Financial markets, banking and money (fourth edition) part 2

Chapter Stocks, Stock Markets, and Market Efficiency Learning Objectives Understand . .  LO1 The characteristics of common stock LO2 Measures of the level of the stock market LO3 The valuation of stocks LO4 Investing in stocks for the long run LO5 The stock market’s role in the economy Stocks play a prominent role in our financial and economic lives For individuals, they provide a key instrument for holding personal wealth as well as a way to diversify, spreading and reducing the risks that we face Importantly, diversifiable risks are risks that are more likely to be taken By giving individuals a way to transfer risk, stocks supply a type of insurance enhancing our ability to take risk.1 For companies, they are one of several ways to obtain financing Beyond that, though, stocks and stock markets are a central link between the financial world and the real economy Stock prices are fundamental to the functioning of a market-based economy They tell us the value of the companies that issued the stocks and, like all other prices, they allocate scarce investment resources The firms deemed most valuable in the marketplace for stocks are the ones that will be able to obtain financing for growth When resources flow to their most valued uses, the economy operates more efficiently Mention of the stock market provokes an emotional reaction in many people They see it as a place where fortunes are easily made or lost, and they recoil at its unfathomable booms and busts During one infamous week in October 1929, the New York Stock Exchange lost more than 25 percent of its value—an event that marked the beginning of the Great Depression In October 1987, prices fell nearly 30 percent in one week, including a record decline of 20 percent in a single day Crashes of this magnitude have become part of the stock market’s folklore, creating the popular impression that stocks are very risky In the 1990s, stock prices increased nearly fivefold and Americans forgot about the “black Octobers.” By the end of the decade, many people had come to see stocks as This point was central to our discussions of risk in Chapter Our ability to diversify risk either through the explicit purchase of insurance or through investment strategies means that we are able to risky things that we otherwise would not 190 l Chapter Stocks, Stock Markets, and Market Efficiency almost a sure thing; you could not afford not to own them In 1998, nearly half of all U.S households owned some stock, either directly or indirectly through mutual funds and managed retirement accounts When the market’s inexorable rise finally ended, the ensuing decline seemed more like a slowly deflating balloon than a crash From early 2000 to the week following the terrorist attacks of September 11, 2001, the stock prices of the United States’ biggest companies, as measured by the Dow Jones Industrial Average, fell more than 30 percent While many stocks recovered much of their loss fairly quickly, a large number did not During the same period, the Nasdaq Composite index fell 70 percent, from 5,000 to 1,500; it has remained well below its March 2000 peak ever since Because the Nasdaq tracks smaller, newer, more technologically oriented companies, many observers dubbed this episode the “Internet bubble.” The plunge of the U.S stock market in the recent financial crisis was much broader and greater, roughly halving the market value by early 2009 from its 2007 peak of about $26 trillion And, although the stock market surpassed this peak in the first quarter of 2013, it fared less well after accounting for inflation Yet, contrary to popular mythology, stock prices tend to rise—even after adjusting for inflation—over the long term, collapsing only on those infrequent occasions when normal market mechanisms are out of alignment For most people, the experience of losing or gaining wealth suddenly is more memorable than the experience of making it gradually By being preoccupied with the potential short-term losses associated with crashes, we lose sight of the gains we could realize if we took a longer-term view The goal of this chapter is to try to make sense of the stock market—to show what fluctuations in stock value mean for individuals and for the economy as a whole and look at a critical connection between the financial system and the real economy We will also explain how it is that things sometimes go awry, resulting in bubbles and crashes First, however, we need to define the basics: what stocks are, how they originated, and how they are valued The Essential Characteristics of Common Stock Stocks, also known as common stock or equity, are shares in a firm’s ownership A firm that issues stock sells part of itself, so that the buyer becomes a part owner Stocks as we know them first appeared in the 16th century They were created to raise funds for global exploration Means had to be found to finance the dangerous voyages of explorers such as Sir Francis Drake, Henry Hudson, and Vasco de Gama Aside from kings and queens, no one was wealthy enough to finance these risky ventures alone The solution was to spread the risk through joint-stock companies, organizations that issued stock and used the proceeds to finance several expeditions at once In exchange for investing, stockholders received a share of the company’s profits These early stocks had two important characteristics that we take for granted today First, the shares were issued in small denominations, allowing investors to buy as little or as much of the company as they wanted; and second, the shares were transferable, meaning that an owner could sell them to someone else Today, the vast majority of large companies issue stock that investors buy and sell regularly The shares normally are quite numerous, each one representing only a small fraction of a company’s total value The large number and small size of individual shares—prices are usually below $100 per share—make the purchase and sale of stocks relatively easy The Essential Characteristics of Common Stock Figure 8.1 Examples of Stock Certificates Until recently, all stockowners received a certificate from the issuing company Figure 8.1, on the left, shows the first stock certificate issued by the Ford Motor Company in 1903, to Henry Ford The right-hand side of the figure shows a more recent stock certificate issued by the World Wrestling Federation (WWF), renamed World Wrestling Enterprises (WWE) The WWE is the media and entertainment company that produces the wrestling events involving characters like The Rock and Hulk Hogan The former governor of Minnesota, Jesse Ventura, worked for the WWF before entering politics Today, most stockholders no longer receive certificates; the odds are that you will never see one Instead, the information they bear is computerized, and the shares are registered in the names of brokerage firms that hold them on investors’ behalf This procedure is safer because computerized certificates can’t be stolen It also makes the process of selling the shares much easier The ownership of common stock conveys a number of rights First and most importantly, a stockholder is entitled to participate in the profits of the enterprise Importantly, however, the stockholder is merely a residual claimant If the company runs into financial trouble, only after all other creditors have been paid what they are owed will the stockholders receive what is left, if anything Stockholders get the leftovers! To understand what being the residual claimant means, let’s look at the case of a software manufacturer The company needs a number of things to make it run The list might include rented office space, computers, programmers, and some cash balances for day-to-day operations These are the inputs into the production of the company’s software output If we took a snapshot of the company’s finances on any given day, we would see that the firm owes payments to a large number of people, including the owner of the office space it rents, the programmers that work for it, the supplier of its computers, and the bondholders and bankers who have lent the firm resources The company uses the revenue from selling its software to pay these people After everyone has been paid, the stockholders get the rest of the revenue In some years, the company does well and there are funds left over, so the stockholders well But when the firm does poorly, the stockholders may get nothing If the firm performs really poorly, failing to sell enough software to cover its obligations, it can go bankrupt and cease operating entirely In that case, the stockholders lose their entire investment The possibility of bankruptcy brings up an interesting question What happens if a company’s revenue is insufficient to cover its obligations to nonstockholders? What if its revenue is too small to pay the landlord, the programmers, the supplier of the computers, Chapter l 191 192 l Chapter Stocks, Stock Markets, and Market Efficiency YOUR FINANCIAL WORLD A Home Is a Place to Live A home is a place to live; it is very different from a stock or a bond When you own a stock, the issuing firm either pays you dividends or reinvests its profits to make the business grow Bonds pay interest, that’s how you are compensated for lending In either case, you receive an explicit financial return on your investment When you buy a house and move in, what you get is a roof over your head And you it without paying rent to someone else That means that you are consuming the dividend or interest payments in the form of what economists call housing services So, if you buy a house, live in it for a while, and then sell it, you should expect to get back the original purchase price, adjusted for inflation It is as if you bought an inflation-indexed bond and used the coupon payments to live on What’s left at the end is the principal amount, no more Data on the long-run real (inflation-adjusted) change in the price of housing are consistent with this Over the 122 years from 1890 to 2012, the average annual real increase in the value of housing in the United States was only 0.17 percent That means that if you were to purchase a house for $100,000 and live in it for 30 years (the time it takes to completely pay off a conventional fixed-rate mortgage), you could expect to sell it for around $105,000 plus any adjustment for inflation An observer in 2006 might be forgiven for thinking that the long-run rules for housing prices had changed with the millennium In the first six years of the decade, real house prices surged by 60 percent By 2009, however, these gains had vanished with the financial crisis, leaving the former long-run pattern intact To see the contrast with a financial investment, compare the purchase of the home to the purchase of $100,000 worth of stock If stocks have an annual average real return of percent, then after 30 years you will have accumulated nearly $575,000 But, unlike the house, this financial investment does not provide you with a place to live So, when you think about the return to owning a house, remember that you get a place to live—that’s the return on your investment and the bondholders and other lenders? It would appear that the stockholders’ promised participation in the firm’s profits would yield a liability rather than a payment If the company does very poorly, will the stockholders have to pay the firm’s creditors? An arrangement in which the stockholders are held liable for the firm’s losses is very unappealing and would surely discourage people from buying stock Stockholders bore that risk until the early 19th century It ended with the introduction of the legal concept of limited liability.2 Limited liability means that, even if a company fails completely, the maximum amount that shareholders can lose is their initial investment Liability for the company’s losses is limited at zero, meaning that investors can never lose more than they have invested Clearly, buying stock is much more attractive if you know that your maximum potential loss is the price you pay for the stock in the first place Beyond participating in the firm’s profits, owners of common stock are entitled to vote at the firm’s annual meeting Though managers supervise a firm’s day-to-day activities, the shareholders elect the board of directors, which meets several times per year to oversee management Ultimately, the shareholders’ ability to dislodge directors and managers who are performing poorly is crucial to their willingness to purchase shares.3 This ability to elect and remove directors and managers varies with a country’s legal structure In places where shareholders’ legal rights are weak, stock ownership is less appealing, and equities are a less important form of corporate financing Today, stock ownership is immensely popular Investors want to own stocks and companies want to issue them Over the past century, markets have developed in which The United States passed the first general law granting limited liability to manufacturing companies in 1811 Managers and directors may have different priorities and objectives from shareholders While the firm’s owners would like to see the value of their investment increase, managers may be more interested in ensuring that they retain their jobs Measuring the Level of the Stock Market Chapter people buy and sell billions of shares every day This thriving financial trade is possible because • An individual share represents only a small fraction of the value of the company that issued it • A large number of shares are outstanding • Prices of individual shares are low, allowing individuals to make relatively small investments • As residual claimants, stockholders receive the proceeds of a firm’s activities only after all other creditors have been paid • Because of limited liability, investors’ losses cannot exceed the price they paid for the stock • Shareholders can replace managers who are doing a bad job Measuring the Level of the Stock Market Stocks are one way in which we choose to hold our wealth When stock values rise, we get richer; when they fall, we get poorer These changes affect our consumption and saving patterns, causing general economic activity to fluctuate We need to understand the dynamics of the stock market, both to manage our personal finances and to see the connections between stock values and economic conditions From a macroeconomic point of view, we need to be able to measure the level of fluctuation in all stock values We will refer to this concept as the value of the stock market and to its measures as stock-market indexes You are probably familiar with price indexes, like the consumer price index, and output indexes, like industrial production and real gross domestic product The purpose of an index number is to give a measure of scale so that we can compute percentage changes The consumer price index, for example, is not measured in dollars Instead, it is a pure number In June 2013, the value of the Consumer Price Index for All Urban Consumers was 232.94, which isn’t very interesting on its own If, however, you know that 12 months earlier, in June 2012, the same index was 228.92, then you can figure out that prices rose by 1.8 percent over a 12-month period—that’s the percentage change in the index Stock-market indexes are the same They are designed to give us a sense of the extent to which things are going up or down Saying that the Dow Jones Industrial Average is at 10,000 doesn’t mean anything on its own But if you know that the Dow index rose from 10,000 to 11,000, that tells you that stock prices (by this measure) went up 10 percent As we will see, stock indexes can tell us both how much the value of an average stock has changed and how much total wealth has gone up or down Beyond that, stock indexes provide benchmarks for performance of money managers, allowing us to measure whether a particular manager has done better or worse than “the market” as a whole A quick look at the financial news reveals a number of stock-market indexes, covering both domestic stocks and stocks issued by firms in foreign countries Our goal in this section is to learn what these are and, more important, what question each is designed to answer We will start with a detailed discussion of the two most well-known U.S indexes, the Dow Jones Industrial Average and the Standard & Poor’s 500 Index A brief description of other indexes and a short history of the performance of the U.S stock market will follow MARKETS l 193 194 l Chapter Stocks, Stock Markets, and Market Efficiency The Dow Jones Industrial Average The first, and still the best known, stock-market index is the Dow Jones Industrial Average (DJIA) Created by Charles Dow in 1884, the DJIA began as an average of the prices of 11 stocks Today, the index is based on the stock prices of 30 of the largest companies in the United States The DJIA measures the value of purchasing a single share of each of the stocks in the index That is, adding up the per-share prices of all 30 stocks and dividing by 30 yields the index The percentage change in the DJIA over time is the percentage change in the sum of the 30 prices Thus, the DJIA measures the return to holding a portfolio of a single share of each stock included in the average The Dow Jones Industrial Average is a price-weighted average Price-weighted averages give greater weight to shares with higher prices To see how this works, take the example of an index composed of just two companies, one with an initial price of $50 and the other with an initial price of $100 The purchase of two shares of stock, one from each company, would cost $150 Now consider the effect of a 15 percent increase in the price of the first stock It raises the value of the two-stock portfolio by $7.50, or percent, to $157.50 Yet a 15 percent increase in the value of the second stock raises the value of the portfolio by $15, or 10 percent, to $165 The behavior of higher-priced stocks, then, dominates the movement of a price-weighted index like the DJIA.4 Since Charles Dow first created his index of 11 stocks, nine of which were railroad stocks, the structure of the U.S economy has changed markedly At various times, steel, chemical, and automobile stocks have dominated the DJIA The index now includes the stocks of information technology firms, such as Microsoft and Intel, as well as of retailing firms, such as Walmart and Home Depot General Electric is the only one of the original 11 stocks that remains in the index.5 The DJIA is a large-company index, but as of mid-2013, it did not include the firms with the second and third largest market values: Apple and Google The Standard & Poor’s 500 Index The Standard & Poor’s 500 Index differs from the Dow Jones Industrial Average in two major respects First, it is constructed from the prices of many more stocks Second, it uses a different weighting scheme As the name suggests, the S&P 500 Index is based on the value of 500 firms, the largest firms in the U.S economy And unlike the DJIA, the S&P 500 tracks the total value of owning the entirety of those firms In the index’s calculation, each firm’s stock price receives a weight equal to its total market value Thus, the S&P 500 is a value-weighted index Unlike the DJIA, in which higher-priced stocks carry more weight, larger firms are more important in the S&P 500 To see this, we can return to the two companies in our last example If the firm whose stock is priced at $100 has 10 million shares outstanding, all its shares together— its total market value, or market capitalization—are worth $1 billion If the second firm—the one whose shares are valued at $50 apiece—has 100 million shares You may wonder how the DJIA has climbed to over 10,000 if it is the average of 30 stock prices, all less than $200 per share The answer is that the averaging process takes stock splits into account and that the companies included in the index change periodically There is a simple way to compute the change in the index level: (1) Take the list of 30 stocks in the DJIA and add up the changes from the previous day’s close, so if each stock rose by $1, that’s $30 (2) Using an online search engine, locate something called the DJIA “divisor.” It’s a number like 0.130216081 (that’s the value for July 29, 2013) (3) Divide the sum of changes in the prices of the DJIA stocks by the divisor and add that to the previous day’s close The result is the current level of the DJIA A detailed description of the history and current composition of the DJIA is on the website www.djindexes.com TOOLS OF THE TRADE Reading Stock Indexes in the Business News Each morning, the business news brings reports of the prior day’s changes in all the major stock-market indexes Table 8.1, reproduced from The Wall Street Journal of February 13, 2013, is an example of this sort of summary It includes a number of indexes besides the DJIA, the S&P 500, and the Nasdaq Composite Some of them cover firms of a particular size For example, Standard & Poor’s MidCap index covers 400 medium-size firms; its SmallCap index covers 600 small firms And the Russell 2000 tracks the value of Table 8.1 the smallest two-thirds of the 3,000 largest U.S companies Other indexes cover a particular sector or industry Note that Dow Jones publishes indexes for transportation and utilities; others provide special indexes for biotechnology, pharmaceuticals, banks, and semiconductors Many more indexes are published, all of them designed for specific functions When you encounter a new index, make sure you understand both how it is constructed and what it is designed to measure Major U.S Stock-Market Indexes February 12, 2013 LATEST High Low Close 52-WEEK RANGE Net chg % chg High Low % CHG % chg YTD 3-yr ann Dow Jones 14038.97 13968.94 14018.70 47.46 5921.83 5893.20 5906.86 22.29 476.74 473.89 476.67 1.84 0.39 16035.23 15967.40 16008.75 29.42 0.18 395.99 395.16 395.62 0.46 0.12 Nasdaq Composite 3196.92 3184.84 3186.49 25.51 Nasdaq 100 2776.71 2761.41 2762.62 212.02 500 Index 1522.29 1515.61 1519.43 2.42 MidCap 400 1112.41 1107.01 1111.72 4.67 514.43 511.69 513.94 2.25 Industrial Average Transportation Avg Utility Average Total Stock Market Barron’s 400 14018.70 12101.46 8.9 7.0 11.6 5911.33 4847.73 11.8 11.3 14.7 496.56 438.05 5.9 5.2 9.4 16008.75 13329.32 12.7 7.0 12.8 395.83 321.50 9.8 8.1 15.5 20.17 3193.87 2747.48 8.7 5.5 13.4 20.43 2864.03 2458.83 7.3 3.8 15.8 0.16 1519.43 1278.04 12.5 6.5 12.2 0.42 1111.72 891.32 14.2 8.9 15.8 0.44 513.94 414.87 12.5 7.8 16.6 0.34 20.04 Nasdaq Stock Market Standard & Poor’s SmallCap 600 Other Indexes 918.17 913.73 917.52 4.49 0.49 917.52 737.24 11.8 8.0 14.5 8970.90 8918.73 8957.61 38.59 0.43 8965.12 7285.53 11.6 6.1 9.2 398.12 396.04 397.76 1.71 0.43 397.76 323.50 9.0 8.1 9.5 NYSE Arca Biotech 1680.80 1663.33 1690.11 1280.90 21.3 7.7 18.9 NYSE Arca Pharma 393.85 391.89 393.03 1.26 397.24 322.03 17.8 6.3 9.2 55.79 55.03 55.71 0.58 1.05 55.71 41.00 25.7 8.6 7.6 PHLX§ Gold/Silver 151.07 148.12 150.62 1.30 0.87 202.36 141.60 221.1 29.0 21.9 PHLX§ Oil Service 246.78 245.45 246.49 0.80 0.32 260.81 186.27 20.9 12.0 8.0 PHLX§ Semiconductor 426.94 423.76 426.28 1.04 0.24 441.88 351.45 0.7 11.0 8.6 13.13 12.63 12.64 20.30 12.43 235.3 229.9 217.8 Russell 2000 NYSE Composite Value Line KBW Bank CBOE Volatility § Philadelphia Stock Exchange 1665.82 212.30 20.73 0.32 22.32 26.66 Sources: SIX Financial Information; WSJ Market Data Group SOURCE: The Wall Street Journal, February 12, 2013 Used with permission of Dow Jones & Company, Inc via Copyright Clearance Center 195 196 l Chapter Stocks, Stock Markets, and Market Efficiency outstanding, its market capitalization is $5 billion Together, the two companies are worth $6 billion Now look at the effect of changes in the two stocks’ prices If the first firm’s pershare price rises by 15 percent, its total value goes up to $1.15 billion, and the value of the two companies together rises to $6.15 billion—an increase of 2½ percent (Remember that in the last example, the price-weighted DJIA rose by 10 percent.) Contrast that with the effect of a 15 percent increase in the price of the second stock, which raises the total value of that firm to $5.75 billion In this case, the value of the two firms together goes from $6 billion to $6.75 billion—an increase of 12½ percent (In the last example, the price-weighted DJIA rose only percent.) Clearly, price-weighted and value-weighted indexes are very different A priceweighted index gives more importance to stocks that have high prices, while a valueweighted index gives more importance to companies with a high market value Price per se is irrelevant Neither price weighting nor value weighting is necessarily the best approach to constructing a stock price index The S&P 500 is neither better nor worse than the DJIA Rather, the two types of index simply answer different questions Changes in a priceweighted index like the DJIA tell us the change in the value of a portfolio composed of a single share of each of the stocks in the index This tells us the change in the price of a typical stock Changes in a value-weighted index tell us the return to holding a portfolio of stocks weighted in proportion to the size of the firms Thus, they accurately mirror changes in the economy’s overall wealth Other U.S Stock Market Indexes Besides the S&P 500 and the DJIA, the most prominent indexes in the United States are the Nasdaq Composite Index, or Nasdaq for short, and the Wilshire 5000 The Nasdaq is a value-weighted index of nearly 3,000 securities traded on the over-thecounter (OTC) market through the National Association of Securities Dealers Automatic Quotations (Nasdaq) service The Nasdaq Composite is composed mainly of smaller, newer firms and in recent years has been dominated by technology and Internet companies The Wilshire 5000 is the most broadly based index in use It covers all publicly traded stocks in the United States with readily available prices, including all the stocks on national stock exchanges, which together total fewer than 4,000 (contrary to the index’s name) as of mid-2013 Like the Nasdaq and the S&P 500, the Wilshire 5000 is value-weighted Because of its great breadth, this index is a useful measure of overall market wealth You can find both the latest value of this index and its history at the Wilshire website: web.wilshire.com/Indexes/Broad/Wilshire5000/ World Stock Indexes Roughly one-third of the countries in the world have stock markets, and each of these markets has an index Most are value-weighted indexes like the S&P 500 Listings of other countries’ stock indexes are in newspapers such as The Wall Street Journal or the Financial Times, as well as online at websites such as www.bloomberg.com (see Table 8.2) Table 8.2 gives some sense of the behavior of stock markets during early 2013 The index levels (in column 3) don’t mean much because the indexes themselves aren’t comparable No one would think that the Brazilian stock exchange was bigger than the New York Stock Exchange, even though the Bovespa index stood at 58,497 when Measuring the Level of the Stock Market Chapter Table 8.2 World Stock Markets February 12, 2013 Close Region/Country Index Name Close YTD % Chg 52-Week 3-Yr Annualized % Chg % Chg 273.36 5.1 9.7 8.3 Merval 3279.96 14.9 20.5 14.5 All Ordinaries 4981.50 6.8 15.3 2.8 Sao Paulo Bovespa 58497.83 24.0 28.6 22.5 Canada S&P/TSX Comp 12789.02 2.9 3.5 3.7 China DJ CBN China 600 22861.92 9.9 9.1 25.2 France CAC 40 3686.58 1.2 9.2 0.8 Germany DAX 7660.19 0.6 13.9 11.7 Hong Kong Hang Seng 23215.16 2.5 11.7 5.9 Italy FTSE MIB 16644.45 2.3 1.2 27.5 Japan Nikkei Stock Avg 11369.12 9.4 25.6 4.1 Mexico IPC All-Share 44873.44 2.7 18.6 13.1 Singapore Straits Times 3270.30 3.3 10.5 6.7 United Kingdom FTSE 100 6338.38 7.5 7.4 7.2 United States S&P 500 1519.43 6.5 12.5 12.2 World DJ Global Index Argentina Australia Brazil SOURCE: The Wall Street Journal, February 12, 2013 Used with permission of Dow Jones & Company, Inc via Copyright Clearance Center the S&P 500 was just 1,519 Instead, we need to focus on the percentage changes in these indexes (in columns and 6) A 100-point move in the Singapore Straits Times index, with a level of 3,270, would be much more significant than a 100-point move in the Japanese Nikkei, with a level of 11,369 But percentage change isn’t everything (see Your Financial World: Beware Percentage Changes, on page 201) Table 8.2 also shows that from February 2012 to February 2013, stock markets rose solidly in many, but not all, countries The increase in the U.S S&P 500 index in the 52 weeks ending February 12, 2013 (12.5 percent), was similar to that of the German DAX (13.9 percent) and the French CAC 40 (9.2 percent) The real star of 2012 was Japan’s Nikkei Stock Average, which jumped 25.6 percent At the other end of the spectrum, Brazil’s Bovespa index dropped 8.6 percent Finally, Table 8.2 shows that the 52-week gains for many countries were larger than the annualized gains over three years Indeed, in Australia, France, Italy, and Japan, the stock market indexes actually declined over the first two years of that three-year interval Investors view global stock markets as a means to diversify risk away from domestic investments While that remains correct, the benefits from such diversification have tended to decline over time Stock markets have become increasingly linked by the choices of investors whose changing preferences are rapidly transmitted from one market to the next The result has been an increased correlation of global markets, especially in periods of financial distress l 197 198 l Chapter Stocks, Stock Markets, and Market Efficiency Valuing Stocks People differ on how stocks should be valued Some believe they can predict changes in a stock’s price by looking at patterns in its past price movements Because these people study charts of stock prices, they are called chartists Other investors, known as behavioralists, estimate the value of stocks based on their perceptions of investor psychology and behavior Still others estimate stock values based on a detailed study of companies’ financial statements In their view, the value of a firm’s stock depends both on its current assets and on estimates of its future profitability—what they call the fundamentals Thus, the fundamental value of a stock is based on the timing and uncertainty of the returns it brings We can use our toolbox for valuing financial instruments to compute the fundamental value of stocks Based on the size and timing of the promised payments, we can use the present-value formula to assess how much a stock is worth in the absence of any risk Then, realizing that the payments are uncertain in both their size and timing, we can adjust our estimate of the stock’s value to accommodate those risks Together, these two steps give us the fundamental value The chartists and behavioralists question the usefulness of fundamentals in understanding the level and movement of stock prices They focus instead on estimates of the deviation of stock prices from those fundamental values These deviations can create short-term bubbles and crashes, which we’ll take up later in the chapter First, though, let’s use some familiar techniques to develop an understanding of basic stock valuation Fundamental Value and the Dividend-Discount Model TIME Like all financial instruments, a stock represents a promise to make monetary payments on future dates, under certain circumstances With stocks, the payments are usually in the form of dividends, or distributions made to the owners of a company when the company makes a profit.6 If the firm is sold, the stockholders receive a final distribution that represents their share of the purchase price Let’s begin with an investor who plans to buy a stock today and sell it in one year The principle of present value tells us that the price of the stock today should equal the present value of the payments the investor will receive from holding the stock This is equal to the selling price of the stock in one year’s time plus the dividend payments received in the interim Thus, the current price is the present value of next year’s price plus the dividend If Ptoday is the purchase price of the stock, Pnext year is the sale price one year later, and Dnext year is the size of the dividend payment, we can write this expression as Dnext year Pnext year Ptoday (1 i) (1 i) (1) where i is the interest rate used to compute the present value (measured as a decimal) What if the investor plans to hold the stock for two years? To figure out the answer, start by using present value to calculate that the price next year equals the value next To be precise, not all profits are distributed to shareholders Some of these “earnings” are retained by the firm and used to increase its size A firm may also use profits to buy back its own stock, thereby increasing the value of the remaining shares We will ignore these complications I-4 l Index Decentralized electronic exchanges, 59 Declining marginal utility, 53n Default by Greece, 215, 235 Long-Term Capital Management, 231 by Russia, 151, 163, 179, 231 by Spain 1557–1696, 134 subprime mortgages, 165 Default-free bonds, risk in, 177 Default potential of banks, 361 Default risk, 81, 143, 152–154, 163, 165, 168, 179, 234 Default-risk premium, 154, 169 Defense Department, 88 Defined-benefit plans, 345 Defined-contribution plans, 345 Deflation, 281, 395, 402, 482, 637n, 664–667 Deflationary spiral, 666 De Gama, Vasco, 190 DeJesus-Rueff, Virginia, 319n Delivery date, 217, 219–220 Dell’ Ariccia, Giovanni, 664n Demand deposits, 299–300 Demand for money, 563–566, 571 Demand shocks, 619, 628 Department of Commerce, Bureau of Economic Analysis, 515 Department of Justice website, 10 Department of the Treasury; see United States Treasury Deposit accounts, 299–300 Deposit creation, 462–467 Deposit expansion, 467–468 Deposit expansion multiplier, 462, 464–467 Deposit Facility (ECB), 495–496 Deposit insurance, 300, 330, 365, 369, 373, 375, 443 Depository institutions, 295 assets in 2012, 340 community banks, 403 composition of portfolios, 299 credit unions, 403 in Dodd-Frank Act, 386 money center banks, 403 on-site examination, 380 regional banks, 403 savings and loan associations, 403 savings banks, 403 savings institutions, 403 summary on, 353 super-regional banks, 403 types of, 66 Deposit restrictions on interest rates, 333n Depreciation (currency), 242, 245, 255, 258, 536, 652 Derivative instruments, 215 and Barings Bank failure, 365n and collapse of Long-Term Capital Management, 214–215, 231 to conceal true nature of transactions, 216 in euro-area crisis, 215 in financial crisis of 2008, 214 forward contracts, 216 futures contracts, 54, 216–221 to hedge risk, 215 and interest-rate benchmarks, 337 interest-rate futures contract, 215 and London Interbank Offered Rate, 336 to manage credit risk, 312 to manage interest-rate risk, 315 and minimum capital requirements, 381 options, 54, 222–230 to profit from stock price decline, 215 proper use of, 315 purpose in managing risk, 215–216 risk-taking with, 65 for speculation, 215 swaps, 230–235 systemic vulnerabilities, 214 Derivatives markets, 58, 63–64 Desmirgüe-Kunt, A., 373 Deutsche Bank, 335 Deutsche Bundesbank, 409, 437n, 495, 564 Deutsche marks, 436 Deutsche Telekom, 253 Devaluation, 259 Dimon, James, 317 Direct finance, 45–46, 268 Dirty float, 259 Disclosure, 378–380, 455–456 Discount lending, 489–491 Discount loans, 453, 459–460 Discount rate, 88, 89, 425, 481, 485, 490–491, 514 Discretionary fiscal policy, 629–631 Disinflation, 637 Distributors of mortgage securitization, 285 Diversifiable risks, 189 Diversification, 120–124, 206, 114, 153, 181–182, 224, 248 Diversification of risk, 272, 276, 670 Dividend-discount model, 200, 202 Dividends, 48, 198–200 Division of Monetary Affairs (FOMC), 429–430 Dlaby, Les, 129n Dodd-Frank Reform Act of 2010, 4–5, 163, 307, 330–331, 350–351, 359, 368n, 372n, 408 additional vice chairman to Board of Governors, 426n changes in Federal Reserve Act, 422n closure of Office of Thrift Supervision, 374 curtailing emergency powers of Fed, 427 and Federal Reserve System Bank board, 424n goals and means, 386–387 and hedge funds, 375 number of new rules in, 386 purpose, 334 shortcomings, 387–388 systemically important financial institutions, 371 and too-big-to-fail problem, 382–383 uncertain impact on financial system, 670 Volcker rule, 387n Dokko, Jane, 662n Dollar(s), 23 to buy foreign assets, 255 demand for, 253–254 depreciation, 652 depreciation of euro against, 243 equilibrium market for, 254 exchange rates pegged to, 538 expected depreciation, 255 liquidity of market for, 245n most sought after currency, 39 reserve currency, 538 shifts in supply and demand for, 254–255 supply of, 253 Dollar-euro exchange rate, 243, 251 Dollar-euro market, 253 Dollarization, 527n, 540, 540–541, 543–545 Dollar-pound exchange rate, 241, 259 Don Quixote (Cervantes), 120 Douglas Amendment to McFadden Act, 332n Dow, Charles, 194 Dow Jones Industrial Average, 61, 190, 193, 194–196 Draghi, Mario, 437, 504–505 Drake, Francis, 190 Draper Fisher, 287 Dreyfus, 347 Dual banking system, 330 Dual mandate, of Federal Reserve System, 499 Dudley, William C., 431 Duke, Elizabeth A., 431 Dun & Bradstreet, 282 Dynamic aggregate demand curve, 585, 599 and causes of inflation, 608, 609 combined with short-run aggregate supply curve, 600 components of aggregate expenditures, 598–599 and consumer confidence, 598 deriving, 595–596 deriving aggregate demand curve, 590–595 downward-sloping, 595, 596–597 effect of interest rate change, 606 effect of monetary policy during crisis, 660 effect of shocks, 619 effect of stabilization policy, 628 and fiscal policy, 629–630 and inflation, 596–597, 617 and monetary policy, 584–585, 590–595 in real-business-cycle theory, 637 and recessions of 1970s, 639 redistribution effect, 596 shifts in, 597–599, 619–624 and shifts in monetary reaction curve, 598, 599 and short-run equilibrium, 605 with supply shocks, 642–643 Dynan, Karen E., 634n E East Asia, financial crisis of 1997–98, 269, 361, 526 Easy money policy, 574–575 eBay, 271–272, 277–278 ECB; see European Central Bank Economic conditions, 177–184, 405, 502–506, 508–509, 581 Economic data, 581, 630 Economic development, 269, 295–296 Economic fluctuations, 608; see also Business cycles; Recessions Economic growth, 47, 269–270, 289, 402–403, 411, 435, 499, 561, 605, 666 Economic predictions, 570 Economies of scale, 275, 338 Economies of scope, 338 Economist, 12, 252, 542, 644 Index l I-5 Economy, 402–403, 607, 611, 617 Ecuador, 543–545 Edge Act corporation, 335 Electronic communication networks, 56, 59–60, 63n Electronic funds transfer, 31–35 Electronic networks, Electronic payments, 23 Electronic processing of checks, 30 Elmendorf, Douglas W., 634n Emerging market countries, 151, 270–271, 526, 528, 542 E-money, 32–33 Enron Corporation, 214, 281 Equation of exchange, 558–559, 569 Equilibrium, 144, 559, 605–610, 619, 637 Equilibrium bond price, 149–150 Equilibrium exchange rate, 254 Equity bubbles, 662 Equity financing, 190, 200, 283, 284 Equity funds, 156 Equity markets, 58, 63–64 Equity prices, 656, 661–664 Equity risk premium, 202–203 Estrella, Arturo, 181n E*Trade, 338 EURIBOR, 337 Euro, 242, 242–243, 422, 428, 522–523, 529, 532 Euro-area, 438 changes needed for survival, 442–443 country rankings, 445 criteria for entering, 412–413 ECB interventions in 2012, 649 membership, 394 monetary policy during crisis of 2007–2009, 661 Stability and Growth Pact of 1998, 413n unsolved fundamental problems, 505 velocity of M3 1995–2013, 573 yield spreads on bonds 1990–2013, 443 Euro-area crisis, 166, 317, 359, 415–416 bank runs, 442 credit-default swaps in, 235 debt crisis, 8, 81 derivatives role in, 215 and ECB, 394–395, 442–443 fragility of banks, 62 inflation rate 2013, 95 nominal interest rate 2013, 95 Eurodollar market, 335–336 European Central Bank, 5, 8, 62, 233, 405, 422, 436–445, 542 acceptance of Greek sovereign debt as collateral, 544n accountability, 441–444 attention to monetary aggregates, 555–557 balance sheet adjustments, 529 collateralized lending, 459n conventional policy tools, 495–497 in crisis of 2007–2009, 483 in euro-area crisis, 394–395, 442–443 European Systemic Risk Board, 370 foreign exchange intervention, 532 functions, 437 Governing Council, 408 interest rate policy, 500–501 lack of control over exchange rates, 529 lender of last resort to debt-stricken governments, 661 and low inflation, 409 low target interest rate in 2013, 591–592 minimum bid rate, 493 monetary policy implementation, 438–440 monetary policy objective, 444–445 organizational structure, 437–441 potential policy shortcomings, 445 on preservation of euro, 504–505 price stability objective, 444–445, 553 primary assets, 453 publication of balance sheet, 452 purchase of euros in 2000, 522 quantitative easing, 511 reference value for money growth, 564, 574 refinancing operations, 493–494 safeguards for independence, 438–440 targeting money growth, 571–575 target refinancing rate, 493–494 transparency, 441–444 and Treaty of Maastricht, 437 two-pillar strategy, 444n European Exchange Rate Mechanism, 536n European monetary union, 242, 422, 437 European options, 223, 226 European Systemic Risk Board, 370 European System of Central Banks, 437, 438, 444 European Union, 370, 377, 394, 422, 436 Eurosystem, 437, 438, 494 Examination, 372, 380 Ex ante real interest rate, 96 Excess reserves, 309, 455, 467–469, 470, 493 Excess reserve-to-deposit ratio, 469–472 Exchange-rate channel, 651–652 Exchange rate management, 337 capital controls and policy options, 527–529 and central bank’s balance sheet, 529–531 China, 540–541 currency boards, 539–543 fixed exchange rates, 524 gold standard, 537 hard pegs, 539–545 and interest rate policy, 523 interest rates and implications of arbitrage, 525–527 and purchasing power parity, 534–525 sterilized intervention, 532–533 unsterilized intervention, 532 Exchange-rate pegs, 538 Exchange-rate risk, 151n Exchange rates and currency risk, 257 determined by inflation differentials, 534 determined by supply and demand, 525 dirty float, 259 dollar-euro, 243, 251 dollar-foreign rates Nov 12, 2012, 247 dollar-pound, 241, 251 effect of changes on trade, 523 effect of foreign exchange intervention, 530–531 effect of quantitative easing, 542 explaining movements of, 256–257 in financial crisis of 1997–98, 528 fixed, 258 floating, 535 forecasting, 254 implications for countries and individuals, 240–241 importance for international trade, 256 inflation differentials 1980–2010, 251 interest-rate parity, 265–266 in international trade, 240 in long run, 246–252 loss of control by Fed and ECB, 529 nominal, 242–243 overvalued in Argentina, 543 real, 243–245 and rollover risk, 257 in short run, 253–257 swings in, 241 in Thailand’s crisis of 1997, 451 unpredictable in short run, 254 won-dollar, 241, 251 Exchange-rate stability, 404–405 Executive Board of the ECB, 437, 438 Exercise price, 222 Expansionary fiscal policy, 621 Expansionary monetary policy, 59 Expansionary output gap, 583, 601, 603, 621, 639 Expectations hypothesis of term structure, 172–177 Expected inflation, 93, 94, 106, 109, 145–146, 148–150, 178, 412 Expected interest rates, 148–149 Expected payoff, 132 Expected return, 106, 109, 114–115, 118, 148–149 Expected value, 106, 107–109, 112, 113, 114 Ex post real interest rate, 96 Externalities, 383–384, 399 ExxonMobil, 58, 119, 163, 164 ezetop, 35 F Facebook initial public offering, 58 Fads, 207 Fallen angels, 166 Fannie Mae, 250–252, 362, 387 Farmland bubble, 207 Farrell, Diana, 306 Federal Deposit Insurance Corporation (FDIC), 300, 369 bank closures in 2009, 371 creation of, 330 and Dodd-Frank Act, 387 on higher capital requirements, 385 institutions not covered by, 369 insurance of retirement savings, 375 orderly liquidation authority, 387, 670 payoff method, 369 purchase and assumption method, 369 regulatory role, 374 Federal funds, 486 Federal funds rate, 62, 428, 481 bank lending rate, 486 1975 to 2013, 576 in overnight cash rate of ECB, 497 projections, 433 real and nominal 1983–2013, 586 versus targeting reserves, 498 in Taylor rule, 501 zero bound, 428n, 482 I-6 l Index Federal Home Loan Mortgage Corporation, 349; see also Freddie Mac Federal Housing Authority, 352 Federal National Mortgage Association, 349; see also Fannie Mae Federal Open Market Committee; see Federal Reserve System Federal Reserve Act of 1913, 422 Federal Reserve Bank of New York, 162, 231, 362, 406, 457, 458 in crisis of 2007–2009, 425 daily open market operations, 463 description, 423 foreign exchange intervention, 532 gold vault, 274, 423 open market operations, 494 president of, 430 purchase of euros, 522–523 service area, 423–424 Federal Reserve Bank of Philadelphia, 96 Federal Reserve Bank of St Louis, 12, 569, 632 Federal Reserve Banks check clearing, 30 discount lending, 488–491 functions, 425 map of, 424 membership, 424–425 number of, 422 number of employees in 2013, 423 organization and operation of, 424 reason for locations, 423–424 regulation by Board of Governors, 427 role in monetary policy, 425 Federal Reserve Economic Data, 12, 21–22; see also FRED Federal Reserve Economic Database, 428 Federal Reserve System, 3, 8, 12, 23 actions in crisis of 2007–2009, 482–484 anti-inflation credibility, 406 assessment of structure, 423–424, 432–433, 435 assets, 453, 383 attacks on, after 2009, 400, 408, 432–433 balance sheet, 360–362, 454, 460–462, 473, 482–483, 529 bank borrowing from, 301 bank deposits with, 297 on bank exposure, 376 blame for recessions, 610 compared to ECB, 437–441 conventional policy tools, 481, 484, 486–488, 495, 490–493 creation and destruction of monetary base, 464 creation of, 422 crisis and postcrisis asset purchases, 431n in crisis of 2007–2009, 370, 394 dual mandate, 499 easy money policy and prices, 574–575 emergency powers curtailed by DoddFrank, 433 errors on reserve requirements in 1930s, 493 evolution of independence, 433 failures in Great Depression, 366–367, 399–400, 451, 644 federal funds rate vs daily market rate 1992–2013, 488, 489 foreign exchange intervention, 532 founded to end financial crises, 403 income of, 432 inflation rate goal, 406 interest rate targeting 1979–82, 498 intermediary of last resort, 451 key players, 430 lack of control over exchange rates, 529 legal organization of, 399n lending to commercial banks 1914–1940, 367 lending to nonbanks 2007–2009, 368 Monetary Report to Congress, 434, 571 money creation, 396 nominal GDP targeting, 441–444 policy for credit bubbles, 668 Primary Dealer Credit Facility, 368 publication of balance sheet, 452 quantitative easing, 511, 542 reaction to terrorist attack, 450 reduction of federal funds rate 2007–2008, 428n regulation of finance companies, 366n regulatory role, 374 response on Sept 11, 2001, 463 response to crisis of 2007–2009, 451 and stock market crashes, 434 structure, 422–428 support for bond market, 156 targeting money growth, 571–575 threats to independence, 406 transparency and accountability, 405–406 and Treasury banking needs, 427 unprecedented actions in crisis of 2007–2009, 507 as U.S central bank, 394 use of forward guidance, 509 Fedwire, 31 Feinman, Joshua N., 492n Fiat money, 28 Finance, 45–46 Finance companies, 68, 340, 347–349, 353, 366n Financial Action Task Force, 35 Financial arbitrage, 246 Financial assets, 36, 81 Financial Conduct Authority, United Kingdom, 370 Financial crises, outside U.S during 1990s, 633 Financial crisis of 1929–33, Financial crisis of 1997–98, 148, 240–241, 269, 451, 526, 528, 535–536 Financial crisis of 1999 in Ecuador, 544 Financial crisis of 2002, Latin America, 526 Financial crisis of 2007–2009, 2–3 attacks on Fed after, 432–433 and bank credit risk, 312 bank crises, 295, 296, 308, 359–361 and bank trading risk, 317 and Basel Accords, 379 bond debt outstanding after, 133 and central counterparties, 220 contagion in, 363 costs of bank deregulation, 334 credit rating failures, 224 currency risk, 257 damage to euro-area banks, 442 discretionary fiscal stimulus, 631 and Dodd-Frank Act of 2010, 330–331 economic impact, 359 effect of regulatory bodies, 370 end of, or interruption in Great Moderation, 634 Federal Reserve Bank of New York in, 425 Fed responsibility in, 400 Fed’s balance sheet, 454 Fed’s response, 451 financial reforms following, 359 and financing by government agencies, 669–670 as game changer for monetary policy, 661 and high-frequency trading, 61 impact on asset-backed commercial paper, 171 impact on auto industry, 162–163 impact on financial system, 268–270, 328 impact on non-U.S banks, 257 impact on rating agencies, 166 impact on riskier securities, 81 increased use of debit cards, 25 information asymmetry and mortgage securitization, 285 insufficient bank capital, 314 interbank lending, 62 lessons from, 10–11 and London Interbank Offered Rate, 336 monetary policy transmission obstruction, 660–661 near collapse of financial system, 8–9 problem of mortgage-backed securities, 53–54 rate of credit-default swaps, 234–235 rate of leverage in, 50 and regulator shopping, 374 role of central banks in, 384 role of derivatives in, 214 role of disclosures in, 380 role of Fannie Mae and Freddie Mac, 350–352 rollover risk, 257 shadow banks, 65 stock market plunge, 190 subprime mortgages, 165 sudden loss of liquidity, 32 Swiss National Bank actions, 539 systemic risk, 116 targeting errors from, 488 weak recovery from, 591, 650–651 worldwide effects, 359, 649 and zero federal funds rate, 482 Financial holding companies, 336–338 Financial Industry Regulatory Authority, 366n, 367 Financial industry structure, 327–353 Financial innovation, 153, 381, 565–566, 571, 574, 634 Financial instability, speculative attacks from, 536 Financial institutions, 46, 47 as cells of financial system, 116 changes over time, depository institutions, 66 diagram, 67 finance companies, 68 functions, funding liquidity, 26 government-sponsored enterprises, 68 highly leveraged, 50 importance for economy, 64–66 insurance companies, 66 Index l I-7 as intermediaries, 268 liquidity shock in financial crisis, 32 market liquidity, 26 market makers, 32 nondepository institutions, 66 no reporting on credit-default swap, 235 pawnshops, 333 pension funds, 66 regulation of, 4–5 restricted to investment grade bonds, 164–165 restrictions on competition, 375–376 role of, 66 securities firms, 67–68 shadow banks, 65 specialization by, 153 systemically important, 330–331, 371 too big to resolve, 371 types of, types of depository institutions, 403 Financial instruments, 4, 47–54, 64–65, 80–92 Financial intermediaries banks as critical providers of financing, 271 banks as most visible, 295 direct finance, 268 disclosure requirements, 378–380 economies of scale in, 275 effect of technology, 338 evasion of regulations, 664 to finance growth and investment, 289 indirect finance, 268 information costs, 286–287 international banks, 272 private equity firms, 287 reasons for importance, 271–272 recapitalized, 371 regulation of, 374 relative importance of financing channels, 270–271 relative size in U.S 1970–2012, 340 roles of, 272–277 shares in individual firms, 287 short-term funding, 361n too-big-to-fail problem, 370–371 too interconnected to fail, 370–371 venture capital firms, 287 Financial intermediation, 64, 268 Financial markets, 47, 54 accelerated structural change, 59 adverse selection in, 279–280 brokers, 55 capital allocation by, 7–8 changes over time, contact with Federal Reserve Banks, 425 dealers, 55 debt market, 63 economic function, 54–55 electronic networks, equity market, 63 essential to economy, 7–8 eurodollar market, 336 functions, funding liquidity, 32 high trading volume, 55 importance of probability theory, 105 information gathered by, 7, 64 interbank lending, 62 investor protection, 64 low transaction costs, 64 market liquidity, 32 pricing and allocation of resources by, 270 roles of, 55–56 rules and authority in, 8–9 secondary, 59, 69 structure, 58–64 trading in, 56 transmission of disturbances in, 528 ways of categorizing, 57–58 Financial market utilities, 427 Financial panics, 421–422 Financial regulation, 654–655, 659 Financial statements, 224, 281 Financial system, 268 changes over time, damage from crisis of 2007–2009, 8, 268–270, 649–650, 662 deposit insurance, 369 in East Asia crisis of 1997–98, 269 effects of Dodd-Frank Act, 386–388 evolving challenges for regulators, 381 evolving structure of, 669–670 financial innovations, 381 flow of funds through, 46 globalization of, 381 government as lender of last resort, 366–368 in Great Depression, 269 impact of terrorist attack, 450 interaction with central banks, 451–452 international regulatory spectrum, 370 lender of last resort and evolution of, 368 near-collapse in crisis of 2007–2009, 660 ongoing concentration, 376 pan-European, 443 problems created by safety net, 369–372 reasons for government intervention, 364–365 regulation of, 376–380 role on economic growth, 47 six parts of, 3–4, 44 stability, 403–404 stability from discount lending, 489–490 stability in, 8–9 supervision and examination, 380–381 systemic risks, 116 unique role of banks and shadow banks, 365–366 Financial System Oversight Council, 386, 670 Financial tail risks, 117 Financial Times, 11, 12, 233 Financial transactions, 5–6 Financial world, 9–12, 108–109 Financing channels, 270–271 Fink, Laurence D., 156 Fire sale of assets, 384 First Bank of the United States, 396n Fiscal free-rider, 443 Fiscal policy, 412–413, 414–416, 442, 523, 524, 536, 628, 629–631 Fiscal stimulus of 2001, 524 Fischer, Stanley, 540n, 653 Fisher, Irving, 94, 559, 560, 563 Fisher, Robert W., 382 Fisher equation, 94–95 Fitch, 163n Fixed exchange rate regime, 258, 524, 535–536, 538–539, 540–451 Fixed-payment loans, 86, 134, 135, 136 Fixed-rate mortgages, 165 Fixed-rate payer, 232 Flash crash of May 2010, 60, 61 Fleming, Michael J., 319n Floating exchange rates, 535 Floating-rate payer, 232 Ford, Henry, 191 Ford Focus, 253 Ford Motor Company, 118–119, 162–163, 191, 335–336 Foreign branch banks, 335 Foreign exchange intervention, 258 to bolster euro, 522–523, 530 in Brazil, 259 buying or selling currency, 258 in Colombia, 259 depreciation, 258 effect on interest rates, 531 and exchange rate change, 530–531 by Fed, 457, 458–459 Federal Reserve Bank of New York, 532 fixed rates, 258 impact on reserves, 530 by non-U.S central banks, 462 in Peru, 259 sterilized, 532–533 unsterilized, 532 Foreign exchange market, 245–247, 254, 451, 562 Foreign exchange reserves, 453, 540, 541, 551 Foreign exchange risk of banks, 317–318 Foreign goods and services, supply of dollars to purchase, 255 Foreign investment, Brazilian taxes on, 259 Formal insurance arrangement, 45 Forward contracts, 216–217 Forward guidance, 431, 506–508 to deal with deflationary spiral, 667 disturbing side-effects, 509 exiting from, 513 in FOMC in 2012, 591 Fed’s use of, 509 inflation and economy, 508 on unemployment and inflation, 611 Forward rate, 246, 254 Fountnouville, Patrick de, 319n 401 (k) plans, 345 Francs, 436 Fraud, in early U.S banking, 329 FRED, 21–22, 232, 665 Freddie Mac, 350–352, 362, 387 Free checking accounts, 566 Free flow of capital, 524, 527 Free rider, 282 Friedman, Milton, 367, 473, 553, 559, 560–561, 573 Friedman’s k-percent rule, 561n Fukao, Mitsuhiro, 659 Full Employment and Balanced Growth Act of 1978, 571 Fundamentals, 198, 202–203, 207 Fund Democracy, 156 Funding liquidity, 26, 32, 660 Future interest rates, 172 Future payoff, 105 Futures contracts, 48–49, 215, 217, 218–222 Future value, 76–82 I-8 l Index G Gambacorta, Leonardo, 653n Gap analysis, 313–314 Garbade, Kenneth D., 319n GDP; see Gross domestic product Genberg, Hans, 663n General Electric, 56, 120–124, 131–132, 164, 194 General Mills, 164 General Motors, 162–163, 164 Georgia, inflation in 1994, 556 Germany, 142, 270–271, 289 Gertler, Mark, 653n, 663n Ginnie Mae, 349 Glass, Carter, 423 Glass-Steagall Act of 1933, 385–386 Global Crossing, 281 Global financing, 378 Global fund managers, 348 Global government bonds, 142–143 Goal independence, 410 Gold as commodity money, 26–27 Goldman Sachs, 167, 286, 347 Goldsmiths, 273 Gold standard, 28, 37, 537 Goodyear Tire Company, 164, 165 Google Inc., 194 Gordon, Robert J., 561 Gorton, Gary B., 364n Governing Council, see European Central Government account, central bank liability, 454–455 Government Accountability Office, 383 Government bailouts and Dodd-Frank Act, 424n of failed banks, 371 moral hazard from, 371–372, 387 not dealt with in Dodd-Frank Act, 388 popular revulsion for, 408 Government bonds, 142–143 Government borrowing, 133 crowding out effect, 590n effect of changes on bond supply curve, 145 and interest-rate swaps, 230, 231, 234 by provincial governments of Argentina, 543 versus taxation, 413 Government National Mortgage Corporation, 349; see also Ginnie Mae Government purchases, 587, 598, 621–624 Government regulation, 372; see also Federal Deposit Insurance Corporation; Federal Reserve System; Securities and Exchange Commission approval of mergers, 375 arbitrary and complex structure, 374–375 asset-holding restrictions, 376–378 on banks, 374 disclosure requirements, 378–380 and externalities, 399 goals vs implementation, 373–374 minimum capital requirements, 376–378 National Best Bid and Offer mechanism, 62 and public goods, 399 and regulator shopping, 374 regulatory competition, 374 restrictions on competition, 375–376 shadow banks, 375–376 Government regulators, evolving challenges for, 381 Governments, debt outstanding inn 2012, 133 Government safety net, 365, 364–365, 366–368, 371–372 Government-sponsored enterprises, 68 assets in 2012, 340 in conservatorship, 328 financial characteristics, 350 in financial crisis of 2007–2009, 350–352 Freddie Mac, 349 post-crisis source of financing, 669–670 proposed reduced role, 352–353 purpose, 349 Gramm-Leach-Bliley Financial Services Modernization Act of 1999, 330, 334, 336–337 Great Depression, 4, 189, 359, 650 bank failures, 330, 364, 366–367 collapse of trade, 527n deflation during, 281 end of gold standard, 28, 537 failures of Fed during, 399–400, 451, 644 financial system in, 269 monetary policy in, 473 reserve requirements, 493 Great Inflation, macroeconomic policy failures, 644 Great Moderation, 618, 632–634 Greece, 62, 164, 166, 215, 233, 235 Greenbook, 429 Gross domestic product, 18 of Botswana, 149 consumption percent of, 586 decline in early 1970s, 638 defense spending percent in 1960s, 623–624 in definition of recession, 626 government purchases percent of, 587 growth and term spread 1970–2010, 181–184 and inflation rate, 19–20 investment percent of, 586 Japan, 149 measurement problems, 641 net exports percent of, 587 private sector credit as percent of, 269 ratio of investments to, 1960–2012, 592 real vs nominal, 19–20 related to productivity, 637 revisions to third-quarter growth, 515 and size of monetary aggregates, 37 term spread and growth of 1970–2010, 181 U.S exports and imports as percent of, 523 in U.S 1993–2012, 641 of world vs volume of foreign exchange transactions, 245 worldwide decline after 2007, 649 Gyntelberg, Jacob, 220 H Hahn, Thomas K., 167n, 168 Hale, Galina, 638n Hamilton, Alexander, 134 Hanke, Steve, 401n Hanson, Samuel, 385n Hard pegs, 539–545 Harmonization index of consumer prices, 444 Hedge funds, 65n, 67–68, 231, 348, 361n, 375 Hedgers, 219 Hedging, 120, 348 with futures contracts, 219 mathematics of risk, 131–132 with options, 223 to reduce idiosyncratic risk, 120–121 Hertz, 164, 165 HFT; see High-frequency trading Hierarchical mandate, 499 High-frequency trading, 60–61 High-inflation environment, 567–568 High-powered money, 456 High-tech sector, 633–634 High-yield bonds, 166 Hitler, Adolf, 397 Hobijn, Bart, 638n Hogan, Hulk, 191 Holding period returns, 139–141 Hollanders, Marc, 220 The Home Depot, 194 Honda Accord, 279 Honda Motors, 253, 528 Hong Kong Monetary Authority, 540–541 Hördahl, Peter, 319 Hot money, 259 Household net worth, 655–656 Housing bubble 2002–2008, 165, 207, 209 Housing market, 55 Housing prices, 192, 661–662 Housing services, 192 Hudson, Henry, 190 Hughes, John P., 305n Hughes, Robert J., 129n Hungary, hyperinflation in, 557 Hunter, William C., 663n Hyperinflation, 35, 401–402, 555n, 557 Hyundai, 240 I IBM, 56, 222, 228–230, 550 Identity theft, 10 Idiosyncratic risk, 118–121, 276 Ihrig, Jane E., 514n Illiquid assets, 365 Immediate annuities, 352 Income tax, 171, 597 Independence, 406–408 Index funds, 206 Index of central bank independence, 409 India, 95, 270–271 306 Indirect finance, 45–46, 268 IndyMac, 374 Inflation, 35–36 in Argentina, 523 and business cycles in U.S 1955–2013, 617–618 common uses of term, 583 and Consumer Price Index, 38, 560–561 costs of, 401 created by expected inflation, 412 and debt repayment, 656 decline in 1990s, 633 Index l I-9 and economic fluctuations, 608 economists’ use of term, 583 and end of Bretton Woods system, 538–539 exceeding money growth, 565 from failed policies, 523 from Fed’s easy money policy, 574–575 and forward guidance, 508–509 impact on dynamic aggregate demand curve, 596–597, 617 impossible without monetary accommodation, 555 increase in 1970s, 639 kept low by central banks, 400–402 and lack of confidence in government, 39 long-run, 583–584 long-run implications of purchasing power parity, 524–525 low and stable worldwide, 405 lowered by globalization, 638 lower with central bank independence, 409 M1 money supply for understanding, 37–39 M2 money supply for understanding, 39–41 and monetary base, 475 as monetary phenomenon, 553, 559 and monetary policy reaction curve, 590–595 permanent increase in, 624 and purchasing power, 557 and purchasing power parity, 249–251 in real-business-cycle theory, 637 during recessions 1957–2009, 608–609 risk for bonds, 154–155 stabilized with output, 640–643 and Taylor rule, 501–502 temptation for policymakers, 413 in United States in 2012, 590–591 in U.S in 1970s, 597 volatility of high, 401 Inflation-adjusted cost of borrowing, 93 Inflation-adjusted interest rate, 92 Inflation-adjusted return, 92 Inflation and output, 600–608, 619–624 Inflation and output gaps, 601 Inflation expectations, 93, 94, 96, 106, 109, 407–408, 412, 585, 600–601, 603; see also Expected inflation Inflation gap, 501, 502 Inflation-indexed bonds, 96, 154 Inflation rate, 35–36 asset price bubbles and changes in, 664 calculating, 38 cross-country analysis, 39–40 decline in U.S., 405 in ECB policy, 444 and GDP, 19–20 and money growth, 554–557 from money growth, 396 national comparisons, 95 need to know, 665 output gap and changes in, 1988–2013, 603 unpredictable, 401 in U.S 1979–2012, 94 Inflation risk, 150, 177–178, 206 Inflation target(ing), 410, 435 common policy framework, 500 driven by government purchases, 622 forward guidance, 508–509 as hierarchical mandate, 499 lowered by central banks, 619–621 moving away from, 441–444 new, for positive supply shocks, 631–632 operation of, 499 response to potential output changes, 636–637 Informal insurance arrangements, 45 Information; see also Asymmetric information; Information asymmetry basis of decisions, collecting and processing, 272, 276–277 communicated and pooled by financial markets, 55–56 communicated by financial instruments, 49–51 disclosure for adverse selection problem, 280–282 effect of deflation, 281 gathered by financial markets, from investment banking, 347 obstacles to flow of, 116 private, 281–282 provided by stock prices, 189 reducing cost of, 66 required for loans, in risk structure of interest rates, 179–180 role of stock exchanges, in term structure of interest rates, 180–184 information asymmetry, 264–265, 276–285 Information costs, 272, 277–285 Information technology, 61, 633 Ingo, Walter, 387n Initial margin, 218 Initial public offerings, 58, 209 Input price changes, 601 Instrument independence, 410 Insurance, 124, 215, 283, 344 Insurance companies, 66, 340–344, 353 Insurance contracts, for transfer of risk, 54 Intel Corporation, 194 Interbank lending/loans, 62, 63, 302n, 366, 549, 650, 660 Interest, 75, 77–80, 376n, 494 Interest payments, Interest-rate benchmarks EURIBOR, 337 LIBOR, 337 TIBOR, 337 Interest-rate changes, 574 Interest-rate channel, 651–652 Interest-rate expectations, 567 Interest-rate futures contract, 215 Interest-rate indexes, 136 Interest-rate indicator, 336 Interest-rate parity condition, 265–266 Interest-rate risk, 150–151, 178, 206, 312–315, 320 Interest rates; see also Nominal interest rate; Real interest rate; Risk structure of interest rates; Term structure of interest rates on adjustable-rate mortgages, 136 annual, 84 for arbitrageurs, 221n basis points, 79 bond market and determination of, 141–144, 145–149 bond sensitivity to changes in, 81 bond value inversely related to, 92 in Brazil, 259 and business cycles 1954–2010, 609 and causes of recessions, 653 on consols, 137 credit cards, 25, 93, 274 destabilized by targeting money growth, 575 determinant of present value of future payment, 83–84 determination of, 412 of different maturities, 175 economic role, 481–82 effect of changes on bond demand curve, 148–149 effect of changes on borrowing costs, 162 effect of changes on holding period returns, 141 effect of decline on investment, 652 effect of foreign exchange intervention, 531 effect of inflation, 154–155 effect on mutual funds, 156 and equilibrium bond price, 149–150 ECB policy, 500–501 expressed in decimal terms, 76–77 federal funds rate, 481 FOMC policy, 500–501 future, on long-term bonds, 172 future value and compound interest, 76–80 importance in economy, 76 information content, 179–184 and internal rate of return, 85–88 and London Interbank Offered Rate, 336, 337 long- vs short-term, 177 near-zero, 597, 610 net worth improved by drop in, 656 on new car purchase, 85 in pawnshops, 333 of payday loans, 307 present value decline with rise in, 81 primary discount rate, 490–491 and real estate market, 656 reduced in Japan, 658–659 relation to stock prices, 656 restrictions on banks, 333n rule of 72, 79 short- and long-term 1971–2013, 170 short-run implications of arbitrage, 525–527 and Taylor rule, 500–506 teaser rates, 165 term structure of, 142 and transactions demand for money, 564–565 as yield, 76 zero target, 415 Interest-rate sensitive, 313, 314n Interest-rate spread, 162, 305 Interest-rate stability, 404 Interest-rate swaps, 315, 231–233 Interest-rate targeting, 498–499 Interest-rate volatility, 404 Intermediary, 46; see also Financial intermediaries I-10 l Index Intermediary of last resort, 451 Intermediate targets, 499, 500, 568–569 Intermediation, 64 Internalizing costs of behavior, 385 Internal rate of return, 85–88 International airtime transfer, 35 International balance of payments, 551 International banking facility, 335 International capital flows, 527 International financial system, 45 International Monetary Fund, 250, 400, 423, 526, 528, 538, 542 International Swap and Derivatives Association, 233 International trade, 240, 245, 254, 256, 335, 523, 527n, 533–534, 542, 550–551, 638 Internet bubble, 190, 209 In-the-money options, 222–223, 230 Intrinsic value, 225–228 Inventory loans, 349 Inverted yield curve, 180–184 Investment(s), 587 average payoff, 108 bonds vs alternatives, 149 and business cycle, 592 causes of supply, 255 compared to home ownership, 192 compared to life insurance, 342 expected return, 109 financed by businesses, 652 financing of, 289 with four possible payoffs, 111–113 future payoff, 105 future value, 76–80 general formula for time to double, 77 interest-rate sensitivity, 587 internal rate of return, 86–88 international diversification, 248 leveraged, 114 mathematics of diversification, 131–132 meaning of term, 587n opportunity cost of, 86 and optimism about future, 598 paying for, 85–88 percentage return, 109 ratio to GDP 1960–2012, 592 and risk, 105 and risk aversion, 117–118 risk-free, 106, 110 risk of stocks in short run, 206 risk premium, 118 risk reduction through diversification, 120–124 in stock for the long run, 205–208 strategies from expectations hypothesis, 174 and supply of dollars, 253 time horizon, 105 Tobin’s q-theory, 658n variance of, 110–111 Investment banks, 58, 67, 347, 353, 381 Investment grade bonds, 164–165 Investment horizon, 141 Investor protection, 64 Investor psychology, 208 Investors behavioralists, 198 chartists, 198 Chinese, 203 default risk, 163 flight to quality, 179 government protection of, 364 hedging risk, 120–121 in joint stock companies, 190 portfolios, 56 reliance on rating agencies, 166 risk averse, 117–118 role in exchange rates, 525–527 short selling, 215n spreading risk, 121–124 trust in financial statements, 224 underestimating risk, 81 in wholesale money market, 301 Irwin, Neil, 668 Israel, 164, 619 Issing, Otmar, 437n Issuer pays model of rating agencies, 166 Italy, 164, 270–271 J Japan, 650 attack on yen, 542 currency depreciation failure, 258 earthquake and tsunami 2011, 117 economic decline in 1990s, 658–659 GDP, 149 inflation rate, 95 interest rates, 95 nonperforming loans, 659 number of banks, 327 poor bank performance, 296 relative importance of financing channels, 270–271 sources of business finance, 289 stagnant economy, 258 stock market, 123, 376n, 648–649 Jawboning, 504–505 Jayaranthe, J., 334n Jenkinson, Tim, 289 Jobless recovery, 644 Jobst, Andreas, 54n John Hancock Mutual Life, 341 Johnson & Johnson, 118 Joint stock companies, 190 Jones, A W., 348 Jordan, John, 319n JPMorgan, 122 JPMorgan Chase, 164, 286, 287, 316, 319, 331, 335, 336, 347, 362, 376, 381, 403 Junk bonds, 6, 166 Just-in-time inventory systems, 633 K Kahn, George A., 501n Kane, E., 373 Kaplan, Ethan, 528 Kapoor, Jack, 129n Kashyup, Anil K., 385n, 659 Kasriel, Paul, 183 Kaufman, George G., 663n Kenya airtime minutes as currency, 35 M-Pesa, 33, 34, 338 Keynes, John Maynard, 563n Kimball, Miles, 428n King, Michael, 319 Klee, Elizabeth C., 514n Kleiner Perkins, 287 Knight Capital, 61 Koenig, Evan F., 501n Kohlberg Kravis Roberts, 287 Korean War, 433 Koszner, R., 332n K-percent rule, 561n Krueger, Alan B., 88 Kruse, Nicholas, 401n L Lacker, Jeffrey M., 431 Laeven, L., 359n, 360, 373 Lagged recognition assumption, 635n Lagged-reserve accounting, 492 Latvia, inflation rate 1991–94, 556 Law of one price, 246–249, 524 Leaning against bubbles, 663 Leeson, Robert, 501n Legal contracts, 275, 284–285 Lehman Brothers, 316, 370, 384, 62, 65, 112, 220, 363, 371, 380, 387, 394, 451, 454, 474, 482, 489, 497, 511, 541 Lender of last resort, 365 contagion not eliminated by, 366 discount lending, 489–490 distinguishing insolvency from illiquidity, 367 eliminated by dollarization, 544 and evolution of financial system, 368 Fed failure in 1930s, 366–367 moral hazard problem, 367, 368 National Central Banks (EU), 437 national comparison of roles, 370 and nonbank intermediaries, 368 as regulator and supervisor, 370 role of central banks, 398 Lenders, 46 collateral and net worth, 282 credit score use, 169 private mortgage insurance, 280 vilification of, 75 zero return, 92 Lending; see also Loans by Fed to commercial banks 1914–1940, 367 opportunity cost of, 75–76 peer-to-peer, 288 LendingClub.com, 288 Letters of credit, 306–307 Leverage, 200 in buying futures, 219 effect on price changes, 114 in financial crisis of 2008, 50 impact on risk, 114–115 impact on value at risk, 115 measure for banks, 305 in options, 224 reduced by banks, 303 restrictions in Basel Accord III, 379 and risk, 314 Leverage ratio, 115 Liabilities, 46, 192 of banks, 299–302 on central bank balance sheet, 453–455 of Fed in crisis of 2007–2009, 454 interest-rate sensitive, 313 of money-market mutual funds guaranteed, 328 Index l total for U.S commercial banks 1979–2012, 301 weighted-average duration, 314n Liability insurance, 111 Life insurance, 66, 342, 345 Limited liability, 192, 340 Limit order, 56 Line of credit, 275–276, 306 Liquidity, 26, 275; see also Funding liquidity; Market liquidity added by government in financial crisis, 62 and bank fragility, 362 banks as providers of, 365 of bonds vs alternatives, 148 criterion for choosing mutual fund, 206 of financial instruments, 33–34 inadequate supply, 116 lack of, 220 loans varying in, 299 loss in financial crisis, 32 of market for dollars, 245n offered by financial markets, 55 and portfolio demand for money, 567 provided by financial intermediaries, 272, 275–276 reducing transactions demand for money, 565–566 from securitization, 153 shortage in Great Depression, 451 short-term, 349 and solvency, 363 Liquidity and credit facilities, 425 Liquidity crisis, 337 and discount loans, 453 in European banks, 62 of 2007–2009, 488 Liquidity preference theory, 563n Liquidity premium of the term structure, 177–178 Liquidity requirements in Basel Accord III, 379 Liquidity risk, 151n, 308–311, 319, 320, 364–365 Liquidity shock, 32 Liquidity spectrum, 36 Liquidity trap, 506, 510 Lloyd, Edward, 340 Lloyd’s of London, 340, 341 Loan commitment, 306 Loan loss reserves, 303 Loans, 66, 134 from business finance companies, 349 categories of, 299 central bank assets, 453 collateral, 53, 282 from consumer finance companies, 348–349 and credit score, 286 discount loans, 453, 459–460 fixed-payment, 86, 135–136 indirect finance, 46 inflation-adjusted return, 92 information required for, interbank, 302n and London Interbank Offered Rate, 336 low-interest, 656 margin, 114 maturity, 64 nonperforming in Japan, 659 past-due, 380 by pawnshops, 333 payday loans, 307 to pay for investment, 86–88 primary asset of commercial banks, 299 reduced supply of, 32 refusal to renew, 310–311 repurchase agreements, 302 restrictive covenants, 284–285 from sales finance companies, 349 subprime, 165 unsecured, 282, 486 written off, 303 Loan-to-value ratio, 165 Lockhart, Dennis P., 431 London, Simon, 573n London Interbank Offered Rate, 232, 336, 337 London stock exchange, 59 London Whale, 316 Longer-term financing operation, 443 Long position, 217, 222 Long-run aggregate supply curve, 602–604, 617, 634–635 Long-run equilibrium, 619, 582–584, 624 Long-run inflation, 583–584 Long-run interest rate, raised by government purchases, 622 Long-run real interest rate, 589–591, 592, 599 Long-term bonds, 81, 140, 156, 170, 172 Long-Term Capital Management, 214–215, 231, 308, 348, 633 Long-term interest rates 1971–2012, 170 Lowenstein, Roger, 231 Low-inflation environment, targeting money growth, 569–575 Low-interest loans, 656 Lucas, Robert E., Jr., 570 Lucas critique, 570 Lund, Susan, 306 Luo Jun, 288 M Maastricht Treaty, 437, 438–440, 442, 444 Mach, Traci L., 655n Machiavelli, N., 397 Macroeconomic model aggregate supply, 600–604 dynamic aggregate demand curve, 584–599 equilibrium and determination of output and inflation, 605–610 long-run equilibrium, 582–584 for understanding business cycles, 625–637, 638–643 Macroeconomic policy failures, 644 Macroeconomic stabilizer, floating exchange rate, 535 Macro fund managers, 348 Macro-prudential regulation, 382, 385 Madoff, Bernard, 278, 367 Maintenance period, 492 Malaysia, capital controls, 528–529 Mallaby, Sebastian, 348 Management, criterion for choosing mutual fund, 206 I-11 Mankiw, Greg, 475 Mantegas, Guido, 259 Marcos, Fernando, 455–456 Margin accounts, 218 Marginal Lending Facility (ECB), 495 Margin loans, 114 Margin requirements, futures contracts, 219 Margins, 136 Marine insurance, 340 Market economy, 361–362, 400–401 Market federal funds rate, 486–488, 491 Market for corporate control, 347 Market for dollars, 253–257 “Market for Lemons” (Akerlof), 278 Market for reserves, 487–488 Market liquidity, 26, 32, 63n Market makers, 32, 56, 59n, 224 Market order, 56 Market risk, 314, 315, 320 Markets, 708, 153 Market system, 269–270 Market value, 18, 64 Marking to market, futures contracts, 218–219 Mark-to-market accounting, 314 Marqués-Ibañez, David, 653n Maturity, 64, 135, 167, 171 Maturity date, 89 Mauro, Paulo, 664n McAndrews, James J., 319n McDonald’s, 241 in Big Mac index, 252 McDonough, William, 162, 163, 179 McFadden Act of 1927, 332, 333, 334 McIvey, Ryan, 156 MCI WorldCom, 166, 167 Mean, 107 Means of payment, 24, 33–34, 36, 48 Measuring Business Cycles (Mitchell & Burns), 626 Median inflation, 633 Megabanks, 382–383 Mergers, 327, 347, 375, 376 Merrill Lynch, 337, 376 Mester, Loretta J., 274, 305n Metropolitan Life, 341 Mexican debt crisis of 1994–95, 455 Meyer, Laurence H., 554 Micro-prudential regulation, 383–385 Microsoft Corporation, 49, 56, 57, 58, 121–124, 132, 163, 164, 194, 288 Milne, Richard, 233 Milwaukee Brewers, 582 Milwaukee Bucks, 582 Minimum average inflation-adjusted return, 206 Minimum bid rate, ECB, 493 Minimum capital requirements, 376–378, 381 Ministry of Finance, Japan, 258 Mishkin, Frederic S., 181n Mitchell, Wesley, 626–627 Mobile money, 34–35 Monaco, euro use, 543–544 M1 money supply, 36–41, 428, 462, 473, 474, 456, 475, 560–561 M2 money supply, 36–41, 428, 456, 462, 473, 474, 475, 493, 500, 560–562,569 M3 money supply, 36n, 573 I-12 l Index Monetary aggregates, 36–41; see also M1 money supply; M2 money supply constant growth rate, 560–561 and GDP, 37 growth rate 1960–2012, 39 guide to short-term policy, 563 as intermediate target, 500 from monetary base, 555 money growth and inflation rate, 554–557 neglected by FOMC, 553–554 stable velocity in U.S., 568 table, 37 for understanding inflation, 37–41 Monetary base of central bank, 456 central bank’s monopoly over, 494 changes in size and composition at Fed, 461 controlled by central bank, 462 created and destroyed by Fed, 464 decline in Great Depression, 473 factors altering demand for, 494 and inflation, 475 and monetary aggregates, 560–561 money multiplier, 468–472 and money supply, 467–468 three uses of, 469–470 turned into monetary aggregates, 555 unsterilized vs sterilized intervention, 532 Monetary Control Act of 1980, 492 Monetary policy, 396 and causes of recessions, 653 channel system, 494–495 choice between interest rates and exchange rates, 527 decision making by committee, 408 and dynamic aggregate demand curve, 584–585, 590–599 effect on currencies, 259 effect on dynamic aggregate demand curve, 660 encouraging bubbles, 668 of ECB in 2013, 591–592 and exchange rate management, 523 failure in Great Depression, 399–400 failure in Japan, 659 failure leading to inflation, 523 of Fed in 2012, 591 Fed policy framework, 435 financial crisis as game changer for, 661 in financial crisis of 2007–2009, 414 in Great Depression, 473 during Great Moderation, 634 impact of globalization, 638 implications of capital market arbitrage for, 525–527 imported by fixed exchange rates, 534 inability to neutralize supply shocks, 640–643 insulated from politicians, 408 Japan, 123 k-percent rule, 561n long-term horizon, 407–408 low inflation goal, 402 mistakes in 1970s, 639 to moderate downswings, money growth as target, 568 not adjustable under currency boards, 541 operating outside of traditional, 414 opportunity from positive supply shocks, 631–632 with permanent increase in inflation, 624 political loss of control over, 409 purchasing power parity implications, 525 reasons for, 396 in relation to fiscal policy, 412–416 response to potential output changes, 636–637 role of Federal Reserve Banks, 425 as stabilizer, 628–629 statistical models for, 570 strategy of ECB, 444–445 tied to economic conditions, 581 transmission impaired, 506n in 21st century, 553 Monetary Policy Committee, Bank of England, 499 Monetary policy framework, 411 Monetary policy instruments, 484; 485, 486–493; see also Conventional policy tools; Unconventional policy tools Monetary Policy of the European Central Bank, 437n Monetary policy reaction curve, 584, 591, 590–595, 598, 599, 620–621, 623, 628, 635, 638–639, 641–64 Monetary policy transmission mechanisms, 652–661 Monetary Report to Congress (FRS), 434, 474n, 571 Monetary supply, 467–472 Monetary union, 544–545 Monetizing the debt, 413 Money, 3, 23; see also Currency; Demand for money; Quantity theory of money; Velocity of money advantage of bonds and stocks over, 25–26 airtime as currency, 35 in central banks’ policies, 553 determinants of price, 557 in European monetary policy, 553 future of, 33–34 means of payment, 24, 557–558 measuring, 35–41 mobile, 34–35 in Monopoly game, 23–24 opportunity cost of holding, 565 paper money, 25, 27 reasons for holding, 563–564 riskiness of, 567n store of value, 25–26 unit of account, 24–25 Money and banking, 6–9 Money center banks, 403 Money creation by central banks, 396 Money growth, 40–41, 564, 568, 570, 573, 574, 584 Money growth and inflation, 554–559, 574–575, 581; see also Targeting money growth Money market, 64 Money market deposit accounts, 37 Money market equilibrium, 559 Money market instruments, 64 Money-Market Investors Funding Facility, 507 Money-market mutual funds, 65, 328, 338, 361n, 363, 375, 387 Money multiplier, 469–472, 473, 474, 492 Money supply, 396, 455, 462–467, 473–474 Monopolistic exploitation, 364 Monopoly game dollars, 23–24, 40 Moody’s Investor Services, 163–169, 282, 312 Moral hazard, 278 addressed by central banks’ information services, 656–657 and competition, 387 in debt financing, 284–285 in Dodd-Frank Act, 387 in equity financing, 283, 284 in euro-area crisis, 442 from government bailouts, 371–372, 387 from government safety net, 369 in insurance, 342–343 intensified by crisis of 2007–2009, 660 in lender of last resort, 367, 368 in Madoff fraud, 278 monitoring to reduce, 287 negative consequences of information costs, 285 origins in insurance, 283 reduced by increase in net worth, 656 Morgan Stanley, 286, 347 Morningstar Inc., 156 Mortgage-backed securities, 53–54, 153, 165, 166, 299, 453, 533, 660, 669 Mortgage delinquencies, Mortgage loans, Mortgage refinancing rates, 571 Mortgages, 50 adjustable-rate, 136 alt-A, 165n and asset-backed commercial paper, 171 conventional fixed-rate, 136 loan-to-value ratio, 165 need for insurance with, 344 outstanding 1980–2012, 153 prime, 165 private mortgage insurance, 280 risky, 384 shopping for, 68 as store of value, 53 subprime, 53–54, 165 underwater values, 209 Mortgage securitization, 285 M-Pesa, Kenya, 33, 34, 338 Multiple deposit creation, 464–467 Municipal bonds, 171–172 Mutual fund companies, 67, 276, 340, 353 Mutual funds, 4, 156, 206 N NASDAQ, 47, 56, 69 NASDAQ Composite Index, 196 decline 2000–2001, 190 from 1984 to 2013, 663 National Banking Act of 1863, 329 National banks, origin of, 329–330 National Best Bid and Offer mechanism, 62 National Bureau of Economic Research, 626–627 National Central Banks (ECB), 437 budget control by, 438 open market operations, 494 National Credit Union Administration, 374 NBER; see National Bureau of Economic Research Index l Near-zero interest rate, 597, 610 Negative amortization, 136 Negative supply shocks, 623, 639 Net exports, 587–588, 598–599 Net interest income, 305 Net interest margin, 305 Net worth, 281, 282, 296, 314, 364, 655–656 New car purchase, 85 New York City Metropolitan Transit Authority, 32 New York Mercantile Exchange, 216 New York Stock Exchange, 3, 4, 47, 55n, 56, 59, 69, 189 New York Stock Exchange Euronext, 59, 337 New York Times, 88–89, 316 New Zealand’s central bank, 494–495 Nikkei 225 index from 1984 to 2013, 658–659 Nikkei Stock Average, 197 Nominal exchange rate, 242–243, 251, 253–254, 256–257 Nominal federal funds rate, 1983–2013, 586 Nominal GDP, 19–20, 297, 454, 58–559, 641 Nominal GDP targeting, 441–444 Nominal income, 564, 569 Nominal interest rate, 92, 106 and cost of borrowing, 145 decline with fall in inflation, 95 directly observable, 96 and Fisher equation, 94–95 and income tax, 597 and money growth, 584 national comparisons, 95 real rate and expected inflation, 93 short-term movements, 585–586 target rate in Japan, U.S., and euro are, 650, 664–665 and transactions demand for money, 564–565 in U.S 1979–2012, 94 in U.S in 1970s, 597 zero, 95 Nonbank institutions, 358, 369 Noncash payments, 23 Noncompetitive bid, 427 Nondepository institutions, 295 brokerages, 346–347 categories of, 339 finance companies, 347–349 government-sponsored enterprises, 349–353 hedge funds, 348 insurance companies, 340–344 investment banks, 347 mutual funds, 347 pawnshops, 333 pension funds, 344–346 percent of assets held by intermediaries, 339 regulation of, 366nn types of, 66 Noninvestment grade bonds, 163–165 Nontransaction accounts, 299 Nontransaction deposits, 300–301 Normand, John, 122 Northern Rock Bank, United Kingdom, 362 Northern Trust Corporation, 183 Notional principle, 231–232 O Oakley, David, 233 Obama, Barack, 352, 621 Off-balance-sheet activities, 171, 306–308 Offers not visible prior to trade, 62–63 Office of Financial Research, 386 Office of the Comptroller of the Currency, 329–330, 374 Official settlements balance, 550–551 One-year zero coupon bond, 141 Online lending, 288 Open market operations, 425 ECB, 493–495 Federal Reserve Bank of New York, 463, 494 National Central Banks (ECB), 494 process, 457–458 purchase and sale of securities, 453 purchases, 457 sales, 458 T-accounts, 457 target federal funds rate, 486–488 Open Market Trading Desk, 532 Operating instruments, 499–500 Operational risks of banks, 318–320 Operation Bernhard, Germany, 397 Opportunistic disinflation, 637 Opportunity cost of holding money, 565, 569–571 of investment, 86 of lending, 75–76 Options American, 223 Black-Scholes pricing formula, 222 call options, 222–223 clearing corporation, 223 European, 223 examples of value of, 228–230 expiration date, 223 factors affecting value, 229 guide to, 226 intrinsic value, 225–227 option holder, 222 option writer, 222 posting margin, 223 pricing, 225–228 and probability theory, 105 put options, 222–223 standardized, 223 stock options, 228 time value, 225–227 for transfer of risk, 54 using, 224–225 value, 227–229 Options writer/writing, 222, 224–225, 231 Oracle Corporation, 164 Originate-to-distribute model of securitization, 153 Originators of mortgage securitization, 285 Other assets, 296–297 Outcomes, 106–107, 110 Outflow controls, 529 Out-of-the money options, 222–223 Output, 191; see also Current output; Inflation and output; Potential output and economic fluctuations, 608 with long-run inflation, 582–584 stabilized with inflation, 640–643 I-13 Output gap, 502, 583, 590–591, 601, 603, 605–607 Output indexes, 193 Overdrafts, 566 Overnight cash rate, ECB, 496–497 Overnight repurchase agreements, 302 Over-the-counter derivatives, 65, 214 Over-the-counter markets, 58, 59, 220, 235 Overvalued currency, 251 P Pacific Investment Management Company, 156, 233 Palmsbruck, Johan, 27 Pan-European financial system, 443 Panic of 1907, 422 Paper money, 25, 27, 28, 459 Paradox of leverage, 50 Parker Brothers, 23, 40 Par value, 89 Passbook savings accounts, 301 Past-due loans, 380 Paul, Ron, 28n Pawnshops, 333 Payday loans, 307 Payments annuity vs lump-sum, 88–89 consols, 136–137 coupon bonds, 136 dividends, 198–200 from financial instruments, 52 on fixed-payment loans, 135 noncash, 23 periodic fixed, 91 size represented by options, 227 valuing, 76–92 Payment systems, 26 access provided by financial intermediaries, 272, 273–275 access to, 365 assessing means of payment, automated clearinghouse transactions, 31 checks, 28–31 with commodity monies, 27–28 credit cards, 31, 93 debit cards, 25, 31 electronic payments, 31–33 e-money, 32–33 ECB, 437 with fiat money, 27–28 and future of money, 33–35 money at heart of, 26–27 prepaid mobile phones, 34–35 role of central banks, 398 stored-value cards, 31–32 volume of noncash payments, 23 Payoff method of FDIC, 369 Payoffs, 105, 107, 108, 111–113, 122–124, 131–132 Peer-to-peer lending, 288 Pence, Karen, 136 Pension Benefit Guaranty Corporation, 345, 366nn Pension funds, 66, 340, 344–345, 353 Pentagon attack of 2001, 450 Per capita real GDP, national comparisons, 269 Percentage changes, 193, 201 Percentage return, 109 I-14 l Index Periodic fixed payments, 91 Perpetuities, 136 Philippine central bank misrepresentations, 455–456 Phillips curve, 600n Pianalto, Sandra, 431 Pimco Total Return Fund, 156 Placing the issue, 347 Pleeter, Saul, 88–89 Plosser, Charles, 637n Policy, time consistent, 28 Policy framework, 435, 444–445 Political influence, Fed independence from, 432–433 Political opportunism, discretionary fiscal stimulus, 630–631 Politicization of central banks, 414–415 Polk, Davis, 387n Pomerleano, Michael, 663n Ponzi, Charles, 278 Ponzi scheme, 278, 367 Poole, William, 499n Pooling of funds, 268 Pooling savings, 272, 273 Pool of mortgages, 165 Portfolio demand for money, 563, 566–567 Portfolio management, 204 Portugal, liquidity crisis, 62 Positive supply shocks, 631–632 Posting margin, 218 Potential output, 402, 501, 582–583 deviation from current output, 600–601 deviations from, and long-run equilibrium, 605–607 effect of changes in, 634–637 and expansionary output gap, 601 and input price changes, 601 and long-run aggregate supply curve, 604 and long-run inflation, 583–584 and long-run real interest rate, 588–590 and policy errors, 644 and recessionary output gap, 601 recessionary gap distinguished from, 638–640 and unexpected events, 583 Potter, Simon, 319n Powell, Jerome H., 431 Ppdai.com, 288 Prasad, Eswar, 541 Precautionary demand for money, 566 Preexisting conditions, 343–344 Prepaid cards, stored-value cards, 31–32 Prepaid mobile phone minutes, 34–35 Present value, 80 additive, 85 algebra of formula, 102–103 analysis of early retirement, 87 analysis of stock prices, 198–199 of annuity payment, 88 applying, 84–92 bond prices and yields, 141 bond principal, 90–91 to compare value of payments, 76 coupon bond, 92 coupon payments, 91–92 credit card payments, 93 decline with rise in interest rates, 81 in future value calculations, 76–78 interest rates, 137–138 and nominal interest rate, 92 and price of consols, 137 properties of, 82 and real interest rate, 92 reasons for change, 82–84 in retirement planning, 107 similarity to future value, 82 Price(s) Brazilian government debt 1998, 151 in deflation, 281 determined by markets, 7–8 and easy money policy, 574–575 and inflation, 35–36 interest-rate swaps, 232–234 law of one price, 246–249 lowered by globalization, 638 in market economy, 400–401 and money as unit of account, 24–25 options, 225–228 purchasing power parity, 249–252 in real-business-cycle theory, 637 relative, 25 and value of dollar, 253 Price changes, effect of leverage, 114 Price indexes, 193, 444 Price index of personal consumption, 502 Price-interest rate relationship, Treasury bills, 135 Price level, 250, 559, 583 Price stability, 410, 499 from gold standard, 28 objective of central banks, 400–402 objective of ECB, 553 rationale for, 400 strategy of ECB, 444–445 Price system, 33 Price-weighted average, 194, 196 Primary credit, 490–491, 495 Primary Dealer Credit Facility, 507 Primary discount rate, 490–491 Primary financial markets, 58 Primary government securities dealers, 457n Prime-grade commercial paper, 167–168 Prime mortgages, 165 Primitive securities, 51 Prince, The (Machiavelli), 397 Principal, 89, 90–91 Principal-agent problem, 283 Private equity firms, 68, 287 Private mortgage insurance, 280 Private sector credit, national comparisons, 269 Probability, 106, 117 Probability theory, 104, 105, 106–107 Procter & Gamble, 164 Pro-cyclicality, 383–385 Production, 402, 583 Productivity, 637,656 Product-price inflation, 600–602 Profit, 335, 375–376 Property and casualty insurance, 341 Property and casualty insurers, 66 Property prices, 656, 659, 661–664 Prosper.com, 288 Protectionism, 541, 542 Prudential of America, 341 Public companies, 281–282 Public debt, 360, 413 Public goods, 399 Purchase and assumption method of FDIC, 369 Purchasing power, 177–178, 557, 597 Purchasing power parity, 249, 254 Big Mac index, 252 exchange rate movements 1980–2010, 251 implications for monetary policy, 525 and inflation, 249–251 inflation and long-run implications, 524–525 and nominal exchange rate, 251 overvalued currencies, 251 and real exchange rate, 244–245 undervalued currencies, 251 Pure discount bonds, 134–135 Put options, 222–223, 224, 226 Q Qiu, Jack, 288 Quantitative easing, 508 appropriate level unknown, 510–511 Bank of England, 511 Bank of Japan, 511 claims of ineffectiveness, 510 versus credit easing, 508n to deal with deflationary spiral, 667 and deleveraging, 510 and economic growth and inflation, 509–510 effect on exchange rates, 542 effect on Fed’s balance sheet, 509 ECB, 511 exiting from, 513, 514 Fed’s use of, 511 impact on supply and demand in federal funds market, 509 operation of, 509 and price level, 510 principal goal of, 542 unpredictable effects, 510 Quantity of money and equation of exchange, 558–559 limits on central bank control of, 473–475 variables supporting, 470–471 and velocity of money, 558 Quantity theory of money, 559–560, 565 Quinn, Daniel W., 514n R Raskin, Sarah Bloom, 431 Rate of return, risk-free, 110 Rating agencies, 163–167, 285 Rating errors, 166 Ratings downgrade/upgrade, 167 Ratings inflation, 166 Ratio of loans to securities, 270–271 Reading Railroad Company bond, 90 Real-business-cycle theory, 637 Real estate market, and interest rates, 656 Real exchange rate, 244–245 Real federal funds rate, 1983–2013, 586 Real GDP, 19–20, 428n, 650 Real housing price index, 1890–2013, 662 Real interest rate, 92, 106 597; see also Aggregate expenditures and real interest rate and bondholders, 154–155 controlled by FOMC, 428 and cost of borrowing, 145 and economic decisions, 585 Index l effect of decline on demand for U.S assets, 652 ex ante, or ex post, 96 increased for foreign bonds, 255 long-run, 590–592 and monetary policy reaction curve, 590–595 need to estimate, 96 rise in, reducing aggregate expenditures, 588 in U.S 1979–2012, 94 zero, 95 Real return, 177–178 Recapitalization, 371 Recession(s), 363–364, 402, 582, 626 causes of, 608–610 decline in frequency, 618 Fed blamed for, 610 fiscal policy and duration of, 630 inflation during, 1957–2009, 608–609 NBER reference cycle, 626–627 normal sharp rebound from, 650 in real-business-cycle theory, 637 in United States, 626, 638–639 Recessionary output gap, 583, 601, 603, 624, 638–640, 665, 666 Redenomination risk, 317 Redrik, Dani, 528 Refinancing, 165 Refinancing operations, ECB, 493–494 Regional banks, 403 Registration requirement, 167n Regulation FD, 281n Regulation Q, 333n, 376n Regulator shopping, 374 Regulatory agencies, 3–5, 8–9 Regulatory competition, 374 Reinhart, Carmen M., 133n Reinsurance companies, 344 Renminbi, 541 Repurchase agreements, 302, 319, 365, 493 Required reserves, 309, 455 Required stock return, 202 Reserve currency, 538 Reserve requirements, 485, 492–493, 497–498 Reserves, 297, 300n, 455, 484, 486, 487–488, 494 Residual claimants, 191, 201 Resource allocation, 7–8, 24–25, 75, 208, 270 Restrictive covenants, 284–285, 287, 343 Retailers, stored-value cards, 31–32 Retail money-market mutual fund shares, 37 Retained earnings, 86 Return on bonds, 137–141 on equity and level of debt, 200 expected, 106 and financial assumptions, 202 from foreign and domestic bonds, 265–266 in foreign stock markets, 248 from German bonds, 265–266 minimum average inflation-adjusted, 206 required on stock, 202 as result of chance, 204–205 Standard and Poor’s 500 Index 1872–2013, 205 Return on assets for banks, 303–305 Return on equity, 305 Reuters, 122–123 Richardson, Matthew P., 387n Riegle-Neal Act of 1984, 334 Riksbank, Sweden, 619 Ringgit, 240 Risk, 105; see also Transfer of risk arising from uncertainty, 105 black swans, 117 of bonds in relation to alternatives, 149 car drivers, 111 common exposure to, 116 created by volatility, creating opportunities, 105 decisions based on, 104 from derivatives, 365n diversifiable, 189 diversification of, 272, 276 and educated guesses, 104 in financial system, 404 of foreign investments decreased, 255 and future payoff, 105 and games of chance, 104, 105 hedging, 120–121, 132 impact of leverage on, 114–115 and investment, 105–106 as measure, 105 in pension funds, 345n and portfolio demand for money, 567 probability theory, 104 and range of possible outcomes, 110 rollover, 171 spreading, 121–124, 132 in stock ownership, 200 systematic, 118 tail risks, 117 tradeoff between expected return and, 118 underestimating, 81 and value of stocks, 202–203 Risk and return, 114 Risk aversion, 117–118 Risk-free assets, 110 Risk-free interest rate, 202 Risk-free investment, 106, 117 Risk-free rate of return, 110 Risk management with derivatives, 215–216 Risk measurement, 106–109, 110–117 Risk neutral, 117 Risk on, risk off, 122 Risk premium, 118, 178, 202 Risk reduction, 120–124, 215, 224 Risk requires compensation, 66, 81 Risk spread, 153, 168, 177–180 Risk structure of interest rates, 163–170, 179–180, 188 Risk-taking with derivatives, 65 Risk tolerance, 119, 129–130 Risk-weighted assets of banks in U.S and European Union, 377 Rogoff, Kenneth S., 133n, 400n, 407n Rollover risk, 171, 257 Romer, Christina D., 653 Romer, David H., 653 Rosenblum, Harvey, 382 Rosengren, Eric, 319n Rosenzweig, M R., 45n Rotation system, Governing Council of the ECB, 440–441 Rule of 72, 79, 403 Russia, 151, 163, 179, 231, 270–271 I-15 S Safekeeping role of financial intermediaries, 272, 273–275 Saft, James, 122 Sales finance companies, 349 Sallie Mae, 350–351 Salomon Smith Barney, 327 Samsung Electronics, 241, 550 Sargent, Thomas, 416 Saunders, Anthony, 314n Savings and loan associations, 374, 403 Savings banks, 374, 403 Savings deposits, 37 Savings institutions, 403 Schoenholtz, Kermit, 445n Scholes, Myron, 222 Schwartz, Anna J., 367, 473 Scott, Kenneth E., 372n Screening, 286–287, 338, 343 Seasonal credit, 491 Secondary discount rate, 491 Secondary markets, 58, 59, 60–63 Secondary reserves, 299 Second Bank of the United States, 396n Securities, 3; see also Bonds; Derivative instruments; Stocks Securities Act of 1933, registration requirement, 167n Securities and Exchange Commission failure to detect Madoff fraud, 278 on financial statements, 281 and high-frequency trading, 61 regulation of money market funds, 375 regulation of securities firms, 366n regulation of shadow banks, 375 Securities financing, 669 Securities firms, 67–68, 346–347, 353 Securities Investor Protection Corporation, 367 Securities markets vs bank financing, 669 Securitization, 153, 285, 669, 670 Seigniorage, 544 Self-correcting mechanism, 606, 617 Self-financing, 652 Settlement date, 217, 219–220 Sforza, Galeazzo, 397 Shadow banks, 65, 171, 209, 288, 361, 362–363, 365–366, 374–375 Shaheen, George T., 120, 121, 124 Shared governance, 544–545 Shell Oil, 119 Sherwell, Chris, 456n Shiller, Robert J., 206, 662 Shock, 619, 665 Short position, 217, 222 Short-run aggregate supply curve, 621 and causes of inflation, 508 combined with dynamic aggregate demand curve, 600 effect of positive supply shocks, 631 effect of shifts in, 600, 601 effect of shocks, 619 effect of stabilization policy, 628 with high inflation, 617 information on inflation and output, 600 and potential output changes, 634–635 shifts from cost of production changes, 623 and short-run equilibrium, 605 I-16 l Index Short-run aggregate supply curve—Cont summary on, 604 when current output equals potential output, 603 Short-run equilibrium, 605, 619 Short selling, 204n, 215n Short-term interest rates 1971–2012, 170 Short-term liquidity, 349 Sichel, Daniel, 634n Siegel, Jeremy, 206, 208 Sight deposits, 300 Singapore Straits Times index, 197 Small denominations of stock, 190 Small firms, 665 Smialek, Jeanne, 610–611 Smith, Paul, 156 Social Security, 53, 346 Société Generale, 122 Solvency, 363 Sony Corporation, 317 Sorkin, Aaron, 541 Soros, George, 536n South Korean financial crisis, 240, 361 Sovereign debt, 166–167, 317 Sovereign risk of banks, 317–318 Soviet Union, 336, 556 Spain, 62, 134, 143, 504–505 Specialization, 153, 274 Specific risks, 118n Speculation, 215, 219, 223–224 Speculative attack, 535–536 Speculative bonds, 164, 165 Speculative bubbles, forecasting, 207 Speculative-grade bonds, 163–165 Speculative-grade commercial paper, 167–168 Spence, A Michael, 278 Spontaneous speculative attacks, 536 Spot price, 221 Spot rate, 246, 254 Spread, 62, 110, 142–143 Spreading risk, mathematics of, 132 Spread over Treasuries, 168 Stability of financial system, 8–9, 364–365 goal of discount lending, 489–490 improving welfare, 630 long period of, 405–407 from macro-prudential regulation, 382–385 role of central banks, 398 Swiss franc, 539 Stability and Growth Pact of 1994, in euro area, 413n “Stability-Oriented Monetary Strategy” (ECB), 444 Stabilization policy, 625, 628–632, 640–643, 605 Stagflation, 623 Standard and Poor’s 500 Index, 194–196, 204, 205, 276 Standard deviation, 110, 111–113, 121, 131 Standardization, 49, 51, 220 Standard of value, 24 Standby letter of credit, 307 Starbucks, 244–245 Stark, Tom, 515 Start-ups, and venture capitalists, 209 State banks, 329 Statement on Longer-Term Goals and Monetary Policy Strategy (FOMC), 435 Statistical discrepancy, in GDP, 641 Statistical models, Lucas critique, 570 Stein, Jeremy C., 385n, 431, 664n, 668 Sterilized intervention, 532–533 Stiglitz, Joseph E., 278, 408n Stock(s) advantage over money, 25–26 banks prevented from holding, 315n common stock, 190–193 dividends, 198–200 in financial and economic life, 189 fundamental value, 198–200 high-frequency trading, 61 investment for the long run, 205–208 less risky than bonds in long run, 206 market makers, 32 means of holding wealth, 25–26, 193 moral hazard problem, 283 price-weighted average, 194 reasons for risk, 200 short selling, 204n as store of value, 53 trading places, underlying instruments, 51 valuation and future payments, 66 Stock certificates, 191 Stock funds, assets in 2012, 340 Stockholders, 191–192, 200–201 Stockholm Banco, 27 Stock indexes, 102, 192, 194–197 Stock market adverse selection in, 279 Black Monday 1987, 61 China, 203 collapse in Japan, 376n crash of 1929, 189 efficient market theory, 203–205 elimination of need to gather information, and Federal Reserve System, 434 flash crash of 2010, 60, 61 Japan, 123 in other countries, 248 plunge in financial crisis of 2008, 190 rebound since 2009, 207 role in economy, 208–210 Stock market bubble, 207, 209, 257 Stock market capitalization as percent of GDP, 270–271 Stock market correlation, 122 Stock of bonds, 141 Stock options, 228, 284 Stock prices booms and busts, 661–664 with changes in fundamentals, 203 decline 2000–2001, 190 fundamental, 200 increase in 1990s, 189–190 information provided by, 189 Internet bubble, 209 NASDAQ Composite Index 1984–2013, 663 percentage changes, 201 present value analysis, 198–199 relation to interest rates, 656 and resource allocation, 208 rise over long term, 190 unpredictable movements, 204 and value of companies, 208 Stocks for the Long Run (Siegel), 206 Stock trading, 55, 56, 58–63 Stock valuation, 198–205 Stored-value cards, 31–32 Store of value, 25–26, 33, 48, 53–54 Strahan, P., 332n, 334n Stress tests for banks, 380 Strike price, 222, 230 Student Loan Marketing Association, 349; see also Sallie Mae Study of Overdraft Program, 566 Subprime mortgages, 53–54, 165 Substitution bias, 38 Summary of Economic Projections (FOMC), 435 Summers, Lawrence H., 409 Super-regional banks, 403 Supervision, 372, 380 Supervisors, 371, 381 Supply and demand determination of exchange rates, 525 determining price of money, 557 shift in, for dollars, 254–256 Supply and demand analysis bond market and interest rates, 141–150 market for bank reserves, 487–488 Supply shock, 619, 623, 624, 628, 639, 640–643 Sustainable growth, 402–403 Swap rate, 232 Swaps, 54, 230, 234–235 Swap spread, 232–233 Sweden, inflation rate, 619–620 Swiss franc, 539 Swiss National Bank, 539 Systematic risk, 116, 118–119, 400, 404 Systemically important financial institutions, 330–331, 371, 386–388, 427, 670 Systemic crisis prevention, 385 Systemic risk central counterparties, 220 common exposure, 383–384 contrasted with systematic risk, 116 in financial system, 116 in high-frequency trading, 61 occasions for, 116 pro-cyclicality, 383, 384–385 Systemic risk management in Dodd-Frank Act, 386–387 Systemic risk surcharge, 385 Systemic vulnerabilities, 214 System open market account manager, 431 T T Rowe Price, 129 T-accounts, 457 Tail risks, 117 Targeted asset purchases, 508, 512, 513, 667 Target federal funds rate, 485 versus daily market rate 1992–2013, 488, 489 and discount lending, 489–490 errors in crisis of 2007–2009, 488 versus market federal funds rate, 486–488 and mortgage loans, 490 Targeting money growth destabilizing interest rates, 575 in high-inflation environment, 567–568 Index l in low-inflation environment, 569–576 reference value of ECB, 564, 573 Target interest rate, 493–495, 591–592 Target stores, 633 Tariffs, and failure of law of one price, 248 Tarullo, Daniel K., 350–351, 431 Tastes, and failure of law of one price, 249 Taxable bonds, 171–172 Taxation, 171–172, 413 Tax-exempt bonds, 171–172 Tax subsidies, 146 Taylor, John B., 372n, 501, 502, 506n Taylor rule, 501–502, 503–506, 593, 634 T-bills, 134 Teal Book, 429, 431, 433, 434 Teaser rates, 165 Technological advances, effect on banking, 338 Technology and economic stability, 405–406 and failure of law of one price, 248–249 impact on banks, 332–333 and transactions demand for money, 565–566 Telecom Italia Capital S.A., 143 Term Asset-Backed Securities Loan Facility, 507 Term Auction Facility, 507 Term Securities Lending Facility, 507 Term spread, 181–184 Term structure of interest rates, 142, 172–177, 180–184 Terrorist attack of 2001, 55n, 59, 318–319, 463, 489 Texaco, 119, 120–121, 131–132 Theory of efficient markets, 203–205 TIBOR, 337 Time, 484 Time-consistency problem, 372, 407–408, 442 Time-consistent policy, 28 Time deposits, 301 Time horizon, 105, 117 Time to maturity, and inflation risk, 178 Time until payment, 82–83 Time value, 225–228, 230 Time Warner, 164 TIPS; see Treasury Inflation-Protected Securities Tobin, James, 658n Tobin’s q-theory, 658n Tokyo-Mitsubishi, 335 Tokyo stock exchange, 59 Too-big-to-fail notion, 214 Too-big-to-fail policy, 371 Too-big-to-fail problem, 334, 350–351, 370–371, 670 in Dodd-Frank Act, 387 made worse by mergers, 376 resolving, 382 Too interconnected to fail, 370–371 Too-small-to-save concept, 383 Torres, Craig, 350, 610–611 Tradeoff between risk and expected return, 118 Trading algorithms, 60 Trading risk of banks, 315, 317, 320 Tranglo, 34–35 Transaction accounts, 299–300 Transaction costs, 55, 61, 66, 272, 275 Transactions demand for money, 564–566, 569–571 Transactions deposits, 492 Transferable stock, 190 Transfer of risk with derivatives, 215–216 by financial instruments, 48–49, 54 financial instruments for, 54 by financial markets, 56 with options, 223 and risk measurement, 105 Transparency of central banks, 409–410 in Dodd-Frank Act, 386 of ECB, 441–444 FOMC, 433–434 in inflation targeting, 499 lack of, 220 Transportation costs, 248 Travelers Insurance Company, 327 Treasury bills, 64, 134–135, 173 Treasury bond futures, 217–218, 219 Treasury bonds, 64, 142, 151, 156, 169, 173, 427 Treasury Direct, 427 Treasury Inflation-Protected Securities, 154, 156, 427 Treasury notes, 64, 118 Treasury securities, 168 Treasury yield curve chart, 173, 176 Treasury yield curve in 2001, 184 Treasury yield drop in 2012, 597 Treaty of Maastricht; see Maastricht Treaty Tri-party repo market, 319 Truman, Harry, 433 Tsatsaronis, Kostas, 385n Turashev, Nikola, 385n Turkey, 40, 164, 165 Two-pillar strategy of ECB, 444n U Ukraine, high inflation in 1990s, 40, 556 Unconventional policy tools, 484 complicated and unpredictable, 506 for crisis of 2007–2009, 649 in crisis of 2007–2009, 660 exiting from, 512–514 forward guidance, 506–509 to help aggregate demand, 611 quantitative easing, 508, 509–511 reasons for reluctance to use, 667 stabilization role, 506 targeted asset purchases, 508, 511–512 types used in crisis of 2007–2009, 507 unpredictable results, 668 at zero target interest rate, 667 Underlying asset, 215, 220, 222, 230 Underlying instruments, 51 Undervalued currency, 251 Underwater housing values, 209 Underwriters, 286–287, 340 Underwriting, 58, 340 Underwriting services, 347 Unemployment, 269, 428n, 605, 610–611 Unique risks, 118 Unit banks, 327, 331 United Kingdom Bank of England, 370 bank runs, 362 I-17 Financial Conduct Authority, 370 and London Interbank Offered Rate scandal, 337 number of banks, 327 origins of peer-to-peer lending, 288 relative importance of financing channels, 270–271 sources of business finance, 289 United Kingdom Treasury, 370 United Services Automobile Association, 344 United States accused of currency war, 542 assets and number of commercial banks, 331 assets of banks, 377 assets of commercial banks 1973–2012, 298 balance sheet of commercial banks 2013, 297 Civil War currency, 27 control of “common currency area” risks, 442 counterfeiting North Vietnamese currency, 397 current account deficit, 254 decline in inflation rate, 405 exports and imports as percent of GDP, 523 GDP 1993–2012, 641 history of banking, 329–331 increase in wealth, 255 inflation in 2012, 590–591 inflation of 1970s, 597 instability of money demand, 569–571 intervention in currency markets, 258 liabilities of commercial banks 1979–2012, 301 low inflation in 1990s, 40 macroeconomic policy failures, 644 19th-century national banks, 396n number of banks, 327 number of regulators, 370, 374 output gap in 2012, 590–591 relative importance of financing channels, 270–271 risk-weighted assets of largest banks, 377 sources of business finance, 289 United States dollar; see Dollar(s) United States Office of Thrift Supervision, 374 United States Supreme Court, 409n United States Treasury, 95 and Federal Reserve System, 427 inflation-indexed bonds, 154 regulatory role, 374 stress tests for banks, 380 Unit of account, 24–25, 33, 563–564 Universal bank, 337 Unlimited liability, 340 Unsecured debt, 167 Unsecured loans, 282, 486 Unsterilized foreign exchange intervention, 532 V Vaishampayan, Saumya, 156 Valencia, F., 373 Valencia, Fabian, 359n, 360 I-18 l Index VA Linux, 209 Valuation, 6, 50–51 Value at risk, 110, 404, 113–117 Value Line, 282 Value of fixed-payment loan, 135 Value of the firm, 281 Value-weighted indexes, 194, 196 Vanguard Group Inc., 156, 347 Van Rensburg, Hannes, 35 Variance, 110–113, 131–132 Vault cash, 297, 455 Velocity of money, 557–559 and constant rate of money growth, 560–563 euro area M3 1995–2013, 573 Fisher’s assumption about, 559 fluctuations, 562–563 and high interest rates, 565n and opportunity cost of holding money, 569–571 in U.S 1979–2013, 569 Venezuela, 40, 164, 165 Venture capital firms, 68, 287 Venture capitalists, 209 Verizon Communications, 166 Vesting, 345 Veterans Administration, 353 Vietnam War, 397, 623–624 Visa, 35 Volatility, 8, 175 Volcker rule, 31, 387n Volkswagen Jetta, 253 Volpert, Ken, 156 W Wachovia Bank, 309, 362, 376, 403 Wadhwani, Sushil, 663n Wage and price decisions, 412 Wages, 600, 537 Wallace, Neil, 416 Wall Street Journal, 11, 12, 149, 173, 176, 228, 254, 282, 382, 475, 504–505, 574–575 Foreign Exchange Column, 246–247 Walmart, 133, 194, 633 Walsh, Carl E., 433 Warner, John, 88–89 Washington Mutual, 362, 374, 376, 403 Wealth, 23 effect of changes on bond demand curve, 146–148 impact of stock market bubble, 209 increase in America, 255 means of holding, 25–26 and portfolio demand for money, 567 stock as means of holding, 193 Weber, Max, 75n Webvan, 120, 124 Weighted-average duration, 314n Welfare, improved by stability, 8–9 Wells Fargo, 331, 349, 376, 403 Wessel, David, 504–505, 574–575 Wheatley, Jonathan, 259 Whitehouse, Mark, 440–441 Whole life insurance, 341, 342 Williams, John C., 431, 589n Wilshire 5000 Index, 196 Wolken, John D., 655n Won-dollar exchange rate, 241, 251 Woodford, Michael, 440–441, 510n World Bank, 33, 245 WorldCom, 281 World stock indexes Bovespa index, 196–197 CAC (France), 197 DAX (Germany), 197 Nikkei Stock Average, 197 Singapore Straits Times index, 197 table of, 197 World Trade Center attack of 2001, 59, 318–319, 428, 450, 489 World War II, German counterfeiting British pounds, 397 World Wrestling Enterprises, 191 World Wrestling Federation, 191 Written-down assets, 314 Written-off loans, 303 Written-up assets, 314 Y Yahoo! Finance, 12, 51 Yellen, Janet L., 431, 575, 610–611 Yield(s), 76 after-tax, 171–172 corporate bonds, 143 current, 138–139 German government bonds, 142 global government bonds, 142–143 holding period returns, 139–141 impact of ratings on, 168–170 known from bond price, 141 long-term higher than short-term, 175 search for, 81 short-term bond volatility, 175 tax implications, 171–172 on TIPS, 154 Treasury bills and bonds 2013, 173 Treasury bonds, 142 yield to maturity, 137–138 Yield curve inverted, 180–181 reaction of banks to, 182–183 slope of, 177 Treasury bills and bonds 2013, 173–174 U.S Treasury in 2001, 184 Yield spreads, euro-area bonds 1990–2013, 443 Yield to maturity, 137–138, 139 Yo! Time, 35 Yuan, 541 Z Zero bound, 482 Zero bound federal funds rate, 428n Zero-coupon bonds, 134–135 Zero inflation rate, and risk of deflation, 402 Zero interest rate, 496, 539 Zero interest rate target, 415 Zero nominal interest rate, 95 Zero nominal-interest-rate bound, 664–667 Zero real interest rate, 95 Zhang Jun, 288 Zimbabwe, 35, 401–402 Zimbabwe National Chamber of Commerce, 35 Zumbrun, Joshua, 350 ... 141.60 22 1.1 29 .0 21 .9 PHLX§ Oil Service 24 6.78 24 5.45 24 6.49 0.80 0. 32 260.81 186 .27 20 .9 12. 0 8.0 PHLX§ Semiconductor 426 .94 423 .76 426 .28 1.04 0 .24 441.88 351.45 0.7 11.0 8.6 13.13 12. 63 12. 64 20 .30... option, 22 3 arbitrage, 22 0 call option, 22 2 central counterparty (CCP), 22 0 credit-default swap (CDS), 23 4 derivatives, 21 5 European option, 22 3 fixed-rate payer, 23 2 floating-rate payer, 23 2 forward... contract, 21 6 futures contract, 21 6 interest-rate swap, 23 1 margin, 21 8 notional principal, 23 1 put option, 22 2 strike price, 22 2 swap, 23 1 swap spread, 23 2 time value of an option, 22 5 www.mhhe.com/moneyandbanking4e