . . . . . . . . . . . . . . .120

Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .120

Risk Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .120

Default Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .120

Application The Enron Bankruptcy and the Baa-Aaa Spread . . . . . . . . . . . . . . . .124

xii Contents

Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .125

Income Tax Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .125

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .127

Application Effects of the Bush Tax Cut on Bond Interest Rates . . . . . . . . . . . . .127

Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .127

Following the Financial News Yield Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . .128

Expectations Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .129

Segmented Markets Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .132

Liquidity Premium and Preferred Habitat Theories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .133

Evidence on the Term Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .136

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .137

Application Interpreting Yield Curves, 1980–2003 . . . . . . . . . . . . . . . . . . . . . . .137

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .138

CHAPTER 7

THE STOCK MARKET, THE THEORY OF RATIONAL EXPECTATIONS,

AND THE EFFICIENT MARKET HYPOTHESIS . . . . . . . . . . . . . . . . . . . . . . . . . . . .141

Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .141

Computing the Price of Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .141

The One-Period Valuation Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .142

The Generalized Dividend Valuation Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .143

The Gordon Growth Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .143

How the Market Sets Security Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .144

Application Monetary Policy and Stock Prices . . . . . . . . . . . . . . . . . . . . . . . . . .146

Application The September 11 Terrorist Attacks, the Enron Scandal,

and the Stock Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .146

The Theory of Rational Expectations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .147

Formal Statement of the Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .148

Rationale Behind the Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .149

Implications of the Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .149

The Efficient Markets Hypothesis: Rational Expectations in Financial Markets . . . .150

Rationale Behind the Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .151

Stronger Version of the Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . .152

Evidence on the Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . .153

Evidence in Favor of Market Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .153

Application Should Foreign Exchange Rates Follow a Random Walk? . . . . . . . .155

Evidence Against Market Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .156

Overview of the Evidence on the Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . .158

Application Practical Guide to Investing in the Stock Market . . . . . . . . . . . . . . .158

How Valuable Are Published Reports by Investment Advisers? . . . . . . . . . . . . . . . . . . . . .158

Contents xiii

Following the Financial News Stock Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . .159

Box 1 Should You Hire an Ape as Your Investment Adviser? . . . . . . . . . . . . . . . .160

Should You Be Skeptical of Hot Tips? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .160

Do Stock Prices Always Rise When There Is Good News? . . . . . . . . . . . . . . . . . . . . . . . . .161

Efficient Market Prescription for the Investor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .161

Evidence on Rational Expectations in Other Markets . . . . . . . . . . . . . . . . . . . . . . .162

Application What Do the Black Monday Crash of 1987 and the Tech

Crash of 2000 Tell Us About Rational Expectations and Efficient Markets? . . . .163

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .164

Financial Institutions 167

CHAPTER 8

AN ECONOMIC ANALYSIS OF FINANCIAL STRUCTURE . . . . . . . . . . . . . . . . . . . .169

Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .169

Basic Puzzles About Financial Structure Throughout the World . . . . . . . . . . . . . . .169

Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .173

How Transaction Costs Influence Financial Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . .173

How Financial Intermediaries Reduce Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . .173

Asymmetric Information: Adverse Selection and Moral Hazard . . . . . . . . . . . . . . . .174

The Lemons Problem: How Adverse Selection Influences Financial Structure . . . . .175

Lemons in the Stock and Bond Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .175

Tools to Help Solve Adverse Selection Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .176

Box 1 The Enron Implosion and the Arthur Andersen Conviction . . . . . . . . . . .178

How Moral Hazard Affects the Choice Between Debt and Equity Contracts . . . . . .180

Moral Hazard in Equity Contracts: The Principal–Agent Problem . . . . . . . . . . . . . . . . . . .181

Tools to Help Solve the Principal–Agent Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .182

Box 2 E-Finance: Venture Capitalists and the High-Tech Sector . . . . . . . . . . . . . .183

How Moral Hazard Influences Financial Structure in Debt Markets . . . . . . . . . . . .184

Tools to Help Solve Moral Hazard in Debt Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . .184

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .186

Application Financial Development and Economic Growth . . . . . . . . . . . . . . . .187

Financial Crises and Aggregate Economic Activity . . . . . . . . . . . . . . . . . . . . . . . . .189

Factors Causing Financial Crises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .189

Application Financial Crises in the United States . . . . . . . . . . . . . . . . . . . . . . . .191

Box 3 Case Study of a Financial Crisis: The Great Depression . . . . . . . . . . . . . . .194

Application Financial Crises in Emerging-Market Countries:

Mexico, 1994–1995; East Asia, 1997–1998; and Argentina, 2001–2002 . . . . . . .194

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .199

PART III

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CHAPTER 9

BANKING AND THE MANAGEMENT OF FINANCIAL INSTITUTIONS . . . . . . . . . . . .201

Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .201

The Bank Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .201

Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .201

Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .204

Basic Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .205

General Principles of Bank Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .208

Liquidity Management and the Role of Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .208

Asset Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .211

Liability Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .212

Capital Adequacy Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .213

Application Strategies for Managing Bank Capital . . . . . . . . . . . . . . . . . . . . . . . .215

Application Did the Capital Crunch Cause a Credit Crunch in the

Early 1990s? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .216

Managing Credit Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .217

Screening and Monitoring . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .217

Long-Term Customer Relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .218

Loan Commitments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .219

Collateral and Compensating Balances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .219

Credit Rationing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .220

Managing Interest-Rate Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .220

Gap and Duration Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .221

Application Strategies for Managing Interest-Rate Risk . . . . . . . . . . . . . . . . . . . .222

Off-Balance-Sheet Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .223

Loan Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .223

Generation of Fee Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .223

Trading Activities and Risk Management Techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . .224

Box 1 Global: Barings, Daiwa, Sumitomo, and Allied Irish:

Rogue Traders and the Principal–Agent Problem . . . . . . . . . . . . . . . . . . . . . . . . .225

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .226

CHAPTER 10

BANKING INDUSTRY: STRUCTURE AND COMPETITION . . . . . . . . . . . . . . . . . . . .229

Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .229

Historical Development of the Banking System . . . . . . . . . . . . . . . . . . . . . . . . . . . .229

Multiple Regulatory Agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .231

Financial Innovation and the Evolution of the Banking Industry . . . . . . . . . . . . . .232

Responses to Changes in Demand Conditions: Interest Rate Volatility . . . . . . . . . . . . . . .233

Responses to Changes in Supply Conditions: Information Technology . . . . . . . . . . . . . . .234

Box 1 E-Finance: Will “Clicks” Dominate “Bricks” in the Banking Industry? . . . .236

Avoidance of Existing Regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .237

Financial Innovation and the Decline of Traditional Banking . . . . . . . . . . . . . . . . . . . . . .239

Contents xv