The financial system banking and money (third edition) part 2

www.downloadslide.net CHAPTER 10 The Economics of Banking Learning Objectives After studying this chapter, you should be able to: 10.1 Evaluate a bank’s balance sheet (pages 307–317) 10.3 Explain how banks manage risk (pages 320–328) 10.2 Describe the basic operations of a commercial bank (pages 317–320) 10.4 Explain the trends in the U.S commercial banking industry (pages 328–337) Small Businesses Flock to the Bank of Bird-in-Hand The Bank of Bird-in-Hand is a small bank in Pennsylvania’s Amish country The Amish are a religious denomination whose members avoid using modern technology such as cars and smartphones Many of the bank’s customers arrive at the drive-through window in a horse and buggy, make relatively small deposits, and ask for relatively small loans Despite the small size of the transactions it makes, the Bank of Bird-in-Hand was prospering in 2016 while many larger banks were struggling The struggles of larger banks were rooted in problems involving the basic business of banking, which is to take in deposits and use the funds to make loans to households and firms The greater the gap between the interest rate at which banks lend and the interest rate they pay on deposits—known as the spread—the more profitable banks are When the Federal Reserve takes steps to lower interest rates, the result is usually a boost to bank profits Fed policies have their greatest effect on short-run interest rates, so the rates that banks pay on deposits typically fall by more than the interest rates banks charge on loans to households and firms, which increases banks’ spreads and their profits As we have seen in previous chapters, though, the situation in 2016 was different because long-term interest rates on bonds and loans had also fallen to historically low levels, and as a result, bank profits were being squeezed As one investment analyst put it: “It’s just really tough for banks overall right now I don’t care how well-managed you are.” How was the Bank of Bird-in-Hand prospering while its larger rivals were hurting? If you were the owner of a small business in the town of Bird-in-Hand, Continued on next page Key Issue and Question Issue: During the past 35 years, the U.S financial system has experienced two periods during which there was a sharp increase in the number of bank failures Question: Is banking a particularly risky business? If so, what types of risks banks face? Answered on page 338 306 BK-PED-708052-HUBBARD-160392-Chp10.indd 306 01/03/17 7:38 PM www.downloadslide.net The Basics of Commercial Banking: The Bank Balance Sheet you might well know the answer Like other community banks, the Bank of Bird-in-Hand concentrates on making loans to small businesses Community banks practice relationship banking, which as we saw in Chapter 9, involves banks gathering private information on borrowers to assess credit risks Many large banks believe that the transactions costs involved in assessing risk on small business loans have made such loans unprofitable As Rebel Cole, a finance professor at DePaul University, put it, large banks “have essentially abandoned the small business market.” The chief loan officer of the Bank of Bird-in-Hand notes that larger banks in his area are usually not interested in loans for less than $1 million As a result, small businesses have flocked to his bank 307 The Bank of Bird-in-Hand has some advantages in lending to the Amish owners of farms and other small businesses in the area One advantage is that for religious reasons, the owners are unlikely to turn to the new fintech web sites we discussed in previous chapters or to rely on credit cards or other sources of short-term credit As we will discuss in Section 10.4, the presence of significant economies of scale in some aspects of banking have led to a rapid consolidation in the industry, with the 10 largest banks now having more than half of all deposits But in some areas of banking services, such as loans to small businesses, economies of scale appear to be much more limited, allowing banks like the Bank of Bird-in-Hand to thrive Sources: Ryan Tracy, “A Local Bank in Amish Country Flourishes Amid Dearth of Small Lenders,” Wall Street Journal, March 29, 2015; “Nice Gig: Lessons from One of America’s Youngest Lenders,” Economist, August 22, 2015; Ruth Simon, “Big Banks Cut Back on Loans to Small Business,” Wall Street Journal, ­November 26, 2015; and Emily Glazer and Peter Rudegeair, “Wells Fargo’s Quarterly Earnings Slip,” Wall Street Journal, July 15, 2016 We saw in Chapter that banks are important to the eff icient functioning of the ­f inancial system In this chapter, we look more closely at how banks business and how they earn a profit We then consider the problems banks face in managing risks In recent years, banks have faced competition from other financial institutions and from fintech firms that can offer savers and borrowers similar services at a potentially lower cost We conclude this chapter by describing some of the steps banks have taken in ­response to increased competition 10.1 The Basics of Commercial Banking: The Bank Balance Sheet Learning Objective: Evaluate a bank’s balance sheet Commercial banking is a business Banks fill a market need by providing a service, and they earn a profit by charging customers for that service The key commercial banking activities are taking in deposits from savers and making loans to households and firms To earn a profit, a bank needs to pay less for the funds it receives from depositors than it earns on the loans it makes We begin our discussion of the business of banking by looking at a bank’s sources of funds—primarily deposits—and uses of funds—primarily loans A bank’s sources and uses of funds are summarized on its balance sheet, which is a statement that lists an individual’s or a firm’s assets and liabilities to indicate the individual’s or firm’s financial position on a particular day An asset is something of value that an individual or a firm owns A Liability is something that an individual or a firm owes, particularly a financial claim on an individual or a firm Table 10.1 combines data from all the banks in the country into a consolidated balance sheet for the whole U.S commercial banking system for July 2016 Normally, balance sheets show dollar values for each entry BK-PED-708052-HUBBARD-160392-Chp10.indd 307 Balance sheet A s­ tatement that lists an ­individual’s or a firm’s assets and liabilities to indicate the individual’s or firm’s financial position on a particular day Asset Something of value that an individual or a firm owns; in particular, a ­financial claim Liability Something that an individual or a firm owes; a claim on an individual or a firm 01/03/17 7:38 PM www.downloadslide.net 308 CHAPTER 10 • The Economics of Banking Table 10.1  Consolidated Balance Sheet of U.S Commercial Banks, July 2016 Assets (uses of funds) Liabilities + Bank capital (sources of funds) (Percentage of total liabilities plus capital) (Percentage of total assets) Reserves and other cash assets 10.6% Securities 22.0 U.S government 4.4 Mortgage-backed securities (MBS) 12.5 State and local government and other securities 5.1 Loans Deposits 74.8% Checkable deposits 12.1 Nontransaction deposits 62.7 Small-denomination time deposits (CDs less than $100,000) plus savings deposits 56.2 Large-denomination time deposits (CDs greater than $100,000) 6.5 58.8 Commercial and industrial 12.3 Real estate (including mortgages) 29.1 Consumer 9.7 Interbank 1.2 Borrowings From banks in the U.S 0.5 Other loans 6.5 Other borrowings 7.7 Trading assets 1.1 Other liabilities Other assets 7.5 Bank capital (or shareholders’ equity) 8.2 4.3 12.7 Note: The data are for all domestically chartered commercial banks in the United States as of July 13, 2016 Source: Federal Reserve Statistical Release H.8, July 22, 2016 For ease of interpretation, we have converted the dollar values to percentages Table 10.1 shows the typical layout of a balance sheet, which is based on the following accounting equation: Assets = Liabilities + Shareholders’ equity Bank capital The ­ ifference between the d value of a bank’s ­assets and the value of its ­liabilities; also called shareholders’ equity BK-PED-708052-HUBBARD-160392-Chp10.indd 308 Shareholders’ equity is the difference between the value of a firm’s assets and the value of its liabilities Shareholders’ equity represents the dollar amount the ­owners of the firm would be left with if the firm were to be closed, its assets sold, and its ­liabilities paid off For a public f irm, the owners are the shareholders Shareholders’ ­equity is also called the firm’s net worth In banking, shareholders’ equity is usually called­ ­bank capital Bank capital is the funds contributed by the shareholders through their purchases of the bank’s stock plus the bank’s accumulated retained profits The accounting equation above tells us that the left side of a firm’s balance sheet must always have the same value as the right side We can think of a bank’s liabilities and its capital as the sources of its funds, and we can think of a bank’s assets as the uses of its funds 01/03/17 7:38 PM www.downloadslide.net The Basics of Commercial Banking: The Bank Balance Sheet 309 Bank Liabilities The most important bank liabilities are the funds a bank acquires from savers The bank uses the funds to make investments, for instance, by buying bonds, or to make loans to households and firms Bank deposits offer households and firms certain advantages over other ways in which they might hold their funds For example, compared with holding cash, deposits offer greater safety against theft and may also pay interest Compared with financial assets such as Treasury bills, deposits are more liquid Deposits against which checks can be written offer a convenient way to make payments Banks offer a variety of deposit accounts because savers have different needs We next review the main types of deposit accounts Checkable  Deposits Banks offer savers checkable deposits, which are accounts against which depositors can write checks Checkable deposits are also called transaction deposits Checkable deposits come in different varieties, which are determined partly by banking regulations and partly by the desire of bank managers to tailor the checking accounts they offer to meet the needs of households and firms Demand deposits and NOW (negotiable order of withdrawal) accounts are the most important categories of checkable deposits Demand deposits are checkable deposits on which banks not pay interest NOW accounts are checking accounts that pay interest Businesses often hold substantial balances in demand deposits, partly because U.S banking regulations not allow them to hold NOW accounts but also because demand deposits represent a liquid asset that can be accessed with very low transactions costs Banks must pay all checkable deposits on demand In other words, a bank must exchange a depositor’s check for cash immediately, provided that the depositor has at least the amount of the check on deposit Finally, note that checkable deposits are ­liabilities to banks because banks have the obligation to pay the funds to depositors on demand But checkable deposits are assets to households and firms because even though banks have physical possession of the funds, households and firms still own the funds An accounting note: It is important to grasp the idea that the same checking account can simultaneously be an asset to a household or firm and a liability to a bank Understanding this point will make it easier for you to follow some of the discussion later in this chapter Checkable deposits ­ Accounts against which depositors can write checks Nontransaction  Deposits Savers use only some of their deposits for day-to-day transactions Banks offer nontransaction deposits for savers who are willing to sacrifice ­immediate access to their funds in exchange for higher interest payments The most important types of nontransaction deposits are savings accounts, money market ­deposit accounts (MMDAs), and time deposits, or certificates of deposit (CDs) With savings accounts—which at one time were generally called passbook accounts—depositors must give the bank 30 days’ notice for a withdrawal In practice, though, banks usually waive this requirement, so most depositors expect to receive immediate access to the funds in their savings accounts MMDAs are a hybrid of savings accounts and checking accounts in that they pay interest, but depositors can write only three checks per month against them BK-PED-708052-HUBBARD-160392-Chp10.indd 309 01/03/17 7:38 PM www.downloadslide.net 310 CHAPTER 10 • The Economics of Banking Federal deposit insurance A government guarantee of deposit account balances up to $250,000 Unlike savings deposits, CDs have specified maturities that typically range from a few months to several years Banks penalize savers who withdraw funds prior to maturity by requiring the savers to forfeit part of the accrued interest CDs are less liquid than savings accounts but pay depositors a higher rate of interest There is an important difference between CDs of less than $100,000, which are called small-denomination time deposits, and CDs of $100,000 or more, which are called large-denomination time deposits CDs worth $100,000 or more are negotiable, which means that investors can buy and sell them in secondary markets prior to maturity Households with limited funds to save often prefer checkable deposits and smalldenomination time deposits because these deposits are covered by federal deposit insurance up to a limit of $250,000 per depositor, per insured bank Because of this insurance, even if your bank fails, you will not lose any of your funds, and typically you will have continuous access to them through ATMs or direct withdrawals Deposit insurance gives banks an edge over other financial intermediaries in acquiring funds from small savers because, for instance, money market mutual fund shares lack this government insurance Borrowings  Banks often have more opportunities to make loans than they can finance with funds they attract from depositors To take advantage of these opportunities, banks raise funds by borrowing A bank can earn a profit from this borrowing if the interest rate it pays to borrow funds is lower than the interest it earns by lending the funds to households and firms Borrowings include short-term loans in the federal funds market, loans from a bank’s foreign branches or other subsidiaries or affiliates, repurchase agreements, and discount loans from the Federal Reserve System The federal funds market is the market in which banks make short-term loans—often just overnight—to other banks Although the name indicates that government money is involved, in fact, the loans in the federal funds market involve the banks’ own funds The interest rate on these interbank loans is called the federal funds rate With repurchase agreements—otherwise known as “repos,” or RPs—banks sell securities, such as Treasury bills, and agree to repurchase them, typically the next day Banks use repos to borrow funds from business firms or other banks, using the underlying securities as collateral A firm or another bank that buys the securities earns interest without any signif icant loss of liquidity Repos are typically between large banks or corporations, so the degree of counterparty risk, or the risk that the other party to the transaction will default on its obligation, was at one time considered to be small But during the f inancial crisis of 2007–2009, it became clear that even a large corporation might be quickly forced into bankruptcy, leaving the counterparties to its repos to suffer significant losses or a delay in accessing their funds, or both For example, concern among the counterparties to the repos of the Lehman Brothers investment bank helped to force the firm into bankruptcy, worsening the financial crisis BK-PED-708052-HUBBARD-160392-Chp10.indd 310 01/03/17 7:38 PM www.downloadslide.net The Basics of Commercial Banking: The Bank Balance Sheet 311 Making the Connection The Rise and Fall and (Partial) Rise of the Checking Account Checkable deposits as a percentage of total bank liabilities In 1960, plain-vanilla demand deposits, which pay no interest, made up more than half of commercial bank liabilities The following graph shows checkable deposits as a fraction of all bank liabilities for the period from January 1973 to June 2016 Although there were some fluctuations over the years, by and large, until the beginning of the financial crisis, checkable deposits made up a declining fraction of bank liabilities By 2008, they reached a low point of a little more than 6% of all bank liabilities Then the financial crisis hit, and households and firms began putting more funds into checkable deposits, so that by 2016, they had risen to more than 13% of bank liabilities 35% 30 25 20 15 10 1973 1975 1980 1985 1990 1995 2000 2005 2010 2015 Sources: Federal Reserve Bank of St Louis; and Board of Governors of the Federal Reserve System The long-run decline in the popularity of checking accounts until the financial crisis may seem puzzling because, in some ways, these accounts became more attractive over time In the 1960s and 1970s, the only checkable deposits available were demand deposits, which paid no interest Interest-paying NOW accounts were authorized by changes in bank regulations that took effect in 1980 In addition, because there were no ATMs in those days, to withdraw money from your checking account, you needed to go to your bank, stand in line, and fill out a withdrawal slip Banks were typically open only during “banker’s hours” of 10 a.m to p.m from Monday to Friday If stores or restaurants declined to accept checks—as many did—consumers could not spend the funds in their accounts Today, debit cards make it possible for consumers to access the funds in their checking accounts even when buying from a store that doesn’t accept checks Until the financial crisis, to many households and firms, the improved services that checking accounts provided were more than offset by alternative assets that offer higher interest rates The following graph shows households’ and firms’ holdings of various short-term financial assets in July 2016 Even though checkable deposits have increased in popularity in recent years, the value of savings accounts and small time deposits (CDs of less than $100,000) was nearly five times greater than the value of checkable d ­ eposits BK-PED-708052-HUBBARD-160392-Chp10.indd 311 01/03/17 7:38 PM www.downloadslide.net CHAPTER 10 • The Economics of Banking Billions of dollars 312 $10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 Currency Large time deposits Checkable deposits Savings Money market mutual fund accounts and small time shares deposits Sources: Federal Reserve Bank of St Louis; and Board of Governors of the Federal Reserve System Households hold less in checking accounts relative to other financial assets than they once did, partly because households have become wealthier over time With greater wealth, households have been better able to afford to hold assets, such as CDs, where their money is tied up for a while but on which they earn a higher rate of interest Money market mutual funds, such as Vanguard’s Prime Money Market Fund, which were first introduced in 1971, have also been popular Like other mutual funds, money market mutual funds sell shares to investors and use the funds to buy f inancial assets These funds buy only money market—or short-term—assets, such as Treasury bills and commercial paper issued by corporations Money market mutual funds pay higher interest than bank deposit accounts, and they also allow for limited check writing, so they have been formidable competition for bank checking accounts The 2007–2009 financial crisis showed that checking accounts are still useful to households and firms, however Checking accounts provide a safe haven for households and small businesses because their funds are protected up to the $250,000 federal deposit insurance ceiling In addition, very low interest rates persisted for years after the end of the recession of 2007–2009 The interest rate on three-month CDs, which had been about 5% at the end of 2007, was only 0.15% in 2016 Similarly, yields on money market mutual funds, which had been about 5% in 2007, were only about 0.20% in 2016 As a result, many households moved their funds from CDs and money market mutual funds to checking accounts to take advantage of their greater liquidity without giving up much interest See related problem 1.5 at the end of the chapter Bank Assets Banks acquire bank assets with the funds they receive from depositors, the funds they borrow, the funds they acquire from their shareholders purchasing the banks’ new stock BK-PED-708052-HUBBARD-160392-Chp10.indd 312 01/03/17 7:38 PM www.downloadslide.net 313 The Basics of Commercial Banking: The Bank Balance Sheet issues, and the profits they retain from their operations A bank’s managers build a portfolio of assets that reflect both the demand for loans by the bank’s customers and the bank’s need to balance returns against risk, liquidity, and information costs The following are the most important bank assets Reserves and Other Cash Assets  The most liquid asset that banks hold is reserves, which consist of vault cash—cash on hand in the bank (including in ATMs) or in deposits at other banks—and deposits banks have with the Federal Reserve System As authorized by Congress, the Fed mandates that banks hold a percentage of their demand deposits and NOW accounts (but not MMDAs) as required reserves Reserves that banks hold over and above those that are required are called excess reserves Banks had long complained that the Fed’s failure to pay interest on the banks’ reserve deposits amounted to a tax because banks earned no interest on the required reserves they could otherwise have used to make loans or purchase securities In October 2008, during the financial crisis, Congress authorized the Fed to begin paying interest on banks’ required and excess reserve deposits The interest rate is low—0.75% as of December 2016—and, of course, banks earn no interest on vault cash Before the financial crisis of 2007–2009, excess reserves had fallen to very low levels, but because these reserves can provide an important source of liquidity to banks, during the financial crisis bank holdings of excess reserves soared Years after the end of the financial crisis, banks have continued to hold substantial excess reserves because, in addition to receiving interest from the Fed on their reserve balances, many banks remain cautious about making loans, believing that the low interest rates they receive on most consumer and business loans are not sufficient compensation for the default risk on the loans except when the banks are lending to the most creditworthy borrowers Another important cash asset is claims banks have on other banks for uncollected funds, which is called cash items in the process of collection Suppose your Aunt Tilly, who lives in Seattle, sends you a $100 check for your birthday Aunt Tilly’s check is written against her checking account in her bank in Seattle If you deposit the check in your bank in Nashville, the check becomes a cash item in the process of collection Eventually, your bank will collect the funds from the Seattle bank, and the cash item in the process of collection will be converted to reserves on your bank’s balance sheet Small banks often maintain deposits at other banks to obtain foreign-exchange transactions, check collection, or other services This activity, called correspondent banking, has diminished in importance over the past 50 years, as the financial system has provided small banks with other ways to obtain these services Reserves A bank asset consisting of vault cash plus bank deposits with the Federal Reserve Vault cash Cash on hand in a bank; includes ­currency in ATMs and ­deposits with other banks Required reserves ­ eserves the Fed requires R banks to hold against ­demand deposit and NOW account balances Excess reserves Any r­eserves banks hold above those necessary to meet reserve requirements Securities  Marketable securities are liquid assets that banks trade in financial markets Banks are allowed to hold securities issued by the U.S Treasury and other government agencies, corporate bonds that received investment-grade ratings when they were first issued, and some limited amounts of municipal bonds, which are bonds issued by state and local governments Because of their liquidity, bank holdings of U.S Treasury ­securities are sometimes called secondary reserves In the United States, commercial banks cannot invest checkable deposits in corporate bonds (although they may purchase them BK-PED-708052-HUBBARD-160392-Chp10.indd 313 01/03/17 7:38 PM www.downloadslide.net 314 CHAPTER 10 • The Economics of Banking using other funds) or common stock in nonfinancial corporations During the past 15 years, banks have increased their holdings of mortgage-backed securities In 2016, mortgage-backed securities made up about 57% of the securities that banks held During the financial crisis of 2007–2009, the value of many mortgage-backed securities declined sharply, which caused many banks to suffer heavy losses and some banks to fail Loans  By far the largest category of bank assets is loans Loans are illiquid relative to marketable securities and entail greater default risk and higher information costs As a result, the interest rates banks receive on loans are higher than those they receive on marketable securities Table 10.1 on page 308 shows that most bank loans fall into three categories: Loans to businesses—called commercial and industrial, or C&I, loans Consumer loans, made to households primarily to buy automobiles, furniture, and other goods Real estate loans, which include mortgage loans and any other loans backed with real estate as collateral Mortgage loans made to purchase homes are called residential mortgages, while mortgages made to purchase stores, offices, factories, and other commercial buildings are called commercial mortgages Figure 10.1 shows that the types of loans granted by banks have changed significantly since the early 1970s Real estate loans have increased tremendously, growing from less than one-third of bank loans in 1973 to 57% of bank loans in 2016 C&I loans, which were the largest category of loans in 1973, have fallen from more than 40% of bank loans to 24% Continuing slow growth in demand for housing since the financial Figure 10.1 The Changing Mix of Bank Loans, 1973–2016 The types of loans granted by banks have changed significantly since the early 1970s Real estate loans grew from less than one-third of bank loans in 1973 to 57% of bank loans in 2016 Commercial and industrial (C&I) loans fell from more than 40% of bank loans to 24% Consumer loans fell from more than 27% of all loans to about 19% Note: The values are the shares of the total of C&I, consumer, and real estate loans at domestically chartered U.S banks Total loans not include interbank loans or other loans Percentage of total loans MyEconLab Real-time data 80% 70 Real estate loans 60 50 40 C&I loans 30 20 Consumer loans 10 1973 1975 1980 1985 1990 1995 2000 2005 2010 2015 Source: Federal Reserve Statistical ­Release H.8, July 29, 2016 BK-PED-708052-HUBBARD-160392-Chp10.indd 314 01/03/17 7:38 PM www.downloadslide.net The Basics of Commercial Banking: The Bank Balance Sheet 315 crisis has caused C&I loans to increase somewhat relative to real estate loans, although not by enough to reverse the long-run trends Firms take out C&I loans either to finance long-term investments, such as purchases of machinery and equipment, or to meet short-term needs, such as financing inventories Beginning in the late 1970s, some firms that had previously used C&I loans began to meet their long-term funding needs by instead issuing junk bonds, which are bonds that receive below-investment-grade ratings from the bond-rating agencies Once a market for newly issued junk bonds developed in the late 1970s, many firms found the interest rates on these bonds to be lower than what they would have paid on C&I loans from banks When the market for commercial paper developed in the 1980s, some firms that had been using short-term C&I loans from banks began issuing commercial paper instead The decline in the importance of C&I loans has fundamentally changed the nature of commercial banking Traditionally, it would not have been too much of an exaggeration to say that commercial banking consisted of taking in funds as checkable deposits and lending them to businesses C&I loans were typically low-risk loans that banks could count on as the basis of their profits Banks made C&I loans primarily to businesses on which they had gathered private information through long-term relationships In addition, the loans were often well collateralized Both of these factors reduced the chances that businesses would default on the loans Banks usually did not face much competition in making the loans, which kept the interest rates on them relatively high As the demand for C&I loans has declined, banks have been forced to turn to riskier uses of their funds, especially residential and commercial real estate lending The bursting of the real estate bubble beginning in 2006 showed that replacing C&I loans with real estate loans had increased the degree of risk in a typical bank’s loan portfolio Other Assets  Other assets include banks’ physical assets, such as computer equipment and buildings This category also includes collateral received from borrowers who have defaulted on loans Following the bursting of the real estate bubble, many banks ended up owning significant numbers of houses and residential lots, as borrowers and developers defaulted on their mortgages Bank Capital Bank capital, also called shareholders’ equity, or bank net worth, is the difference ­between the value of a bank’s assets and the value of its liabilities In 2016, bank capital for the U.S banking system as a whole was about 14.5% of bank assets A bank’s capital equals the funds contributed by the bank’s shareholders through their purchases of the bank’s stock plus accumulated retained profits As the value of a bank’s assets or liabilities changes, so does the value of the bank’s capital For instance, during the f inancial ­crisis of 2007–2009, many banks saw declines in the values of loans and securities they owned These declines in the value of bank assets resulted in declines in the value of their capital BK-PED-708052-HUBBARD-160392-Chp10.indd 315 01/03/17 7:38 PM www.downloadslide.net 678 Index Indirect finance, Indirect quotations of exchange rates, 249 Individual retirement accounts (IRAs), 10, 370 Indonesia, currency crisis in, 266 Industrial loans, 63 Inefficiencies, of barter economies, 26 Inflation central banks and, 454, 529 expected inflation rates, 118 gold and, 461, 484–486 monetary policy and, 496–497, 531 price stability and, 496–497 Venezuela, 25 Zimbabwe, 25 Inflation gap, 526 IS curve and, 623 Inflation rates, 51, 90 in 2016, 24 central bank independence and, 46 compensation for (interest rates), 55 Deutsche Bank during the German hyperinflation, 45 exchange rates in the long run, 254–255 expected inflation rates, 54, 92–93, 105, 107, 109, 112–114, 626, 628 falling bond prices and low inflation rates, 114–116 Fed actions and, 446 the Fed’s and, 24–25 hyperinflation, 43–45 hyperinflation in Zimbabwe, 31, 51 hyperinflation in Zimbabwe and Venezuela, 25, 43 interest rates on bonds and, 54 money growth and inflation over time around the world, 43 money supply and, 39 quantity theory of money, 40–43 rising, and investments in bonds, 116–118 saving plan and, 101 Venezuela, 448 see also Quantity theory of money Inflation targeting, 528–529 Information defined, 14 financial system role and, 14 Information costs, 94, 98, 106 asymmetric information and, 283 bonds and, 106, 107, 148 checks and, 33 creditworthiness of borrowers, 282 defined, 282 liquidity and, 148 stocks and, 198 Information lag, 520 Information technology, 393, 598 ING Direct, 336 Initial public offering (IPO), crowdfunding, 278 defined, 346 Inside information, defined, 191 Insider trading, 191 Insolvent defined, 389 Lehman Brothers, 411 Institutional investors, 294 Insurance, 213, 304 BK-PED-708052-HUBBARD-160392-Index.indd 678 Insurance companies, 8, 303, 372–374 actuaries, 373 adverse selection, 372, 373 coinsurance, 374 deductibles, 374 defined, 372 financial assets of U.S insurance companies, 373 in financial crisis, 405 law of large numbers, 372–373 life insurance companies, 372, 383 moral hazard, 372, 373–374 premiums, 372 private placement, 372 probability tables, 373 property and casualty companies, 372 restrictive covenants, 374 risk-based premiums, 373 risk pooling, 372–373 screening, 373 Intel, 9, 177, 191 Interest-carry-trade strategy, 159-161 See also Term structure of interest rates Interest-rate ceilings, 416, 417 Interest rate channel, 643 Interest-rate determination in a large open economy, 133–134 in a small open economy, 132–133 the bond market model and changes in interest rates, 110–118 demand and supply for bonds and, 101–110 expected inflation and, 112–114 investment portfolios, 94–99 loanable funds model and the international capital market, 127–136 Interest-rate futures contracts, 222 Interest rate on excess reserves (IOER), 517, 519 Interest-rate parity condition, 260–264 default risk, 263 defined, 263 demand and supply model compared, 265 exchange-rate risk, 264 international capital mobility, 262 and the Internet, 260, 262 investing in Japanese bonds, 262 investing in Mexican bonds, 264–265 liquidity, 263 transaction costs and, 263 see also Foreign exchange market Interest-rate risk, 54, 325–328 defined, 79–80, 325 financial futures to hedge, 221 in investment banking, 349 maturity and, 79 measuring, 326–328 Treasury bonds and, 80 using financial futures to hedge interest-rate risk, 221 Interest rates, 84–85 bond market model and changes in interest rates, 110–118 bond prices and bond yields, 67–68, 71–77 compounding and discounting, 56–62 debt instruments and, 62–65 defined, demand and supply for bonds and, 101–110 extending payback period, 65–66 factors determining, 92, 122 factors for consideration, 56 Fed actions, 499–500 financial transactions involve payments in the future, 55–56 gap between, 139–140 hedging an investment in Treasury notes when interest rates are low, 223 historical lows, 53–54 investment-grade corporate bonds, 299–300 low, 92–93, 387–388 low bond interest rates, 112, 114–116 mortgage, 641 negative on Treasury bills, 154–155 nominal interest rates vs real interest rates, 80–83 notation, 60 peer-to-peer lending, present value and future value and, 54–62 prices of financial securities and, 54, 81 rates of return and, 78–80, 89 real interest rates vs nominal interest rates, 80–83 real world interest rate, 131–134 reasons for, 55 during recessions, 112 Regulation Q ceiling, 415 spread, 306 stability as goal of monetary policy, 500 student loans and, 65–66 tax changes and, 150–151 time, the interest rate, and the present value of a payment example, 60 using the yield curve to predict interest rates, 158–159 yields to maturity, 66–71 see also Bonds; Compounding; Debt instruments; Discounting; Risk structure of interest rates; Term structure of interest rates; Yields to maturity Interest-rate swaps, 234–236, 328 Intermediate targets, in monetary targeting, 521 Internal funding, 286, 297 Internal Revenue Service Code, 371 International capital market, loanable funds model and, 127–136, 136–137 International capital market, 320 open economies, 131 International capital mobility, and interest-rate parity condition, 262 International Energy Agency, 593 International financial markets, 247 International financial system, 542–573 and the euro, 542–543, 575 international reserves defined, 544 see also Balance of payments account; Exchange rate regimes; Foreign exchange market intervention International Monetary Fund, 273 austerity programs, 558 capital controls, 549 defined, 558 Greece, 567 Jamaican Conference (1976), 561 Special Drawing Rights, 552, 561 International reserve currency, U.S dollar as, 557, 562–563 28/02/17 6:53 PM www.downloadslide.net Index International reserves, defined, 544 Internet and interest-rate parity condition, 260, 262 and international capital mobility, 262 new economy of, 598 In the money, 228, 230 Intrinsic value, 228, 231 Inverted yield curves (downward-sloping yield curves), 153 Investment incentives and inflation, 599 in Japanese bonds, 262 Investment analysts, 192–193 Investment banking, 8, 346–362, 379–380 advice and financing for mergers and acquisitions, 346, 347–348 advice on new security issues, 346–347 analysts, 360–361, 380 background and history, 356–359 back-office jobs, 361 boutique banks, 357, 361 “bulge bracket” firms, 357 capital requirements and, 320 career as an investment banker, 360–361, 380 commercial banking and, 356–357 contractual savings institutions, 369–374 credit risk, 349 deal teams, 361 defined, 346 fate of large investment banks, 359–360 finance companies, 368–369 financial crisis of 2007–2009 and, 405 financial engineering and risk management, 346, 348 financial holding companies, 359, 360 funding risk, 349, 350 Glass-Steagall Act (1933), 356, 357–359, 380 Gramm-Leach-Bliley (or Financial Services Modernization) Act (1999), 356, 357 interest-rate risk, 349 leverage, 353 leverage in, 350–354 moral hazard, 354–355 proprietary trading, 346, 349–350 and recession of 2007–2009, 356–357 repurchase agreements (repos), 350–351, 353 research, 346, 348–349 separation from commercial banking, 358, 380 syndicates defined, 346 underwriting new securities, 346, 356 “up or out” policy, 380 see also Hedge funds; Mutual funds Investment-grade bonds, 142 Investment-grade corporate bonds, 299–300 Investment institutions, 381–382 defined, 362 Investment portfolio managers, 253 Investment portfolios See Portfolios Investors in gold, 460–461, 484–486 small, 278 Investor sentiment, measuring with VIX, 244 IOUs, 62 See also Debt instruments iPad, 173 iPhones, 173, 206, 219 BK-PED-708052-HUBBARD-160392-Index.indd 679 IPO See Initial public offering iPod, 173 Iraq, 219, 280 IRAs See Individual retirement accounts Ireland, 566 budget deficits in, 453 in recession, 531, 543 Irwin, Douglas A., 280, 302, 484 Isaac, Earl, 322 IS curve, 615–626, 647–648 actual investment, 616 aggregate demand shock defined, 625 aggregate expenditure, 615–616 American Recovery and Reinvestment Act (2009), 622 autonomous expenditure, 619 calculating equilibrium real GDP, 620–621 constructing, 622–623 consumption function, 617 defined, 615 deriving, 623 equilibrium in the goods market, 615–617 fiscal policy and, 622–623 45 degree-line diagram, 616, 618 full-employment GDP, 618 goods market, 615 inflation gap, 623 multiplier effect, 619–620 negative demand shock, 625 nominal GDP, 615 output gap, 623–625, 625 planned investment spending, 616 positive demand shock, 625 potential GDP defined, 618 real GDP, 615 relationship between aggregate expenditure and GDP, 616 shifts of the IS curve, 625–626 see also IS-MP model IS-LM model, 654–657 defined, 654 deriving the LM curve, 654–655 history and origin of, 635 LM curve, 654–655 shifting the LM curve, 655–656 IS-MP model, 613–646 AD-AS model compared, 614–615 defined, 615 effectiveness of federal funds rate target in recessions, 613, 646 forecasting and macroeconomic models, 614–615 historical origins of, 634–635 IS sands for investment and saving, 614 MP stands for monetary policy, 614 three parts summarized, 615 see also Aggregate demand and aggregate supply model; Channels of monetary policy; IS curve; MP curve; Phillips curve Israel, 598 Big Mac prices in, 273 Italian lira, 542 Italy, 280 central bank independence in, 42, 46 debt default possible, 543 reparations against Germany after WW1, 45, 51 679 Jackson, Andrew, 328, 431 James, Harold, 557 January effect, 198 Japan, 35, 115, 116, 135, 154–155, 171, 272, 274, 329, 394 Bank of Japan, 451–452, 458–459, 487 foreign-exchange cross rates, 250 inflation rate in 1973, 531 inflation rates, 255 MacDonald’s Big Mac prices, 256 military purchases, 576 real GDP, 280 savings rates, 533 see also Bank of Japan Japanese yen, 4, 220, 225, 247–248, 530, 569 and euro, 250 exchange rates, 274 reducing value of, 546 and U.S dollar, 249–250, 250, 251 JCPenney, 369 JDS Uniphase, 196–197 Jobs, Steve, 286–287 JOBS Act See Jumpstart Our Business Startups Act John Deere, 563 Jones, Norman, 84 JPMorgan Chase, 18, 236, 332, 340, 354, 357, 359, 360, 381, 488 and Bear Stearns, 405, 409, 414, 427–428 Bear Sterns, 385 purchase Bear Stearns, 358 TARP/CPP program and, 337 Jumpstart Our Business Startups (JOBS) Act, 278, 295 Junk bonds, 141, 142, 151–152, 169, 172, 194 C&I loans versus, 315 Kabbage, 277, 333 Keynes, John Maynard, 581, 583, 589, 649–650 on multipliers, 647 The Economic Consequences of the Peace, 51 The General Theory of Employment, Interest, and Money, 209, 620, 634–635, 647 King, Angus, 357 KKR See Kohlberg Kravis Roberts & Co Klein, Michael W., 577 Kleiner Perkins Caufield & Byers, 294 Klingebiel, Daniela, 392 Kohlberg Kravis Roberts & Co (KKR), 294, 379 Kohn, Donald, 439 Komatsu, 275 Korea, 116, 135, 280 Kotlikoff, Laurence J., 391, 422 Kruger, Daniel, 155 Kuroda, Haruhiko, 532 Kuznets, Simon, 620 Lacker, Jeffrey, 442, 456 Lanman, Scott, 197 Laplanche, Renaud, Large banks assets, 413 small business lending, 332–333, 342 threat to system of, 358 “too-big-to-fail,” 413 Large-denomination time deposits, 310 Large open economies, 133–134 Latin America, inflation in 1990s, 31 28/02/17 6:53 PM www.downloadslide.net 680 Index Latvia, 577 Law of large numbers, 372–373 Law of one price, 74–75, 253–254 defined, 253 Lazard, 357 Leading indicators, 179 Legal tender, defined, 29 Lehman Brothers, 345, 354, 355, 357 activities, 358 bankruptcy of, 18, 234, 239, 354, 359, 360, 378, 405, 409, 410, 414, 637 compared, 427 counterparties to the repurchase agreements, 310 effect of Fed actions, 410–412 Fed actions, 494 loss on shares, 405 Lehman paper, 381 “Lemons problems” in financial markets, 284–286 Lender of last resort, 11, 432 Bernanke on, 424 Bretton Woods system as, 561 defined, 390 Dodd-Frank restrictions, 443 Federal Reserve as, 329, 401 financial crises and, 390, 407–413 Lenders, LendingClub, 8, 277, 303–304 Lending facilities, Fed assets and, 513 Leverage, 270 defined, 319 hedge funds and, 382 in investment banking, 350–354 perils of, 351–352 ratio, 340 Levich, Richard M., 148 Levie, Aaron, 303 Lewis, Michael, 207, 355 The Big Short: Inside the Doomsday Machine, 207, 238 Li, Geng, 324 Liabilities, 94 defined, 307 Liability of banks, 309–312 defined, 307 LIBOR (London Interbank Offered Rate), 235 Libya, 219 Life insurance companies, 372, 383 Limited liability, defined, 174 LinkedIn, 242 Liquidationist policy, of Federal Reserve, 401 Liquidity, 94, 98 bonds and, 106, 107, 148 defined, 13, 28, 50 financial system and, 13–14 information costs and, 148 and interest-rate parity condition, 263 stocks and, 198 Liquidity management, in bank risk management, 320 Liquidity premium theory (or preferred habitat theory) of the term structure, 162–164, 583 defined, 162 example, 171 summary of, 164 BK-PED-708052-HUBBARD-160392-Index.indd 680 term premium and, 162 using to calculate expected interest rates, 163–164 see also Term structure of interest rates Liquidity risk, 320–321 of commercial banks, 389 defined, 320 Listed options, 225 Lithuania, 577 Living wills, 377, 412–413, 414, 427 LM curve defined, 654 IS-LM model and, 654–657 Loanable funds model, 127–137 demand and supply for loanable funds, 127–129 equilibrium in the bond market and, 129, 131–132 international capital market and the interest rate, 130–131 large open economy, 133–134 small open economy, 131–133 Loan commitment, defined, 334 Loan loss reserve, 418 Loans as bank assets, 308, 314–315 changing mix of bank loans (1973–2016), 314–315 contracts sold without recourse, 335 matching savers and borrowers, 281–282 reasons for interest, 55 securitization, 334–335 simple, 63, 69, 70–71 student loans and interest rates, 65–66 Loan sales, 335–336 defined, 336 Loan securitization, 334–335 Lockhart, Dennis, 533 Lock-in effect, 184 London, 252 London Interbank Offered Rate See LIBOR London Stock Exchange, 9, 176, 208 Long position, defined, 216 Long-run aggregate supply (LRAS) curve ­defined, 590–591 Long-run averages, 95 Long-run equilibrium, 596–597 Long-term bonds, 3, 93 inflation related, 118 Long-term business relationships, in bank risk management, 325 Long-Term Capital Management (LTCM), 365–366, 379–380 Long-term contracts, rigidity of, 589 Long-term loans, 339 Loss aversion, 202 Losses, 98 Lowenstein, Roger, 354, 384 Lucas, Robert E., Jr., 588 M1 aggregate, 50, 52, 521 changing nature of, 523–524 defined, 37 growth rate (1970–2016), 39 level of (1970–2016), 39 measuring (May 2016), 38 see also Money supply M2 aggregate, 50, 52, 521 changing nature of, 523–524 defined, 38 growth rate of (1970–2016), 39 level of (1970–2016), 39 measuring (May 2016), 38 money supply process, 492–493 see also Money supply Maastricht Treaty, 452, 565 Macaulay, Frederick, 326 McAvoy, Michael, 433–434, 457 McCain, John, 357 McCarthy, Jonathan, 499, 500 McCraw, Thomas K., 45 McCulley, Paul, 344 McDonald’s, 97, 175, 192 McDonald’s Big Mac, 250–251, 273 Economist Big Mac Index, 256, 273 prices, 256–257 McFadden Act (1927), 330 McKinsey Global Institute, 195, 196 Macroeconomic equilibrium and AD-AS model, 595–597, 609–610 adjustment to long-run equilibrium, 596 automatic mechanisms, 597 credit crunch and aggregate demand (2007–1009 recession), 598–599 economic fluctuations in the U.S., 597–599 investment incentives and, 599 investment incentives and inflation, 599 long-run equilibrium, 596–597 monetary neutrality defined, 597 money supply changes, 597 negative supply shocks, 598 new Keynesian view, 597 positive supply shocks, 598 shocks to aggregate demand (1964–1969), 597–598 short-run equilibrium, 595–596 stagflation, 598 sticky prices, 597 supply shocks (1973–1975) and after 1995, 598 see also Aggregate demand and aggregate ­supply model Macroeconomic equilibrium and IS-MP model, 633–643, 649–651 complications fighting the recession of 2007–2009, 636–638 expansionary monetary policy, 636, 637–638 forecasting with “real-time data,” 650 increasing risk premium during 2007–2009 recession, 637–638 using monetary policy to fight a recession, 635–636 using monetary policy to fight inflation, 641–643 Macroeconomics, 581 Macroprudential regulation, 417 Macy’s, 369 Madoff, Bernard, 194, 367 Magellan Fund (Fidelity Investment), 8, 176 “Main Street,” 25 Maintenance margin, 224 Make a market, NYSE trading, 408 Malaysia, currency crisis in, 266 Malkiel, Burton, 204, 207 A Random Walk Down Wall Street, 193 28/02/17 6:53 PM www.downloadslide.net Index Mallaby, Sebastian, 382, 426 Malmendier, Ulrike, 196 Managed floating exchange rate, 569–570 Managed float regime (dirty float regime), ­defined, 562 Map of the Federal Reserve System, 12 Margin account, 224 Margin call, 224 Margin requirement, defined, 224 Market (or systematic) risk, defined, 99 Marketable securities, 313 Market capitalization, 175 Market for corporate control, 295 Market for loanable funds approach, 102 Market makers, 252 defined, 350 Market operations, and discount loans ­compared, 468 Marketplace lenders, 6–7 Market value, 347 Market Volatility Index (VIX), 233–234, 245 as a measure of investor sentiment, 244 from Jan 2004–June 2016, 233–234 Marking to market, defined, 224 Marlboro, 27 Martin, William McChesney, 437 Martinez-Peria, Maria Soledad, 392 Massachusetts Financial Services, Inc., 362 Massachusetts Investors Trust, 362 MasterCard, 324 Matched sale-purchase agreement or reverse repo, 502 Matched sale-purchase transactions, 512 Material information, adverse selection and, 286 Mathematical models, 229 Maturity of bonds, 3, 79–80 defined, 64 of Treasury bills, 77 see also Risk structure of interest rates; Term structure of interest rates Maturity mismatch, 354 commercial banks, 389 MBSs See Mortgage-backed securities Mean reversion, 199 Medical insurance, 383 Medium of exchange, defined, 28 Mellon, Andrew, 401, 424 Meltzer, Allan H., 403, 424, 434, 455, 457, 490, 574 Menu costs, 590 Merck, 99 Mergers, investment banking and, 346, 347–348 Mergers and acquisitions (M&A), 347–348 Merrill Lynch, 172, 176, 357, 359, 360, 384, 405 Merton, Robert, 365 Metallic coins, historical background, 32 Mexican bonds, investing in, 264–265 Mexican peso, 247, 273 Mexico currency crisis of 1994–1995, 549, 558 foreign-exchange cross rates, 250 inflation rates, 255 McDonald’s Big Mac prices, 256 Meyer, Brent, 649 Meyer, Eugene, 401 BK-PED-708052-HUBBARD-160392-Index.indd 681 Microsoft, 182–183, 227–228, 281, 291, 346, 347, 444 dividends and, 186–187 on the Dow, 177 example of efficient market hypothesis, 190–191 selling debentures, 287 stock in, Middle Ages, interest rates and, 54 Milken, Michael, 151–152 Miller, G William, 437 Miller, Rich, 137 Mining companies, gold, 461 Misperception theory, 588 Missouri, St Louis and Kansas City Federal ­Reserve District Banks, 433–434 MMDAs See Money market deposit accounts Mobile banking services, 335–336 Mohamad, Matathir, Malaysian Prime Minister, 549 Mojang AB, 347 Momentum investing, 199 Momentum trading, 208 Monaco, 131 Monetarists, 522–523 Monetary aggregate, defined, 37 Monetary base, 462–469 after financial crisis of 2007–2009, 480–482 banking system and, 462–464 bank reserves defined, 464, 475 changing the, 465–468 comparing open market operations and ­discount loans, 468 currency in circulation defined, 464 currency in M1, 464 defined, 462 discount loans defined, 467–468 discount rate defined, 468 excess reserves defined, 465, 475, 482–484 explosion in fall of 2008, 468–470 Federal Reserve and, 462, 462–464 foreign exchange market intervention and, 543–545 money multiplier, 462 money supply process and, 462 movements in (1995–2016), 481 nonbank public and, 462, 475 open market operations defined, 465 open market purchase defined, 465 primary dealers, 465 required reserve ratio, 465 required reserves defined, 465 trading desk, 465 vault cash defined, 464 see also Federal Reserve balance sheet; Money supply process; Simple deposit multiplier A Monetary History of the United States (Friedman and Schwartz), 402, 403, 422, 484 Monetary neutrality, defined, 597 Monetary policy, 494–534 activist policy in, 601 aggregate demand and aggregate supply model and, 600–606, 610–611 balance sheet channel and, 645–646 Bank of England, 531 Bank of Japan, 530–531 Bundesbank, 531 defined, 11 deflation, 530, 535 681 economic growth defined, 498 economic well-being of population, 496 effectiveness during the 2007–2009 recession, 600, 604 Employment Act of 1946, 497 end of “normal,” 494–495, 534 European System of Central Banks (ESCB), 531–532 exit strategy of Fed, 494–495 expansionary, 600–603, 606, 636, 637–638, 656–657 Federal Reserve District Banks and, 435 Federal Reserve System structure formal ­influence on, 440 Fed’s dual mandate, 501 to fight a recession, 635–636 to fight inflation, 641–643 fine-tuning the economy, 601 flow chart for achieving Fed goals, 522 foreign-exchange market stability, 500–501 Full Employment and Balanced Growth Act of 1978 (Humphrey-Hawkins Act), 497 goals of, 496–501, 535–536 high employment, 497, 501 high employment and price stability, 495 high employment in, 497 inflation, 496–497, 501, 530, 531, 535 interest rate stability, 500 international comparisons of, 529–532 IS-LM model and, 656–657 monetary targeting, 539–540 net worth and, 645–646 new policy tools in financial crisis, 494, 532 policy trilemma and, 570–573 price stability, 496–497, 501, 531, 535 price stability and, 496–497 quantitative easing (QE) in, 512 stability of financial markets and institutions, 498 stabilization of financial markets and ­institutions, 600 see also Discount policy; Federal Reserve; Monetary policy tools; Monetary targeting Monetary policy independence, 571 Monetary policy tools, 501–510 analyzing federal funds market, 508–510 benchmark default-free interest rate on 10-year Treasury notes, 513 bond purchases during and after financial crisis, 512–513 changes in discount rate, 506–507 changes in required reserve ratio, 507–508 demand for reserves, 503–504 discount policy defined, 501 discount window defined, 501 effect of change in the required reserve ratio on federal funds market, 508 effect of changes in discount rate and reserve requirements, 506–508 equilibrium in the federal funds market, 503, 505 federal funds rate, 503–505, 517–519, 535–538 federal funds rate and interest rates on ­corporate bonds and mortgages, 506 federal funds rate target, 505–506, 517–519 Federal Reserve assets 2007–2016, 514 interest on reserve balances, 502 28/02/17 6:53 PM www.downloadslide.net 682 Index negative interest rates as, 532–533 Operation Twist, 513 overnight reverse repurchase agreement ­facility, 502, 517 quantitative easing (QE), 512–513, 537 reserve requirement defined, 501 supply of reserves, 504–505 term deposit facility, 502–503 see also Monetary policy; Open market ­operations Monetary targeting, 519, 539–540 choosing between policy instruments, 525 criteria for policy instruments, 524 federal funds rate, 524–525 impact lag, 520 inflation gap, 526 inflation targeting, 528–529 information lag, 520 intermediate targets, 521 output gap, 526 policy instruments or operating targets, 511–522 reserves, 524–525 Taylor rule and federal funds rate, 527 Taylor rule defined, 526–527 using targets to meet goals, 520–522 see also Monetary policy; Monetary policy tools Monetary theory, 581 Money barter, 26 commodity money, 26–27 defined, 3, 25 distinguishing among money, income, and wealth, 29 fiat money, 29 invention of, 26–27 legal tender (Federal Reserve Notes), 29–30 as a medium of exchange, 28, 29 medium of exchange criteria, 29 and prices link, 522–524 relationship with income, 41–42 specialization and, 27 as a standard of deferred payment, 29 as a store of value, 28, 29 transactions costs, 26, 282 as a unit of account, 28, 29 see also Money supply; Payments system; Quantity theory of money Money aggregate See Money supply Money growth and inflation over time around the world, 43 Money market aggregate demand (AD) curve and, 582–584 increase in price level, effect, 583–584 use of term, 582 Money market accounts, 37, 38 Money market deposit accounts (MMDAs), 309, 416 Money market mutual funds, 363–364, 384 bank deposits vs., 415–416 commercial paper and, 363 defined, 363 in financial crisis, 405 net asset values (NAVs), 364 prime money market funds, 363–364 run on in financial crisis of 2007–2009, 405–406 see also Mutual funds BK-PED-708052-HUBBARD-160392-Index.indd 682 Money multiplier, 462, 489–490 after the 2007–2009 financial crisis, 480–482 deriving, 476–480 movement in (1995–2016), 481 Money supply, 50 changes in, 597 defined, financial crisis of 2007–2009 and, 480–482 inflation rates and, 39 M1 aggregate, 37–38, 39 M1 and M2 (1970–2016), 39 M2 aggregate, 38, 39 measuring, 37–39 see also Money; Payments system; Quantity theory of money Money supply process, 461–486 after the 2007–2009 financial crisis, 480–482 currency-to-deposit ratio (C/D) defined, 476–478 deriving a realistic money multiplier, 476–480 effect of increases in currency holding and excess reserves, 475–476 for M2, 492–493 monetary base and, 462 movement in currency-to-deposit ratio (1995–2015), 482 movement in excessive reserves-to-deposit ratio (1995–2015), 482 variables in, 480 see also Federal Reserve balance sheet; Monetary base; Simple deposit multiplier Monopolistically competitive markets, 589 Moody, John, Moody’s Analyses of Railroad Investments, 146 Moody’s Investors Service, 141, 142, 151, 168, 169, 287, 289, 300, 348, 637 Moral hazard, 18, 291–295, 299 backdating stock options, 293 bail-out of banks and, 337, 408 bank leverage and, 320 in bank risk management, 321, 324, 325 in bond market, 293–294 commercial banks and, 321 defined, 283 FDIC insurance, 358 Great Depression, 401 incentive contracts, 292 insurance and, 294 in insurance companies, 372, 373–374 in investment banking, 354–355 mortgage insurance, 640 principal-agent problem, 291 reducing problems with, 294–295 restrictive covenants, 293–294 in shadow banking system, 378 in stock market, 291–293 Morgan, J.P., 431 Morgan Stanley, 8, 192, 353, 357, 359, 360, 361, 377 TARP/CPP program and, 337 Mortgage-backed securities (MBSs), 4, 17, 147, 314, 344 bonds as, 73 swaps and, 237–238 Mortgage insurance proposal, 640–641 Mortgage loans, 4, 8, 22–23 FICO scores, 323 Mortgage market Geithner on, 650 problems with current conditions in, 640 see also Housing market Mortgages defaulting on, 404, 405 residential, 299, 314 as source of external funds, 296–297 Moss, David A., 45 MP curve, 626–627, 648–649 defined, 615 federal funds rate, 626–627 Federal Open Market Committee (FOMC), 626 Taylor rule, 627 see also IS-MP model Mt Gox, 35 Multiple deposit contraction, 474 Multiple deposit creation, defined, 473 Multiple deposit expansion, 470–473 as heart of banking theory, 489 Multiplier defined, 619 Keynes on, 647 Multiplier effect defined, 492–493, 619 IS curve and, 618–620 Mundell, Robert, 571 Municipal bonds defined, 149 tax treatment and, 149–150 Muth, John, 189 Mutual funds, 8, 10, 37, 176, 211, 362–365 benefits and drawbacks of, 368 closed-end mutual funds, 362 creation unit aggregation, 363 defined, 362 exchange-traded funds (ETFs), 363 hedge funds and, 270 hedge funds compared, 368 index fund, 363 load funds, 363 net asset value (NAV), 362 no-load funds, 363 open-end mutual funds, 362 small investors and, 282 types of, 362–365 see also Investment banking; Money market mutual funds Nagel, Stefan, 196 NASDAQ (National Association of Securities Dealers Automated Quotation System), 9, 175–178, 252 NASDAQ Composite index, 177–178, 194, 200 National Association of Securities Dealers Automated Quotation System See NASDAQ National Banking Acts of 1863 and 1864, 329 National banks, 332, 435 defined, 329 National Bureau of Economic Research (NBER), 305, 326, 343, 392, 395 business cycle dating, 578, 579, 652 National income, 617 National Monetary Commission, 431 National saving, 635 NationsBank, merger with Bank of America, 331 Nationwide banking, 330–332 28/02/17 6:53 PM www.downloadslide.net Index Natural gas prices, fracking and, 592–593 Natural rate of unemployment, 497, 629 Yellen on, 649 NAVs See Net asset values NBER See National Bureau of Economic ­Research Negative demand shock, IS curve and, 625 Negative interest rates Denmark, 540 as monetary policy tool, 532–533 on Treasury bills, 154–155 Treasury bonds, 648 Negative supply shocks, 598 Negotiable certificates of deposit (CDs), 416 Negotiable order of withdrawal (NOW) ­accounts, 309, 407, 416, 523 Net asset values (NAVs) money market mutual funds and, 364 mutual funds, 362 share prices and, 377, 384 Net exports, 582 Netherlands, 131, 144–145 Net interest margin, defined, 318–319 Net worth, 308, 315 defined, 287–288 monetary policy and, 645–646 New classical view, 588 New Deal (Franklin Roosevelt), 605 New Keynesian view, 589, 590, 597 New policy tools, in financial crisis of 2007-2009, 532 New York City, 9, 252, 279 role as financial center, 563 New York Clearing House, 431 New York Mercantile Exchange (NYMEX), 215 New York Stock Exchange (NYSE), 2, 4, 9, 175, 176, 225 Big Board, 175 corporate bonds tables, 77 crash of 1987, 408 crash of October 1929, 286 New Zealand central bank in, 454 central bank independence in, 46 NextSeed, 295 Nigeria, 219 Nixon, Richard, 447, 561 Noise trading, 202 Nokia, 176 Nominal and real price of gold, 485–486 Nominal exchange rate defined, 247 equation for nominal and real exchange rates, 252 Nominal GDP, 42, 615 Nominal interest rates, 401 from 1982–2016, 82 defined, 80 vs real interest rates, 80–83, 90, 101 Nominal money balances, alternative approach to, 583 Nonbank financial institutions interconnections, 426 in shadow banking system, 344–345 Nonbank financial intermediaries, 8–9 Nonbank public, monetary base and, 462, 475 Noninstitutional money market mutual fund shares, 38 BK-PED-708052-HUBBARD-160392-Index.indd 683 Non-investment-grade bonds, 142 Nontransaction deposits, 309–310 money market deposit accounts (MMDAs), 309 passbook accounts, 309 savings accounts, 309 time deposits or certificates of deposit (CDs), 309–310 Nonusage fee, 334 Norfolk Southern Corp., 206–207 Northwestern Mutual Insurance Company, 87 Norway, 394 McDonald’s Big Mac prices, 256 Notional principal, 234–235 NOW accounts See Negotiable order of ­withdrawal (NOW) accounts NYMEX See New York Mercantile Exchange NYSE See New York Stock Exchange Obama, Barack, 11, 22, 52, 65, 109–110, 345, 406, 457 American Recovery and Reinvestment Act (2009), 622 appointing Ben Bernanke as chairman of Board of Governors, 437 on exchange rates, 569 President’s Council of Economic Advisers, 608 proposal to raise taxes on dividends and ­capital gains, 185 Small Business Jobs Act of 2010, 599 stimulus program, 632 Volcker as head of economic recovery ­advisory board, 335 Obama, Michelle, 65, 66 O’Brien, Shaun, 37 Off-balance-sheet activities, 334–335 defined, 334 Office of Credit Ratings, 147 Office of the Comptroller of the Currency, U.S Treasury Department, 11, 329, 416 Official reserve assets, 552 Official settlements, 550, 552 OIG See Office of Inspector General Oil prices, 211–212, 393, 593, 602, 604, 628 in financial crisis of 2007–2009, 403 fracking and, 592–593 hedges, 241 speculating with, 219–220 Okun, Arthur, 630, 635 Okun’s law and an output gap Phillips curve, 630–633 defined, 630 poor performance of, 633 to predict the cyclical unemployment rate, 630–631, 632–633 recession of 2007–2009 and, 632–633 as unstable, 649 see also Phillips curve Olney, Martha, 181 Online brokerage firms, 176 ON RRP rate, 502 OPEC See Organization of the Petroleum ­Exporting Countries Open economies, 131–134 OpenInt, 242 Open market operations, 505–506, 510–513, 537 defensive open market operations, 511–512 defined, 465–466, 501 683 dynamic open market operations, 511–512 effect on federal funds market, 507 Federal Reserve float, 511 implemented, 511–513 matched sale-purchase transactions, 512 open market purchase defined, 465 versus other policy tools, 517 see also Federal Reserve Bank of New York; Monetary policy tools Open Market Policy Conference, 401 Open market purchases, 505 defined, 465 Open market sales, 506 defined, 466 reducing reserves, 474 Open Market Trading Desk, 465, 511–513 Operating targets, 511–522 Operation Twist, 513 Opinions, credit rating agencies and, 141 Opportunity costs of holding money, 583 interest rates and, 55 Option premium, 225 defined, 227 Options (calls and puts), 243–244 Amazon stock, 230–232 Apple stock, 225–227, 229–230 Black-Scholes formula, 229 call options defined, 225 defined, 225 interpreting options listings for Amazon.com, 230–232 key features of, 228 for managing risk, 232–233 payoffs to owning options on Apple stock, 227 pricing and the rise of “quants,” 227–229 put options defined, 225 reading the options listings, 229–230 reason for buying or selling options, 226–227 strike price (or exercise price), 225–233 volatility in the stock market (Market ­Volatility Index, VIX) and, 233–234 Options contracts, in foreign exchange market, 267–268 Options listings for Amazon, 230–232 for Apple, 229–230 Option writer, 225 “Oracle of Omaha,” 212 See also Buffet, Warren Orderly liquidation authority, 413, 414 Organization and authority chart, Federal Reserve System structure, 441 Organization of the Petroleum Exporting Countries (OPEC), oil shock (1973), 530, 598 Originate-to-distribute business model, 289 Originator, Out of the money, 228, 230 Output gap, 526, 623–625 defined, 623 federal funds rate target, 626 version of the Phillips curve, 630–631 Overconfidence in investors, 201–202 Overnight reverse repurchase agreements (ON RRPs), 502 Over-the-counter market, defined, 175 Overweight and underweight stocks, 349 28/02/17 6:53 PM www.downloadslide.net 684 Index Pacific Investment Management Company (PIMCO), 344 PaineWebber, 360 Panama, 31 Paper currency, 32–33 Par (or face) value, 63, 64 Partnerships, 9–10, 175 liability, 174 Passbook accounts, 309 Passive funds, 194 Paul, Rand, 450, 458 Paul, Ron, End the Fed, 450 Paulson, Henry, Jr., 412, 428 Paulson, Henry, 411, 412, 446 Paulson, John, 367, 461 Payback period, extending, 65–66 Payments in kind, 49–50 Payments system, 32–37 checks, 33 defined, 32 electronic funds and electronic cash (e-money), 34 new technology and, 33–34 transition from commodity money to fiat money, 32–33 see also Money; Money supply; Quantity theory of money PayPal, 34–35, 49 PayPhrase, 49 Payroll deductions, 371 Peach, Richard W., 499, 500 Peer-to-peer lending, 6–7, 22 Pegging, 395–396, 568–569 Penn Central Railroad, 407 Pension Benefit Guaranty Corporation (PBGC or “Penny Benny”), 371 Pension funds, 8, 10, 369–372 assets of pension funds (2016), 370 defined, 369 defined benefit plan, 370, 371 defined benefit plans, 84–85 defined contribution plan, 371 Employee Retirement Income Security Act of 1974 (ERISA), 371 Europe, 533 401(k) plans, 371, 382–383 interest rates, 383 payroll deductions, 371 Pension Benefit Guaranty Corporation (PBGC or “Penny Benny”), 371 tax treatment of, 370, 371 underfunding, 370, 371–372 vesting, 370–371, 383 People’s Bank of China (PBOC), 569–570 currency intervention, 574 P/E ratio, 195 Perella Weinberg, 357 Perpetuities, yield to maturity, 69–70 Persson, Markus, 347 Pets.com, 178, 203, 499 Philadelphia, 279 Phillips, A W., 627, 635 Phillips curve, 627–633, 648–649, 653 defined, 615 equation for, 629 Fisher effect, 628 inflation rate expectations, 627–628, 649 BK-PED-708052-HUBBARD-160392-Index.indd 684 oil prices, 628 Okun’s law and an output gap Phillips curve, 630–633 Okun’s law to predict the cyclical unemployment rate, 630–631, 632–633 output gap version of the Phillips curve, 630–631 shifts in the Phillips curve, 630 supply shocks, 628 unemployment, 628, 630 Yellen on, 648 see also IS-MP model Physical bank assets, 315 Physical capital investment, expected pretax profitability of, 108–109 PIMCO See Pacific Investment Management Company Piper Jaffray, 357 Planned investment spending, 616 Planned spending, 581 PNC Bank, 332, 487–488 TARP/CPP program and, 337 PNP Paribas, 404 Policy directive, 511 Policy instruments choosing among, 525 criteria for, 524 or operating targets, 511–522 Policy trilemma, 570–573 China, 572–573, 578 defined, 571 Political business cycle defined, 447 Federal Reserve and, 447 Politics, Federal Reserve and, 430, 444 Poloz, Stephen, 452 Ponzi schemes, 194 Portfolios allocation of, 192 churning, 192 cost of acquiring information about, 94, 98 defined, determinants of portfolio choice, 93–99 diversification, 99–101 expected rate of return, 94–95 expected return, 94–95 factors in building, 93–101 liquidity, 94, 98 risk and, 95–96, 95–98, 99–100, 100–101 summary of choices, 99 wealth, 94 Portugal, 144–146, 249 and the euro, 566 in recession, 531, 543 Posen, Adam, 459 Positive demand shocks, 625 government spending after mid-2014, 625 Positive supply shocks, 598 Potential GDP, 618–619, 647 defined, 618 Pound (U.K.) See British pound Powell, Jerome H., 611 PPP See Purchasing power parity Preferred habitat theory See Liquidity premium theory Preferred stockholders, 175 Preferred stock vs common stock, 175 Premiums, in insurance companies, 8, 372 Premiums, risk-based, 373 Present discounted value, 59 See also Discounting; Present value (PV) Present value (PV), 58–62, 85 calculating for a college education, 60–62 defined, 58 see also Discounting; Present discounted value President of United States authority over the Fed, 429–430, 454 the Fed and, 444, 445 the Fed’s Board of Governors and, 444 high employment goal of, 497 President’s Council of Economic Advisers, 581, 608 Price, discounting and the prices of financial assets, 62 Price and money relationship, 40-43 See also Quantity theory of money Price behavior, imperfect competition and, 589 Price levels, 80, 90 consumer price index and, 251 see also Inflation Prices, McDonald’s Big Mac, 250–251, 256–257 Prices and money link, 522–524 Price setters, 589 Price-specie flow mechanism, 555 Price stability, as goal of monetary policy, 495, 496–497, 501, 531 Price takers, 589 Pricing anomalies, 197–199 Primary credit, defined, 514 Primary credit facility or standing lending facility, 514 Primary Dealer Credit Facility, 515 Primary dealers, 439, 465 Primary markets, 176 defined, Prime money market funds, 363–364, 377 new regulations, 384 Prime rate, defined, 324 Principal, 63 Principals, 291 Principal-agent problem defined, 291 speculation by bank employees, 335 Principal-agent problem view of central bank decision-making, 446–448 defined, 447 Principal risk, 346 Private banking services, 334 Private equity firms (or corporate restructuring firms), 294, 295 defined, 294–295 Private firms, 175 adverse selection and, 287 Private information-gatherers, 287 Private-label MBS, 639 Private loans, student, 65 Private placement, 372 Private property rights, 605 Probability, 95 Probability tables, 373 Procter & Gamble (P&G), 246–247 Productivity growth, 594 education and, 595 and the Internet, 598 28/02/17 6:53 PM www.downloadslide.net Index technological advances and, 595 worker training and, 595 Products differentiated, 255 traded internationally, 255 Property and casualty companies, 372 Proprietary trading, 8, 346 Proprietary trading (prop trading), 349–350 Prospectus, 347 Prosper, Prosperity, 16 Proximity mobile payments, 34–35 Public interest view, defined, 446 Publicly traded companies, 285 defined, 175 Publicly traded company, defined, 175 Purchasing power, 40 Purchasing power parity (PPP), 254–256, 272, 273 defined, 254 exchange rates and, 563–564 as theory of exchange rates, 255–256 Putnam Management Company, 362 Put options, 243–244 for Amazon, 230–232 for Apple, 229–230 defined, 225 in foreign exchange market, 267–268, 268 key features of, 228 payoffs from purchasing options on Apple stock, 227 see also Options (calls and puts) PV See Present value Qatar, 279 QE2, 513 QE3, 513 Quantitative easing (QE) defined, 512 Federal Reserve, 116 Japan, 530 in monetary policy, 512 as monetary policy tool, 512–513, 537 yield structure and, 167 Quantity equation, 42 Quantity theory of money, 51–52 accuracy of inflation forecasts and, 42–43 central bank independence, 46–47 defined, 40 equation of exchange, 40 explanation of inflation, 41 hyperinflation, 43–45 money and income relationship, 41–42 money growth and inflation over time around the world, 43 “Quants” or “rocket scientists,” 229 Quota, defined, 255 Raichle v Federal Reserve Bank of New York, 450 Random walk, defined, 191–192 A Random Walk Down Wall Street (Malkiel), 193 Ransom, Roger L., 397 Rates of return on a one-year investment in a stock, 183 defined, 78 general equation for return on a bond, 78–79 interest-rate risk and maturity, 79–80 BK-PED-708052-HUBBARD-160392-Index.indd 685 interest-rate risk for Treasury bonds, 80 interest rates and, 89 trade-off between risk and return, 96 Rational expectations, 188–194, 206–207 vs adaptive expectations, 188–189 defined, 189 stock market and, 188–189 Raymond James, 357 Reagan, Ronald, 446 Real, after-tax return, 101 Real estate loans by banks, 314, 315, 318 Real exchange rate defined, 250 equation for nominal and real exchange rates, 252 Real GDP calculating, 615 calculating equilibrium real GDP, 620–621 during Great Depression, 394, 397 post-recession, 495 Real GDP per capita, 302 financial development related, 280 Real interest rates, 401 defined, 80 determining in a large open economy, 133–134 determining in a small open economy, 132–133 negative, 81 vs nominal interest rates, 80–83, 90, 101 Real money balances, defined, 583 Recession of 2007–2009, 2, 10–11 called “The Great Recession,” 579 commercial bank failures in the U.S (1960–2016), 330 complications fighting, 636–638 credit crunch impact, 599 credit default swaps and, 237–238 default premiums during, 143–144 defaults and, 6–7 derivatives and, 211, 212, 238–239, 239 described, 336 efficient markets theory and, 200 the Fed and inflation, 24 Fed and Treasury Department’s response to, 18–19 federal budget deficit and, 109 “flight to quality” during, 263, 266 Great Depression and, 605–606 growth rates of M1 and M2, 39 housing bubble and, 134–136 increasing risk premium during, 637–638 indicators compared to postwar recessions, 394 investment banking and, 356–357 long term effects (2016), 605, 606–607 low interest rates during, 92, 223 Market Volatility Index (VIX) and, 233–234 monetary policy after, 494–495 monetary policy effectiveness during, 600, 604 mortgage-backed bonds and, 73–74 mortgage-backed securities (MBSs), 638–641 negative interest rates and, 154–155 Okun’s law and, 632–633 relatively slow employment growth after, 579, 606–607 severity of, 614 stock market decline during, 174, 178, 182 685 trends in the U.S commercial banking ­industry, 336–337 U.S Treasury bonds impact, 299 willingness to invest in the stock market after, 174–175, 203 yield curves for, 165–167 see also Financial crisis of 2007–2009 Recessions, 491 in 1937–1938, 482–484 in 1981–1982, 624 in 2001, 178 bank panics and, 391–393, 394 in business cycle, 394 default risk premiums during, 143–144 European, 531–532 interest rates during, 112 predicting with the term structure, 165–167 Red Robin Gourmet Burgers, 99 Regulation Call Reports, 333 risk retention regulation, 289 Regulation Q, 415–416 four instruments, 416 Regulatory agencies, 10–12 See also Federal Reserve Regulatory pattern of crisis and response, 406–407, 420–421 Reinhart, Carmen M., 392, 394, 395, 421, 422–423 Reinvestment risk, 160 Relationship banking, 289 community banks, 307 defined, 288 Relative prices, 496 Reparations, 51 on Germany after WWI, 45 Republic Airways, 174 Repurchase agreements (repos), 310, 350–351, 353 Required reserve ratio, 465 changes in, 507–508 Required reserves as bank asset, 313 defined, 465 Federal Reserve and, 313 Required return on equities, 200 defined, 182 Research, in investment banking, 346, 348–349 Reserve aggregates, 524 Reserve balances, interest on, 502 Reserve Bank Organizing Committee, 433–434 Reserve Bank presidents, 443 Reserve currency, 563 Reserve Management, 364 Reserve Primary Fund, 364, 381, 405 Reserve requirement costs to banks, 435–437 defined, 501 effect of changes in reserve requirements, 507–508 Reserves as bank asset, defined, 313 demand for, 503–504 monetary targeting, 524–525 single bank responding to increase in, 470–471 supply of, 504–505 28/02/17 6:53 PM www.downloadslide.net 686 Index Residential mortgages, 299, 314 Restrictive covenants, 293–294, 299 in bank risk management, 325 defined, 293 in insurance companies, 374 Retail funding, 350 commercial banks and, 375 Retained earnings, dividends vs., 184 Retirement savings, 8, 201 Return, defined, 78 Return on assets (ROA) defined, 319 leverage and, 351 Return on equity (ROE) defined, 319–320 leverage and, 351 Revaluation, defined, 559 Reverse repurchase agreements (reverse repos), 502, 512, 538 in bank risk management, 321 Revised Pay As You Earn (or REPAYE) plan, 65–66 Riegle-Neal Interstate Banking and Branching Efficiency Act (1994), 331 Risk, 95–98 bonds and, 106, 107 counterparty, 215 default risk, 53 defined, 95 idiosyncratic (or unsystematic risk), 100, 182 market (or systematic) risk, 99 reinvestment, 160 stocks and, 198 trade-off between risk and return, 96 of Treasury bonds, 53–54 see also Default risk; Default risk premium Risk-adjusted assets, 418–419 Risk averse, 96 Risk-based premiums, 373 Risk loving, 96 Risk management financial engineering and, 348 investment banking, 346 options for, 232–233 Risk neutral, 96 Risk pooling, 372–373 Risk reduction, using financial derivatives, 212–213 see also Derivatives; Hedging Risk retention regulation, 289 Risk sharing defined, 13 financial system and, 13 Risk structure of interest rates, 140–152, 168–170 bond rating agencies and conflict of interest, 139–140 bond ratings (interpreting), 142 credit rating agencies and conflict of interest, 146–148 default premiums during recessions, 143–144 default risk premiums on bonds, 141–144 defined, 140 junk bonds, 151–152 liquidity and information costs, 148 summary of, 151 BK-PED-708052-HUBBARD-160392-Index.indd 686 tax treatment, 148–151 see also Bonds; Default risk (or credit risk) ROA See Return on assets “Rocket scientists” or “quants,” 229 ROE See Return on equity Rogoff, Kenneth S., 392, 394, 395, 421, 422–423 Rolling over, 56 Rollover risk, 350 Rollover strategy, 156–157 investment banking, 350 see also Expectations theory of the term structure Rolls-Royce, 249 Rolnick, Arthur J., 403, 424 Roman Empire, 49 debasement of coinage during, 49 history of coin use, 32 Romer, Christine, 181, 204, 608, 632–633 Romer, David, 635 Roosevelt, Franklin, 400, 424, 445 death of, 605 New Deal, 605 Rosengren, Eric S., 613, 614 Russia, 246–247 McDonald’s Big Mac prices, 256–257 Russian rubles, 27 S&P 500 index, 97, 177–178, 194, 200, 208, 211, 220, 233, 363, 366 from 1920–1939, 398 see also Standard & Poor’s Sachs, Jeffrey, 577 Sales finance companies, 368, 369 Salomon Brothers, 354–355, 360 Sanders, Bernie, 24, 25, 442, 443 Sands, Peter, 32 Sapienza, Paola, 196 Sargent, Thomas, 45 Savers, interest rates and, 299 matching with borrowers, 281–282, 301–302, 498 “Saving glut”, U.S housing boom and, 134–136, 137 Savings, household holdings of financial assets, 9–10 Savings accounts, 10, 38, 309 automatic transfer of, 523 Savings and loans, crisis, 417–418 Savings banks, Savings institutions, 38 Savings rates, negative interest rates and, 533 Scherzer, Max, 85 Schiller, Robert, 23, 199–200, 398 Schlesigner, Arthur M., Jr., 423 Scholes, Myron, 229, 365 Schwab Total Stock Market Index Fund, 282 Schwartz, Anna, 43, 181, 402, 403, 422, 424, 484 Scott, Hal, 350 ScottTrade, 305 Screening, in insurance companies, 373 Seasonal credit, defined, 515 SEC See Securities and Exchange Commission Secondary (or seasonal) offering, 346 Secondary credit, defined, 514 Secondary loan participation, 335 Secondary markets, 23, 71, 73, 74–75, 176 defined, Secondary reserves, 313 Second Bank of the United States, 328, 431 Secretary of the Treasury, 400, 409, 440 Securities as bank asset, 313–314 defined, investment banking, 346 Securities and Exchange Commission (SEC), 11, 147, 191, 245, 302 accredited investors, 366 Congress establishing in 1934, 286 crowdfunding sites, 296 prospectus for, 347 regulating stock and bond market, 375 regulating stock and bond markets, 376 top managers’ financial statements, 291–292 Securitization adverse selection and, 288–290 after Lehman Brothers failure, 599 defined, Securitized loans, services provided by, 15 Security issues, investment banking and, 346, 346–347 Segmented markets theory of the term structure, 161–162 defined, 161 shortcomings of, 162 summary of, 164 upward sloping yield curve and, 162 see also Term structure of interest rates Sell side mandate, 347 Senior debt, 418 Separation of ownership from control, 291 Settlement by delivery, 217 Settlement by offset, 217 Settlement date, 215, 267 defined, 215 Shadow banking system, 344–378 background and history, 374–378 bank panics in, 393–394 in financial crisis of 2007–2009, 405 fragility, 376–377 lending channel, 644–645 nonbank financial institutions, 344–345 regulation of, 376 risk level, 425–426 risks, 384–385 systemic risk and, 375–376 as threat to stability of U.S financial system, 344, 378 vulnerability to runs, 377 see also Hedge funds; Insurance companies; Investment banking; Mutual funds; Pension funds Shakespeare, William, Shanghai Stock Exchange, 176 Shareholders, 3, 174, 291, 440 Shareholders’ equity (bank capital), 308, 315 Shenzhen Stock Exchange, 176 Shiller, Robert, 23, 181 Shocks to aggregate demand (1964–1969), 597–598 in aggregate demand and aggregate supply model, 602–603 Short position, defined, 216 28/02/17 6:53 PM www.downloadslide.net Index Short-run aggregate supply (SRAS) curve, 591–592 defined, 588–590 Short-run equilibrium, 595–596 Short sales, 226 Short selling, 365, 366 Short-term bonds, Short-term business loans, 63 See also Simple loans Short-term investments, 38 Simple deposit multiplier, 470–474, 487–489 banking system responding to increase in reserves, 471–473 calculating, 473–474 defined, 473 multiple deposit creation defined, 473 multiple deposit expansion, 470–473 single bank responding to increase in reserves, 470–471 see also Federal Reserve balance sheet; Monetary base; Money supply process Simple loans defined, 63 yield to maturity, 69, 70–71 Singapore, 252 Slovakia, 577 Slovenia, 280 Small Business Administration, 333 Small businesses credit rationing to, 290–291 lending by large banks, 332–333, 342 peer-to-peer lending, see also Corporations; Firms; Startup businesses Small Business Jobs Act of 2010, 599 Small-denomination time deposits, 310 Small firm effect, 198 Small investors, 281–282 fintech and crowdsourcing, 278 problems facing, 281–282 Small open economies, 131–133 Small to medium-sized firms, external finance for, 297, 299 Smartphones banking transactions and, 336 digital currency, 35 Sweden’s cashless society, 36–37, 49 Smithsonian Conference, 561 Smoot-Hawley Tariff Act (1930), 398 Smucker’s, 268–269 Social networking, and crowdfunding sites, 278 SoFi (Social Finance), 7, 169, 277 credit scores, 323 creditworthiness, 278 Sole proprietorships, 10, 174, 175 defined, 174 Sony, 4, 176, 247–248 Soros, George, 270, 388, 461, 564 South Korea Big Mac prices in, 273 currency crisis in, 266 South Korean won, 394, 395, 395–396, 569 Sovereign debt, 453 Sovereign debt crises, 395, 396–397 central banks and, 453 default, 423 and eurozone, 543 BK-PED-708052-HUBBARD-160392-Index.indd 687 Soviet Union, former USSR, 253 Spain, 169, 280, 566 budget deficits in, 453 central bank independence in, 46 debt default possible, 543 and the euro, 566 in recession, 531–532, 543 Spanish conquest of Mexico and Peru, gold and silver exports to Europe, 40 Special Drawing Rights, International Monetary Fund, 552, 561 Special investment vehicles (SIVs), 419, 426–427 Specialization, 44 defined, 27 Speculating, 240, 268–271 by banks, 335 with commodity futures, 218, 232 defined, 214 hedge funds, 365 on movements in exchange rates, 260 Speculative attacks, 559–560 Speculative excess, Federal Reserve and, 401 Speculators, 212 driving down value of a currency, 270–271 exchange rate risk, 269 and liquidity, 270 Spot market transactions, in foreign exchange market, 267 Spot price, defined, 215 Spread, 306 interest rate, 318 underwriting new securities, 346 Stability of financial markets and institutions, 498 Stabilization policy, 601, 606, 650 defined, 600 Stagflation, 598 Standard & Poor’s, 141, 142, 146, 177, 287, 289, 348 Standard and Poor’s Ratings Definitions, 142 see also S&P500 Index Standard of deferred payment, defined, 29 Standard of living, 279 Standby letter of credit, defined, 334 Standing lending facility, 514 Startup businesses, 303 crowdfunding for, 278 see also Corporations; Firms; Small businesses State banks, 329, 431, 435 See also Commercial banks State Street Investment Corporation, 362 Sterilized intervention, 545, 574 Sticky prices, 589, 597 Stock exchanges, 175–177 defined, 175 Deutsche Borse (Germany), 176 Euronext, 176 Hong Kong Exchanges, 176 London Stock Exchange, 176 NASDAQ (National Association of Securities Dealers Automated Quotation System), 9, 175–178, 200 New York Stock Exchange (NYSE), 2, 4, 9, 77, 175, 176, 225 Shanghai Stock Exchange, 176 Shenzhen Stock Exchange, 176 Tokyo SE Group, 176 Toronto Stock Exchange, 176 world stock exchanges (2015), 176 687 Stock indexes, 220 Stock market actual efficiency in financial markets, 197–200, 208 adverse selection and, 284–285 behavioral finance and, 201–203, 209 bubbles, 202–203 common stock vs preferred stock, 175 corporation defined, 174 crash of 1929, 398, 408 crash of 1987, 408, 498 dot.com bubble, 393, 498–499 economy and, 179 efficient markets hypothesis, 190–196, 206–207 financial analysts and hot tips, 192 financial crisis of 2007–2009 and the efficient markets theory, 200, 208 fluctuations (Jan 1999–May 2016), 178–179 fundamental value of stock, 185–186, 189, 190–191, 197, 199–200, 202 Gordon growth model, 186–188 indexes on Wall Street Journal, Web site, 298 inside information and, 191 investing $100 per month from age 22 (results), 195 investing in, 182–183 investment analysts, 196–197 investor distrust of, 194–195 limited liability defined, 174 Market Volatility Index (VIX), 233–234 mean reversion, 199 measuring the performance of, 177–178 moral hazard in, 291–295 noise trading, 202 portfolio allocation, 192 predictability of stock prices, 190–191 price determination for stocks, 174, 182–183, 205 pricing anomalies, 197–199 publicly traded companies, 175 randomly picking stocks, 193 rational expectations and, 188–189, 206–207 sole proprietors defined, 174 stock exchanges, 175–177 taxes on dividends and capital gains, 184–185 trading, 192 volatility in, 199–200, 233–234 willingness to invest in after the recession of 2007–2009, 174–175, 203 see also Efficient markets hypothesis Stock market indexes, 177–178 defined, 177 see also Stock exchanges Stock mutual funds, 176 Stock prices, in Great Depression, 394 Stocks, Apple, prices, 173 backdating stock options, 293 black swan event, 97–98 defined, Dow Jones Industrial Average (often called “the Dow”), 174 investing in for one year, 183–184 prices as leading indicators, 179 as source of external finance, 277, 297, 298, 299, 301 28/02/17 6:53 PM www.downloadslide.net 688 Index Stock values, 297 Store of value, defined, 28 Stress index, 410 Stress tests SIFIs, 412–413 by the Treasury, 406 Strike price, 225–233, 267 defined, 225 Structural unemployment, 497 Student loans, 85–86 compounding and discounting, 65–66 extending payback period, 65–66 interest rates and, 65–66 types of, 65 yield to maturity, 70–71 Subordinated or junior debt, 418 Subprime borrowers, 17, 23, 349 Subprime mortgages, in financial crisis of 2007–2009, 404–405, 405 Subsidized student loans, 65 Summers, Lawrence, 32, 46, 454 Sunshine Act (1976), 439 Sun Trust, 332 SunTrust, TARP/CPP program and, 337 Supply curve for bonds, 108, 108–111 Supply shocks from 1973–1975 and after 1995, 598 defined, 591 Phillips curve and, 628 Surplus in balance-of-payments, 552 Sutch, Richard, 397 Swap contracts, 234 Swap dealers, 236 Swaps, 244–245 credit default swaps, 236–238 credit swaps, 236 currency swaps, 236 defined, 234 interest-rate swaps, 234–236 payments in, 236 regulation of, 236 Sweden, 36–37, 49, 394, 426, 454 exchange rates, 572 savings rates, 533 Swedish Hasbeens, 49 Sweep accounts, 523 Swish, 36 Swiss central bank, rising franc, 547–548, 562 Swiss National Bank, 532 exchange rates, 572 Switzerland, 280 Big Mac prices in, 273 central bank independence in, 46 exchange rates, 572 foreign-exchange cross rates, 250 savings rates, 533 Sylla, Richard, 148, 279, 280, 302 Syndicates defined, 346 Systemically important financial institutions (SIFIs), 377, 412–413 Systemic risk, 99 defined, 375, 408 shadow banking system and, 375–376 “too-big-to-fail” and, 408 T-accounts, 317–318, 340 defined, 317 BK-PED-708052-HUBBARD-160392-Index.indd 688 Taleb, Nassim Nicholas, The Black Swan: The Impact of the Highly Improbable, 97–98 TALF See Term Asset-Backed Securities Loan Facility Tariff, defined, 255 TARP See Troubled Asset Relief Program Tasci, Murat, 649 Taxes, 101, 109 bonds and, 109, 148–151 double taxation of dividends, 184–185 effect of tax changes on bond prices, 150–151 how tax treatment of bonds differ, 149 pension funds and, 370, 371 risk structure of interest rates and, 148–151 on stocks, 184–185, 199 Taxi example of barter, 27 Taylor, John B., 136, 526, 540 Taylor rule, 526–527, 540 defined, 526 MP curve, 627 summarized, 623 TD Ameritrade, 176, 305 TD Bank, 332 Technical analysis by investors, 201 as version of adaptive expectations, 188 Technical analysts, 192–193 Technological advances, productivity growth and, 595 Technological change, 594 Temin, Peter, 204 Temporary employment, 633 Temporary lending facilities, 515 Term Asset-Backed Securities Loan Facility (TALF), 516 Term deposit facility, 502–503 Term premium, defined, 162 Term Securities Lending Facility, 515 Term spread, 165 yields on 10-year Treasury notes vs 3-month Treasury bills, 165 Term structure of interest rates, 170–171 defined, 152 expectations theory of the term structure, 155–159 explaining, 155 interest carry trade and, 159–161 interest rates on 3-month Treasury bills and 10-year Treasury notes (1970–2016), 154 liquidity premium theory (or preferred habitat theory), 162–164 negative interest rates on Treasury bills, 154–155 predicting recessions and, 165–167 segmented markets theory of the term structure, 161–162, 164 summary of theories of, 164 Treasury yield curves and, 152–154 yield curves (Feb 2007, Jan 2008, Jun 2016), 165–167 see also Bonds Terrorist attacks of September 11, 2001, 498 Thailand, currency crisis in, 266 Thailand bat, 395 Thatcher, Margaret, 531 Thinly traded derivatives, 238–239 Thornton, Daniel L., 489 Tier capital, 418 Tier capital, 418 Time, the interest rate, and the present value of a payment example, 60 Time deposits, 38, 309 small- and large-denomination, 310 Time horizon, 100 Timelines, 63–65, 101 Time value, 228, 231 Time value of money, defined, 58 TIPS See Treasury Inflation-Protection Securities Tokyo, 252 Tokyo SE Group, 176 Too-big-to-fail policy, 358 “Too-big-to-fail” policy, 403, 407–409 Bank of the United States, 424 defined, 409 Dodd-Frank Act (2010) and, 412 Federal Reserve, 403 large banks, 413 Top managers, moral hazard and, 291–292 Toronto Stock Exchange, 176 Toxic assets, 336 Toyota, 176 Toys “R” Us, 168 Tradable securities, Trade balance, 550 Trade barriers, 255–256 quotas, 255–256 tariffs, 255–256 Trade credit, as source of external finance, 296–297 Trade-off between risk and return, 96 Traders, 74 Trade-weighted exchange rate, 265–266 Trading activities, 335 Trading costs, 199 Trading desks, 349, 465 Trading Room Automated Processing System (TRAPS), 511 Federal Reserve Bank of New York, 511 Transaction costs, 27, 208, 282–283, 299, 302 crowdfunding, 278 defined, 26, 282 economies of scale, 282 financial intermediaries and, 282–283 in interest-rate parity condition, 263 Transaction deposits, 309 Transaction fees, 305 Transactions motive, 583 Transferring funds, 34 Transparency of operations, 528 Federal Reserve System structure, 444 Transportation stocks, 208 TransUnion, 322 TRAPS See Trading Room Automated Processing System Traveler’s checks, 38 Travelers insurance company, 360 Treasury bills, 90, 101 bill tables, 76–77 defined (maturity of year or less), 152 institutional investors, 160 investment returns, 182–183 negative interest rates on, 154–155 see also U.S Treasury Department; U.S ­Treasury securities 28/02/17 6:53 PM www.downloadslide.net Index Treasury bonds, 88, 90 bond tables, 74–75 default risk, 141 defined, 152–153 futures contracts and, 232 interest rates (1999–2016), 143–144 interest rates and, 53–54, 83 investment risk and, 53–54, 80 post-recession, 114–115 tax treatment and, 149 see also Bonds; Risk structure of interest rates; Term structure of interest rates; U.S Treasury Department; U.S Treasury securities Treasury-Federal Reserve Accord, 445 Treasury futures, 221, 232, 242 See also U.S Treasury Department; U.S Treasury securities Treasury Inflation-Protection Securities (TIPS), 82–83, 90, 91 Treasury notes defined, 152–153 five-year Treasury note futures, 222 futures contracts and, 232, 242 hedging, 220–221 hedging and, 213, 221, 222 interest on 10-year (1970–2012), 154 note tables, 74–75 see also U.S Treasury Department; U.S ­Treasury securities Treasury put options, 232 Treasury yield curves, 152–154, 171 Trends in the U.S commercial banking industry, 328–332 bail-out of banks and, 337 bank panics, 329 Capital Purchase Program (CPP), 337 commercial bank failures in the U.S (1960–2016), 330 early history of U.S banking, 328 electronic banking, 335–336 expanding the boundaries of banking, 333–336 Federal Deposit Insurance Corporation (FDIC), 329–330 Federal Reserve, 329–330 off-balance-sheet activities, 334–335 recession of 2007–2009, 336–337 rise of nationwide banking, 330–332 ten banks receiving largest Treasury investments under the TARP/CPP program, 337 ten largest U.S banks (2015), 332 Troubled Asset Relief Program (TARP), 337, 342 see also Commercial banks Trichet, Jean-Claude, 453 Tropicana, 213 Troubled Asset Relief Program (TARP), 18, 73, 337, 342, 359, 406 capital injections to commercial banks, 420 criticism of, 412 T Rowe Price, 363 Truman, Harry S., 445, 605 Trump, Donald, 24, 116, 117 banking regulations, 333 China as currency manipulator, 578 value of dollar and, 266 BK-PED-708052-HUBBARD-160392-Index.indd 689 Tullock, Gordon, 447 Turner, Sarah, 61 21st Century Glass-Steagall Act, 357–359 UBS, 357, 360 Underfunded pension plans, 370, 371–372 Underwater, 228 Underwriting, Underwriting new securities, 346–347, 356 defined, 346 Unemployment after Lehman Brothers insolvency, 411, 412 natural rate of, 497 Phillips curve and, 628, 629, 630 types of, 497, 629 Unemployment insurance compensation, 497, 604 Unemployment rates in 2016, 495 AD-AS model, 581, 606 after financial crisis of 2007–2009, 16 during Great Depression, 397, 398 at end of recession, 579–581, 606 full-employment rate of unemployment, 497 in Great Depression, 394 hysteresis and, 604–605 zero percent rate of, 497 Unforecastable error, 189 Unincorporated businesses, 9–10 Unionization, decline in, 633 Unit banking states, 330 United Kingdom, 115, 205, 460, 461, 612 Bank of England, 451, 459 at Bretton Woods, 557 consols, 87 declining to enter the euro zone, 542 Dr Pepper prices, 254 flight to quality, 263 flight to safety, 275 foreign-exchange cross rates, 250 MacDonald’s Big Mac prices, 256–257 oil futures, 241 reparations against Germany after WW1, 45, 51 withdrawing from exchange rate mechanism (ERM), 564 see also Bank of England; Brexit; British pound United Negro College Fund, 409 United States Bank of the United States, 279, 431 bank panics list, 392 at Bretton Woods, 557 central bank independence, 46 China and the dollar peg, 569–570 commercial bank failures in the U.S (1960– 2016), 330 dollar retaining role as a reserve currency, 563 economic fluctuations, 597–599 foreign-exchange cross rates, 249–250 McDonald’s Big Mac prices, 250–251, 256–257, 273 movements in the trade-weighted exchange rate of U.S dollar, 266 real GDP, 280 real world interest rate, 131, 133–134 reparations against Germany after WW1, 45, 51 yuan-dollar exchange rate, 570 689 Unit of account, defined, 28 Unsterilized intervention, defined, 545, 546–547 Unsubsidized student loans, 65, 86 Unsystematic risk (or idiosyncratic risk), 100, 182 Upfront fee, 334 Upstart, 341 Upward-sloping yield curves, 153 Urban League, 409 Uruguay, 280 U.S Bancorp, 332 TARP/CPP program and, 337 U.S Bureau of Economic Analysis, 395, 397 U.S Bureau of Labor Statistics, 395 U.S Congress See Congress U.S Constitution, and the Fed, 449–450 U.S dollar, 220, 236 China and the dollar peg, 569–570 as dominant international currency, 577 and euro, 250, 251 “exorbitant privilege” of, 562–563 factors influencing exchange rate, 271 fluctuations in exchange rates (2004–2016), 250 free capital flows, 571 as international reserve currency, 557, 562–563 Oct 2016 exchange rates, 247 retaining role as a reserve currency, 563 and yen, 249–250, 250, 251 Zimbabwe’s use of as currency, 25, 31 U.S House of Representatives, 429–430 U.S Mint, 461, 485 metal prices, 490 U.S Senate, 429–430 U.S Treasury Department, 2, conflict with Federal Reserve, 445–446 coupon bonds, 64 currency in circulation, 464 Daily Treasury Yield Curve Rates, 153, 172 on desirable payments systems, 33–34 Office of the Comptroller of the Currency, 329 on paper money, 30 policy for accepting legal tender, 30 response to recession (2007–2009), 18–19, 23 secretary of, 400, 409, 440 stress test by, 406 Treasury-Federal Reserve Accord, 445 U.S Treasury securities, 170–171 in bank risk management, 321 benchmark default-free interest rate on 10-year Treasury notes, 513 defined (general term: Treasury bonds), 153 Federal Reserve and, 299 foreign demand for, 266, 275 interest rate on 10-year notes, 300 TIPS (Treasury Inflation-Protection Securities) as a percentage of all Treasury securities (1996–2014), 83 see also Treasury bills; Treasury bonds; Treasury futures; Treasury notes Value-at-risk (VAR) approach, 335 Value Line, 287 Vanguard, 362, 363 Vanguard 500 Index Fund, 193, 195, 366–367 Vanguard Large-Cap ETF, 363 Vanguard’s Global Equity Fund, 176 28/02/17 6:53 PM www.downloadslide.net 690 Index Vanguard’s Prime Money Market Fund, 312 Variable rates, in bank risk management, 325 Vault cash as bank asset, 313 defined, 464 Velocity of money, 40, 42, 51 See also Quantity theory of money Venezuela, 25, 448 Big Mac prices in, 273 Venture capital firms, 294 Verlager, Philip, 593 Vermann, E Katarina, 610 Vietnam, 280 Vietnam War, 597 Virtual banks, 336 Visa, 324 VIX See Market Volatility Index Volatility excess, 199–200 in exchange rates, 246–247 Market Volatility Index (VIX), 233–234 of stock, 174, 229, 233–234 Volcker, Paul, 335, 437, 446, 522 appointed Fed chairman in 1979, 629, 641 mandate to bring down inflation, 629 Volcker Rule, 335, 350 Dodd-Frank on, 420 Volkswagen, 576 Wachovia Bank, 357, 360 Walgreens Boots Alliance Inc., 379 “Wall Street,” 25 Wall Street (New York City), 9, 175 Wall Street Journal original editor Charles Dow, 208 stock market indexes on Web site, 298 on stock selection, 194 Wall Street Reform and Consumer Protection Act See Dodd-Frank Act, or Wall Street Reform and Consumer Protection Act Wal-Mart, 77, 175 Walt Disney, 177 Walt Disney World Orlando, 272 Warburg, Paul, 455 Warburg, Siegmund, 379 Warner, Mark, 640 War of 1812, 431 BK-PED-708052-HUBBARD-160392-Index.indd 690 Warren, Elizabeth, 357 Warsh, Kevin, 439 Washington Mutual, 358 Washington Nationals baseball team, 85 Wealth defined, 29 demand for bonds and, 104–105, 107 households, 179, 608 portfolios, 94 Webvan, 178, 498, 499 Weir, David R., 397 Wells Fargo Bank, 2, 317–318, 332, 436, 465, 487, 488 Fed ownership by, 429 interest rates on CDs, 92 lending to small business, 342 payments in a swap transaction with IBM, 234–235 TARP/CPP program and, 337 Wessel, David, 381, 439 West Texas Intermediate crude oil prices, 219 Whaley, Robert E., 233, 234 Wheelock, David C., 165, 330, 434, 455, 457, 484 Wholesale funding, 350 Shadow banking system, 375 Wicker, Elmus, 403 Williams, John C., 495, 539–540, 613, 614 Wilson, Woodrow, 431, 433, 455 Wohar, Mark E., 165 Wolff, Edward, 101 Worker training, productivity growth and, 595 World Bank, 280, 301 World-exchanges.org, 176 World real interest rate, 131–134 World stock exchanges (2015), 176 World War I Liberty Bonds, 510 World War II, postwar prosperity, 605 Yield curves “Daily Treasury Yield Curve Rates” (treasury gov), 172 interpreting (Feb 2007, Jan 2008, Jun 2016), 165–167 for predicting inflation, 165 for predicting recessions, 165–167 segmented markets theory, 161–162 Treasury yield curves, 152–154, 171 using the yield curve to predict interest rates, 158–159 Yields to maturity, 86–87, 102 corporate bonds, 70–71 defined, 68 determining default risk in, 143 discount bonds, 69, 70–71 dividend yield, 183 fixed-payment loans, 69 inverse relationship with bond prices, 67–68, 74 perpetuities, 69–70 simple loans, 69, 70–71 student loans, 70–71 see also Debt instruments; Interest rates; Risk structure of interest rates; Term structure of interest rates Young, Roy, 401 Zero-sum game, 217 ZestFinance, 278 Zimbabwe, 24, 25, 31, 43, 51 Zingales, Luigi, 196 Zogby Interactive, 196 Zumbrun, Josh, 137 Zurich, 252 Yahoo!, 75, 98 Yellen, Janet L., 11, 52, 388, 437, 442, 458 employment and federal funds rate, 580, 581 on inflation and interest rates on bonds, 54 interest rates, 52 Jackson Hole (2016 conference), 495, 534, 538 on natural rate of unemployment, 649 on Phillips curve, 648 threat of bubbles, 500 28/02/17 6:53 PM www.downloadslide.net Key Symbols and Abbreviations *: Equilibrium value of a variable ∆: Change in a variable ∆D: Change in deposits ∆R: Change in reserves p: Current inflation rate pe: Expected inflation rate a: A constant that represents how much the gap between the current rate of unemployment and the natural rate affects the inflation rate AD: Aggregate demand AD–AS model: Aggregate demand and aggregate supply model AE: Aggregate expenditure AS: Aggregate supply B: Monetary base Bnon: Nonborrowed monetary base BR: Borrowed reserves C: Consumption spending C: Coupon (on a bond) C: Currency in circulation C/D: Currency-to-deposit ratio D: Checkable deposits e: Real exchange rate E: Nominal exchange rate ER: Excess reserves ER/D: Excess reserves-to-deposit ratio FP: Fixed payments FV: Future value g: Constant growth rate of dividends in the Gordon growth model G: Local, state, and federal government purchases i: Nominal interest rate i1t: Interest rate at time t on a one-year bond int: Interest rate at time t on an n-year bond iD: Discount rate; interest rate the Federal Reserve charges on discount loans to banks iff: Federal funds rate iIOER: Interest rate paid by the Federal Reserve on banks’ reserve deposits I: Investment spending (on real physical capital) IS curve: Equilibrium in the goods market LRAS: Long-run aggregate supply m: Money multiplier M: Quantity of money M1: Currency plus checkable deposits; narrow definition of the money supply M2: Broad definition of the money supply MP curve: Monetary policy M/P: Real money balances MPC: Marginal propensity to consume n: Years NX: Net exports ON RPP: Overnight reverse repurchase agreements P: Price level P e: Expected price level PPP: Theory of purchasing power parity r: Real interest rate R: Rate of return R: Total reserves equals required reserves (RR) plus excess reserves (ER) rE: Required return on equities ROA: Return on assets ROE: Return on equity rrD: Required reserve ratio RR: Required reserves s: A variable representing the effects of a supply shock SRAS: Short-run aggregate supply U: Current unemployment rate U*: Natural rate of unemployment V: Velocity of money Y: Real aggregate output, or real GDP Y P: Potential GDP, sometimes referred to as ­f ull-employment GDP Equations Aggregate expenditure: AE = C + I + G + NX Assets = Liabilities + Shareholders> equity C C C C FV Bond price: P = + n + + c + + (1 + i) (1 + i) (1 + i)n (1 + i) (1 + i) Compounding: PV * 11 + i2 n = FVn Consumption function: C = MPC * Y Currency in M1 = Currency outstanding - Vault cash FVn Discounting: PV = 11 + i2 n Equation of exchange: M * V = P * Y BK-PED-708052-HUBBARD-160392-BEP.indd Chapter 17, page 582 Chapter 10, page 308 Chapter 3, page 67 Chapter 3, page 59 Chapter 18, page 617 Chapter 14, page 464 Chapter 3, page 59 Chapter 2, page 40 28/02/17 3:56 PM www.downloadslide.net 1P et + - Pt2 Det + Expected rate of capital gain: R = + Pt Pt Expected rate of inflation: r = i - pe Gordon growth model: Pt = Dt * 11 + g2 1rE - g2 Interest-rate parity condition:   Interest rate on domestic bond = Interest rate on foreign bond - Expected appreciation of the domestic currency FP FP FP Loan value = + + g + 11 + i2 11 + i2 n 11 + i2 Monetary base = Currency in M1 + Total reserves of banks and B = Bnon + BR Money multiplier: M = m * B where 1C>D2 + m = 1C>D2 + rrD + 1ER>D2 Money supply = Money multiplier * Monetary base ∆Y Multiplier = ∆I ∆Y = Multiplier for government purchases: ∆G 11 - MPC2 ∼ Okun’s Law: Y = - * 1U - U *2 Phillips curve: p = pe - a1U - U*2 - s Quantity equation: M * V = P * Y Coupon + Capital gain Rate of return on a coupon bond: R = Purchase price e Dt + P et + Rate of return on a one-year investment in a stock: Pt = + 11 + rE2 11 + rE2 P Domestic Real exchange rate: e = E * a Foreign b P Relationship between aggregate output and the price level, new classical view: Y = Y P + a1P - P e2 Relationship between the money supply and the monetary base: 1C>D2 + M = a b * 1Bnon + BR2 1C>D2 + rrD + 1ER>D2 Reserves = Required reserves + Excess reserves After@tax profit Return on assets (ROA): Bank assets After@tax profit Return on equity (ROE): Bank capital Simple deposit multiplier = rrD Taylor rule: Federal funds rate target = Current inflation rate + Equilibrium real federal funds rate + 11>2 * Inflation gap2 + 11>2 * Output gap2 PY Velocity of money (V): M BK-PED-708052-HUBBARD-160392-BEP.indd Chapter 6, page 183 Chapter 3, page 80 Chapter 6, page 186 Chapter 8, page 264 Chapter 3, page 69 Chapter 14, page 464 Chapter 14, page 468 Chapter 14, page 476 Chapter 14, page 476 Chapter 14, page 477 Chapter 18, page 619 Chapter 18 page 621 Chapter 18, page 630 Chapter 18, page 629 Chapter 2, page 40 Chapter 3, page 78 Chapter 6, page 183 Chapter 8, page 252 Chapter 17, page 588 Chapter 14, page 479 Chapter 14, page 465 Chapter 10, page 319 Chapter 10, page 319 Chapter 14, page 474 Chapter 15, page 526 Chapter 2, page 40 28/02/17 3:56 PM ... afflicted the commercial banking system before the establishment of the Fed and the FDIC Partly as a result of the financial crisis, the size of the shadow banking system has declined relative to the. .. (a) Leverage at large commercial banks and investment banks, 20 07 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 2013 20 14 20 15 (b) Deleveraging at Goldman Sachs and Morgan Stanley Figure 11.1  Leverage... = +2, 223 billion Bank capital = +23 1 billion Bank capital as a percentage of assets = +23 1 billion = 0.104, or 10.4% +2, 223 billion See related problem 1.7 at the end of the chapter 10 .2 The